. 2
( 10)


of numerous actions, but a logical necessity. We can say that
the first use was most important to Rich precisely because he
chose to satisfy that felt need first.
As long as Rich has set his goal as survival, he will use the
first bucket of water he can collect for drinking. Only when
he is confident that he has enough water to prevent death
from thirst will he consider using some for cooking. Since
each additional bucket of water is directed to a less important
use, then for Rich, each additional bucket has a lower value
than the previously acquired buckets. The utility to Rich of
each additional bucket declines. When faced with a choice, it
is always the next item to be acquired, or the first to be given
up, that is relevant. Economists say that these are the mar-
ginal units, and refer to this principle as the law of diminish-
ing marginal utility.
The margin in question is not a physical property of the
event under consideration, nor can it be determined by objec-
tive calculations. The margin is the line between yes and no,
between choosing and setting aside. The marginal unit is the
one about which you are deciding: Will you work an extra
hour today? Should you stay at a party and have one more
drink? Will you sign up for that extra day at the hotel on your
vacation? Those are quite different questions than: “Is work-
ing a good thing?” “Are parties fun?” “Are vacations relaxing?”
What must be determined is whether the next hour of work
would provide more benefit than another hour of leisure. Is
the relaxation gained from an extra day™s vacation worth the
cost? Our choices are made at the margin, and are made in ref-
erence to the marginal unit.
When Rich begins his day, the marginal utility he expects to
gain from an hour of work is far higher than what he expects
from an hour of leisure. If he doesn™t start working, he won™t
, 45

be able to eat or drink! But each successive hour of work is
devoted to a purpose considered less important than the pur-
pose achieved by the previous hour. Finally”let™s say after
ten hours”Rich arrives at a point where the satisfaction he
expects from another hour of work has fallen below the sat-
isfaction he expects to gain from another hour of leisure. The
marginal utility of the next contemplated hour of labor has
fallen below that of the next contemplated hour of leisure,
and Rich rests.
The question of valuation is resolved at the moment of
choice. Because all action is directed toward an uncertain
future, the possibility of error is always present. Rich may feel
he has collected enough food and decide to nap for a while.
While he sleeps, a monkey steals half of his coconuts. In ret-
rospect, he may regret his decision and decide that he ought
to have collected more food or built a fence instead. Perhaps
the next time he has to make such a choice, his valuation will
be different. He has learned.
The uncertainty of the future is implied by the very exis-
tence of action. In a world where the future is known with
exacting certainty, action is not possible. If I know what is
coming and there is no possibility of altering it, there is no
point in attempting to do so. If I can act to alter the course of
future events, then the future was not certain after all!
The fact that earlier actions may be regretted later does not
invalidate the fact that people choose what they prefer, at the
moment the choice has to be made. Waking up with a hang-
over on Sunday morning, a person may regret Saturday night™s
party. Still, on Saturday night that person preferred partying to
being at home in bed.
It is true that a “fit of passion” may make certain actions
seem much more desirable than they would in a moment of

calm reflection. However, the fan at a game, so incensed by
an opposing fan™s taunts that he “had to fight him,” will still
refrain if an armed cop steps between him and his antagonist.
A married man, so enamored that “he couldn™t help himself,”
about to make a pass at a woman, will still stop should his
wife suddenly appear on the scene.
Intense emotional feelings are another factor that is
weighed when choosing. The fact that people do sometimes
resist a fit of passion shows that, even under these circum-
stances, people choose. Only, for instance, in the final stages
of inebriation before complete unconsciousness occurs, as an
infant, in senility, or after severe brain damage, are people
truly incapable of choice. But such people are not economic
actors, and economics does not attempt to describe the activ-
ity of humans under those conditions.
Even for fully conscious humans there are moments of
mere reaction. There is no plan or meaning involved when
you immediately pull your hand off of a hot stove, or when
you duck at a loud sound overhead. Economics is not a the-
ory of reaction, but of purposeful behavior. It is the ongoing
discovery of the implications of human action.

As Time Goes By


R effort to change what is into what ought to be,
may realize that his ability to acquire food and water
could be increased. Perhaps, by building a few traps, he
could have six roasted rats a day instead of four. And, he
thinks, if he had a barrel for collecting rainwater, he could use
that water for cooking, and enjoy boiled rats as an occasional
change from roasted rats. He sets about constructing those
In order to build them, Rich will have to sacrifice some-
thing else. Since his time is not unlimited, the construction of
such items has a cost: the value Rich places on what he could
have been doing instead of building traps and barrels. This is
true even if he just gives up time that would have been spent
relaxing. Having grasped the principle of marginal utility, we
can see that, whatever activity Rich puts aside to make time
for building traps and barrels, it will be the activity of which
the next unit had the lowest marginal utility, for him. (To reit-
erate, “utility” should not be taken to mean some measurable


substance. “Lowest utility” is just shorthand for “what pleases
Rich the least.”) And he will give up units of that activity only
so long as the value of additional traps and barrels is greater,
to him, than what he is giving up.
Perhaps Rich is working on traps, when he could have
been relaxing. Each trap takes an hour to build. When the
value to Rich of the next trap he could build is less than
another hour of relaxation, Rich will stop work for the day.
The marginal utility of an additional trap has fallen below the
marginal utility of an additional hour of leisure.
But where does the value of goods like traps and barrels
come from? Rich cannot eat a trap, or (comfortably) wear a
barrel. And yet it is clear that these goods do have value to
Rich, because he has decided to sacrifice other things of value
in order to acquire them.
The value of the goods we examined in Chapter 2”food,
water, shelter, rest”springs from their ability to immediately
alleviate some dissatisfaction. Rich values food because he
values life, and food helps to directly satisfy his desire to stay
alive. Although less than he values life itself, he may also
value comfort in that life. Therefore, food is also valued
because it directly satisfies the pangs of hunger. (Again, eco-
nomics does not claim that Rich should value his life more
than anything else, or that everyone does so. It does not claim
even that everyone does or should value life at all. Econom-
ics is about the consequences of the fact that we evaluate our
Upon a little reflection, we can see that the value of goods
such as traps and barrels comes from their ability to produce
goods that do directly bring satisfaction. Rich values the trap
for the rats, and the barrel for the cooking water.

