It’s worth pointing out that one of the three instigators of the marginal revolution and founder of the Austrian school, Carl Menger, did not use a ponderously mathematical methodology. He studied jurisprudence and worked as a journalist.
But he still arrived at the marginal conclusion.
The foundation of it doesn’t take any math more sophisticated than what Adam Smith employs in his own book. The idea can be explained in plain English, for anyone who understands it. Adam Smith was a damn genius, and he would’ve been able to grasp the idea without any trouble if it had been stated clearly in regular language.
But that’s a bigger task than it seems. This is just an extremely elusive idea, amazingly difficult to state clearly the first time. Hell, economists have been trying to explain the idea since the 1870s and plenty of folks today still have problems with it. Even now, there are posters who claim that exchanges are between items of equivalent value. (You can see the LTV thread for examples of that.) That can’t be right. If exchange were between genuine equivalents, then it could continue indefinitely without ever stopping. This is patently untrue, for reasons the milk example demonstrates. Exchange of equivalents can go on forever, but exchange between items of declining marginal value has a fixed terminal point.
Someone like Marx would say that exchange is between “equivalent values”, as long as “use-value” also exists on both sides. This is also patently untrue, again using the same milk example. If milk were significantly cheaper than water, I might start bathing with it. “Use-values” aren’t binary. Utility is not a light switch that is either off or on. Utility decreases as we have more and more units of a thing, but if the relative price is low enough, we’ll keep buying more and more units because even the lower marginal value of additional units will still be higher than the extremely low price. People who delude themselves into thinking exchange is between objects of equivalent value have to treat utility like a binary – either off or on – because the conception falls apart immediately when you consider any other option.
This is getting little far afield, but my point here is that all the explanation in this particular post is more in the old Austrian style, which is to say, in words. The math isn’t necessary. I agree with you more generally, tho. I want to state that I agree absolutely that the use of mathematics can sometimes delude economists. I’ve seen some very strange errors from highly educated people. These are folks who can manipulate equations without any problems but on occasion forget entirely what those equations are supposed to stand for.
It is a strange thing to experience.
It’s also worth pointing out that everything we’ve discussed so far is as true for the economy today as it was for Adam Smith’s time.
That is part of the power of the work. Many of the principles he outlined belong to more than one age. Not all of them, of course, but enough to make this discussion worthwhile.
I think the OP makes clear my admiration for the book. “Off the rails” is probly the wrong phrase. What we have today is more a generalization than a repudiation of what Adam Smith accomplished. We build up from what he thought up, we don’t overturn it.
But one of my great historical regrets is that marginal utility wasn’t clearly described sooner, in a more comprehensive fashion. There are hints of it here and there, like Daniel Bernoulli’s “moral expectation” in his solution to the St Petersburg paradox. That is declining marginal utility, but utility comes from log of wealth, not from combinations of goods. And then there is Adam Smith… He gets so close. But still not close enough. He didn’t end the debate definitely. We were left with people like Ricardo and Marx dicking around with the LTV for another hundred years.
Adam Smith was just not persuasive enough to stop those dead end investigations, because he didn’t have the last piece in place. David Hume was a big source of inspiration for the Wealth of Nations, but he wasn’t convinced either:
People like Hume were looking for supply and demand to determine price, and they didn’t get that from Adam Smith in a form that made a complete picture. Marginalism swept through economic thought extremely quickly after it was developed. It just had to wait another century to be developed.
That’s why I think we absolutely need the pieces in place before we get into Adam Smith’s explanation of price. We’ll have a better view of how astonishing his book is, if we see how close to got to ideas that were finally fleshed out a century later.
One thing to keep in mind is that GDP is not wealth, but production. Gross Domestic Production. It’s a flow, not a stock. For instance, let’s say that I inherit from my space cousin a Star Trek-style replicator that I keep in the basement. It can techno-magically produce advanced objects from the 24th century. I’m thirsty when I get it and don’t have a handy glass around, so my first use of this replicator is create one of those plastic red cups for cheap college shindigs, market value of five cents on a good day. Then I forget I have it.
If people knew I had such a thing, the wealth in my basement would be beyond any easy measure. It would easily be worth trillions of dollars.
The GDP from my basement would be five cents, in the form of one red cup. That is all that I have produced.
I find it very easy to imagine that the GDP of a world-class city/county can be greater even than the GDP of a large and resource-rich and mismanaged country that doesn’t produce nearly as much as it could. Just because they have the resources for great potential productivity does not mean that they are achieving their potential. Russia is large enough, though, that it has annual production at least a couple trillion. (LA County is just over half a trillion GDP. Bigger than Belgium (pop 11 mil) or Sweden (pop 10 mil), but not Russia.)
