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Economics for Real People
An Introduction to the
Austrian School

2nd Edition
Economics for Real People
An Introduction to the
Austrian School

2nd Edition

Gene Callahan
Copyright 2002, 2004 by Gene Callahan

All rights reserved. Written permission must be secured from the publisher
to use or reproduce any part of this book, except for brief quotations in
critical reviews or articles.

Published by the Ludwig von Mises Institute, 518 West Magnolia Avenue,
Auburn, Alabama 36832-4528.

ISBN: 0-945466-41-2

Dedicated to Professor Israel Kirzner, on the occasion of
his retirement from economics.
My deepest gratitude to my wife, Elen, for her support and
forbearance during the many hours it took to complete this
Special thanks to Lew Rockwell, president of the Ludwig
von Mises Institute, for conceiving of this project, and having
enough faith in me to put it in my hands.
Thanks to Jonathan Erickson of Dr. Dobb™s Journal for per-
mission to use my Dr. Dobb™s online op-eds, “Just What Is
Superior Technology?” as the basis for Chapter 16, and “Those
Damned Bugs!” as the basis for part of Chapter 14.
Thanks to Michael Novak of the American Enterprise Insti-
tute for permission to use his phrase, “social justice, rightly
understood,” as the title for Part 4 of the book.
Thanks to Professor Mario Rizzo for kindly inviting me to
attend the NYU Colloquium on Market Institutions and Eco-
nomic Processes.
Thanks to Robert Murphy of Hillsdale College for his fre-
quent collaboration, including on two parts of this book, and for
many fruitful discussions.
Thanks to the many commentators on the book (and sections
of it as they appeared in article form), whose efforts improved
this book tremendously and drove me to greater precision
and clarity of expression. These include Walter Block (Loyola


University), Peter Boettke (George Mason University), Sam
Bostaph (University of Dallas), Colin Colenso (Shanghai,
China), Harry David (New Haven, Conn.), Brian Doherty
(Reason), Richard Ebeling (Hillsdale College), Roger Garrison
(Auburn University), Jeffrey Herbener (Grove City College),
Sanford Ikeda (SUNY Purchase), Stephan Kinsella (Houston,
Texas), Peter Lewin (University of Texas at Dallas), Stan
Liebowitz (University of Texas at Dallas), Jeanne Locklair
(Laboratory Institute of Merchandising), Marcel Popescu
(Romania), Joseph Salerno (Pace University), Jeff Scott (Wells
Fargo), Glen Tenney (Great Basin College), Jeff Tucker (Mises
Institute), Christopher Westley (Jacksonville State University),
Rich Wilcke (University of Louisville), Marco de Wit (Univer-
sity of Turku), James Yohe (University of West Florida), Sean
Callahan (my brother), and my parents, Eugene and Patricia
Any errors that remain are, of course, entirely mine.
Thanks to Pete Kavall, for teaching me what science is, and
to Chogyam Trungpu and Tarthang Tulku, for continuing

The harm done . . . was that they removed economics from
reality. The task of economics, as many [successors] of the
classical economists practiced it, was to deal not with
events as they really happened, but only with forces that
contributed in some not clearly defined manner to the
emergence of what really happened. Economics did not
actually aim at explaining the formation of market prices,
but at the description of something that together with other
factors played a certain, not clearly described role in this
process. Virtually it did not deal with real living beings, but
with a phantom, “economic man,” a creature essentially dif-
ferent from real man.
”Ludwig von Mises
The Ultimate Foundation of Economic Science

Stayin™ Alive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11



What™s Going On?
On the nature of economics . . . . . . . . . . . . . . . . . . . . . . . . 17

Alone Again, Unnaturally
On the economic circumstances of the isolated
individual . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33



As Time Goes By
On the factor of time in human action . . . . . . . . . . . . . . . 47



Let™s Stay Together
On direct exchange and the social order . . . . . . . . . . . . . . 59

Money Changes Everything
On indirect exchange and economic calculation . . . . . . . . 81

A Place Where Nothing Ever Happens
On the employment of imaginary constructs
in economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95

Butcher, Baker, Candlestick Maker
On economic roles and the theory of distribution . . . . . . 101

Make a New Plan, Stan
On the place of capital in the economy . . . . . . . . . . . . . . 121

What Goes Up, Must Come Down
On the effect of fluctuations in the money supply . . . . . 137



A World Become One
On the difficulties of the socialist commonwealth . . . . . . 157

The Third Way
On government interference in the market process . . . . . 177

Fiddling with Prices While the Market Burns
On price floors and price ceilings and other
interferences with market prices . . . . . . . . . . . . . . . . . . . 189

Times Are Hard
On the causes of the business cycle . . . . . . . . . . . . . . . . . 209

Unsafe at Any Speed
On improving the market through regulation . . . . . . . . . 237

One Man Gathers What Another Man Spills
On externalities, positive and negative . . . . . . . . . . . . . . 249

Stuck on You
On the theory of path dependence . . . . . . . . . . . . . . . . . . 259

See the Pyramids Along the Nile
On government efforts to promote industry . . . . . . . . . . . 271



Where Do We Go from Here?
On the political economy of the Austrian School . . . . . . . . . 291



A Brief History of the Austrian School . . . . . . . . . . . . . . 307

Praxeological Economics and Mathematical Economics . . 321

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
About the Author . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352

Stayin™ Alive


P point, you have heard about the Aus-
trian School of economics and are curious as to what
it is. Or you may be discouraged by the economics
you have encountered in textbooks and newspapers, and are
searching for a more realistic view of economic life. The dom-
inant school of economics, often referred to as the Neoclassi-
cal School, seems to describe people behaving in ways that
are hard to relate to the human activity we see around us
every day. The textbook humans seem robotic, rigidly obey-
ing a set of equations that “maximizes their utility” based on
a set of parameters. The equations themselves are said to
“cause” supply and demand to meet at an equilibrium price”
one that sets the quantity demanded equal to the quantity
supplied. What place do humans have in such a system of
equations? It seems difficult to relate those mathematical con-
structs to the world in which we live. How is the idea of man
as a utility equation solver relevant to an Islamic revolution,
to Mother Teresa, to Jimi Hendrix, or to your own decision to
take a vacation that you “really can™t afford,” but really need?