Carl Menger termed goods that directly relieve some dis-
satisfaction, such as water or food, goods of the first order.
They can also be called consumer goods. Goods whose value
comes from their aid in producing goods of the first order,
such as traps and barrels, are called goods of a higher order,
producer goods, or capital goods. Note that this distinction
does not exist in the goods themselves, but in human thought
and planning. If I collect barrels as objects of art, then they
are, for me, consumer goods. If I own a grocery store, then
food items I stock are, for me, producer goods. As the Aus-
trian economist Ludwig Lachmann put it in Capital and Its
The generic concept of capital . . . has no measura-
ble counterpart among material objects; it reflects
the entrepreneurial appraisal of such objects. Beer
barrels and blast furnaces, harbour installations and
hotel-room furniture are capital not by virtue of
their physical properties but by virtue of their eco-
nomic functions.

When Rich decided to produce higher-order goods, he
began saving. Saving can be defined as the decision to guide
actions toward satisfactions more distant in time, even though
more immediate satisfactions are known to be available.
The higher-order goods that Rich accumulates through sav-
ing comprise his capital stock. At some point in time, we find
that he has five traps and two barrels. At this point there is no
way to total Rich™s capital goods other than listing the items of
which it consists. We cannot add up traps and barrels. The
value that Rich assigns to them is subjective. We don™t have
any sort of yardstick, scale, or stopwatch by which we might
measure this “quantity” of satisfaction. In fact, the value of
these capital goods is what Rich estimates to be their value for

satisfying future, uncertain needs. Even if we could stick a
“satisfaction meter” on Rich and determine how intense cer-
tain satisfactions are to him, it would not solve the problem
Rich faces at the moment of choice: He must estimate how
much satisfaction his choice will bring to “Future Rich,” whose
knowledge and tastes are unknown to “Present Rich,” and
who will be living in a world that, for Present Rich, is filled
with uncertainty.
As his effort to build traps and barrels continues, Rich may
decide that having a hammer, a saw, and some nails would be
useful. He sets about making them. Now Rich is working two
orders of goods removed from consumption. He will value the
hammer, the saw, and the nails for the aid they will provide
in constructing traps and barrels, which are valued for the
food and water they help produce. All goods of higher orders
derive their value from the goods of the next lower order that
they help create. Ultimately, any producer good is valuable
only because it finally yields one or more consumer goods.
That dependence can be illustrated by considering what
happens when Rich™s valuation of a consumer good changes.
Perhaps Rich discovers that the rats on the island are diseased,
and that eating them is harmful. Rich will no longer value the
rats. So long as there is no other use Rich can make of the
traps, they will lose their value as well. Rich will no longer be
willing to sacrifice anything to get more traps, and he will not
care about the fate of the ones he has already made. (Of
course, if he has some other use for the traps”perhaps as
kindling”they will retain some of their value.)
An interesting question arises when we begin to look at the
valuation of goods of a higher order. Let™s say that, without the
aid of traps, Rich can catch four rats a day. With his traps, he
hopes to catch eight a day. Given the productivity advantage

that trap making has over catching rats by hand, why doesn™t
Rich spend 100 percent of his working time making traps?
The first answer that pops to mind is that he will starve to
death with that work schedule. Certainly, any saving for the
future that involves cutting back current consumption below
the level needed to sustain life doesn™t make sense”unless
one is saving solely for one™s heirs! However, we can imagine
that Rich might be able to get by on only two rats a day, albeit
with some discomfort. Why doesn™t he postpone all con-
sumption beyond minimal sustenance in order to save?
All around us, every day, people consume far more than
they need to survive, therefore saving far less than they could.
Yet, we all know that saving is the road to wealth. Why don™t
top Wall Street traders live in tiny shacks, eat canned beans,
and ride old bicycles to the train station? Why do movie stars
go on mad shopping sprees and stay at fabulous vacation
resorts? Shouldn™t they live as paupers in order to save every
penny they can?
The questions should suggest the answer. There would be
something very curious about a world in which people
worked hard so that they could save for future consumption”
yet never engaged in that future consumption, because when
that future arrived, they were saving for consumption in an
even more remote future. It would be a looking-glass world,
such as the Red Queen described to Alice: jam tomorrow, and
jam yesterday, but never jam today. (In fact, there wouldn™t
have been jam yesterday, either.)
Humans can only consume in the present. It is our present
dissatisfactions that call out for relief. It is in the present that
we experience pleasure and pain. Saving in the interest of infi-
nitely postponed consumption is not saving at all”it is pure

Now we are faced with explaining the other side of the
saving question”given that we can only consume in the pres-
ent, why does anyone ever save? The answer is that, while we
cannot consume in the future, we can imagine it. We can envi-
sion that in this future, we also will feel dissatisfactions and
will want to alleviate them. In addition, we can imagine that
a high enough degree of satisfaction on some future day
might compensate us for some additional dissatisfaction
The key to understanding saving is to recognize that the
image of future dissatisfaction is itself a source of present
unease. The notion that I might find myself starving next week
is disturbing. I can alleviate the feeling by saving. However, if
I am in danger of starving to death today, eliminating my
worry about starving next week will not appear as urgent to
me as getting some food right now. The satisfaction in know-
ing that I have made provision for eating next week is mini-
mal compared to the dissatisfaction of knowing that I™ll be
dead by dinnertime. Likewise, the imagining of future satis-
faction is itself a source of present satisfaction. The swimmer
training to win an Olympic gold medal keeps herself going by
imagining how magnificent she will feel when she touches the
wall first. If we could not bring a sense of these future pains
and pleasures into our present deliberations, we would have
no way of orienting our actions toward that future.
The extent to which an individual will save is explained by
his time preference, meaning the degree to which he prefers a
present satisfaction to the same satisfaction in the future. With
time preference we are again dealing with a subjective factor.
The degree of time preference will differ from person to per-
son, and, for the same person, will differ from one moment to
the next. A person™s time preference at thirty might be lower
than the same person™s time preference at eighty. At thirty, he

may be quite willing to hold off on that trip to the Alps in
order to save for a house for his new family, whereas at eighty
he is much more likely to think, “Hey, I™d better get over there
now!” However, that does not imply that there is some “func-
tion” that “determines” time preference as one ages. The
opposite progression of time preference could just as well
occur: At thirty, one might think of nothing but “living for the
moment,” while at eighty, one™s entire focus is on building up
the grandchildren™s trust funds.
Those are some of the psychological factors influencing
time preference. But time preference itself is implied by the
existence of human action, quite aside from any psychologi-
cal influences. If we didn™t prefer, all other things being equal,
the same satisfaction sooner rather than later, we would never
act. Inert existence would be sufficient for us. For any given
satisfaction, we wouldn™t care whether it arrived tomorrow or
took all of eternity to come around. As Mises said in Human
We must conceive that a man who does not prefer
satisfaction within a nearer period of the future to
that in a remoter period would never achieve con-
sumption and enjoyment at all.

There is no economic sense in which we can say that one
degree of time preference is better than another. Therefore,
from an economic point of view, there is no “correct” level of
saving. Some people may want to “live for the moment,”
whereas others save with the idea of starting a perpetually
endowed foundation. Economics cannot say that one of them
is right and the other wrong. It can, however, clarify the con-
ditions under which an individual will choose to save, and
point out some consequences of those circumstances.

We are now in a position to examine Rich™s decision to
save with more precision. Let™s say that Rich must sacrifice
one rat a day of present consumption for one week to gain
the time to build one trap. In addition, we™ll suppose that he
expects the trap to last for one week, during which time he
will catch 14 more rats than without the trap. Roughly speak-
ing, we can say that he must sacrifice seven rats now to gain
fourteen a week from now. His rate of return on this invest-
ment is 100 percent per week.
If Rich chooses to go ahead and produce the traps, we can
say that he values one rat available now less than two avail-
able a week from now. A 100-percent weekly rate of return
was sufficient to persuade him to exchange present for future
consumption. If he does not make the traps, we know that he
values one present rat more than two future rats. A 100-per-
cent rate of return was not sufficient to persuade him to trade
present for future rats. We will return to this topic in Chapter
7 and Chapter 8, when we examine the rate of interest in a
market economy.
It is important to note that Rich™s valuation depends on his
circumstances. If he were to suddenly find a crate of canned
sardines and crackers left behind by the TV crew, his decision
might be altered significantly. Recall that, per the law of mar-
ginal utility, each succeeding unit of a good is considered less
valuable to an individual than the previous unit. I might pay
$50 to buy one cat, but by the time I had 300 I™d be paying to
get rid of them.
Therefore, well stocked with food for present consump-
tion, Rich would be much more likely to forgo catching a rat
today in order to build capital goods that promise a greater
supply of food in the future. The additional rat today would
have less value to him than it had before he found the crate,

since the sardines and crackers satisfy the same physical need
as the rat”and probably taste better, too.
That must not be taken to indicate some universal rule
such as “the rich will save more than the poor.” There are no
constant laws that determine what valuation a particular per-
son will place on future satisfactions as opposed to present
ones. We have all heard stories of some little old lady who has
worked as a secretary her whole life, for a moderate wage, liv-
ing in modest circumstances. Upon her death, her friends are
shocked to discover that she had amassed a fortune in stocks
and bonds. Equally familiar are the stories of the profligate
rich, who squander a fortune in riotous living.
The law of marginal utility applies to savings as well as to
consumption. Each additional dollar saved will have less
value, to the saver, than the previous dollar did. You can eas-
ily relate that to your own circumstances. If you have $50 in
the bank, the chance to put away another $50 will seem much
more important to you than if you have $50 million in the
Even in this extremely simple economy, Rich™s capital
goods have a structure. We imagined that he made a hammer,
nails, and a saw. The hammer and nails have a noteworthy
relationship”they are complementary goods. Without the
hammer, there is nothing with which to drive the nails, and
without the nails, there is nothing for the hammer to drive.
Every day we deal with goods that are useless without other,
complementary goods: a portable radio and batteries, an
amplifier and some speakers, a lamp and a light bulb. In every
one of these cases, such goods lose some or all of their value
without the complementary good available. If some inventor
develops a way to use shower mold as a cheap, plentiful
source of lighting, and manufacturers cease to produce light