There is no perfect economic number that encapsulates all information. GDP has numerous problems. But the fact that a land like Russia, rich in resources and potential, has a GDP of only 2 trillion does tell an important little chapter of a story, even if that little piece is not anything close to the full story.
David Friedman (who posted at the Dope a couple times in a single thread) has a quote that is appropriate here.
The key is the context of the comparisons.
That is a tougher story. We make comparisons on the margin, not in any absolute sense. GDP is one of the figures whose significance exists only along the current margin, which is one of the causes of its many shortcomings. But the number can nevertheless be informative.
This continues the digression into modern value theory.
I might start using spoiler boxes to keep the length of each loaded page more manageable, as the posts start piling up. This post is more about demand, understood as an independent piece. Then will be supply, understood as an independent piece.
[spoiler]Demand curves slope down.
Marginal utility decreases.
The first unit of an item is assigned, naturally and often without conscious consideration, to the use that we consider highest value. The second unit is less valuable precisely because it can’t be assigned to the highest value use. That first, best use was already taken care of with the first unit of the good. Our natural instinct to take care of the most important things first is precisely why any additional units will be less valuable to us.
Although there are naturally exceptions – we’re not talking about iron laws of the universe here – this tendency seems near omnipresent when you look at it. There’s a huge piece of psychological truth here, that the value of fungible items decreases as we have more of them.
This fact is the same as demand curves sloping down. The demand curve is basically just a visualization of diminishing marginal value.
If you haven’t seen one of these babies before, the first thing to look at is the space. Look at the labels of the axes that define the space. The space is the plane.
We’re comparing price with quantity here. Demand is an inverse relationship between price and quantity demanded: as one goes down, the other goes up. Specifically: as the price of a good goes down, the quantity demanded goes up. (In contrast to the inverse relationship of demand, supply will be a direct relationship. Quantity supplied and price will move upward together.)
Again: this is exactly the same story of declining marginal value we were talking about before. The demand curve is one particular way of visualizing the idea. Demand curves slope down for an individual, because each additional unit is going to be less valuable than the previous unit. They also tend to slope down for the market as a whole, because the market is made up of individuals. (This is a tougher case to make, so we’ll skip it.)
All of us look at the price of milk at our grocery store, and we take that price as given. If it’s sufficiently high, we don’t purchase: the quantity demanded is zero. But as the price goes lower, more people will think the marginal value of picking up an extra unit will be more valuable to them than the price.
The first unit of a good is assigned to its highest value use. That’s why we’re willing to pay the most for that first unit. Any additional units cannot be assigned to the highest value use, because that particular need has already been satisfied by the first unit. This means that the marginal value of additional units will be less than the first unit. We’re not willing to pay as much for additional units as we were for the first unit.
The implication is amazing. This tells us where relative prices come from, how the price relates directly to the value. Price is value, but it is not the first-unit value of goods. Price is marginal value. Or more precisely, the price is the upper-bound on marginal value. That’s not just true for one person. It’s true for literally everyone who participates in market exchange.
The value of the first unit is more than the price, so I buy it. (Marginal value drops.) But the value of the second unit is still more than the price, so I buy another unit. (Marginal value drops again.) This keeps happening until the price of the good exceeds the marginal value of buying one more unit.
When I’m doing shopping and leave the grocery store, the price of every single good in that store is greater than my marginal value for those goods. If the value of an additional unit were greater than the price, I would’ve picked up one more unit before leaving. Every other shopper does the same thing. Price is not first-unit value, price is an upper bound on marginal value for every shopper in the store. This applies to every single shopper in the grocery store, after they’re leaving the store with goods in hand.
**Trades are not between objects of equivalent value for the two sides. **
Most of our trades are not like for like.
Exchanges are not between goods of “equal value” on the part of both people. In the overwhelming majority of basic purchases, both sides are receiving greater value from the transaction than they would have without it. Given the state of the world we live in, both sides would prefer to exchange than not, otherwise the exchange would not take place. The two people are working on different margins, and that is exactly what makes a trade possible that could make both people better off.
It is simultaneously true that all of us would prefer to live in an even better world where we could get an even better price in return for the fruits of our efforts. This is not the best of all possible worlds. But taking as given the circumstances in front of our faces, we engage in market exchange because we are generally better off doing so than not doing so. And that is precisely why market exchange, for all its various problems, has been the primary processes that has made this world a better place, at least since the introduction of agricultural societies.
