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

Economics and Kepler’s Economics and Kepler’s AngelsAngels

Defending the Law of Marginal Defending the Law of Marginal

UtilitiesUtilities Barry Schwartz, Ph.D. Barry Schwartz, Ph.D.

For the Mises SocietyFor the Mises Society

March 2011March 2011

Law of Marginal UtilitiesLaw of Marginal Utilities

Price reflects Value at the Margin of Price reflects Value at the Margin of “need” … “need” …

1862 1862 Discovered separately byDiscovered separately by

Jevons, UK Jevons, UK Walras, France Walras, France Menger, Austria Menger, Austria

Comparison … Comparison … LMU vs Law of GravitationLMU vs Law of Gravitation

Kepler’s laws described planetsKepler’s laws described planets Mathematical precisionMathematical precision Causal connection to local events – UNKNOWNCausal connection to local events – UNKNOWN Newton’s law Newton’s law

locallocal (falling apples) (falling apples) large-scale large-scale (solar system) (solar system) Same law governs two realms Same law governs two realms

Classical Economic laws described supply & Classical Economic laws described supply & demanddemand LMU LMU locallocal (personal) utilities (personal) utilities large scalelarge scale (market) prices (market) prices

LMU deserves to be regarded as a Universal LawLMU deserves to be regarded as a Universal Law

Before Newton & Before Before Newton & Before LMULMU

KeplerKepler

Adam Smith Adam Smith

AngelsAngels

Invisible HandInvisible Hand

““let’s ask Newton …” let’s ask Newton …” @1690’s@1690’s

QuestionQuestion::British treasury British treasury

officials asked officials asked Newton how to Newton how to price the Pound price the Pound Sterling … Sterling …

AnswerAnswer:: “ “ in applied in applied mathematics, mathematics,

you must you must describe describe your unityour unit.” .”

It took 175 years for It took 175 years for economists to define their unit economists to define their unit

LMU dissolved the “Central Paradox” LMU dissolved the “Central Paradox” 1687 – Philosophiæ Naturalis Principia 1687 – Philosophiæ Naturalis Principia

Mathematica Mathematica 1862 – Law of Marginal Utilities 1862 – Law of Marginal Utilities

Challenge: Relating two unlike Challenge: Relating two unlike kinds of valuationkinds of valuation

1.1. The The personal utilitypersonal utility of a good 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 …

2.2. in the in the MarketplaceMarketplace – scarcity means – scarcity means higher higher priceprice

Is a diamond more useful for being rare?Is a diamond more useful for being rare?

““Central Paradox of Central Paradox of Economics”Economics”

WaterWater is essential for is essential for life, diamonds are not, life, diamonds are not, so Why are so Why are diamondsdiamonds costlier than costlier than waterwater?? Do personal values Do personal values

contradict market contradict market prices?prices?

Are markets irrational?Are markets irrational? Are preferences un-Are preferences un-

economical?economical?

The LMU insightThe LMU insight

Error – valuing the whole world’s Error – valuing the whole world’s supplysupply Value depends on available supply in Value depends on available supply in

relation to needs that remain unsatisfied relation to needs that remain unsatisfied Goods are valued at the margin of Goods are valued at the margin of

subjective scale of utilities subjective scale of utilities Last satisfied need Last satisfied need or first unmet needor first unmet need

How LMU Solves the How LMU Solves the Water/Diamond Paradox Water/Diamond Paradox

Before buying a diamond, many uses Before buying a diamond, many uses for water have already been metfor water have already been met

The 1The 1stst useuse of a of a diamonddiamond is typically is typically greater than the greater than the nextnext (27(27thth ) ) useuse for a for a gallon of water gallon of water In a lifeboat: $ water may > $ diamondIn a lifeboat: $ water may > $ diamond

LMU Basic tenets – LMU Basic tenets – defining the unit of actiondefining the unit of action

#1 Two people trading two goods#1 Two people trading two goods Trading is done among “consenting” peopleTrading is done among “consenting” people ““Rational” = capable of choosing freelyRational” = capable of choosing freely

#2 Every economizing trader has a #2 Every economizing trader has a personal hierarchy of wantspersonal hierarchy of wants Both sides expect more utility after the Both sides expect more utility after the

tradetrade (They don’t have to achieve it!)(They don’t have to achieve it!)

Newton’s development of Newton’s development of unitsunits

F = G*mF = G*m11*m*m22 / r / r22 F= gravitational forceF= gravitational force Point masses - to define “Point masses - to define “rr” precisely” precisely

Infinitessimals to describe curved motionInfinitessimals to describe curved motion

Integral and Differential CalculusIntegral and Differential Calculus Two inventors – Newton & LeibnizTwo inventors – Newton & Leibniz

Fundamental unit of actionFundamental unit of action

Two people, two goods, two Two people, two goods, two quantitiesquantities

Two actors Two actors AA11 & & AA22 trade an amount trade an amount qq1 1 of good of good GG11 for an amount for an amount qq2 2 of good of good GG22

Before and after an economic Before and after an economic exchangeexchange

0

20

40

60

80

100

120

Peraon A Person B

Peanut Butter Jelly

0

20

40

60

80

100

120

Peraon A Person B

Peanut Butter Jelly

Mixed economy sandwich Mixed economy sandwich planning mentality planning mentality

Does either A or B know about global Does either A or B know about global supply of peanut butter or jelly?supply of peanut butter or jelly?