bulbs, existing electric lights will have value only as nostalgia
That could be termed the horizontal structure of capital. We
have already introduced the vertical structure: capital can be
arranged into goods of the second order, which are used to
produce consumer goods, and goods of the third order, which
are used to produce goods of the second order, and so on.
Rich™s economy has not, so far, passed beyond producing
goods of the third order, but it is easy to see how our princi-
ple extends through as many orders of goods as people
The value of a capital good is related to its position in the
capital structure. A good of a higher order will lose its value
if all goods of lower orders that it can be used to produce lose
their value. If Rich no longer had a use for traps or barrels,
and he could not think of anything else to build with a ham-
mer and nails, then the hammer and nails would also lose
their value to him. As we noted above, ultimately, all capital
goods only have value due to their finally yielding some con-
sumer good.
The importance of capital structure increases tremendously
as we begin to examine more complex economies. Capital
structure will be crucial to our examination of socialism. But
it is here, in the most primitive of economies, that we can see
such basic economic concepts most clearly”which is why, as
I mentioned, that we bother looking at such an economy at
all. But to proceed further, we must complicate our picture”
first, by adding more people to Rich™s isolated world.


Let™s Stay Together


R out the details of his solitary economy
and has a somewhat comfortable existence. Then, one
day he is walking along the beach, and who should he
see approaching him but . . . Helena Bonham-Carter. (Stranded,
perhaps, during the filming of the latest Merchant-Ivory pro-
His solitude broken, what does Rich decide to do? More
generally, what factors would lead man to choose between an
isolated existence and life in society?
One possibility is that Rich might react like a bear does
when another bear enters its territory. He could, through the
threat of or actual use of force, attempt to drive the intruder
away. Now, he might refrain from doing so due to moral con-
straints or benevolent feelings. But there is another reason for
him not to drive Helena off”as long as there are sufficient
unused resources on the island, it will materially benefit both
of them to cooperate rather than fight. They can initiate the
vastly enriching processes of the division of labor and volun-
tary exchange.


Adam Smith pointed out the enormous increases in mate-
rial production that came about through the division of labor.
The example with which Smith opens The Wealth of Nations
is pin manufacturing. A lone workman could “scarce, perhaps,
with his utmost industry, make one pin in a day.” But even
225 years ago, when Smith was writing, a small pin shop,
dividing the manufacture into eighteen distinct tasks, allowed
a ten-man shop to produce 48,000 pins in a day, or 4,800 per
The division of labor produces greater material output for
three reasons. The first is that people live in parts of the world
that differ from each other in many respects. Someone living
in Florida is in much better circumstances to grow oranges
than I am in New England. On the other hand, I™m in a better
position to produce maple syrup.
The second benefit of the division of labor is that not
everyone comes to the table with the same capabilities. A
book on economics is not the place to attempt to resolve the
nature/nurture debate, so we will simply say that, for what-
ever reasons, people enter the labor market with different
aptitudes. I™m five feet nine inches tall and have trouble jump-
ing over the Sunday New York Times, so I™m hardly suitable,
even with “the right training,” to fill in for Kobe Bryant should
he need some time off from playing basketball.
Training is, however, the third benefit. The division of labor
allows people to focus their efforts on building up certain
skills and to ignore a vast array of other skills that are unnec-
essary to their jobs. The people who design personal com-
puters usually have little knowledge of the aspects of the sys-
tem for which they are not responsible. At the lowest levels of
the system, chip designers employ their knowledge of quan-
tum physics to achieve higher-speed components. Several
™ 61

levels above that, operating system programmers use their
knowledge of the logical structure of the machine to create
efficient code for writing disk files and displaying graphics.
Another several levels of abstraction up, we find user-interface
designers who specialize in creating a “look-and-feel” for a
program that allows ease of learning and of use. None of
these workers could accomplish their tasks if they also had to
concern themselves with all of the other levels of the system.
And lest you think that it is only an extremely complex device
like a PC for which this is true, I recommend Leonard Read™s
famous essay, “I, Pencil,” where he demonstrates that no indi-
vidual in the world is capable of creating something as simple
as a pencil on his own.
Some of the critics of modern industrial society bemoan
just that specialization. People, they complain, become nar-
row-minded, mere cogs in a machine, and find their work
boring and repetitive under a system of ever increasing divi-
sion of labor. Economics cannot answer such complaints. As
I™ve pointed out, it doesn™t attempt to recommend one set of
values over another. It can™t say that those who chose a more
interesting and varied life over greater material prosperity
have chosen badly. However, economics can inform anyone
who wishes to impose such a choice on all of society that
without the division of labor the Earth could support only a
tiny fraction of its current population. Perhaps those who sur-
vive the transition period will find their world more satisfac-
tory than ours, but the billions who die during the transition
might be forgiven for dissenting.
Smith recognized these various advantages of the division
of labor, but left unsolved an interesting problem, which arose
in discussions of international trade. The solution has impli-
cations far beyond that field, however, and it is worth our time
to examine the problem.

