Objective Economics

Marginalism IV

By M. Northrup Buechner

May 13, 2013

Another in a series of essays elaborating Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.

Now, let us see what is wrong with the subjectivist conception of the economy. There are three fundamental errors.

1) The subjectivists claim that consumer preferences are the starting point for the economy. That is not true. Production comes before consumption. You cannot consume, or prefer, what has not been produced.

The starting point for the economy is the production of objective economic values. Economic values are goods and services. Objective economic values are goods and services whose value is based on a rational grasp of the facts, evaluated (at least implicitly) on some version of the standard: “good for my life.” They are a subdivision (a very large subdivision) of Ayn Rand’s objective concept of the good: “an evaluation of the facts of reality by man’s consciousness according to a rational standard of value” (CUI, p. 14; also see “The Theory of Price 4”).

An objective value is not a mere subjective feeling or desire or preference. Human beings can and do desire all sorts of things that are destructive of their own lives and the lives of others. Today’s terrorists openly worship death. Many others pursue death in ways less obvious and more drawn out. More people still desire things that are obviously bad for them. An economic system which simply expressed peoples’ subjective preferences would have nothing to recommend it. One could not say why such a system should be defended or put into effect.

There is a life and death difference between objective values and subjective preferences: a preference may be bad for your life, and an unexamined preference probably is. The failure to satisfy such a preference may be displeasing. But the loss of an objective value is a hole in one’s life. A free economy produces primarily objective values, that is, values that support human life and happiness. Economically, that is its most important attribute.

2) Subjectivists hold that the prices of consumer goods are determined by consumer preferences. That is not true either.

Every price is set by someone. This is the starting point for any theory of price. The prices of most consumer goods are set by businessmen who have never heard of consumer preferences and could care less.

The businessman sets a price that he hopes and expects his customers will be willing to pay in sufficient numbers to yield a total revenue that will cover his costs and create a profit. This total revenue is what Ayn Rand called socially objective value, that is, “the sum of the individual judgments of all the men involved in trade at a given time, the sum of what they valued, each in the context of his own life” (her emphasis). Socially objective value is not a sum of preferences. It is a sum of objective, rational judgments. That is the form in which objective value rules a free market.

The objectivity of prices is also reflected in the market context. The market context consists of the quality and prices of competitors’ products, plus everyone’s expectations for the near future. The businessman takes those facts into account when setting his price, as do his customers when deciding whether or not to pay the price.

Finally, the businessman knows that over the long run, his total sales receipts must exceed his total costs (see “The Theory of Price 1, 2, & 3”). This absolute requirement is independent of consumer preferences, but it is irrevocably linked to the socially objective value of the product: the higher that value is relative to costs, the greater are the profits.

The root significance of profits to the businessman is that, at least for the time being, the survival of his business is assured. The greater his profits, the better positioned he is to go on producing and selling and, perhaps, expand his business.

3) The subjectivists hold that the wages of workers are bid up and down by businessmen to reflect the value of the workers’ products to consumers. Again, that is not true. Indeed, it is hard to think of plausible examples of such a phenomenon. (McDonalds’ hamburgers vis–á–vis minimum wage labor is one.)

The wages of any particular type of worker are set by businessmen’s demand relative to the supply of workers of that type. If demand exceeds the supply, businesses find it difficult to hire the workers they need. In the competition for employees, some businessman will go first, raising the wage he offers, and his competitors must follow. Wages rise. If supply exceeds demand, businesses are inundated by workers looking for jobs. As a consequence, businessmen offer lower wages and/or workers volunteer to take less. Wages fall.

There is nothing about this process that links the individual worker’s wage rate to the value of his product. In fact, most workers do not have a product; that is, they do not produce something that is sold to a customer.

A car manufacturer, for example, consists of thousands upon thousands of people performing thousands of jobs, all of which are necessary to the production and sale of the firm’s cars. These include accountants and secretaries, salesmen and janitors, assembly-line workers and foremen, vice presidents and clerks, and so on and on and on. Of these, only the assembly-line workers actually do something to the car in production, and even they perform some narrow service, like installing seats (OE, pp. 45-46).