Can an outside agency determine the Can an outside agency determine the right p-b/j ratio for everyone’s lunch?right p-b/j ratio for everyone’s lunch?

Is there enough aggregate demand Is there enough aggregate demand for jelly without a federal stimulus?for jelly without a federal stimulus?

‘‘unit of action’ – 2 systemsunit of action’ – 2 systems

The properties of local The properties of local individual units individual units

2 masses 2 masses mm11 & & mm22 at a at a distance distance rr

2 actors 2 actors AA11 & & AA22 trade an trade an amount amount qq11of good of good GG11 for for an amount an amount qq22of good of good GG22

The dynamics The dynamics

of the of the systemsystem

Moons & planets in Moons & planets in Orbit & local motions of Orbit & local motions of pendulums, falling pendulums, falling applesapples

Market Prices, Supply, Market Prices, Supply, DemandDemand

LMU and free marketsLMU and free markets

Voluntary trades Voluntary trades are sufficient to are sufficient to explain the market explain the market laws of Classical laws of Classical EconomicsEconomics No external or No external or

collective influences collective influences are needed are needed

No coercion is No coercion is needed needed

HELP WANTED

No Angels Need

Apply

Angels & DemonsAngels & Demons

Kepler’s Angels went unemployedKepler’s Angels went unemployed But the angels of Economics had alliesBut the angels of Economics had allies

In universities, treasuries, and legislaturesIn universities, treasuries, and legislatures

Many arguments to dismiss or ignore LMUMany arguments to dismiss or ignore LMU Consider one set– challenges to its Consider one set– challenges to its

UniversalityUniversality

Meeting Objections Meeting Objections

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

““LMU might work for simple trades LMU might work for simple trades with only economic goods but …not in with only economic goods but …not in

real life real life .”.”1.1. Real life economics is more complexReal life economics is more complex

2.2. Groups (corporations) change Groups (corporations) change everythingeverything

3.3. There are non economic There are non economic “Externalities”“Externalities”

4.4. It’s not mathematical enough for It’s not mathematical enough for sciencescience

5.5. People are not rationalPeople are not rational

1.1. Real life economics is more Real life economics is more complexcomplex

Objection: LMU – just 2 actors, 2 goods – Objection: LMU – just 2 actors, 2 goods – never occursnever occurs

Answer: abstraction Answer: abstraction Trade with many goods & parties can be broken Trade with many goods & parties can be broken

down conceptually … down conceptually … Separate trades need not really existSeparate trades need not really exist

Comparison with GravitationComparison with Gravitation There are no cases with 2 isolated masses, and There are no cases with 2 isolated masses, and

point masses don’t really exist eitherpoint masses don’t really exist either You need to use an abstraction to apply the unitYou need to use an abstraction to apply the unit

Irony – the 3 body problemIrony – the 3 body problem

2. Groups (corporations) change 2. Groups (corporations) change everythingeverything

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 As long as combinations are voluntary, the same abstraction applies … abstraction applies …

Comparison with GravitationComparison with Gravitation Point masses don’t really exist either, but the law Point masses don’t really exist either, but the law

still applies to complex planets with moons, and still applies to complex planets with moons, and asteroid fields … all are combinations of “point asteroid fields … all are combinations of “point masses”masses”

You need to use an abstraction to apply the unitYou need to use an abstraction to apply the unit

3. There are non economic 3. There are non economic

“Externalities“Externalities”” Objection: “not everything reduces to economics Objection: “not everything reduces to economics

and price—there are passions and there are natural and price—there are passions and there are natural disasters too” disasters too”

Answer: LMU describes economic action, not all of Answer: LMU describes economic action, not all of psychology. Other forces don’t cancel out economic psychology. Other forces don’t cancel out economic ones. ones.

Comparison with GravitationComparison with Gravitation Newton’s law does not claim that Gravitation is the only Newton’s law does not claim that Gravitation is the only

force. The equation refers only to the force due to the force. The equation refers only to the force due to the effect of gravity. effect of gravity.

Other forces (momentum, magnetic fields) will alter the Other forces (momentum, magnetic fields) will alter the position of two masses, but once you know mass and position of two masses, but once you know mass and distance, you can calculate the gravitational force distance, you can calculate the gravitational force perfectly well.perfectly well.

You need to use an abstraction to apply the unitYou need to use an abstraction to apply the unit

4. It’s not mathematical enough for 4. It’s not mathematical enough for sciencescience

Objection: “LMU is too qualitative. Real economists use Objection: “LMU is too qualitative. Real economists use numbers.” numbers.”

Answer: Answer: Numbers without the right units are empty. LMU is the BASIS Numbers without the right units are empty. LMU is the BASIS

for using numbers. for using numbers. It’s wrong to throw out a law because it doesn’t deliver It’s wrong to throw out a law because it doesn’t deliver

predictions in one step. When observed conditions are added, predictions in one step. When observed conditions are added, one can make quantitative conclusions. one can make quantitative conclusions.