Yet, you feel that economics ought to be relevant to real
life. Doesn™t it deal with jobs, money, taxes, prices, and indus-
try: stuff of everyday existence? Why should the subject seem
so obscure?
The Austrian School of economics is an alternative to the
mainstream approach. It places economics on a sound, human
basis. It avoids the traps that plague most of modern econom-
ics: the assumption of selfishness as the basic human motiva-
tion, a narrow definition of rational behavior, and the overuse
of unrealistic models. This book is an attempt to introduce
you to the main ideas of the school.
The Austrian School is so-named because most of its early
members hailed from”you™ve probably guessed by now”
Austria. The Nazi occupation of that country, however, scat-
tered the practitioners. Today we can find prominent Austrian
School economists all over the world. I will use “Austrian
economist” to mean a member of the Austrian School,
whether or not the person in question ever lived in Austria.
My focus will not be on the history of the school, although
I have included an appendix with a brief overview of that his-
tory. Nor is my goal to convince professional economists of
other schools to “convert.” It is instead intended to be the
proverbial “guide for the intelligent layman.” While I have
always tried to be precise, I have tried to avoid entering into
the fine details of esoteric debates from the economics pro-
fession, which would only create a schizophrenic book.
Because of the nature of this book, it cannot explore Aus-
trian economics in the same depth as do systematic treatises
such as Murray Rothbard™s Man, Economy, and State or Lud-
wig von Mises™s Human Action. If this book succeeds in inter-
esting you in this subject, it will have done its job; I urge you
to then pick up one of these masterworks on the topic. (There
is also a bibliography at the end of the book recommending
further reading.)

But there are advantages to the approach taken by this
book. First of all, Rothbard™s and Mises™s tomes are huge: you
don™t really want to be hauling a book like that to the beach,
now, do you? Second, most people are not attempting to
become professional economists. You probably have a very
limited amount of time and effort you are willing to put into
the subject, at least until you sense of how it might benefit you
to know more. Last, neither of those great works has anything
about the hit TV show Survivor 1 in it, nor does either of them
so much as mention the actress Helena Bonham-Carter. I guar-
antee that this book will be free of both of those flaws.
Speaking of Survivor (see, you didn™t even have to wait
long before I took care of the first problem!), I™m going to ask
you to imagine a slightly different conclusion to the series. In
the original television show, the winner”the fellow who “sur-
vived” the longest”was a guy named Rich. In our alternate
universe Rich is still the winner, but, as the film crew packs
up, they decide that they are fed up with his antics. Instead of
transporting him home, they quietly slip off of the island while
Rich is getting in a last session of nude sunbathing.
Rich arises to find that he is alone. He is now facing the
most elementary human problem, how to survive, in the most

For those who don't follow what's on TV, or who might be
reading this book twenty years after its publication: Survivor was a
show where a number of contestants were placed, by a TV network,
on a desert island. Then they were presented with a series of “sur-
vival” challenges. A voting process eliminated contestants until only
the winner was left. This turned out to be a fellow named Rich. The
particular details of the show are unimportant to this book, as Rich
is merely used as an example of an isolated individual and the eco-
nomic problems he faces. (Hey, using Robinson Crusoe has become
a clich©, so I had to think of something else.)

basic of settings. What can economics say about his situation?
Is our science rooted in man™s nature, or is it just a creation of
certain social arrangements that we can change at will? If
someone isn™t concerned with becoming as wealthy as possi-
ble, or rejects consumerism, is economics still relevant to
them? These are some of the questions that this book will
attempt to answer.
We will come back to Rich in Chapter 2, but first, we will
examine the question of what, exactly, economics is.


What™s Going On?

[Economics] is universally valid and absolutely and plainly human.


W approach a science we want to know,
“What does it study?” Another way of approaching
the same issue is to ask, “What basic assumptions
does it bring to its examination of the world?” As a first step
in tackling a new subject, you usually try to gain an idea of
what it is all about. Before buying a book on biology, you
determine that you will be reading about living organisms. At
the beginning of a chemistry course, you learn that you can
expect to study the ways in which matter combines in differ-
ent forms.
Many people feel that they are generally familiar with eco-
nomics. However, if you ask around, you will find that peo-
ple have difficulty in defining the subject. “It™s the study of
money,” some might tell you. “It has to do with business,
profit and loss, and so forth,” someone else asserts. “No, it™s
about how society chooses to distribute wealth,” another per-
son argues. “Wrong! It™s the search for mathematical patterns
that describe the movement of prices,” a fourth insists. Pro-
fessor Israel Kirzner points out, in The Economic Point of


View, that even among professional economists, there are “a
series of formulations of the economic point of view that are
astounding in their variety.”
The primary reason for this confusion is that economics is
one of the youngest sciences known to man. Certainly there
has been a proliferation of new branches of existing sciences
in the several centuries since economics came to be recog-
nized as a distinct subject. But molecular biology, for exam-
ple, is a division of biology, not a brand-new science.
Economics, however, is different. The existence of a dis-
tinct science of economics can be traced back to the discov-
ery that there is a predictable regularity to the interaction of
people in society, and that this regularity emerged without
being planned by anyone.
The inkling of such regularity, standing apart from both the
mechanical regularity of the physical universe and the con-
scious plans of any specific individual, was the first emer-
gence of the idea of spontaneous order into the Western sci-
entific consciousness. Before the emergence of economics as
a science, it was simply assumed that if we found order in
things, then those things must have been put in order by
someone”God in the case of physical laws, and specific
humans in the case of man-made objects and institutions.
Earlier political philosophers proposed various schemes for
organizing human society. If the plan did not work out, the
plan™s creator generally assumed that the rulers or the citizens
had not been virtuous enough to execute his plan. It didn™t
occur to him that his plan contradicted universal rules of
human action and could not succeed no matter how virtuous
the participants were.
The increase in human freedom that began in Europe dur-
ing the Middle Ages and culminated in the Industrial Revolution
™ ? 19

exposed a tremendous gap in the existing scheme of knowl-
edge. Increasingly, Western European society was not being
explicitly ordered by the command of a ruler. One by one,
restrictions on production were falling. No longer was the
entry into trades strictly controlled by a guild. Yet somehow
there seemed to be about the right number of carpenters,
blacksmiths, masons, and so on. No longer was a royal license
necessary to enter into some line of manufacturing. And yet,
although anyone could open a brewery, the world was not
flooded with beer. Once again, the amount made seemed just
about right. Even without anyone creating a master plan for a
city™s imports, the mix of goods that showed up at the city
gates seemed roughly correct. In the nineteenth century,
French economist Fr©d©ric Bastiat remarked on the wonder of
that phenomenon by exclaiming, “Paris gets fed!” Economics
did not create that regularity, nor is it faced with the task of
proving that it exists”we see it in front of us every day. Eco-
nomics, rather, must explain how it comes about.
Many scholars contributed to the dawning realization that
economics was a new way of looking at society. The origins
of economic science stretch back earlier than is frequently
thought, certainly back to at least the fifteenth century, when
work done by the Late Scholastics at the University of Sala-
manca in Spain later prompted Joseph Schumpeter to dub
them the first economists.
Adam Smith may not have been the first economist, as he
is sometimes called. But more than any other social philosopher
he popularized the notion that human beings, left free to pur-
sue their own goals, would give rise to a social order that none
of them had consciously planned. As Smith famously put it in
The Wealth of Nations, free man acts as if “led by an invisible
hand to promote an end which was no part of his intention.”

The Austrian economist Ludwig von Mises said in his mag-
num opus, Human Action, that this discovery left people filled
stupefaction that there is another aspect from which
human action might be viewed than that of good
and bad, of fair and unfair, of just and unjust. In the
course of social events there prevails a regularity of
phenomena to which man must adjust his actions if
he wishes to succeed.

Mises described the initial difficulties in determining the
nature of economics:
In the new science everything seemed to be prob-
lematic. It was a stranger in the traditional system of
knowledge; people were perplexed and did not
know how to classify it and to assign it its proper
place. But on the other hand they were convinced
that the inclusion of economics in the catalogue of
knowledge did not require a rearrangement or
expansion of the total scheme. They considered
their catalogue system complete. If economics did
not fit into it, the fault could only rest with the
unsatisfactory treatment that the economists applied
to their problems. (Human Action)

For many, the feeling of stupefaction was soon replaced by
one of frustration. They had ideas for reforming society, and
now they discovered that the emerging science of economics
stood in their way. Economics advised these reformers that
some plans for social organization would fail regardless of
how well they were carried out, because the plans violated
basic laws of human interaction.
Stopped in their tracks by the achievements of the early
economists, some of these reformers, such as Karl Marx,
™ ? 21

attempted to invalidate the entire subject. Economists, Marx
contended, were simply describing society as they found it
under the domination of the capitalists. There are no economic
truths that apply to all men in all times and places; most specif-
ically, the laws formulated by the classical school, by writers
such as Smith, Thomas Malthus, and David Ricardo, will not
apply to those living in the future socialist utopia. In fact, said
the Marxists, these thinkers were merely apologists for the
exploitation of the masses by the wealthy few. The classical
economists were, to phrase it in the style of the Chinese Marx-
ists, running dog lackeys of the imperialist warmonger pigs.
The extent to which Marx and like-minded thinkers suc-
ceeded in their goal of undermining the foundations of eco-
nomics reflected the fragility of those foundations. The classi-
cal economists had discovered many economic truths, but they
were plagued by certain inconsistencies in their own theories,
such as their inability to construct a coherent theory of value.
(We will address this specific difficulty in more detail later.)
It was Mises, building on the work of earlier Austrian econ-
omists such as Carl Menger, who finally reconstructed eco-
nomics “upon the solid foundation of a general theory of
human action.”
For some purposes it might be important to differentiate
between the general science of human action, which Mises
called praxeology, and economics as the branch of that sci-
ence that deals with exchange. However, since the term prax-
eology has not gained widespread use, and a sharp delin-
eation of economics from the rest of praxeology is unimpor-
tant in an introductory book, I will use economics as the name
for the entire science of human action. Mises himself often
uses it in this manner: “Economics . . . is the theory of all
human action, the general science of the immutable categories

of action and of their operation under all thinkable special
conditions under which man acts” (Human Action).
What does Mises mean by “human action”? Let him tell us:
Human action is purposeful behavior. Or we may
say: Action is will put into operation and trans-
formed into an agency, is aiming at ends and goals,
is the ego™s meaningful response to stimuli and to
the conditions of its environment, is a person™s con-
scious adjustment to the state of the universe that
determines his life. (Human Action)

In a similar vein, the British philosopher Michael Oakeshott
described human action as the attempt to replace what is with
what ought to be, in the eyes of the person acting.
The wellspring of human action is dissatisfaction, or, if you
want to see the glass as half full, the idea that life might be
better than it is at present. “What is” is judged to be deficient
in some way. If we are completely satisfied with the way
things are at this moment, we have no motivation to act”any
action could only make matters worse! But as soon as we per-
ceive something in our world that we judge to be less than
satisfactory, the possibility of acting in order to remedy this sit-
uation arises.
For example, you lie on a hammock, perfectly happy with
the world, letting everything pass you by. But your idle is dis-
turbed by a buzzing sound. It occurs to you that you would
certainly feel more relaxed if this sound stopped, in other
words, you can envision circumstances that you feel ought to
be. You are experiencing the first component of human
action, dissatisfaction.
However, in order to act, dissatisfaction is not enough. First
of all, you must understand the cause of the uneasiness. Well,
™ ? 23

the noise, of course. But we cannot simply wish noises away.
We must discover what is causing the noise. In order to act,
we must understand that each cause is the effect of some other
cause. We must be able to follow a chain of cause and effect
until we reach a place where we feel our intervention, our
action, will break the chain and eliminate our dissatisfaction. We
must see a plan for moving from what is to what ought to be.
If the buzzing is from an airplane passing overhead, you
will not act. (Unless your house has an anti-aircraft gun
installed, there is nothing that you™ll be able to do about the
plane.) You must believe that your action can cause an effect
in your world. In order to act, it™s not necessary that you are
correct in your belief! Ancient man often believed that per-
forming certain rites could improve his environment, perhaps
bringing rain during a drought or causing the herds he hunted
to increase. As far as I know, those approaches did not work.
But the belief that they would was enough to lead people to
act on them.
So you look around to find the cause of the noise and see
a mosquito. Perhaps you can do something about the
buzzing”you can swat the little bugger. You are contemplat-
ing an end, that of being rid of the mosquito. You see that
achieving the end will bring you a benefit”the noise will be
gone, and you can rest undisturbed.
So, you could get up and kill the mosquito. But you had
come outside with another end in mind”just loafing around
on the hammock. You are now grappling with another com-
ponent of human action”you have to make a choice. Being
rid of the mosquito would be grand, sure”but you™ll have to
get up. And that™s a bummer. The benefit you expect to
receive from being rid of the mosquito comes at the cost of

getting up. If the benefit from your action exceeds your cost,
you will profit from the action.
Although we often use profit to refer to monetary gain, it
also has a wider sense, as in, “How does it profit a man to
gain the world but lose his soul?” We perform all of our
actions, whether buying a stock or retreating to a mountain to
meditate, with an eye to profiting in this psychic sense. As the
above quotation indicates, if we choose to lead a pious life in
poverty, it is because we expect the end result to benefit us
more than the cost of surrendering the pursuit of worldly
goods: we expect to profit from the choice.
Choices involve considering the means necessary to
achieve our ends. I wouldn™t mind being the strongest man in
the world. But if I contemplate pursuing this end, I must also
think about what I would have to do to achieve it. I would
need to have access to strength-training equipment, to buy
nutritional supplements, and I would have to spend many
hours each day in training. In our world, everything we desire
does not appear simply by wishing for it. Many things that we
want, even things that we need to stay alive, can be had only
after an expenditure of time and effort. Strength-training
equipment does not simply fall from the sky. (Thank God!)
And if I™m spending several hours a day weight lifting, I can™t
spend those hours writing a book, or playing with my kids.
For mortal man, time is the ultimate scarce item. Even for
Bill Gates, time is in short supply. Although he can afford to
charter private jets to both Aruba and Tahiti on the same
morning, he still can™t fly to both places simultaneously! To be
human is to know that our days on Earth are numbered, and
that we must choose how to use them. Because we live in a
world of scarcity, the use of means to pursue an end involves
costs. To me, the cost of spending my time weight training is
™ ? 25

determined by how much I value the other ways I could
spend that time.
For economics, the value of the particular ends we might
choose is subjective. No one else can tell me whether an hour
spent weight lifting is more or less valuable to me than one
spent writing. Nor is there any possible way to objectively
measure the difference in my valuation of these activities. No
one has invented a “value-ometer.” Expressions such as “That
dinner was twice as good as last night™s” are simply figures of
speech. They don™t imply an actual ability to measure satis-
faction. As Murray Rothbard pointed out, the way to verify this
is to ask, “Twice as much of what?” We don™t even have a unit
by which we might measure satisfaction.
The subjective nature of value was one of Carl Menger™s
major insights. For the classical economists, value was a par-
adox. They attempted to base their theory of value on the
labor involved in producing a good or the usefulness of the
good, by some objective measure. But consider such a simple
case as finding a diamond lying on the ground during a stroll.
No labor was required to produce the diamond, nor is it more
useful, at least to directly maintaining life, than a cup of water.
And yet a diamond is generally considered much more valu-
able than a cup of water. Menger cut this Gordian knot by
basing his theory of value on just that fact”things are valu-
able because acting humans consider them to be so.
Austrian economics does not attempt to decide whether
our choice of ends to pursue is wise. It does not tell us that
we are wrong if we value a certain amount of leisure more
than some amount of money. It does not view humans as
being only worried about monetary gain. There is nothing
“noneconomical” about someone giving away a fortune, or
turning down a high-paying job to become a monk.

The question of whether or not there are objective values
does not concern economics. Again, that should not be taken
to mean that Austrian economics is hostile to any religion or
system of ethics. I personally know of Austrian economists
who are Catholics, atheists, Orthodox Jews, Buddhists, Objec-
tivists, Protestants, and agnostics, and, if I only knew more
economists, I™m sure I could mention Muslims, Hindus, and so
on. Economics should, quite properly, leave comparing values
to ethics, religion, and philosophy. Economics is not a theory
of everything, but simply a theory of the consequences of
choice. In studying economics, we take human ends as an
ultimate given. People, somehow, do choose ends and do act
to pursue them. The goal of our science is to explore the
implications of these facts.
Mises said in the introduction to Human Action:
Choosing determines all human decisions. In mak-
ing his choice man chooses not only between vari-
ous material things and services. All human values
are offered for option. All ends and all means, both
material and ideal issues, the sublime and the base,
the noble and the ignoble, are ranged in a single row
and subjected to a decision which picks out one
thing and sets aside another. Nothing that men aim at
or want to avoid remains outside of this arrangement
into a unique scale of gradation and preference. The
modern theory of value widens the scientific horizon
and enlarges the field of economic studies.