Cars are the joint product of all the employees of the business. The idea that each of those employees’ wage rates is determined by the value of the cars is simply unintelligible. The connection between employee wage rates and the price of cars is the universal requirement that the socially objective value of the business must exceed its total costs, which includes the cost of its employees. In principle, this is the connection between wage rates and prices throughout the economy.

The preceding is the essence of my case against the subjectivist conception of the economy. My conception represents a different universe from the subjectivist conception, and subjectivist economists want nothing to do with it.

We have not yet considered the law of utility, which is deeply flawed on its own account. We will take up that law next time.

Marginalism III

By M. Northrup Buechner

May 5, 2013

Another in a series of essays elaborating Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.

Last time, I defined Marginalism as the principle that people value things at the margin; they value one more or one less; they do not value an entire quantity unless the entire quantity is at stake. This insight resolved the diamond/water paradox and opened the door to the idea that the prices of goods are not independent of the value people place on them—which is true.

What is not true is the alternative conclusion that was drawn—that the value people place on goods determines their prices. It is alleged to work like this: The value placed on a good by consumers is reflected back to the labor that produces that good. Workers who produce highly valued goods, such as jewelry, are paid a high wage, while workers who produce goods on which people place a relatively low value, such as McDonald’s hamburgers, are paid a low wage.

The prices of things tend to equal their cost of production (the classical economists were right about that), but that is because businessmen bid the wages of various workers up or down depending on what consumers are willing to pay for the things those workers produce. The result is that, according to modern economics, everything in the economy, all its prices, interest rates, wage rates, contracts, output, costs, employment, jobs, etc., is caused by the subjective preferences of consumers.

This is where the economy begins: with what consumers want and how much they want it—and over time, the whole economic system automatically falls in line with those desires. If consumers’ desires change, if they want more chicken and less beef, the whole economic system shifts to accommodate their desires.

This is what modern economists call “consumer sovereignty.” The consumer is king; the consumer rules the economy. When they feel like defending the free economy, this is modern economists’ defense.

This also is the subjectivism of modern economics. Economic thought has gone from the view that consumer desires are irrelevant to understanding the economy to the idea that consumer desires determine everything about the economy. Modern economic subjectivism holds that the whole economic system is an expression of the subjective preferences of consumers.

In other words, the modern idea is that consumer desires create the economy. This is a minor variation on philosophical subjectivism—the idea that man’s mind determines the facts, that what people think creates reality.

In its original form, economic subjectivism was relatively benign. It was wrong, but it arose as an answer to economic intrinsicism, which was even more wrong and needed to be answered. The early economic subjectivists had no concept of objectivism (small “o”) as an alternative and made no distinction between objectivism and subjectivism. As a result, their implicit philosophical perspective was a hodgepodge of both concepts. Sometimes they made valid points, but when they did, those points depended on the objective part of the hodgepodge. But this is important: sometimes they made valid points. That could not save them or economics.

In the realm of ideas, you cannot get away with just a little poison. The implications of an idea eventually will out. The rise of philosophical subjectivism throughout all fields of knowledge in the twentieth century was duplicated in economics, resulting in a completely subjective economic theory. Its signpost is the premise that facts are relevant only insofar as consumer preferences make them relevant.

For an Objectivist, there is obviously something wrong here. It cannot be true that the subjective desires of consumers are the basis for the whole economy. At the same time, the above description of how consumer desires determine wages has a certain plausibility to it. What is wrong with it? The short answer is “everything.” That answer is actually true, but it is hardly illuminating.

Next time, I will bring the light.

Marginalism II

By M. Northrup Buechner

April 23, 2013

Another in a series of essays elaborating Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.

The best way to convey the meaning of marginalism is to tell the story of its discovery in economics.

In The Wealth of Nations, Adam Smith (the father of economics) introduced his analysis of prices by pointing out a paradox in the prices of goods (1776, 28): Those goods which have the greatest importance for human life, such as water, often have very low prices, while goods which are relatively unimportant in supporting human life often have very high prices (for example, diamonds). This came to be called the diamond/water paradox.

Adam Smith drew a huge conclusion from this paradox. He concluded that the prices of goods are independent of people’s evaluation of goods. Since the things that people value the most often have low prices, while the things that are frivolous and unimportant frequently have the highest prices, prices must be caused by something other than what people want and how much they want it.

If the value people placed on goods was the cause of their prices, water would be expensive and diamonds would be cheap. Since they are not, some other factor must be at work. Adam Smith and his followers (the classical school of economics) broadly settled on the cost of production as the explanation of price. (This explanation does not work because the cost of every good is composed of prices, the prices of the factors of production which produce it.)

The paradox was solved by three different economists writing in different languages in different countries at almost the same time—an amazing, unprecedented coincidence, explained, perhaps, by the logical hierarchy of ideas—because it is not so unusual for two men to make the same discovery at about the same time in other scientific fields.

In economics, the three men who independently reached the same solution to the diamond/water paradox were Jevons (writing in English, 1871), Walras (writing in French, 1874), and Menger (writing in German, 1871). Smith’s error, each of them said, was that when he compared water to diamonds, he thought of both goods as a class or a category or a group, whereas in everyday life, people do not value goods as classes, they value goods the same way they acquire them, that is one by one.

Suppose we were conquered by space aliens who gave us this choice: they will take all the earth’s diamonds or all its water. Which would we chose? Of course, we would tell them to take the diamonds, because if they take the water, we would all be dead in a week, whereas we would hardly miss the diamonds. This is not Adam Smith’s example, but it is consistent with the underlying context he was assuming when he implied that water is inherently more valuable than diamonds. As a class, water is more valuable than diamonds, but nobody chooses between water and diamonds as classes.

The key to marginalism and the solution to the diamond/water paradox is called the Law of Diminishing Marginal Utility (which we will call the law of utility). In economics, utility means the feeling of satisfaction or enjoyment one gets from buying, using, and consuming a consumer good or service—for example, the utility one gets from eating a banana or driving one’s car or going to the movies.

Marginal utility is the additional utility one gets from buying, using, and consuming one more unit of a consumer good or service, for example, a second banana, another trip in one’s car, or going to a second movie. The marginal unit is the additional unit.

The law of utility says that the value of a good varies inversely with the quantity which one has available. The greater the quantity of any specific good that a man has, the lower the value he places on one more.

Suppose you are throwing a party, and you have asked guests to bring snacks. If the last guest shows up with a pound of Buffalo chicken wings, those wings will be worth more to you if you have no wings, less if you already have a pound, and much less if you have ten pounds. A new pair of socks is worth more to you if you have no socks than if you have a dozen. A fondue set may be a nice wedding present, but five fondue sets certainly are not.

The solution to the diamond/water paradox follows directly from the law of utility: Since in a modern industrial civilization there is a great abundance of water, we put a very low value on an additional gallon (perhaps to spray the leaves off the sidewalk) and we are willing to pay a correspondingly low price. By comparison, there are very few diamonds in the world—an infinitesimal fraction of  the number of gallons of water—so one diamond has great value to whomever can afford it and he is willing to pay a high price.

Marginalism can be defined as the principle that people value things at the margin; they value one more or one less. They do not value the entire quantity that they own or that they buy, unless the entire quantity is at stake. If you are deciding between buying two pounds or three pounds of cheese, you have already decided to buy two pounds. The value you put on the third pound determines what you do. If you value the third pound more than the price, you buy, and you go home with three pounds of cheese. If you value the third pound less than the price, you do not buy, and you go home with two pounds of cheese.

The discovery of marginalism constituted a revolution in economic thought, a major part of which was to entrench subjectivism at its base. We will take that up next time.

Marginalism I

By M. Northrup Buechner

April 15, 2013

Another in a series of essays elaborating Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.

We begin this analysis of “marginalism” with an overview of the current state of economics:

There are three basic premises that together explain virtually every detail of modern economics (by modern economics, I mean economics as it is practiced and taught today in graduate schools). Those premises are: (1) subjectivism; (2) marginalism; and (3) model-building. Underlying all these is altruism, as I explain in the Preface to Objective Economics. Here, I want to deal with premises that are specifically economic premises.

