1. Skip to navigation
  2. Skip to content
  3. Skip to sidebar
Source link: http://archive.mises.org/12422/did-rothbard-borrow-the-income-and-substitution-effects/

Did Rothbard “Borrow” the Income and Substitution Effects?

April 8, 2010 by

Murray Rothbard and other economists of the Austrian School have rejected the concept of indifference and have developed an approach based on Menger’s law of diminishing marginal utility and Mises’s axiom of action. FULL ARTICLE by Predrag Rajsic

{ 25 comments }

thelion April 8, 2010 at 11:20 am

Great essay.
I can’t list how many student in economics think income and substitution effects require the neoclassical graphical approach; will send them this article to read.

Predrag April 8, 2010 at 5:26 pm

Thanks; that’s very nice to hear.

Elliott Siewert April 8, 2010 at 11:27 am

Interesting article but I am not sure I buy the idea that $1 oranges and $2 oranges are different goods, would they not supply the same level of utility? If you ask me “income effect” and substitution effect” are irrelevent concepts as they cannot be seperatly observed in an actor, all we ever observe is the total effect.

Predrag April 8, 2010 at 2:44 pm

I would say that individuals attach utility or importance to material objects rather than that the objects supply utility. Since the utility that individuals attach to things depends on the individual perception on how these things can be used to meet one’s ends, one will not attach the same utility to a $1 orange and a $2 orange. Importance that individuals put on objects does not depend only on the physical properties of those objects – it depends on all the relevant attributes of the object. One of those characteristics is how much money (and other things you might enjoy) needs to be given up to attain them.

What if the money price of oranges was $30,000 per orange instead of $1? Suppose you came to a store and found two physically identical (inside and outside, in all possible respects) oranges – one at $1 and the other at $30,000. Which orange would you use to meet your end – physical survival on a yearly income of, say, $30,000? If you attach the same utility to both, you would not care which one you pick.

Jonathan Finegold Catalán April 8, 2010 at 2:53 pm

If the $1 and $30,000 orange both have the same utility then I think the individual would opt for the former, since the individual could then turn around and further satisfy his needs with the other $29,000 by some other means.

You write:

I would say that individuals attach utility or importance to material objects rather than that the objects supply utility. Since the utility that individuals attach to things depends on the individual perception on how these things can be used to meet one’s ends, one will not attach the same utility to a $1 orange and a $2 orange.

This is not true in all cases. This is only true if the particular store the individual goes to sells only $2 oranges and the individual knows that another store sells the same orange at $1. Then, we are not talking about the utility of just the orange, but the utility of the orange weighed in with the attached cost of having to go to another store just to save a dollar. In other words, we are also talking about opportunity cost. But, if a $1 and a $2 orange were sold side by side, and both fulfilled the same utility, I’m sure most individuals would opt for the former, even if they could easily afford the latter.

Predrag April 8, 2010 at 2:59 pm

If you opt for the former, then the former is better than the latter. If the former is better than the latter, you attached a higher importance or utility to the former.

Jonathan Finegold Catalán April 8, 2010 at 3:08 pm

Well, that’s my point. The higher utility is that you get the same utility out of the orange + $1. If price didn’t matter then the demand curve would not be inversely related, it would be vertical.

Predrag April 8, 2010 at 3:16 pm

It seems that we are saying the same thing. My (not actually mine but Rothbard’s) whole point is that a change in money prices changes the orderings in the value scale.

Predrag April 8, 2010 at 3:03 pm

“This is not true in all cases. This is only true if the particular store the individual goes to sells only $2 oranges and the individual knows that another store sells the same orange at $1. Then, we are not talking about the utility of just the orange, but the utility of the orange weighed in with the attached cost of having to go to another store just to save a dollar. In other words, we are also talking about opportunity cost. But, if a $1 and a $2 orange were sold side by side, and both fulfilled the same utility, I’m sure most individuals would opt for the former, even if they could easily afford the latter.”

That’s fine; My claim was ceteris paribus.

Ryan April 8, 2010 at 12:15 pm

I love it! Well done!

billwald April 8, 2010 at 12:23 pm

Thinking back on 30 years of police work, less than 5 percent of the people to whom I wrote a traffic ticket unintentionally violated the traffic code – or most any other law which is commonly enforced. If disregard of the social contract is the norm . . . why do economists insist that purchasing decisions are generally rational? A person who normally blows stop signs will give much thought to choosing between an apple and an orange?

Steve April 8, 2010 at 1:17 pm

Is it your assumption that the “social contract” (laws) is rational? Waiting at a stop sign at 2 a.m. with no other cars in sight, because it’s the law, might seem irrational to some people. Deciding to smoke pot, even though it’s against the law, might seem completely rational to some. From what I understand ratiocination is the logical mental process people go through to make a decision, not an arbitrary law someone dictates and tries enforce.

Predrag April 8, 2010 at 5:07 pm

I had my fair share of encounters with the traffic police. In retrospect, it was a fun experience. However, how much effort someone puts in weighing costs and benefits of an action is not really relevant for the purpose of the article.

