Economics and Keplers Angels Defending the Law of Marginal Utilities Barry Schwartz, Ph.D. For the Mises Society March 2011

Law of Marginal Utilities Price reflects Value at the Margin of need … Price reflects Value at the Margin of need … Discovered separately by Discovered separately by Jevons, UK Jevons, UK Walras, France Walras, France Menger, Austria Menger, Austria

Comparison … LMU vs Law of Gravitation Keplers laws described planets Keplers laws described planets Mathematical precision Mathematical precision Causal connection to local events – UNKNOWN Causal connection to local events – UNKNOWN Newtons law Newtons law local (falling apples) large-scale (solar system) local (falling apples) large-scale (solar system) Same law governs two realms Same law governs two realms Classical Economic laws described supply & demand Classical Economic laws described supply & demand LMU LMU local (personal) utilities large scale (market) prices local (personal) utilities large scale (market) prices LMU deserves to be regarded as a Universal Law LMU deserves to be regarded as a Universal Law

Before Newton & Before LMU Kepler Adam Smith Angels Invisible Hand

lets ask Newton Question: Question: British treasury officials asked Newton how to price the Pound Sterling … Answer: Answer: in applied mathematics, in applied mathematics, you must describe your unit.

It took 175 years for economists to define their unit LMU dissolved the Central Paradox LMU dissolved the Central Paradox 1687 – Philosophiæ Naturalis Principia Mathematica 1687 – Philosophiæ Naturalis Principia Mathematica 1862 – Law of Marginal Utilities 1862 – Law of Marginal Utilities

Challenge: Relating two unlike kinds of valuation 1. The personal utility of a good e.g. ice-cream e.g. ice-cream Scarcity has no intrinsic value, and yet … Scarcity has no intrinsic value, and yet … 2. in the Marketplace – scarcity means higher price Is a diamond more useful for being rare? Is a diamond more useful for being rare?

Central Paradox of Economics Water is essential for life, diamonds are not, so Why are diamonds costlier than water? Water is essential for life, diamonds are not, so Why are diamonds costlier than water? Do personal values contradict market prices? Do personal values contradict market prices? Are markets irrational? Are markets irrational? Are preferences un- economical? Are preferences un- economical?

The LMU insight Error – valuing the whole worlds supply Error – valuing the whole worlds supply Value depends on available supply in relation to needs that remain unsatisfied Value depends on available supply in relation to needs that remain unsatisfied Goods are valued at the margin of subjective scale of utilities Goods are valued at the margin of subjective scale of utilities Last satisfied need Last satisfied need or first unmet need or first unmet need

How LMU Solves the Water/Diamond Paradox Before buying a diamond, many uses for water have already been met Before buying a diamond, many uses for water have already been met The 1 st use of a diamond is typically greater than the next (27 th ) use for a gallon of water The 1 st use of a diamond is typically greater than the next (27 th ) use for a gallon of water In a lifeboat: $ water may > $ diamond In a lifeboat: $ water may > $ diamond

LMU Basic tenets – defining the unit of action #1 Two people trading two goods #1 Two people trading two goods Trading is done among consenting people Trading is done among consenting people Rational = capable of choosing freely Rational = capable of choosing freely #2 Every economizing trader has a personal hierarchy of wants #2 Every economizing trader has a personal hierarchy of wants Both sides expect more utility after the trade Both sides expect more utility after the trade (They dont have to achieve it!) (They dont have to achieve it!)

Newtons development of units F = G*m 1 *m 2 / r 2 F = G*m 1 *m 2 / r 2 F= gravitational force F= gravitational force Point masses - to define r precisely Point masses - to define r precisely Infinitessimals to describe curved motion Infinitessimals to describe curved motion Integral and Differential Calculus Integral and Differential Calculus Two inventors – Newton & Leibniz Two inventors – Newton & Leibniz

Fundamental unit of action Two people, two goods, two quantities Two people, two goods, two quantities Two actors A 1 & A 2 Two actors A 1 & A 2 trade an amount q 1 of good G 1 trade an amount q 1 of good G 1 for an amount q 2 of good G 2 for an amount q 2 of good G 2

Before and after an economic exchange

Mixed economy sandwich planning mentality Does either A or B know about global supply of peanut butter or jelly? Does either A or B know about global supply of peanut butter or jelly? Can an outside agency determine the right p-b/j ratio for everyones lunch? Can an outside agency determine the right p-b/j ratio for everyones lunch? Is there enough aggregate demand for jelly without a federal stimulus? Is there enough aggregate demand for jelly without a federal stimulus?

unit of action – 2 systems The properties of local individual units 2 masses m 1 & m 2 at a distance r 2 masses m 1 & m 2 at a distance r 2 actors A 1 & A 2 trade an amount q 1 of good G 1 for an amount q 2 of good G 2 2 actors A 1 & A 2 trade an amount q 1 of good G 1 for an amount q 2 of good G 2 The dynamics of the system Moons & planets in Orbit & local motions of pendulums, falling apples Market Prices, Supply, Demand