O an idea what our subject is, the next ques-
tion is whether it is worth studying. Given that you™ve
picked up this book, you must have some notion that it
™ ? 27

could be useful. But if you don™t intend to become a professor
of economics, what can you gain from learning about it?
One of the benefits of studying economics is a deeper
understanding of our own situation as acting humans. For
instance, people often fail to properly account for the cost of
their choices. Once we understand that our costs are meas-
ured in terms of our foregone alternatives, we might have a
very different view of some common choices.
Let™s look at a mundane example. We all know someone
who has spent a great deal of time on some home improve-
ment project. Perhaps this person undertook the project for
sheer enjoyment. Economics will not attempt to recommend
something else that would have been more enjoyable”it is
not a self-improvement guide!
But often, the “do-it-yourselfer” will say that he is doing the
work to “save money.” “Look,” he™ll tell you, “it would have
cost me $5,000 to get my roof done professionally. I managed
to do it for only $1,000 in materials.” An economist is able to
point out that his calculation is faulty, and that he may have
acted contrary to his own purpose. He has not taken into
account the cost of his forgone opportunities. If the job took
him 100 hours, and he could have put this time in at work and
earned an additional $8,000, he has actually suffered a large
monetary loss by doing the job himself. This example turns on
dollars and cents, but in other cases, it is psychic costs that we
fail to account for properly. When a philanderer cheats on his
wife, we may wonder if he has fully considered the costs
involved. Perhaps he has, in which case economics can turn
the problem over to ethics and religion. But all too often, peo-
ple take account of the immediately visible profit from an
action and fail to account for the less visible, more distant
costs. Bastiat referred to this as the problem of what is seen

and what is not seen. He felt that it was an important task of
economics to teach us “not to judge things solely by what is
seen, but rather by what is not seen.”
Another benefit of an understanding of economics is that it
is crucial to evaluating questions of public policy. Should we
raise the minimum wage, leave it alone, or even eliminate it?
Can we lift our standard of living by protecting domestic
industries? What would be the result of privatizing Social
Security? These are all economic questions.
Some people feel that these questions should be answered
on a “practical,” case-by-case basis. They claim to disdain the
use of theory in resolving them. The English economist John
Maynard Keynes saw the error in such thinking:
The ideas of economists and political philosophers,
both when they are right and when they are wrong,
are more powerful than is commonly understood.
Indeed, the world is ruled by little else. Practical
men, who believe themselves to be quite exempt
from any intellectual influences, are usually slaves
of some defunct economist. (The General Theory of
Employment, Interest, and Money)


T that we will tackle here is how we can
best approach our science. The startling success of
physics and chemistry over the last three centuries in
mastering matter and energy has often blinded people to the
fact that this question has more than one possible answer.
But looking at some other established disciplines shows us
that this is the case. For instance, I don™t know of anyone who
™ ? 29

suggests that the right way to gain a deep understanding of
Shakespeare is to analyze the chemical composition of the
paper and ink he used to compose his plays.
We don™t expect to study geometry or logic in the same
way as the physical sciences, either. To determine that the
three angles of a triangle add up to 180 degrees, we don™t
measure thousands of real triangles. In fact, the triangle of
geometry is an idealized figure that we could not find in real-
ity. Or take the following syllogism: “All men are mortal. John
is a man. Therefore, John is mortal.” We do not have to wait
around for John to kick the bucket to see that this is true.
Should we discover that John is, in fact, immortal, we would
have found that one of our premises was false. But the syllo-
gism itself would still be valid.
We can see this more clearly when we look at a syllogism
that has no basis in reality, for instance: “All unicorns have a
single horn. If I see a unicorn in my yard today, it will have a
single horn.” The syllogism is clearly true, even though no
unicorns have ever existed, so that we could not possibly
have any empirical facts about them.
The question of why we can assert that the propositions of
geometry and logic are true has been the subject of much
philosophical and theological debate. The principles of
human action are similar in that, once we notice them, they
appear self-evidently true, without it immediately being clear
why that is so. But economics does not attempt to solve the
riddle of why we think the way we do. To economics, this fact
is an ultimate given.
All sciences have limits, determined by what may be seen
from their vantage point on the world. Physics, for all its pride
in having reached back to “the origins of the universe,” has
only succeeded in explaining one physical state of the world

in terms of an earlier one. For physics, the fact that there are
physical states is an ultimate given. This is not a failure of
physics”it is only because a subject has limits that it is a
coherent subject. The alternative is to have a single subject
named, perhaps, “Everything.” Human attempts to acquire
knowledge in this fashion have not been highly successful.
Because the subject matter of economics is human action,
and because human action proceeds by plans formulated by
humans, it is the nature of our own human mind that is our
chief exploratory tool. In this respect, economics has an
advantage over physics and chemistry. We do not understand
why matter and energy act as they do, only that they do so.
(Certainly, we can explain some facts of their behavior in
terms of more elementary facts. But however far back we take
these explanations, we will ultimately hit a point where all we
can say is, “Well, it just does behave that way.”)
But economics is different. We are all human. (At least I
don™t think Amazon.com has any extraplanetary sales yet.)
Our minds are like the minds of the economic actors (includ-
ing ourselves!) whom we hope to understand. We know, in a
basic, direct sense, what it is to choose, to suffer loss, to
achieve happiness. Our chief tool in studying economics is
our knowledge of what it is to be human, to prefer certain
outcomes to others, and to act to bring about those preferred
As an example of the centrality of the human mind to eco-
nomics, let™s examine a commonplace economic event: a real
estate closing on a piece of land. How can we understand
what has occurred?
Let us say that we choose to examine this event from the
points of view of physics and chemistry. The closing might be
many miles from the land itself. Nevertheless, we diligently set
™ ? 31