Smith pointed out that it made no sense, for example, for
Scotland to try to manufacture wine, although through the use
of greenhouses it undoubtedly could do so. If Scotland pro-
duces wool and Spain makes wine, and the citizens of the two
countries trade for the goods not available from domestic
industry, both countries™ inhabitants will be better off. But
what of the case where one country, perhaps due to geo-
graphical disadvantage and an uneducated populace, is worse
at producing everything than some other country is? Shouldn™t
the more backward nation erect trade barriers, allowing
domestic industry to develop? How can it possibly offer the
more advanced nation anything in trade?
The answer to this problem is Ricardo™s law of comparative
advantage, named after English economist David Ricardo.
Although the initial application of the law was to trade, it is a
universal law applying to all human cooperation. Because of
the broad applicability of the law, Mises felt it was better
named the law of association. In fact, it is easiest to under-
stand this law at a personal level, after which its implications
for trade become clear.
Let™s use as an example a great athlete: Michael Jordan. Jor-
dan™s physical skills are truly extraordinary. There is little
doubt that should he choose to apply them to, for instance,
house painting, that he could be one of the best house
painters in the world.
Yet it™s doubtful that Jordan paints his own house.
Although he could probably, with a little practice, do so far
better than anyone he can hire, he still finds someone else to
paint it for him. How can we explain that fact?
The law of comparative advantage is the answer. Although
Jordan is better than his painter at both basketball and house
painting, Jordan has a comparative advantage in basketball,
™ 63

while his painter has a comparative advantage in house paint-
ing. It™s easiest to comprehend that arithmetically, by using
wage rates as a basis for the comparison.
Let™s say that Jordan can hire a house painter for $20 per
hour. With a little practice, Jordan could be twice as efficient
a painter as the man he has hired. We will imagine that he
could market his own house-painting services for $40 per
However, by playing basketball, we will suppose that Jor-
dan can earn $10,000 per hour. Meanwhile, Joe, his painter,
who can hardly sink a free throw, couldn™t make more than $1
an hour playing basketball. (Perhaps some people will find his
play amusing!) Jordan has a 2-to-1 advantage as a house
painter, but a 10,000-to-1 advantage as a hoop star.
Perhaps Jordan plans on working twenty hours in a partic-
ular week. If he divides his time equally between painting his
own house and playing basketball, his total output for the
week can be valued at:

10 hours painting x $40 per hour = $400
10 hours basketball x $10,000 per hour = $100,000
Total output: $100,400

If Joe divides his time the same way we could value his
production as follows:

10 hours painting x $20 per hour = $200
10 hours basketball x $1 per hour = $10
Total output: $210

Between them, Michael and Joe have produced $100,610
worth of output. Now let™s examine the situation if, as we

expect, Jordan hires Joe. Jordan™s production can now be val-
ued at:

20 hours basketball x $10,000 per hour = $200,000
Total output: $200,000

And Joe™s at:

20 hours painting x $20 per hour = $400
Total output: $400

Their total output has risen to $200,400. But, more impor-
tantly for an understanding of the law of association, both of
them are better off, at least in dollar terms. The painter, who
was worse at both jobs, was still able to nearly double the
value of his output by concentrating on painting, in which he
had a comparative advantage, then by exchanging with Jor-
dan. The law of association demonstrates that, even putting
aside moral considerations, it is to everyone™s material advan-
tage to cooperate through the division of labor and voluntary
exchange. It is the basis of the extended social order.
The application of this law to international trade is a
straightforward extension of our analysis above. Even if a
country is worse at producing everything than is some other
country, it can still net a material gain by specializing in the
areas where it has a comparative advantage and trading for
other goods. It is only in the obviously unrealistic scenario
where everyone is exactly the “same amount” better or worse
than everyone else at every job that the law of association
would find no application.
This law only shows that a material gain is available
through specialization. It doesn™t take into account any per-
sonal preferences other than material gain. It could well be
™ 65

the case that Jordan simply loves house painting, and would
not for the world consider hiring someone else to paint for
him, harking back to our discussion in Chapter 1 of the per-
son who decides to do his own roofing. If people believe they
are saving money doing their own home repairs, they are
often mistaken. However, if they love doing the work, per-
haps finding it a nice break from their regular job, they may
be getting a psychic profit that outweighs their monetary loss.


L the beach, and the fateful meeting of Rich
and Helena. Each of them realizes that his or her prospects
for survival will be enhanced if they can develop a sys-
tem of cooperative effort. Rather than producing for a general
demand, Rich and Helena will find it best to agree in advance
on a particular division of labor. Yet the basic principles of
exchange will still apply to them. Following Carl Menger™s
directive to “reduce the complex phenomena of human eco-
nomic activity to the simplest elements,” we will first attempt
to comprehend exchange in a simple setting, such as our lit-
tle island economy.
Given that they have decided to cooperate, our two cast-
aways next must decide how to cooperate. They come to an
agreement that Rich, the more dexterous of the two, will make
traps, while Helena, the more cunning, will do the hunting.
Still, what is the best amount of each activity for them to per-
form? How can each of them be sure that he or she is getting
a fair deal from the other?
Simply relying on goodwill does not work. The history of
the Soviet Union illustrates the problems inherent in separating

the performance of labor from the self-interest of the laborer.
But even if the Soviet Union had succeeded in creating the
New Socialist Man, only interested in the well-being of his fel-
lows, there would have remained an insurmountable obstacle
to efficient production. How can these altruistic fellows know
exactly what should be produced, in what quantities, and
employing what resources? I might spend my time creating
finger paintings, in the belief that these will produce tremen-
dous happiness for those around me. But if no one else likes
them, I™ve not only wasted my time, I™ve also wasted the
resources”paper, pigment, and so on”that went into the
paintings. In the interest of pleasing those around me, I™ve
actually caused them to suffer a loss in satisfaction, even
compared to a situation in which I had merely loafed around.
The same holds true even if folks love my paintings but are
deeply unhappy that I™ve given up writing to indulge my artis-
tic ambitions. In the balance, and given available resources,
people want my writing more than they want my art. Absent
a market price system, there is no way for consumers to
inform producers of their relative values.
The route past that difficulty is interpersonal exchange. To
ensure that they are actually benefiting each other, Rich and
Helena must recognize that the other has a right to the goods
he or she has acquired through his or her own efforts. As a
corollary to that recognition, the exchanges they make must be
voluntary. For every so many rats that Helena captures and
gives to him, Rich agrees to trade a certain number of traps. If
Helena threatens Rich with a club to get rats, we can bet the
exchange is benefiting, in their own view, only one of them.
The law of diminishing marginal utility explains the
exchange ratio that they will work out. Rich will trade traps
for rats until the cost, as subjectively perceived by him, of
™ 67

producing one more trap exceeds the benefit, again as he
subjectively perceives it, of the number of rats Helena will
give him for that next trap. On the other side of the trade,
Helena will trade rats until the subjective cost of the next rat
she must give up exceeds the benefit she expects from hav-
ing one more trap. The next trap that Rich considers trading
and the next rat that Helena considers trading are the marginal
units. It is the perceived benefits and costs of those units that
determine the exchange ratio.
Let™s imagine what is likely to happen in our island™s rat
and trap market. We begin with no rats caught and no traps
made. At that point, the value to Rich of the first rat with
which Helena can provide him is relatively high”after all, he
may starve to death without it. Similarly, the value to Helena
of the first trap is large. The first trap will increase her catch
tremendously, as she can use that one on the most popular rat
trail on the island.
We™ll postulate that Rich is willing to give up his first trap
for as few as three rats, while Helena is willing to trade as
many as five rats to acquire that trap. We™ll assume that they
meet in the middle, and trade one trap for four rats.
The value to our traders of each succeeding unit acquired
will be lower than that of the first one. As Rich™s supply of rats
increases, he will use each new rat in a way that is less impor-
tant to him than the previous rat. Once he has had his fill for
the day, he may begin to smoke the critters to preserve them
for later. But he will not consider it as important that he have
smoked rats as he considers it to have the rats that will keep
him from starvation. And on the other side of the trade, Helena
won™t consider the second trap as valuable as the first”after all,
she can only deploy it on the second most-frequented trail.

Each trap thereafter will be put to a use that she considers less
important than the previous trap.
Similarly, each additional item given up by one of our
traders will be more valuable to him or her than the previous
unit surrendered. That is because they will first give up what
are the least important uses, in their own valuation. It is not
the traps or rats that are different when we consider subse-
quent trades: it is the fact that acting humans will first give up
the least valued use of the good in question, then the next
least valued, and so on. Each additional trap Rich builds
requires him to sacrifice additional leisure time. With each sac-
rifice, his remaining amount of leisure is smaller. The initial
units he gives up were nice to have, but soon he is cutting
into rest he needs to stay healthy.
Therefore, after the first trade has been made and Rich has
four rats, he is no longer as desperate for them. Similarly, hav-
ing one trap, the next trap Helena could acquire will be less
valuable to her. Let™s imagine our traders™ value scales for trad-
ing rats and traps are these:

Rich Helena

1st trap < 3 rats 5 rats < 1st trap
2nd trap < 4 rats 4 rats < 2nd trap
3rd trap < 5 rats 3 rats < 3rd trap

We™re assuming that Rich will require at least four rats for
giving up a second trap (up from three for the first one), while
Helena will give up at most four rats (down from five). Even
though the value of the next units they can acquire has gone
™ 69

down for both Rich and Helena, they still have a trade from
which each of them can profit. They will make the second
trade, exchanging four more rats for a trap.
However, our traders™ valuations do not support a third
exchange. Helena is only willing to trade three rats for a third
trap, while Rich will not trade the third trap unless he gets at
least five more rats. Trading will cease in this market. It has
reached what we will call the plain state of rest (examined fur-
ther in Chapter 6).
It is important to note that the fact that an exchange took
place does not mean that the values of the goods traded were
equivalent to the two participants. It is only the fact that they
valued the goods in question differently that caused them to
trade at all. Helena valued the two traps more than she val-
ued eight rats, while Rich valued eight rats more than he val-
ued two traps.
Carl Menger pointed out that to regard an exchange as
occurring at a point of equal valuation leads to absurdities. If
two people exchange when they consider the value of what
they are getting to be equal to the value of what they are giv-
ing up, there is no reason that they shouldn™t simply reverse
the trade a moment later. If you sell your house for $200,000,
then you valued $200,000 more highly than you did your
house. Conversely, the buyer valued your house more highly
than he did $200,000. Otherwise (ignoring transaction costs),
there is no reason that, as soon as the exchange is made, you
wouldn™t immediately take the house back and give up the
$200,000. In fact, if the exchange took place at a point of equal
valuation, there is no reason you and the other party shouldn™t
swap the house back and forth any number of times.

However, if we contemplate exchange from the point of
view of human action, we see that people do not exchange
simply to have the pleasure of contemplating goods changing
hands. Exchange does not arise from a “propensity to trade.”
In order for an exchange to take place, both parties must feel
that they will be better off after the exchange. That is the pre-
requisite for all action”the actor must feel that the action will
improve his state of satisfaction when compared to not acting.
He is attempting to move from what is to what ought to be.
The above sheds light on a phrase that is in common use
when discussing exchange. Who hasn™t heard someone say,
after purchasing some item, that the price he paid for it was a
“rip-off”? Let™s set aside the case where the speaker was
deceived as to the quality or nature of the good”that is fraud,
and really is a “rip-off.” We™ll take the good in question to be
something of known and consistent quality”say, bottled,
brand name beer. At work Monday morning, your friend says,
“We went to a ball game over the weekend. Paid five dollars
for a beer”what a rip-off!”
What does he mean? As long as he wasn™t tricked or forced
into buying the beer, and he really did go through with the
purchase, he valued the beer more highly than the five dollars.
Otherwise, why would he have gone ahead and bought it? If
his five dollars meant more to him than the beer, all he had to
do was put it back in his pocket and walk away. Given that
your friend voluntarily gave up something he valued less than
the beer, the vendor might make the exact same complaint”
he was ripped-off as well! What your friend really means is, “I
wish the beer had been cheaper.” However, we all wish to give
up less in order to gain more, in other words, to increase our
profit. That is the universal basis of all human action. As we try
to improve our own condition, we have no reason to expect
that others, such as the vendor, are not doing the same.
™ 71


A our human actors have no way to employ eco-
nomic calculation in our little economy. Rich and Helena
can compare specific quantities of specific goods and
decide which bundle of goods they find more valuable. They
can™t, however, calculate how much they profited or lost in
any exchange, either before or after the fact. We can say that
Rich preferred eight rats to two traps, but there is no way to
answer the question “How much did he prefer it?” The pref-
erence is something he feels. There is no measuring rod we
can dip into his psyche to determine the “size” of that feeling.
Certainly, he may perceive some satisfactions as more desir-
able than others. But, as we have pointed out, a phrase such
as “I like that trap twice as much as the other” is simply a fig-
ure of speech. If someone tries to take it literally, we ask Roth-
bard™s question: “Twice as much of what?”
Trying to calculate in terms of rats and traps will not work
either. There is no arithmetical meaning to expressions such
as “eight rats minus two traps,” or “one trap plus three rats.”
The attempt to use labor as the common unit of value, as
did Marx and the British classical economists, doesn™t succeed.
The cost of Rich™s labor is his subjective evaluation of what he
had to give up in order to perform the work in question. The
value to Helena of Rich™s labor is her subjective valuation of
the fruits of his efforts. To attempt to calculate profit and loss
in terms of the ticking of a clock or the expenditure of energy
is to miss entirely the economic aspect of what is occurring.
Rich might expend just as much time and effort grinding exist-
ing traps into sawdust as building new traps, but, in our sce-
nario, Helena certainly will not pay him to grind up traps! The
fact that creating traps is valuable and destroying them isn™t

depends entirely on the valuation of those involved in
exchanging them, and can™t be determined by physical meas-
urement. In fact, we can easily imagine a situation where the
exact same physical activities have their valuations reversed.
If our castaways found themselves in a situation where the
rats had been hunted to extinction, but the island was littered
with useless traps, building traps would have no value, while
destroying them, in order to tidy up, would have value.
The lack of economic calculation does not hamper our lit-
tle economy significantly. Only two people are trading all
goods. Since a trader is the creator of his own value scale, he
only has to get a sense of his partner™s values in order to trade
sensibly. But as an economy grows larger the absence of cal-
culation will become a roadblock.


fast-forward the history of our island”let™s
christen it “Richland””economy. We will move forward
several generations. (We can imagine that Rich and
Helena found yet another way to cooperate for their mutual
benefit.) For some strange reason, the island has remained
isolated from the global economy. But the population has
grown, a village has been built, fields tilled, shops opened,
and professions begun. A flourishing trade exists among the
The basics of exchange have not altered from our two-per-
son economy. The addition of other people who might want
to exchange complicates our picture, but does not alter it in
any basic respect. It will behoove us to take a little time and
™ 73

study the multiperson situation, in order to be prepared for
the further complications to come.
We™ll imagine that goats were domesticated on the island,
and that the cultivation of corn is now practiced. We have two
goat herders, Kyle and Stephen, and two corn farmers, Emma
and Rachel. For people living in a modern economy, there is
an inherent difficulty in studying such a situation”we are not
used to dealing with exchanges where goats and corn are
traded directly for each other. Since we haven™t yet brought
money into the picture, we must think of the price of goats as
their price in terms of corn, and the price of corn as its price
in terms of goats. This type of exchange is called barter, or
direct exchange. It takes some getting used to, but it is worth
the effort in order to gain a better comprehension of how mar-
ket prices are established.
Let us imagine that Rachel will pay up to four bushels of
corn for her first goat, up to three for her second, and as many
as two for her third. Emma will pay up to three bushels for
her first goat, up to two for her second, and no more than one
for her third.
On the other side of the market, Kyle will accept as few as
two bushels of corn for his first goat, as few as three for his
second, and as few as four for his third. Stephen will accept
as few as three bushels of corn for his first goat, as few as four
for his second, and as few as five for his third. So, we have:

Kyle Rachel

1st goat < 2 bushels 4 bushels < 1st goat
2nd goat < 3 bushels 3 bushels < 2nd goat
3rd goat < 4 bushels 2 bushels < 3rd goat

Stephen Emma

1st goat < 3 bushels 3 bushels < 1st goat
2nd goat < 4 bushels 2 bushels < 2nd goat
3rd goat < 5 bushels 1 bushel < 3rd goat