Anthony April 8, 2010 at 8:44 pm

Also, people weigh the advantages of violating traffic laws (like speeding, running stop signs, etc.) with the perceived risk of getting caught.

If I can save an hour on my weekly commute by speeding and I figure I will only have a 2% chance of getting caught and fined $100, the $2 per week average I spend on speeding tickets might be more than worth it.

Michael A. Clem April 12, 2010 at 3:29 pm

If disregard of the social contract is the norm

Simple statistical fallacy–How many people did you NOT write traffic tickets for (i.e. didn’t break the law)? Add in all those people, and then see if “disregard of the social contract” is the norm.

Jonathan Finegold Catalán April 8, 2010 at 12:54 pm

Predrag,

What graphics program do you use to make your graphs?

Predrag April 8, 2010 at 1:09 pm

I just use the “insert shape” option in Excel and then pick different shapes. First I adjust the size of the cells so that the width and height are equal – so that I can draw things in desired proportions. When it’s all done, I put a white background, select and copy the graph into the “Paint” program in Windows XP, and, finally, save it as a JPG file.

Jonathan Finegold Catalán April 8, 2010 at 1:35 pm

Thanks! Your graphics come out really clean.

Predrag April 8, 2010 at 3:09 pm

I don’t know why the script does not let me post “Thanks!”. It says I’ve said it before (I guess it treats it as spam).

Anyway – Thanks!

Del Lindley April 8, 2010 at 5:58 pm

Well done.

I realize that the scope of this piece is limited to showing that the substitution and income effects of a price change can be conceptualized through a discrete linear (i.e. one-dimensional) value scale as well as a continuous model that decomposes this value scale into indifference curves and budget constraints. By accepting the existence of continuous cardinal utility I would not be surprised if each approach were found to be mathematically equivalent, much the same as deciding whether to use rectilinear or spherical coordinates to determine a position in space. Following the maxim that “a picture (or diagram) is worth a thousand words,” the economics of pedagogy would naturally favor the use of indifference curves in a graphical representation.

I am sure you know that Rothbard’s objection to the indifference curve description goes well beyond the “humans don’t decide that way” statement. His first objection would be that value scales must be ordinal rather than cardinal. By itself this objection implies that an indifference-budget decomposition of the one’s value scale is impossible since the concept of “equal utility” could not exist. His second objection would be that humans value things only in discrete units of perceptible difference, and so even two supposed cardinal utility functions (and their associated indifference curve) would not possess continuous first derivatives. Hence the concept of “tangent to the indifference curve” would not have the intended meaning. The graphical representation merely provides the illusion that an optimal combination of goods is being found by mutual determination.

It should also be obvious that the apparent advantage of the graphical approach diminishes rapidly as the number of goods under consideration grows. For the general problem of N goods the indifference “curve” would become an N-dimensional hyper-surface, whereas the linear value scale approach can easily accommodate any number of goods.

The final pedagogical question becomes: does the limited advantage of displaying the substitution and income effects graphically outweigh the glossing over of the fundamental principles emphasized by the Austrian school?

Predrag April 8, 2010 at 8:04 pm

Del, yes, I am familiar with Rothbard’s objections, but I didn’t want to shift my focus in that direction. And, I agree that the question of appropriateness of different approaches is important. I think students should be introduced to these questions early on. I think honesty of the teachers about what is being taught is very important in building student interest in the subject. Unfortunately, we rarely see this happen.

Angel Martin April 8, 2010 at 5:59 pm

Predrag,
Great article. I think the Austrian position is far more realistic than the neoclassical one. You say: “The consumer, would, according to Rothbard’s framework, rank his ends in the order of diminishing marginal importance or utility.”
Yet, do humans in the real world really rank his ends in a value-scale like the one you have presented? Do those plans really exist in the minds of economic agents, or only as an abstraction, as plans that have been manifested through action? I think a level of abstraction is necessary in order to do economic theory, so maybe my question is answered by resorting to that. But realistically, I have some doubts that we humans can make such a thing as rank our ends in that precise way. There’s the question of time. With the passage of time (which is a subjective concept: “real time” as expressed by Rizzo and others) that ranking will surely change; and can change very rapidly. Also, people usually doubt on which our ends are. We only manifest our preferences through action, which undoubtedly is guided by plans, preferences and so on; but that can be hardly known precisely even by the same agents.

Well, hope not to have been too confusing here. (Please, have in mind I’m a beginner in these issues). Thanks.

Predrag April 8, 2010 at 7:59 pm

No, it’s not confusing at all. I agree with you on that.

Lucas M. Engelhardt April 8, 2010 at 6:54 pm

A nice piece. I have a few quibbles, but definitely appreciate the general story. This is definitely something that intermediate micro students should read.

Predrag April 8, 2010 at 8:05 pm

Thanks, Lucas!

Comments on this entry are closed.

Previous post:

Next post: