The Theory of Consumer Choice II

The Theory of Consumer Choice II

By M. Northrup Buechner

July 23, 2013

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

Summing up from last time: Modern economists view the consumer as the primary force of the economy for two related and mistaken reasons. First, they hold that the consumer is the first cause in the economy, that the economy is driven by the desires of consumers. Second, they think that all prices can be traced back to the prices of consumer goods. Neither of these things is true, but the economists who believe them have their reasons.

The primary goal of an economic system is to support the lives of the people living under the system. If some people want things that are bad for them, some producer probably will provide it. A producer who did not contribute in some way to what people want could not exist. All this is true, and such considerations underlie the modern view of the consumer as first cause. But, consumption is the end of the production process, not the beginning.

My theory of consumer choice does not make the consumer the cause of anything. Rather, it is the basis for deriving the law of demand and the principle of gains from trade. In addition, it is part of the answer to the advocates of unreason.

This is the third reason we need to understand consumer choice. We need to know what it means to be rational in this realm. Reason is the leitmotiv of a free economy. For a long time, economists have sniped at businessmen for their alleged irrationality, but in the modern era, those attacks have focused on consumers and have become influential.

A free economy is an economy governed by reason as a matter of metaphysical necessity—that is, without reason, there is no economy. In the words of Dr. Binswanger, a free economy represents “the reign of reason.” Because property rights are protected and forcible interference is legally outlawed, a free economy is the only economy in which it is guaranteed that men can act on their best rational judgment. Such a system does not guarantee that people will be rational, but any other system guarantees that they cannot.

This is an issue of polemics.  We need to know what it means for consumer choice to be rational, in order to answer the charge that consumers are systematically irrational. If the latter were true, the reign of reason would be an illusion and human beings would be unsuited for free markets. Of course, they would not be suited for any other kind of market either.

The real meaning of the charge of irrationality directed at the human race is that men are not fit to live on earth. The theocracy that Dr. Peikoff predicts in The DIM Hypothesis would create such a race of men. Should that occur, we will have nothing to say to them, just as we have nothing to say to them today. But while we can still speak and be heard by thinking minds somewhere, let us say what it means for consumer choice to be rational.

A valid theory of consumer choice requires the introduction and integration of a new concept into economics: “a hierarchy of values.” This concept in turn requires an understanding of the two concepts of which it is composed: hierarchy and values. We will pick up here next time.

 

 

 

 

The Theory of Consumer Choice I

The Theory of Consumer Choice I

By M. Northrup Buechner

July 17, 2013

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

The theory of consumer choice is the theory of how consumers decide what to buy and what not to buy. In advanced undergraduate textbooks, this is the first topic that receives the full treatment. The “full treatment” consists of graphical and mathematical analysis, defining what the consumer does, or should do, in terms of lines on a graph and mathematical equations. The consumer’s goal is assumed to be to maximize the satisfaction he derives from the goods and services he buys.

Why should we care about this? Why would we want to define in complex graphs and mathematics, that only economists can understand, exactly what consumers should do in order to maximize their satisfaction? Ninety-nine percent of consumers could not grasp the instructions.

We can look at it another way: The ultimate units of existence are individual things or entities. The units of a society are individual human beings. The units of an economy are the millions of business firms who produce in order to buy from and sell to one another (and also from and to consumers).

The primary goal of economics is to understand how an economy works. We need to know the principles governing the choices of businessmen, because their choices determine the functioning of the economy. In an economy free of government controls, all the businesses act together like a giant machine, integrated by the price system into another unit—an enormous unit, embracing every market participant.

This is why we need a theory for understanding the choices of businessmen. But why on earth do we need a theory for understanding the choices of consumers. Consumption is the “dead end” of an economy. After we get there, there is nothing left for economists to explain.

The answer of modern economics lies in the diamond/water paradox and in its solution by the law of diminishing marginal utility (LDMU) [Marginalism II, 4/23/13]. The LDMU proposed that the value people place on things depends on the quantity they possess—that water is valued low because it is abundant and diamonds are valued high because they are scarce. This means that there is a parallelism between price and value; things valued low have low prices and things valued high have high prices. It seems hard to believe now, but before the LDMU, that parallelism went unrecognized. Indeed, it was explicitly denied.

Based on that parallelism, modern economics holds that the evaluation of consumers is the starting point for the economy, that the prices of consumer goods are first and foremost a measure of what consumers want and how much they want it. The value of the tools, machines, buildings, and people used in production (the factors of production) depends on the value to consumers of what the factors produce.

I have shown in previous posts (Marginalism V & VII, 6/1 & 6/24/13) that the LDMU applies to money, but that it is largely irrelevant to the goods and services of the economy. Further, it is not true that the economy begins with consumption and flows out of what consumers want. You cannot consume what has not been produced. You cannot want what is yet to be discovered. Production comes before consumption. Consumption depends on and is created by production. The modern economic view has it precisely backward. Modern economists emphasize the theory of consumer choice because they believe consumption comes first.

Nevertheless, economics does need a theory of consumer choice. We need it because two great economic principles depend on and originate in that theory. One is the Law of Demand, the most fundamental law in economics, without which an economic system cannot be understood. The Law of Demand says that people want to buy more at low prices than at high prices.

The second is the Principle of Gains from Trade, the most general and widespread principle of a free economy, underlying every single trade and exchange. The principle of gains from trade says both parties gain from trade. This principle is the basis for holding that there is a harmony of interests in a free economy, which is one of its main pillars of support.

These are the two positive reasons that we need to examine the theory of consumer choice. There is a third reason that comes under the heading of polemics. We will take that up next time.

MARGINALISM VIII

MARGINALISM VIII

By M. Northrup Buechner

June 30, 2013

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

The standard interpretation of the diminishing marginal value of money (DMVM) is that, as we get additional money, we work our way down our hierarchy of economic values, buying things of less and less value, and that is why the value of additional dollars declines. This represents an enormous misunderstanding.

We do not spend our economic lives buying things of less and less value—working for an increase in salary so we can buy things of less value than what we bought with the last increase. This conception represents an attack on economic progress as such. It says that for human beings, a rising standard of living is nothing more than acquiring items of continually diminishing importance—so that if we make it big and hit the jackpot, we can buy things of no importance at all.

The flaw in this argument is that it focuses on adding first one dollar and then another dollar, that is, on adding almost nothing. In today’s economy, neither a dollar nor a penny can raise one’s standard of living. If you won at bingo, one dollar on Friday and then another dollar on Saturday, each successive item you bought with each additional dollar would indeed be ranked lower and lower, but nothing you bought would matter to you.

To grasp the truth about the value of additional amounts of money, we need to think in terms of larger amounts, amounts that could conceivably make a difference to someone’s standard of living. Suppose a young man has a part-time job making a hundred dollars a week; with that income, he has to live with his parents and take the subway or walk to his job. Now suppose he finds a real full-time job making a thousand dollars a week; with that income, he can buy a used car, stop taking the subway, and move into a little place of his own. If and when he advances to making ten thousand dollars a week, he can buy a house in the suburbs with a swimming pool, join the local country club, take tennis lessons, and go to the theater.

This is how increases in income work. With every increase, you are able to buy goods and services of greater and greater value. We can observe that, when people’s income rises, a significant proportion of their additional expenditures go for better versions of things they were already consuming: a TV with a bigger screen, a new Lexus instead of a used Ford, better food at home and eating-out more often, etc. We can also observe that in the advanced exchange economies of the modern world, there is virtually no limit to how high the values can be. But if that is so, why does the marginal value of money decrease? If with more and more money, we can buy things that are worth more and more, it seems that the marginal value of money should rise, not fall.

Let us remind ourselves of what the issue is here. As I said last time, of course more money is worth more than less money. We did not need economists to  point that out to us. That is not what the DMVM is about. The DMVM is about the value of a specific sum of money (such as a thousand dollars) to people who have alternative total amounts of money (or income levels or wealth). The DVMV says that if your total income is ten thousand dollars a year, a thousand dollars will be worth more to you than if your income is one hundred thousand dollars a year and much more than if your income is a million dollars a year. If we look at it in terms of adding money, an additional thousand dollars is worth more to the man with ten thousand dollars than to the man with a hundred thousand dollars.

This explanation strongly suggests that the DMVM is true. But why? Because, as we acquire more and more money, any specific sum (such as a thousand dollars) represents a smaller and smaller proportion of the total. Thus, a thousand dollars is ten percent (10%) of ten thousand dollars, one percent (1%) of one hundred thousand dollars, and one tenth of one percent (0.1%) of a million dollars. This is why one thousand dollars is much more important to a man with an income of ten thousand dollars a year than to a man with an income of one million dollars a year. The man with ten thousand dollars only has ten such sums while the man with a million dollars has a thousand such sums.

(The preceding words are my own, but I learned this explanation of the DMVM from Harry Binswanger (“Philosophic Issues in Economics” OCON, June 2008). Possibly, some other economist in the history of economics also has offered this explanation, but until I read Dr. Binswanger’s lectures, the only explanation I had ever heard was the one given in the first paragraph of this blog.)

Now we can take up the issue of consumer choice and why people buy what they buy and why an understanding of that is important.