Subjectivism sets the philosophical context, the basic philosophical assumptions. Marginalism names the basic economic insight, the new way of looking at economic choices and actions, that originated about 140 years ago. Marginalism drew a hard line, a line in principle, between the classical economists and the neoclassical (new classical) economists that followed them. Model-building names the universal method of today’s economics and includes “higher mathematics” as an integral part of this method.

Contemporary economics has been called neoclassical economics for a long time. Too long. Today, some economists are calling for a new name for modern economics because today’s economics no longer resembles the neoclassical economics of the late 19^th and early 20^th centuries—which is when the name “neoclassical” originated. Beginning about fifty years ago, mathematical model-building began to accelerate its take-over of economics, until today this method totally dominates the field.

Over the same period that mathematical model-building was becoming the method of economics, the content of economics was splintering into many subdivisions—for example, public choice economics (the economics of political decision-making), the economics of crime, the economics of marriage and divorce, agricultural economics, urban economics, the economics of growth and development, housing economics, transportation economics, natural resource economics, environmental economics, the economics of religion, the economics of the arts, labor economics, forensic economics, neuroeconomics, sports economics, the list goes on and on. In principle, modern economics now embraces every sphere of human thought and endeavor.

Why are all of these subjects called “economics?” Because mathematical model-building is the method used to study them, and predominantly, they are studied by people with Ph.Ds. in economics, who are employed in departments of economics in colleges and universities across the country.

I am completely opposed to the method of mathematical model-building, as it is practiced in modern economics (see Appendix B of Objective Economics). But I want to make clear here something that is not clear in Appendix B. In principle, I am not opposed to the application of mathematics to economics. I think it is possible that someday, mathematics may contribute important insights to our understanding of how an economy works. But I am afraid that contribution is far in the future.

Why?

Human beings are by far the most complicated existents of which we are aware in the universe, much more complicated than the objects of study in any of the branches of physics. The mathematics that today is invaluable to the understanding of inanimate phenomena is helpless to illuminate anything about the economic activity of human beings.

Perhaps one hundred or two hundred years from now, mathematics will have advanced to the point that it can deal meaningfully with beings of volitional consciousness. Today, “volitional consciousness” is the insuperable barrier that mathematics cannot cross. The subject matter of economics is human beings, and the consciousness of human beings is volitional. Today’s mathematics has no way of “modeling” a creature whose actions, by their nature, are freely chosen.

Instead, the pretense of applying contemporary mathematics to economics requires a blizzard of assumptions that are patently untrue, that distort everything out of any resemblance to reality, but which are required to create a subject matter with which the relatively primitive mathematics of our time can deal. Every alleged item of knowledge that comes out of this method is a distortion.

What about subjectivism? As an Objectivist, I am unalterably opposed to it in all its forms and expressions. Those forms are legion in modern economics and they vitiate the value of all the work that is inspired by or an expression of subjectivist philosophy. I have much more to say about this in my book. Here, we will deal only with how subjectivism entered economics (next time).

So I reject mathematical model-building and subjectivism. Marginalism is not so easily dealt with, because there are both valid and invalid aspects to the marginalist idea. Next time, we will look at how subjectivism and marginalism entered economic thought.

The Theory of Price 8

By M. Northrup Buechner

March 30, 2013

Another in a series of essays elaborating Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.

Let us sum up the theory of price as I have developed it over the last seven entries here.

Objective economic values are values evaluated by an individual consciousness as good for his life “according to a rational standard of value”—that is, a standard “derived from the facts of reality and validated by a process of reason.” This is the basis on which people make most of their purchases and sales in a free market. Putting aside irrational values, the summation of all the payments by individual men for a product represents the product’s socially objective value.

Ayn Rand says, “Values cannot exist (cannot be valued) outside the full context of a man’s life, needs, goals, and knowledge” (her emphasis). But within that context, the values people chose are overwhelmingly rational, in the sense she defines. If that were not true, if the opposite were the case, if people overwhelmingly chose irrational values, that could only mean that they had given up their minds and the desire to live on earth. There would be no price system, and the theories of economics would be moot.