Our ability to exchange things I like better, for things you like better, does not cause a revolution in a single transaction. It’s one small push in the right direction. But small changes add up to big ones, until eventually the world is so different that people from a mere couple centuries ago would hardly recognize the way we live today.
It is a marginal revolution.
Supply is harder than demand.
Let’s start again with the space. We’re looking at exactly the same space as before: we’re comparing price with quantity.
But instead of the inverse relationship with demand, where higher prices caused a decrease in the quantity demanded, in this case we believe that quantity supplied has a direct relationship with price, meaning an upward slope in the space we’ve defined. At higher prices, firms want to produce and sell more.
Why?
It’s all about how we allocate resources to productive tasks.
Imagine you’re a farmer with many different fields of wildly variable soil quality. Some of your fields are nice and fertile, and these fields can be prepared to produce bushels of wheat at extremely low cost. Other fields are more ornery, rocks lining the poor soil, and can only be prepared to produce output at high cost.
Now suppose the price in the market is low. Which field do you allocate to the production of wheat? The good field or the bad field?
We’re again in a case where the entire art of figuring out the answer is to first ask the right question. State the problem in a clear fashion, and the answer is self-evident. It’s setting up the right question that’s the difficult part. At a low price for selling wheat, a farmer is only going to utilize the cheapest (most suitable) resources available in order to supply the market.
But if the price of wheat doubles or triples, then the farmer is going to look for other resources available in order to increase production. The best, cheapest, most productive field has already been allocated to wheat production. It can’t be allocated a second time. But if the price of wheat is high enough, it will become sensible to allocate the shitty fields to wheat production. These fields cost more money to prepare. It is much more difficult to allocate them to the task at hand. But a high enough price will justify the additional expense. A high enough wheat price will also justify shifting other resources in different industries toward this industry. A high enough wheat price can quite possibly decrease the number of soy farms, as those farms repurpose their fields to a different output.
Supply curves slope upward because higher prices allow producers to allocate less suitable resources to the production of the good. A very similar idea also appears in the Wealth of Nations, but not in the same context. Here is Adam Smith on specialized nail-makers vs general purpose metal workers:
If the price of nails is low, then only the people who are specialized to the task will focus on making them. A common smith will not be talented enough to create enough output to justify the production.
The common smiths are themselves the lower-quality resource, when it comes to making nails. When nail prices are low, they can’t justify turning their attention away from their other more profitable lines of business.
But suppose the price of nails skyrockets, so that all the specialized nailers are producing at their full capacity, and even the smiths somewhat used to making nails are also producing at capacity. If there is sufficient demand to keep the price high, then we can easily imagine that the lower-quality resource – the common smiths who have never before made nails – will bend their talents to the task at hand. A higher price will bring in lower quality resources. A higher price will mean that there is higher quantity supplied. This shift in the allocation of resources is why supply curves slope upward.
Okay. So far it seems fairly straightforward. But there are wrinkles…
A decent intro micro theory class would spend some time now discussing price-makers vs price-takers, the inside margin vs the outside margin, labor supply vs product supply. (These ideas show up using all kinds of different terminology, so maybe you’ve seen them described using different words.) Interesting stuff, but unfortunately off topic for our purposes here, since I’m trying to rope Adam Smith back in as soon as possible.
Opportunity Cost
We’re not done yet. But we are – finally! – getting closer to the Wealth of Nations.
Another complexity here is opportunity cost. This is a funny term, because all costs are opportunity costs. The term is kind of a redundancy. We don’t actually make decisions without considering the next best option. But because sometimes we have trouble thinking about costs in clear fashion, it can be helpful to use the redundant term in order to call attention to the importance of the idea.
Let’s suppose you’re an investment banker who could earn 200k dollars on Wall Street, or a farmer who could earn a clear accounting profit of 15k dollars.
To become a farmer would mean giving up the banker salary. The apparent profit from farming, taking into account the opportunity cost of what you’re giving up, is not a profit at all. You would lose big by becoming a farmer. You are a low-quality resource to produce bushels of wheat – not because you’d be bad at farming, but because you are a high-quality resource elsewhere when you consult for mergers and acquisitions.
Personal preferences are important for supply, too. You might hate being a farmer. Even on the supply side, we often need to think about what people like and dislike. If a large number of workers have equal opportunity to do a pleasant job, or an onerous job, then the onerous job is going to have to pay more to entice people away from the more pleasant job opportunity.
Opportunity cost is essential when we’re thinking about production. It might be the cornerstone of Adam Smith’s system of prices, and just as it is a cornerstone today. Here is the main idea:
If we want to buy a good, we need to pay the opportunity cost for all the resources that are allocated to produce that good.
If we want resources allocated to the production of nice things, then we need to pay more for the allocation of those resources than the next best option for every necessary condition of production. If it takes a ten hours of labor from a skilled mechanic to fix your car, but that same mechanic could easily find constant employment fixing air conditioners for 20 bucks an hour, then you’re going to have to pay at least 20 dollars per hour to get your car fixed. If you want the valuable resource of this mechanic’s skill assigned to your own car, rather than air conditioners, you need to offer more than the next best option.
If the car repair shop earns a rate of return of 3%, but the owner of the business thinks they could repurpose the building they’re renting into an art exhibition that would return 10% on the investment, then your car repair shop is not going to be in business much longer. You need to pay enough so that the return to the auto shop is larger than the next best option.
If the owner of the land thinks they could earn a higher rent from a new tenant, rather from the current car repair business, then when the lease comes up, it won’t be renewed. The owner of the land might start renting to a new tenant, who repurposes the space to a new activity that can pay a higher rent. If people want a car repair shop on that piece of land, they need to pay enough so that the rent the owner receives is higher than their next best option.
All of these costs have to be considered, when we’re thinking about supply. If you want an item brought to market, you need to cough up enough money so that you can pay the opportunity cost of every necessary condition of production.
Short-run vs Long-run
We need to make one last note on supply, which will be important when returning to the book.
A final complication is that long-run supply is much different from short-run supply. Technology changes not only over time, but also with the scale of production – based on equipment and the division of labor.
If you’re a farmer for long enough, you might be justified in making an investment in the quality of your fields. A bit of fertilizer and whatnot. Farm-type-stuff. If demand for nails becomes higher and higher, then rather than having a few individuals specializing as nailers, it can be worthwhile to produce nail-making factories that automate the process.
With a sufficiently large market, which allows for extensive specialization in labor and machinery, the long-run supply curve is going to be much “further out” than the short-run supply curve. At the same relative price, the quantity supplied will be significantly higher with the aid of machinery and the division of labor. In contrast, human preferences (and therefore demand curves) tend to be remarkably more stable than our production technologies over time. Obviously our tastes can change. Still, people have been enjoying steak for thousands and years, and will likely enjoy steak for many more. It’s not the enjoyment of a nice cut of meat that has changed, as much as the production technologies of raising cattle and bringing them to market.
Long-run supply is a very different beast from short-run supply. When you compare different time periods, it can actually look like “supply slopes down” because of the effect of better technology, given a large enough market to support the opportunity cost of the better technology.
So now we have supply and demand. Next we put them together.
This is much more complex than it sounds.[/spoiler]
The last post looked at supply and demand as independent entities.
This puts the two together. Together they are something very different from what they are apart.
[spoiler]Supply and Demand
Consumers generally take the price as given, and decide how many units they want to buy.
Some types of producers also generally take the price as given, and decide how many units they want to sell. (As mentioned, we’re skipping for now the complication of price-makers, which a proper intro micro class would cover.)
In other words, our story so far has been the case of both the buyers and the sellers making decisions based on the price that they see. The price has already sort of existed in our analysis, at least hypothetically, and both sides of the market have considered how they would react in different situations to different market prices. But when we put the two pieces together, everything flips on its head.
Demand curves slope down. Supply curves slope up. They cross at a single point. This point gives us our market price. Market price, and the actual quantity produced, pops out of the interaction between supply and demand.
In the market as a whole, price is an EFFECT and not a CAUSE.
If you can internalize this one point, you’ll be able to do better practical economics than many economists.
An individual most often takes prices as given. Even some kinds of firms take prices as given. For them, the price is the cause. We look at the price at the supermarket, and the price induces us to buy a certain quantity of stuff. The causation runs: price => quantity demanded.
But for the market as a whole, using equilibrium analysis, things are exactly backward. The causation run: supply and demand => market price and quantity. Supply and demand are the primary forces that exist first, and they are the cause. Supply and demand are the cause and price is the effect. The bottom line here when you’re doing supply and demand analysis is that you should never reason from a price change. The change in price is the effect, not the cause.
Never reason from a price change.
The price of gasoline is higher. The tempting thing to do is ask: What happens next? That is the wrong question. Some people fail to resist this temptation to answer the question, and they say something like, hey, gasoline is more expensive so people are going to use less of it. That is 180 degrees backwards. We need to know why the price is higher before we can say anything. Never reason from a price change.