Comparison with GravitationComparison with Gravitation Newton’s law was much simpler and less numerical than the Newton’s law was much simpler and less numerical than the

Ptolemaic wheels within wheels model of the solar system. Ptolemaic wheels within wheels model of the solar system. To apply the law, one must add in specifics of mass, velocity, To apply the law, one must add in specifics of mass, velocity,

position and other forces. The law doesn’t generate ellipses in position and other forces. The law doesn’t generate ellipses in one step. one step.

You need to use an abstraction to apply the unitYou need to use an abstraction to apply the unit GIGOGIGO

5. 5. People are not rationalPeople are not rational

Objection: “Do you really believe that myth about the Objection: “Do you really believe that myth about the rational economic man? Not with this crazy economy!” rational economic man? Not with this crazy economy!”

Answer: Answer: The objection uses “rational” to mean “wise, logical” – The objection uses “rational” to mean “wise, logical” –

economists don’t say that man is wise…it’s naïve and economists don’t say that man is wise…it’s naïve and irrelevant.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 The “myth” rests on a crude equivocation on the term

“rational”“rational”

Comparison with GravitationComparison with Gravitation Is there a “myth” of a perfect planetary system with no Is there a “myth” of a perfect planetary system with no

explosions, collisions, comets or disasters? That has nothing explosions, collisions, comets or disasters? That has nothing to do with the law of gravitation.to do with the law of gravitation.

Ceteris ParabisCeteris Parabis

All extraneous variations are held All extraneous variations are held constantconstant

The expression is justThe expression is just a form of method of JS Mill’s joint a form of method of JS Mill’s joint

method of agreement and differencemethod of agreement and difference Applied to economic questionsApplied to economic questions

Bring on the AngelsBring on the Angels

Physicists Physicists were wise enough to test and adopt Newton’s were wise enough to test and adopt Newton’s

universal laws of gravitation universal laws of gravitation Economics Economics

borrowed the borrowed the solutionsolution to the economic paradox, to the economic paradox, but combined it with “classical” economics – ie but combined it with “classical” economics – ie

NO THEORY OF VALUE AT ALL …NO THEORY OF VALUE AT ALL … Neoclassical economics is like …Neoclassical economics is like …

F = G*mF = G*m11*m*m22 / r / r22 + Angels+ Angels

LMU is Scientific because…LMU is Scientific because…

Subject to empirical testsSubject to empirical tests Needs to be employed in context of dataNeeds to be employed in context of data Universal to economic phenomenaUniversal to economic phenomena

Like Evolution is to biology, Gravitation to physicsLike Evolution is to biology, Gravitation to physics Can be challenged but not dismissedCan be challenged but not dismissed

Unless there’s a contradiction or contrary Unless there’s a contradiction or contrary predictionprediction

Or unless there’s a more universal and Or unless there’s a more universal and parsimonious theory to take overparsimonious theory to take over

The AustriansThe Austrians

Austrian economics – adheres to LMU Austrian economics – adheres to LMU Extended LMU to … money, interest, Extended LMU to … money, interest,

business cycles, employment, and so business cycles, employment, and so on…on…

Don’t ask whether economists Don’t ask whether economists support the free market … support the free market … ask they agree with LMU ask they agree with LMU

Non Marginal Economics?Non Marginal Economics?

Any factor “added to” Marginal Any factor “added to” Marginal Utilities Utilities Joker in the deck – arbitrary and Joker in the deck – arbitrary and

unscientific unscientific prevents economists from making prevents economists from making

accurate predictionsaccurate predictions It’s a step backwardsIt’s a step backwards

New RuleNew Rule

If you don’t adhere to Marginal If you don’t adhere to Marginal UtilitiesUtilities Then, you can’t claim to solve the earlier Then, you can’t claim to solve the earlier

“economic paradox”“economic paradox” You can’t have angels AND science. You can’t have angels AND science.

You have to chooseYou have to choose

ConclusionsConclusions LMU got the units rightLMU got the units right

It can claim to be scientificIt can claim to be scientific No other system has made a serious No other system has made a serious

attempt to formulate its units of action attempt to formulate its units of action Newton said he saw further because Newton said he saw further because

he “stood on the shoulders of giants”he “stood on the shoulders of giants” He didn’t step in their faces!He didn’t step in their faces!

Questions?Questions?

Barry Schwartz, Ph.D.Barry Schwartz, Ph.D.

Topics for QuestionsTopics for Questions

Does LMU deny that Economics is Does LMU deny that Economics is value free value free “Wertfrei”“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 Does LMU still work if people are

irrational? irrational?

Topics for QuestionsTopics for Questions

Does LMU deny that Economics is value free? Does LMU deny that Economics is value free? No—values are factored out via ceteris parabisNo—values 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 Rationality determines how much wealth you get, just the way

altitude determines how far someone falls – it doesn’t altitude determines how far someone falls – it doesn’t CHANGE CHANGE the law!the law!