The theory of objective prices begins with the observation that every price is set by someone. As a consequence, prices reflect the relevant economic facts grasped by the people who exchange at those prices. Prices set in this way are objective prices in the full meaning of Ayn Rand’s concept of objective. Prices are the product of a relation between a conceptual consciousness and the facts; they are the result of volitional processing by man’s mind of the evidence of reality given by his senses. Prices are not forced on man by some intrinsic aspect of reality. They are not dictated by God, or supply and demand, or the labor embodied in a good, or the cost of production. But neither are they the result of the businessman’s arbitrary feeling. Prices are the result of a human consciousness grasping economic facts (Objective Economics, pp. 139-40).

In economics, an objective price is a price set to reflect the potential customers’ willingness to pay, based on the price-setter’s grasp of the economic facts. Willingness to pay is primarily caused by the facts of demand and competition. A long-run perspective is insured by the necessity of making a profit (total revenue must exceed total cost). Prices set in this way represent the objective economic value of the good. The underlying principle is that prices are based on facts—prices reflect facts—prices originate in facts. In a free economy, businessmen set prices that reflect the facts of their markets, because they want to stay in business.

Now we can say what is objective about irrational values. It is, of course, their price. The sellers of irrational goods and services want to set prices that reflect their customers’ willingness to pay, just like their rational counterparts, and like their rational counterparts, they are constrained by the necessity of making a profit over the long run if they want to stay in business.

It is probably true that irrational products give rise to more “fly-by-night” operators than we find for rational products—that is, purveyors who are uninterested in the long run, whose main concern is to grab a fast profit and disappear. This is because if you are selling charms or love potions or “cure-all” medicine or the knuckle-bone of a saint, most of your customers are going to be dissatisfied. This is no more than they deserve, but it does make such businesses more precarious that normal.

Let us conclude by observing that the business practices ascribed to all businesses by the enemies of capitalism are largely restricted to the cases of irrational products. Of course, as the rationality of people continues to shrink, we can expect irrational products and their associated practices to grow. Early in the twenty-first century, governments (including our own) have lost billions in the pursuit of green products. However, that is a reflection on policies of unreason, not on freedom or a free economy.

Next time, a new subject, yet to be determined.

The Theory of Price 7

By M. Northrup Buechner

March 16, 2013

Another in a series of essays elaborating Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.

Now we take up the subject of irrational values, or, what I called in my book, nonobjective values. We want to know the significance of such values, and in particular, how we should understand them in relation to socially objective value and philosophically objective value. Let us begin again with the statement in which Ayn Rand defines “the objective theory of the good”—that is, her theory:

“The objective theory holds that the good is . . . an evaluation of the facts of reality by man’s consciousness according to a rational standard of value. (Rational, in this context means: derived from the facts of reality and validated by a process of reason.) The objective theory holds that the good is an aspect of reality in relation to man” (1966, p. 14; her italics)

This paragraph sets the context for everything that follows in this essay. Throughout, her subject is objective values in the sense defined here. She mentions many values in these pages for the purpose of illustration and concretization: airplanes, bicycles, the works of Victor Hugo, true-confession magazines, lipstick, microscopes, a hospital, a research laboratory, a space ship’s journey to the moon, and the automobile. This represents an enormous range of values. All of them are values “according to a rational standard of value.” She does not mention one irrational value.

The context Ayn Rand established for this essay excludes irrational values. Irrational values are values like psychic hotlines, divining rods, charms, love potions, and religious relics. Obviously, they are not values “according to a rational standard of value.” Accordingly, they do not have a socially objective value, much less a philosophically objective value. The standard of value by which people choose irrational values is not rational, and consequently, these values fall outside the realm of objective values.

Ayn Rand could have introduced the subject of irrational values alongside the subject of objective values in this essay. She chose not to do so—I think because it would have disrupted the train of her argument. The goal of that argument was to prove her theme that “capitalism is the only system based on an objective theory of values” (her italics)—to show exactly how and why this is true—and as the means to that end, to introduce the concepts of philosophically objective value and socially objective value.

She could have introduced the subject of irrational values at the end of the essay. Again, she chose not to do so—I think because it was a side issue, she was not interested in it, and it would have been a distraction from her theme.

But for us, the question remains—what is the meaning of philosophically objective value and socially objective value in the context of irrational values?