up our instruments on both the land and in the bank where the
closing is taking place. We collect all information on every atom
and every bit of energy that we are capable of gathering. We
pore over the data with the aid of the fastest supercomputers
available. Still, it is hard to imagine that we could find any-
thing tying the events at the bank to the piece of land being
Perhaps the seller has never been to the property, and the
buyer doesn™t intend to go there either. No amount of obser-
vation of the property could discover the transaction that has
occurred. What has happened is real in that it is a real idea,
believed in by the people involved. It is the meaning attached
to the closing by those participating that makes it a transaction.
Now, let us say that this land is located in an area that
undergoes rapid development. The value of the open parcel
soars. The new owner now knows that he could sell his land
for double the price at which he bought it. But where would
our intrepid physicists and chemists discover this fact? It exists
only as an idea in the mind of one or more human beings.
And yet we can™t explain the fact that the owner would turn
down an offer for one-and-a-half times his purchase price
without taking into account that idea.
The subject matter of economics is human plans and the
actions resulting from those plans. We must study the various
options which the world presents to human actors, as they
themselves interpret them. We must consider the meaning that
they attach to the ends that they seek to achieve by choosing
one of these options. The central concept of economics is the
planned actions of real human beings, and it advances by ana-
lyzing the thinking used in making those plans.
The attempt to make economics a “real” science by basing
its study on “hard, objective data,” such as physical quantities

of goods, misses the essence of the subject. It is as though we
undertook a study of biology by limiting our research to the
behavior of the subatomic particles making up organic bod-
ies. We would never even detect that we were dealing with a
living creature! All fields of study are, after all, investigating
the same world. It is only that they approach that world from
different points of view, through the use of different central
concepts, that makes them different subjects. In studying eco-
nomics, we take the thoughts and plans of acting humans as
an ultimate given, and begin our investigation there.

Alone Again, Unnaturally


W introduction by considering the situation
of Rich, from the TV show Survivor, stranded on a
desert island. Living alone, does the subject of eco-
nomics still apply to him? Furthermore, what is the point of
studying the situation of an isolated human being? Isn™t man a
social animal? And isn™t our interest in economics based on its
applicability to our real situation, where we live in interaction
with countless others?
While it is true that man is a social being, contemplating
the situation of an isolated individual is, for economics, as
necessary as isolating particles in a nuclear reactor is for
physics. It is in the conditions of an isolated individual that the
basics of economics emerge in their clearest outline, and it is
these basics that we are after. Carl Menger said in Principles
of Economics:
In what follows I have endeavored to reduce the
complex phenomena of human economic activity to
the simplest elements that can still be subjected to
accurate observation . . . [and] to investigate the
manner in which the more complex phenomena


evolve from their elements according to definite

Austrian School economists, basing economics on human
choice, are committed to methodological individualism, because
only individuals make choices. Whenever we analyze a situation
where we would colloquially say that a group has “chosen,” we
see that one or more individuals made the choice. Perhaps a
dictator chose for the whole nation, or the citizens of a town
made a choice by majority vote. However the choice came
about, it occurred first in the minds of individuals.
Indeed, when we say that an individual belongs to a group,
we mean that he is considered to be in the group, by some
individual(s). Group membership exists in human minds.
Whether a group milling about outside your door is an acci-
dental crowd or an angry mob depends on what meaning the
individuals in the crowd assign to the gathering. If, in the
minds of the individuals, they are there to violently protest
your recent decision to fill your yard with flamingos, then they
are a mob. Similarly, the group nature of a crowd in a stadium
depends on why the individuals believe they are there. We
can characterize such a group as fans of satanic rocker Mari-
lyn Manson or Christian evangelicals only based on the mean-
ing that the individuals in the group attach to the gathering.
No physical survey of the scene could yield us this informa-
tion. If, through a scheduling mix-up, Marilyn Manson arrived
at an evangelical convention, that would not make the atten-
dees Marilyn Manson fans, nor would it make Marilyn Manson
a Christian minister.
Fair enough, you may say, but why are we merely imagin-
ing Rich™s situation on the island? Couldn™t we make econom-
ics a “real,” empirical science by doing actual experiments like
, 35

physics does, rather than thought experiments? Given the
astounding success of empiricism in the physical sciences, it
is tempting to at least try this approach. We must be cautious,
however”simply because a sledgehammer does a good job
breaking up stones does not mean that it™s the right tool for
slicing tomatoes. Such experimentation is not without value”
indeed, Nobel Prize-winning economist Vernon Smith has
done important work in the area”but we cannot rely on it in
the same way we do experimentation in the physical sciences.
The first obstacle to trying to proceed along strongly empir-
ical grounds in economics is that humans act differently when
they know they are being watched. Now, many people are
familiar with the role of “the observer” in quantum mechan-
ics, where it seems that, at the level of subatomic particles,
energy, the subject matter of physics, acts differently if it is
“being observed.” (Just what this “being observed” consists of
is a matter of intense debate in interpreting quantum mechan-
ics, and is quite beyond the scope of this book.) Isn™t this the
same problem that economics faces?
But the behavior of subatomic particles varies in pre-
dictable, mathematically describable ways depending on
whether or not they are under observation. Light acts like a
wave when we don™t try to detect particles, and like a particle
when we do try to detect them, but it does this every time. It
can™t choose to ignore “the observer,” nor can it learn anything
about the experiment and then modify its behavior accord-
ingly. This is not true of people!
Humans, as experimental subjects, do attempt to learn
about the experiment, and they modify their behavior based
on what they learn. For one thing, if the person running the
experiment is liked by the subjects, they will often try to fig-
ure out what result he wants, and act to bring it about.

Merely knowing that they are in an experimental setting
modifies their behavior as well. Survivor was not a test of how
humans act when placed in a small group with minimal
resources available. Every participant knew that he or she
would be fine, as far as the TV crew was able to make it so.
They would not be allowed to starve to death, to go to war
with each other, or to suffer a severe illness without medical
assistance. Every one of them also knew that they were on
camera, competing with each other for a prize, with a definite
limit as to how long they would have to spend on the island
together. There was no incentive to cooperate beyond the
minimum necessary to avoid being tossed from the island, and
there was no incentive to try to create a lasting social struc-
Survivor could be viewed as an experiment in how humans
act when on a television show that places them in a “survival”
contest, in conditions set up by the producers. However, even
that view of the experiment is of limited usefulness, since
future contestants, participating in Survivor II, will have
learned something from the first series, and will modify their
behavior accordingly. I know of no interpretation of quantum
physics that contends that photons learn from having been
watched. They behave in the same particulate way every time
you try to detect them as particles”they don™t ever try to out-
fox the measuring device. The fact that humans learn makes
exact prediction in the social sciences impossible. It means
that we will never discover constants in human behavior
equivalent to the constants representing the speed of light in
a vacuum or the ratio of hydrogen to oxygen in water. The
effects of future learning on human behavior are by definition
unknown. We can™t already know what we have yet to learn,
because that would mean we had already learned it.
, 37

Because humans do understand the idea of an experiment
and take the fact that they are participating in one into
account, we cannot test human action in the same way we do
the behavior of photons. Instead, we must mentally isolate the
basic components of human action. Based on the fact that we
ourselves are human and employ the same logic of action as
our isolated actor, we try to understand those components.


S RICH IS alone on the island, and does not know if or
when he will be rescued. What insights can economics
bring to his situation?
First of all, Rich must choose an end for his time upon the
island. OK, he™s stuck there for now. Accepting that as his
basic condition, what should he do? To answer this question
is to choose an end. Perhaps his goal will be to survive until
he is rescued. While this end seems reasonable enough, we
must realize that other ends are possible. From the point of
view of economics, no particular end is more or less valid. (To
again stress an important point, that does not mean econom-
ics holds that any system of values is just as good as any other.
Economics simply does not attempt to address the problem of
what we should value.)
Let™s say that Rich is a devoted follower of the religion of
Jainism. It is against his religious principles to harm any living
creature. While he is able to scrape up a coconut or two, he
realizes that by passing up all of the island™s abundant rats,
which he could be roasting, he will slowly starve to death.
Yet, he lives by his principles anyway. Does this mean that

Rich ignored economics, or behaved irrationally? While some
schools of economics would say “yes,” to an Austrian econo-
mist the answer is an emphatic “no.” Rich simply pursued the
end that he valued most highly, that of adhering to his reli-
gious beliefs.
Anyway, let us imagine that Rich does choose survival as
his ultimate end. To survive, he needs water, food, shelter, and
rest. Those are the means by which he hopes to achieve his
end. However, he has no shelter built. Food is available, but
scattered around the island, taking some effort to collect.
There are springs, but with only a minimal flow of fresh water.
Since Rich must employ yet other means to acquire water,
food, shelter, and rest, they become subsidiary ends. Food is
a means toward the end of survival, but an end sought by
employing the means of rat hunting. The same good can be a
means from the vantage point of plan A and an end from the
vantage point of plan B.
So, Rich finds himself in a similar situation to all other
humans: He has some ends in mind, and limited means by
which he might achieve those ends. He must economize his
means in order to achieve the most valuable of his ends. For
instance, if he spends all his time building a shelter, he will
not have food or water.
Rich must economize his time. He also must conserve other
resources. He cannot afford to shake all of the coconuts off of
a tree in one day, only to have those he can™t eat rot. Although
he™d like to use water for cooking, if he only has enough for
drinking, then he will have to use his supply for drinking in
order to live.
How does Rich decide how he will employ his scarce
means? To do so, he has to make choices. Even after he has
, 39

chosen survival as his primary goal, he still has to choose how
to go about achieving it. And as long as Rich™s minimal needs
can be met with less than his highest possible expenditure of
energy, he also must choose how to expend that surplus
energy. Perhaps Rich is vain, and very concerned about how
he looks when he is rescued. In this case, he will spend a
great deal of his surplus time tending to his appearance. If he
is a person with a low tolerance for risk, he might spend his
time stockpiling food. If he is a scientist, he might conduct
experiments with the local flora and fauna.
Economics is unconcerned with how Rich arrives at his val-
ues. It takes as its starting point the fact that humans do value
some things more highly than others, and that their actions are
the manifestation of those values. To economics, it is an ulti-
mate given that what is valued more is chosen, and what is
valued less is forsaken. This is the very logic of human action,
and thinking beings that did not follow such logic would be
sorely puzzling to us.
Let™s say I could have taken a vacation in Athens, but I
chose Istanbul instead. It is a loose use of words to say that I
“really preferred Athens,” but nevertheless picked Istanbul.
The fact that I really did go to Istanbul is the essence of pre-
ferring. It may have been because the airfares were cheaper
to Turkey, or because my wife chose Istanbul and I didn™t
want to argue. In any case, I picked Istanbul and the associ-
ated cost of going there because I preferred that option to
Athens and the associated costs of going there.
When we say that my picking Istanbul shows I preferred it,
we do not imply that, after the fact, I might not decide I had
been wrong in my initial judgment. After the trip, I might
decide that Istanbul is not the place for me, and that I ought
to have picked Athens. We must take care to distinguish

forward-looking and backward-looking evaluations. Action
implies learning, and learning implies that sometimes, in choos-
ing A, I will discover that I really ought to have chosen B.
The notion that we always choose what we prefer may
seem too extreme. You might claim, in protest: “I prefer not
to go to the dentist, yet I go anyway.” Such a statement is fine
in common speech, but economics must be more precise. In
making your choice, you weigh the benefits of not going to
the dentist (e.g., no scraping) against the costs (e.g., tooth
decay). The fact that you do go implies that you prefer the
dentist to the alternative of rotten teeth, despite the pain
involved. What you mean, stated more precisely, is that you
wish that your teeth never decayed and dentists were unnec-
Economics is not concerned with the world of wishes and
idle fancy, except when these daydreams manifest themselves
in action. In everyday speech, we may say, while on a long
walk, “I™d prefer an iced tea when I get home.” This indicates
a plan of action. But to economics, it is action itself that
counts, and the plan only matters so far as it influences action.
Preferences, from the point of view of economics, become
real at the moment of choice. You may constantly assert that
you prefer losing weight to eating cake. But economics
ignores such assertions. It is only interested in what you do
when the dessert tray comes out.
So Rich chooses, apportioning his time. Let™s say he spends
the first four hours of every day gathering food, the next two
hours collecting water, and the next four working on a lean-
to. For the remainder of the day he relaxes.
All of the above actions have as their goal the direct
removal of some dissatisfaction. The food directly satisfies
Rich™s hunger, the water his thirst, and the lean-to his desire
, 41

to be sheltered from the wind and rain. Even his leisure time
is action, with an end in mind”relaxation. As long as Rich is
physically capable of continuing work, to stop and rest is a
We will examine the point at which Rich makes this choice,
because it illustrates the crucial insight by which Carl Menger
solved the value problem that had plagued classical econom-
ics.1 Imagine Rich tying poles together for his lean-to. He has
eaten, he has water, and the lean-to is progressing nicely.
What™s more, he™s beginning to feel a little weary.
Just when will he stop working? It will be at the point when
the satisfaction that Rich expects from the next “unit” of work
falls below the satisfaction that he expects from his first “unit”
of rest. That fact is implied by the very existence of choice.
Since, as we™ve seen, to choose means to prefer, Rich will
work as long as he prefers the gains he expects from the next
unit of work to the gains he expects from his next unit of rest.
The “unit” in question is simply whatever time intervals
Rich mentally slices his work into. The next unit might be, for
instance, tying the next set of poles together, or collecting one
more coconut. The unit will most likely be a task that, if not
finished, is not worth starting. There is no point, for instance,
in Rich picking up a coconut, but then dropping it to the
ground and going home before placing it in his bag. The
amount of “clock time” that Rich considers to be a unit will
change from one task to the next and one day to the next,

1In one of the amazing incidents of simultaneous discovery

sprinkled through the history of science, L©on Walras and William
Stanley Jevons, working independently of Menger, arrived at similar
solutions to this problem in the early 1870s as well.

even for the same task”it is subjective. What matters is the
particular task that he is contemplating as his next action at
the moment he knocks off for the day.
Rich is about to start tying some poles, when he feels a
twinge in his back. “Hmm,” he wonders, “time to rest?” He is
going to choose between the satisfaction that he believes he will
receive from binding the next set of poles and the satisfaction
he believes he will receive from a few extra minutes of rest.
Because preference is tied to a concrete act of choice among
particular means aiming at particular ends, economic choice
does not pick among abstractions. Rich doesn™t choose
between “work” and “leisure,” but between a specific amount
of a specific kind of work and a specific amount of leisure, in
the context of a specific set of circumstances.
That insight resolves the paradox of value that bedeviled
the classical economists. “Why,” they wondered, “since water
is so much more valuable than diamonds, do people pay so
much for diamonds and so little, perhaps even nothing, for
water?” The disastrous labor theory of value, which attempted
to equate value with the amount of labor that had gone into
a good, was developed in an attempt to patch over this defi-
ciency. Karl Marx based much of his economic thought on the
labor theory of value.
What the classical economists missed is that no one ever
chooses between “water” and “diamonds.” These are just
abstract classes by which we categorize the world. Indeed, no
one even chooses between “all of the water in the world” and
“all of the diamonds in the world.” When choosing, acting
man is always faced with a choice between definite quantities
of goods. He is faced with a choice between, let™s say, a bar-
rel of water and a ten-carat diamond.
, 43

“But wait,” you ask, “isn™t the water still more useful than
the diamond?” The answer is, “It depends.” It depends entirely
on the valuation of the person who must choose. If a man liv-
ing next to a clean mountain stream is offered a barrel of
water, he may not value it at all. The stream itself provides
him with more water than he can possibly use, so the value
of this extra quantity to him is literally nothing. (Perhaps it is
even negative”it might be a nuisance having the barrel
around.) But this fellow may not have any diamonds, so the
possibility of acquiring even one might be enticing. It is clear
that the man will value the diamond more than the water.
But even for the same man, if we change his circum-
stances, then his valuation may change completely. If he is
crossing the Sahara, with the diamond already in his pocket,
but he has run out of water and is on the verge of dying, most
likely he would trade the diamond for even a single cup of
water. (Of course, if he were a miser, he might still value the
diamond more highly than the water, even at the risk of dying
of thirst.) The value of goods is subjective”the exact same
diamond and barrel of water may be valued differently by dif-
ferent people, and even valued differently at different times
by the same person. To quote Menger:
Value is therefore nothing inherent in goods, no
property of them, but merely the importance that we
first attribute to the satisfaction of our needs . . . and
in consequence carry over to economic goods as the
. . . causes of the satisfaction of our needs. (Princi-
ples of Economics)

Many means can be employed toward more than one end.
Rich might put water to any of a variety of uses. He will first
direct any means with more than one use to that use he feels
is most important. That is not a fact arrived at through a survey

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