LMU and free markets Voluntary trades are sufficient to explain the market laws of Classical Economics Voluntary trades are sufficient to explain the market laws of Classical Economics No external or collective influences are needed No external or collective influences are needed No coercion is needed No coercion is needed HELP WANTED No Angels Need Apply

Angels & Demons Keplers Angels went unemployed Keplers Angels went unemployed But the angels of Economics had allies But the angels of Economics had allies In universities, treasuries, and legislatures In universities, treasuries, and legislatures Many arguments to dismiss or ignore LMU Many arguments to dismiss or ignore LMU Consider one set– challenges to its Universality Consider one set– challenges to its Universality

Meeting Objections Objections (from various books) to the UNIVERSALITY of LMU Objections (from various books) to the UNIVERSALITY of LMU

LMU might work for simple trades with only economic goods but …not in real life. 1. Real life economics is more complex 2. Groups (corporations) change everything 3. There are non economic Externalities 4. Its not mathematical enough for science 5. People are not rational

1. Real life economics is more complex Objection: LMU – just 2 actors, 2 goods – never occurs Objection: LMU – just 2 actors, 2 goods – never occurs Answer: abstraction Answer: abstraction Trade with many goods & parties can be broken down conceptually … Trade with many goods & parties can be broken down conceptually … Separate trades need not really exist Separate trades need not really exist Comparison with Gravitation Comparison with Gravitation There are no cases with 2 isolated masses, and point masses dont really exist either There are no cases with 2 isolated masses, and point masses dont really exist either You need to use an abstraction to apply the unit You need to use an abstraction to apply the unit Irony – the 3 body problem Irony – the 3 body problem

2. Groups (corporations) change everything Objection: corporations are not like 2 actors Objection: corporations are not like 2 actors Answer: use abstractions Answer: use abstractions As long as combinations are voluntary, the same abstraction applies … As long as combinations are voluntary, the same abstraction applies … Comparison with Gravitation Comparison with Gravitation Point masses dont really exist either, but the law still applies to complex planets with moons, and asteroid fields … all are combinations of point masses Point masses dont really exist either, but the law still applies to complex planets with moons, and asteroid fields … all are combinations of point masses You need to use an abstraction to apply the unit You need to use an abstraction to apply the unit

3. There are non economic Externalities 3. There are non economic Externalities Objection: not everything reduces to economics and pricethere are passions and there are natural disasters too Objection: not everything reduces to economics and pricethere are passions and there are natural disasters too Answer: LMU describes economic action, not all of psychology. Other forces dont cancel out economic ones. Answer: LMU describes economic action, not all of psychology. Other forces dont cancel out economic ones. Comparison with Gravitation Comparison with Gravitation Newtons law does not claim that Gravitation is the only force. The equation refers only to the force due to the effect of gravity. Newtons law does not claim that Gravitation is the only force. The equation refers only to the force due to the effect of gravity. Other forces (momentum, magnetic fields) will alter the position of two masses, but once you know mass and distance, you can calculate the gravitational force perfectly well. Other forces (momentum, magnetic fields) will alter the position of two masses, but once you know mass and distance, you can calculate the gravitational force perfectly well. You need to use an abstraction to apply the unit You need to use an abstraction to apply the unit

4. Its not mathematical enough for science Objection: LMU is too qualitative. Real economists use numbers. Objection: LMU is too qualitative. Real economists use numbers. Answer: Answer: Numbers without the right units are empty. LMU is the BASIS for using numbers. Numbers without the right units are empty. LMU is the BASIS for using numbers. Its wrong to throw out a law because it doesnt deliver predictions in one step. When observed conditions are added, one can make quantitative conclusions. Its wrong to throw out a law because it doesnt deliver predictions in one step. When observed conditions are added, one can make quantitative conclusions. Comparison with Gravitation Comparison with Gravitation Newtons law was much simpler and less numerical than the Ptolemaic wheels within wheels model of the solar system. Newtons law was much simpler and less numerical than the Ptolemaic wheels within wheels model of the solar system. To apply the law, one must add in specifics of mass, velocity, position and other forces. The law doesnt generate ellipses in one step. To apply the law, one must add in specifics of mass, velocity, position and other forces. The law doesnt generate ellipses in one step. You need to use an abstraction to apply the unit You need to use an abstraction to apply the unit GIGO GIGO

5. People are not rational Objection: Do you really believe that myth about the rational economic man? Not with this crazy economy! Objection: Do you really believe that myth about the rational economic man? Not with this crazy economy! Answer: Answer: The objection uses rational to mean wise, logical – economists dont say that man is wise…its naïve and irrelevant. The objection uses rational to mean wise, logical – economists dont say that man is wise…its naïve and irrelevant. LMU assumes rational in the sense of capable of choosing LMU assumes rational in the sense of capable of choosing LMU requires no specific degree of logical consistency. LMU requires no specific degree of logical consistency. The myth rests on a crude equivocation on the term rational The myth rests on a crude equivocation on the term rational Comparison with Gravitation Comparison with Gravitation Is there a myth of a perfect planetary system with no explosions, collisions, comets or disasters? That has nothing to do with the law of gravitation. Is there a myth of a perfect planetary system with no explosions, collisions, comets or disasters? That has nothing to do with the law of gravitation.

Ceteris Parabis All extraneous variations are held constant All extraneous variations are held constant The expression is just The expression is just a form of method of JS Mills joint method of agreement and difference a form of method of JS Mills joint method of agreement and difference Applied to economic questions Applied to economic questions

Bring on the Angels Physicists Physicists were wise enough to test and adopt Newtons universal laws of gravitation were wise enough to test and adopt Newtons universal laws of gravitation Economics Economics borrowed the solution to the economic paradox, borrowed the solution to the economic paradox, but combined it with classical economics – ie NO THEORY OF VALUE AT ALL … but combined it with classical economics – ie NO THEORY OF VALUE AT ALL … Neoclassical economics is like … Neoclassical economics is like … F = G*m 1 *m 2 / r 2 + Angels F = G*m 1 *m 2 / r 2 + Angels

LMU is Scientific because… Subject to empirical tests Subject to empirical tests Needs to be employed in context of data Needs to be employed in context of data Universal to economic phenomena Universal to economic phenomena Like Evolution is to biology, Gravitation to physics Like Evolution is to biology, Gravitation to physics Can be challenged but not dismissed Can be challenged but not dismissed Unless theres a contradiction or contrary prediction Unless theres a contradiction or contrary prediction Or unless theres a more universal and parsimonious theory to take over Or unless theres a more universal and parsimonious theory to take over

The Austrians Austrian economics – adheres to LMU Austrian economics – adheres to LMU Extended LMU to … money, interest, business cycles, employment, and so on… Extended LMU to … money, interest, business cycles, employment, and so on… Dont ask whether economists support the free market … Dont ask whether economists support the free market … ask they agree with LMU ask they agree with LMU

Non Marginal Economics? Any factor added to Marginal Utilities Any factor added to Marginal Utilities Joker in the deck – arbitrary and unscientific Joker in the deck – arbitrary and unscientific prevents economists from making accurate predictions prevents economists from making accurate predictions Its a step backwards Its a step backwards

New Rule If you dont adhere to Marginal Utilities If you dont adhere to Marginal Utilities Then, you cant claim to solve the earlier economic paradox Then, you cant claim to solve the earlier economic paradox You cant have angels AND science. You cant have angels AND science. You have to choose You have to choose

Conclusions LMU got the units right LMU got the units right It can claim to be scientific It can claim to be scientific No other system has made a serious attempt to formulate its units of action No other system has made a serious attempt to formulate its units of action Newton said he saw further because he stood on the shoulders of giants Newton said he saw further because he stood on the shoulders of giants He didnt step in their faces! He didnt step in their faces!

Questions? Barry Schwartz, Ph.D. Barry Schwartz, Ph.D.

Topics for Questions Does LMU deny that Economics is value free Wertfrei ? Does LMU deny that Economics is value free Wertfrei ? Is LMU un-mathematical? Is LMU un-mathematical? Is numerical math valid in economics? Is numerical math valid in economics? Does using money change anything? Does using money change anything? Does LMU still work if people are irrational? Does LMU still work if people are irrational?

Topics for Questions Does LMU deny that Economics is value free? Does LMU deny that Economics is value free? Novalues are factored out via ceteris parabis Novalues are factored out via ceteris parabis The only value is presupposed: trade assumes non aggression The only value is presupposed: trade assumes non aggression Is LMU un-mathematical? Is LMU un-mathematical? It is mathematical… Ordinal Scale vs Interval and Ratio scales It is mathematical… Ordinal Scale vs Interval and Ratio scales Parallel in Psychophysics (Thresholds) Parallel in Psychophysics (Thresholds) Is numerical math useful in economics? Is numerical math useful in economics? Yes in application to Catallactics - (but only if the units are right!) Yes in application to Catallactics - (but only if the units are right!) Does using money change anything? Does using money change anything? No – real $ is a commodity No – real $ is a commodity As a medium, it is an intermediary exchange As a medium, it is an intermediary exchange Does LMU still work if people are irrational? Does LMU still work if people are irrational? Rationality determines how much wealth you get, just the way altitude determines how far someone falls – it doesnt CHANGE the law! Rationality determines how much wealth you get, just the way altitude determines how far someone falls – it doesnt CHANGE the law!