First, the philosophically objective value of irrational values is zero or less, depending on the extent of the irrationality involved.

Second, the total revenue derived from psychic hotlines, divining rods, and the like, is not their socially objective value. To call it objective would nullify the meaning Ayn Rand gave to objective in her defining statement quoted above. As long as we do not use the word “objective,” I do not think it makes much difference what we call the total sales receipts from an irrational value. I would suggest “social economic value” or “total economic value,” but I would not insist on either one, because it does not matter. Irrational values are of no consequence to an economic system that is not already doomed.

However, there is one important aspect of irrational values that is objective. We will take that up next time—and conclude this series on the theory of price.

THE THEORY OF PRICE 6

By M. Northrup Buechner

February 28, 2013

Another in a series of essays elaborating Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.

Ayn Rand said that “the free-market value of goods or services does not necessarily represent their philosophically objective value, but only their socially objective value.” Remember (I have to keep reminding myself of this), the free-market value is the total sales receipts of businesses producing the product. The words “not necessarily” imply that the free-market value of goods or services may or could or sometimes do represent both their philosophically objective value and their socially objective value. I think something like the following is at least part of what she had in mind.

For obvious reasons, new and better products are not instantly embraced by businessmen and/or their employees and/or their customers. Let us take the typewriter as an example. The first commercially successful typewriter was invented in 1868. Up to that time (and indeed long after), written personal communication and record-keeping was predominantly by pen and ink on paper. This method was thoroughly integrated into the operation of businesses across the economy. The invention of the typewriter meant that secretaries (and many others) had to acquire a completely new and different set of skills. At the beginning, no one had this skill-set and very few typewriters were sold. Consequently, the total revenue of typewriter companies was low, and so was the socially objective value of typewriters.

At the same time, the philosophically objective value of typewriters was the value “estimated from the standpoint of the best possible to man, i.e., by the criterion of the most rational mind with the greatest knowledge.” From this standpoint, the typewriter was a wonderful invention which would transform the workplace and multiply the productivity of everyone in the economy—in effect, putting a printing press in the hands of anyone who wanted one. But in the beginning, only a very few saw this.

As time went by, more and more people grasped the philosophically objective value of typewriters, more and more typewriters were sold, and the total sales receipts of the typewriter companies began to exceed their costs—then greatly exceed their costs—then result in fortunes for their owners. This rise in sales receipts represented an enormous increase in the socially objective value of typewriters. Eventually, there came a time when typewriters were completely integrated into the economy, and even the least mentally active typists grasped their philosophically objective value in some form. Then the total revenue of the typewriter companies represented both the socially objective value and the philosophically objective value of typewriters. (And then the personal computer came along.)

The pattern of rising socially objective value is repeated over and over again in the history of economic development. For example, the replacement of the horse and buggy by the automobile,  vinyl records by compact disks, typewriters by personal computers, commercial sailing ships by steamships and then steamships by railroads. More impressive is the rise in socially objective value of all those products for which there is no precedent, such as electricity, telephones, and commercial airlines. At first the demand is low because the product is new and unfamiliar and misunderstood. Then, as time goes by, more and more people grasp the product’s philosophically objective value, more and more people buy the product, and the socially objective value rises apace until it reflects the grasp by everyone (or almost everyone) of the philosophically objective value.

In other words, “The ‘philosophically objective value’ of a new product serves as the teacher for those who are willing to exercise their rational faculty, each to the extent of his ability” (CUI, p. 18).

Next time, I will take up things like psychic hotlines, divining rods, charms, love potions, horoscopes, and all the goods and services of mysticism (relics, bibles, temples, crosses, holy water, priests, etc.). We can call these irrational values or nonobjective values or objective disvalues. Of course, their philosophically objective value is nil. But what about their socially objective value?

THE THEORY OF PRICE 5

By M. Northrup Buechner

February 22, 2013

Another in a series of essays elaborating Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.

In my book, I misinterpreted Ayn Rand’s concept of socially objective value. Remember what she says: “The free-market value of goods or services” represents “their socially objective value, i.e., the sum of the individual judgments of all the men involved in trade at a given time, the sum of what they valued, each in the context of his own life (Capitalism: The Unknown Ideal [CUI], 17, her italics).

In economics, the term “market value” almost always means “price.” Ayn Rand does not use the word price in her discussion of this subject (CUI, 16-17), but she says “market value” three times. I interpreted market value to mean price. I now believe that this was a mistake.

When she says that socially objective value is “the sum of the individual judgments of all the men involved in trade at a given time” (my italics), we need to take the word “sum” literally. We need to add up all the prices paid by everyone who bought the product. By market value, she meant the total value of all the sales of the product—not the price of one unit, but the value of all the units added up.

In “What Is Capitalism?”, Ayn Rand was aiming at something different than what I was aiming at in Objective Economics. Her goal was to present a moral/philosophical overview of the capitalist system, showing that objective values rule the economy, that the values of a free market are objective values. Consequently, her perspective was from the side of the buyers and the moral significance of their purchases, namely, that each buyer values the good at its price, and the total spending on the good reflects its socially objective value.

I was not that ambitious (though I was not unambitious). I was primarily looking for a theory of the economy, for an explanation of how an economic system works, and for a theory of price that would enable that explanation. Consequently, my focus was on the sellers and the fact that the prices they set represent the objective economic value of their products—“objective” because businessmen choose prices based on their grasp of the surrounding economic facts. When all the sales receipts are added up, from the perspective of the businessman, that is his reward for producing that output. The same total sales receipts, from a moral/philosophical perspective, represent the socially objective value of the businessman’s output.

This is the only place in my book where I am aware of having made an error. Everything else I stand by as written. With this blog, I am elaborating, explaining, and clarifying ideas that I think are true as they stand.

Next time, we will consider how to interpret this statement by Ayn Rand: “the free-market value of goods or services does not necessarily represent their philosophically objective value, but only their socially objective value.”

THE THEORY OF PRICE 4

By M. Northrup Buechner

February 13, 2013

Another in a series of essays elaborating Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.

My theory of price is a theory of objective prices, in which price measures the objective economic value of a good or service. The concept of “objective” I use is based on Ayn Rand’s concept of objective—the concept after which she named her philosophy. She discussed this concept in writing in her article “What Is Capitalism,” the opening essay of Capitalism: The Unknown Ideal (CUI). Her defining statement is:

The objective theory holds that the good is . . . an evaluation of the facts of reality by man’s consciousness according to a rational standard of value. (Rational, in this context means: derived from the facts of reality and validated by a process of reason.) The objective theory holds that the good is an aspect of reality in relation to man” (1966, p. 14; her italics)

The objective theory of the good defined in this paragraph posits a standard that is wider than the standard of the Objectivist ethics. The standard of value for her ethics is man’s life, that is “the terms, methods, conditions and goals required for the survival of a rational being through the whole of his lifespan—in all those aspects of existence which are open to his choice.” [VOS, 18].

There are other standards of value that satisfy the objective theory of the good, standards that are common among the participants of a free economy—for example, the accumulation of wealth, the welfare of my family, the advancement of my career, my children’s preparation for life, my enjoyment of life, my family’s happiness, and many others. These are all rational standards according to her definition of rational in this context: “derived from the facts of reality and validated by a process of reason.”

Ayn Rand stated the theme of “What Is Capitalism?” in this sentence: “Of all the social systems in mankind’s history, capitalism is the only system based on an objective theory of values” (her italics). To establish this, she had to overturn the foundational viewpoint of all of modern economics (including the Austrians), that the root of the economy is subjective feelings. (To soften and obscure their actual position, economists often call these feelings “preferences.”).

Her answer was: “The free market represents the social application of an objective theory of values.” To prove that, she carved out two new categories of economic value, philosophically objective value (POV) and socially objective value (SOV).

She defined philosophically objective value as:

a value estimated from the standpoint of the best possible to man, i.e., by the criterion of the most rational mind possessing the greatest knowledge, in a given category, in a given period, and in a defined context (nothing can be estimated in an undefined context) (1966, 16; her italics).

She defined socially objective value as “the sum of the individual judgments of all the men involved in trade at a given time, the sum of what they valued, each in the context of his own life (1966, 17, her italics).