The right question is: what caused the price of gasoline to increase?
There could be two possible causes: a decrease in the supply, or an increase in demand. A decrease in supply could result from a massive war in Saudi Arabia that spreads to other oil exporting countries. In that case, we’d expect the restriction in supply to lead to both a higher price and a reduced quantity.
But there’s another possibility that can move price higher. Suppose a new car is invented that is twice as safe, luxurious, and comfortable as current cars, and also is much easier to manufacture than previous cars. What happens?
People buy more cars, and because they have more cars, they try to buy more gas. The demand for gasoline increases, and the price of gasoline goes up. The price of gasoline is higher and simultaneously people are buying more gasoline.
In this case, the higher price of gasoline is not the cause of anything. Looking through supply and demand analysis, prices aren’t causes. They are effects. The cause of more gasoline demand was better automobile technology that made cars cheaper. Cheaper cars made gasoline to power those cars more desirable. Demand for gasoline increased, and that is what caused the price of gasoline to go up. It is not the case that the higher price must coincide with people buying less. What happens is that gasoline purchased and price go up together.
We cannot say that the higher gas prices will necessarily cause less consumption, because that is totally backward. The higher price of gasoline is not going to cause anything at all. Prices are effects, not causes. The price of gasoline is higher as an effect of the improvement in car technology.
Even professional economists can get this wrong. Happens all the time. If you ever hear someone on the news say “The price of X is lower, therefore blah-blah-blah…” they are very likely making an introductory error in economic analysis. Prices are endogenous in market models using equilibrium analysis. Endogenous means that prices are an output of the models, an effect of other things going on.
If you remember that one fact, more than any other, you will do better than many economists in public discussion.
Never reason from a price change. When the price changes, you always need to ask an additional question: what caused the price to change? Was it a shift in supply, or a shift in demand?
Price theory is strange.
We started off with prices leading us to change our behavior. The price existed first, and then we adjusted our behavior based on what prices where. We built our understanding of supply by itself, and demand by itself, off this basic framework. When we were looking at them in isolation, price was a cause. But then when we put the two together, we completely flipped everything around. Price became the effect, not the cause.
This is, of course, a mathematical cheat.
But it’s an extremely useful mathematical cheat. It is part of the usefulness of the abstraction. The purpose of this mathematical abstraction is to point out that different people have different preferences, that difference resources are better suited for the purposes of certain production than other resources, and that the market is a system that takes these disparate elements and puts them together in a way that no individual inside the system could have anticipated. We can provide a short summary of that idea:
The logic of the system as a whole is completely different from the logic of the individuals within the system.
Telling the story with a single market.
And really, our story in this one market makes a certain sort of sense. Imagine that the price is too high, above the place where supply and demand cross. At that high price, buyers don’t want to purchase many units of good. The price is higher than the marginal value of all units except the very first batch. Quantity demanded is low. Another problem is that at that high price, suppliers allocated lower-quality resources to production, in anticipation that the lower-quality resources would be justified for production because of a sufficiently high sales price. They took their product to the market, and were disappointed in the result. They would’ve been fully satisfied if they had found buyers at that high price, but instead, product is left on the shelves.
The price has got to fall, if quantity demanded is going to equal quantity supplied. This should make perfect sense.
But when we draw two lines crossing, we don’t really have any explanation for how exactly the price falls. In the real world, obviously the suppliers lower their prices, and stop allocating low-quality resources to this market because it isn’t justified. But how fast do they drop the price? How accurately? How do they learn what the “right price” is?
This is a dynamic process that our abstraction is skipping. When we draw two lines on a blackboard and point to the magical place where they cross, we’re making the executive decision to disengage with those questions. We’re just saying, hey, for very good reasons we believe that this is what the price is going to be. Supply and demand meet, and they cause the price. Price is the effect. If supply changes, or demand changes, or both, then the price is also going to change again.
This is an extremely powerful abstraction.
If you can use it accurately, and precisely, and consistently in many different contexts, then you’ll do a better job than many economists. But we should keep in mind the nature of this abstraction. We’re giving something up when we rely on this conception. The classical economists, including Adam Smith, were trying to describe real-world markets as they actually existed without the benefit of this abstraction. Some of them got closer than others.
Adam Smith, bless him, got closer than anyone else for a hundred years. Now we’re going to see why.[/spoiler]
That’s it for this digression into modern value theory. Next we’re going back to the book for Adam Smith’s version.