What are these “individual judgments”? They are the judgment of each individual buyer that the product is worth the price he has to pay. If this were not his judgment, he would not pay it. When we sum up the prices paid by all the buyers of a product, we get the socially objective value.

The standard term for this total in economics is “total revenue” or, less often, total sales receipts. This sum is the socially objective value because the buyers purchase each good and service based on an evaluation of the facts of reality by each man’s mind according to a rational standard of value (see the opening paragraph).

Now we can answer the common objection to capitalism that the market is irrational because the manufacturer of lipstick makes a greater fortune than the manufacturer of microscopes, “even though it can be rationally demonstrated that microscopes are scientifically more valuable than lipstick” (p. 17). The greater fortune of the lipstick manufacturer is the product of millions and millions of lipstick sales, while the microscope manufacturer sells a few thousand. The result is that the socially objective value of lipstick greatly exceeds the socially objective value of microscopes.

But, Ayn Rand says, “this does not mean that the values ruling a free market are subjective.” There follows a brilliant analysis, that could only have been penned by Ayn Rand, of how and why objectivity and rationality rule the market—even though the socially objective value of lipstick exceeds that of microscopes. I leave it to my reader to read or reread that paragraph (Capitalism: The Unknown Ideal, 1966, p.17).

Next time, I will explain how and why I misinterpreted this material in my book.

THE THEORY OF PRICE 3

By M. Northrup Buechner

February 5, 2013

Another in a series of essays elaborating Objective Economics: How Ayn Rand’s Philosophy Changes Everything about Economics by the author.

Parts 1 and 2 of “The Theory of Price” established two facts: demand and competition—as facts that price-setters consider in deciding upon a price. Demand is the basic concept; it is how much people are willing to pay and in what numbers. Competition is the most important auxiliary factor directly affecting demand—which it does by offering alternatives to potential buyers.

Competing firms may offer (1) the same product at a lower price, or at the same price or at a higher price, or (2) an inferior good at a lower price or at the same price or at a higher price or (3) a superior good at a lower price or at the same price or at a higher price. There are nine different alternatives here, and this is just the beginning. There may be two or nine or a ninety different competitors, each of them offering a variation of the same product at a different price. However many there are, their prices and the quality of their products all together create the competitive context in which a businessman sells his products. In the face of this competitive context, the price-setter chooses a price which is his best estimate of people’s willingness to pay for his product.

However, there is a third factor that a businessman must consider in setting his price: his cost of production. The businessman has to cover his costs. How do costs affect price?

Suppose he is manufacturing yachts. He estimates that fifty people are willing to pay $1,000,000 for each yacht yielding a total revenue of $50,000,000. He also estimates that two hundred people would be willing to pay $500,000 for each yacht yielding a total revenue of $100,000,000. $500,000 appears to be the better price—but suppose it costs $750,000 to build each yacht. At a price of $1,000,000, he can sell fifty yachts, making $250,000 on each one for a total profit of $12,500,000. If he charges $500,000, he loses $250,000 on each yacht, and the more he sells, the more he loses.

Both demand and competition are clear causes of people’s willingness to pay. A higher demand means people are willing to pay a higher price. Higher quality and lower prices of competing products reduce that price. But the cost of production is not related to willingness to pay. Customers do not know what it costs to produce a product and have no reason to care. Since the cost of production affects the price set by a business, how can we integrate that fact with the principle that price measures willingness to pay?

The cost of production is a qualification on price as a measure of willingness to pay. Over the long run, total revenue must exceed total cost; that is, income receipts must exceed cost outlays; that is, the firm must make a profit. In addition, the profit must be sufficient to provide the funds necessary to replace plant and equipment when they wear out.

This is the businessman’s ABSOLUTE. He must on average make a profit year after year. He does not need to make a profit every day, week, or month that he stays in business. Businessmen frequently do things that they know will reduce their profits in the short run. But over the long run, a business either makes a profit or it vanishes from the economic scene.

So this is the integration: Every price measures willingness to pay, subject to the necessity of making a profit over the long run—where the businessman estimates willingness to pay based on the facts of the market in which he sells his product.

Next time we will take up Ayn Rand’s concept of “socially objective value” and define its relation to the objective theory of price.