We can picture the market progressing as follows: First,
Rachel trades three bushels of corn for Kyle™s first goat
offered”clearly, as Rachel prefers to surrender up to four
bushels for that goat, and Kyle will accept as few as two, the
trade is mutually beneficial. In this “round” of trading, another
trade also takes place: Emma trades three bushels of corn for
Stephen™s first goat offered.
Now, the possibility of another round of trading is consid-
ered. Emma will pay at most two more bushels for another
goat. But neither Kyle nor Stephen is prepared to supply a
goat at that price”Kyle demands at least three bushels for the
next goat, while Stephen demands four.
Similarly, Stephen will supply another goat for a minimum
of four bushels, but no one in the market is willing to bid four
bushels for that second goat”Rachel will bid at most three,
while Emma will bid at most two.
Therefore, Emma and Stephen drop out of the market. But
Rachel and Kyle have one more mutually profitable trade to
make”the trade where Kyle gives up his second goat for
three more bushels of corn, and Rachel gives up three more
bushels for a second goat.
In this scenario, Kyle™s goat-demand for corn is greater than
Stephen™s”perhaps Stephen really loves goat meat, and so is
more reluctant to give up goats. Kyle sells a second goat for
only three bushels of corn, while Stephen would have sold a
™ 75

second goat only if he could have gotten at least four bushels.
Similarly, Rachel™s demand for goats is greater than Emma™s”
she pays three bushels of corn for her second goat, while
Emma would only pay two bushels.
In any market, it is the buyers such as Kyle and Rachel”
called the most capable buyers”who will acquire more of the
goods in question. Because, for whatever reason, those buy-
ers are willing to pay more, they will use this willingness to
outbid the less capable buyers. Similarly, the most capable sell-
ers, those who are the most anxious to move the goods they
are selling, will move more of their stock than the less capa-
ble sellers.
It is the very nature of human action, the desire to improve
our situation as much as possible, that propels the market
process. Traders will exchange as long as they feel their trades
are improving their situation, and no longer.
The principles of human action only guarantee that people
will attempt to find all profitable exchanges. There may be
trades available where the cost of finding the trading partner
is simply too high, and would turn what otherwise might have
been a profitable trade into a losing trade. There are other
cases where potential traders simply fail to discover one
another. Just over the next hill, there might be a corn farmer
who would pay four bushels for a goat, if only he knew that
goats were available. The market process does not guarantee
that all traders who might be able to make profitable
exchanges will always discover one another. But the human
drive to better our circumstances implies that people will
always be on the lookout for such opportunities. The search
for potential profit opportunities that are not being taken
advantage of is the role of the entrepreneur, which we will
discuss at length in Chapter 7.

So the goat-corn market will establish a price of three
bushels of corn per goat. At that price, Emma™s demand is for
one goat, and Rachel™s is for two. From the perspective of the
corn buyers, the market price is one-third goat per bushel. At
that price, Kyle demands six bushels and Stephen demands
three bushels. The market process will tend to establish a
price that clears the market: all sellers willing to sell at the
market price will be able to do so, and all buyers willing to
buy at that price will also be able to do so. At the market
price, Stephen and Kyle between them attempt to sell three
goats, while Emma and Rachel, between them, attempt to buy
three goats. And Emma and Rachel will attempt to sell nine
bushels of corn, while Stephen and Kyle will attempt to buy
nine bushels.
If these dynamics of supply and demand change, the mar-
ket process will adjust the price to the new realities. Let™s say
that Stephen and Kyle get sick of eating corn. What™s more, a
farmer down the road has started growing squash, which they
can eat instead. Their demand for corn will drop, and they
will not be willing to offer as much goat per bushel as
before”they find it better to spend some of their goats on
squash. If Emma and Rachel still want goats, they will have to
bid more for them. A new market price will emerge”let™s say,
four bushels per goat”and the market will clear at that new
price. If Emma™s and Rachel™s value scales have not changed,
then Rachel will buy one goat for four bushels, and Emma will
not buy any. No one had to decree a higher price for goats in
order to bring one about.
It is this seemingly magical property of markets that led
Adam Smith to speak of the “invisible hand” guiding market
participants. Without any central authority directing them,
their own plans and desires tend to create a situation in which
all those exchanges take place that both parties believe will
™ 77

benefit them. (As we have mentioned, human action, directed
toward an uncertain future, always contains the possibility of
error. After the fact, any trader might decide that he or she had
made a mistake.)
Because market exchange is voluntary, it allows every par-
ticipant to express the urgency with which he demands partic-
ular goods. It allows humans to cope with the scarcity of means
through cooperation, rather than through violence and plunder.
Scarcity is a necessary condition of something being an
economic good. Air is not scarce, and, therefore, it is free, and
outside the scope of economics. We must not take “scarce” in
an absolute sense, but instead consider scarcity relative to
demand. There are few videotapes of me rapping”only one
that I™m aware of”but they are not scarce in the economic
sense, as the supply of one is infinitely greater than the
demand of zero. No price will be paid for such a tape, or at
least no price greater than the going rate for used tapes sold
for retaping.
In the above scenario, Stephen would have been happy to
buy more bushels of corn, if the price were lower. If corn
were so abundant that it littered the ground everywhere in
Richland, Stephen might use far more than the three bushels
he actually purchased. But, given that corn is scarce, the mar-
ket process sends it to whoever demands it most urgently.
Kyle, for whatever reason”perhaps he likes corn more than
Stephen does, or he has a plan for a new food product made
from corn, which he feels will be a big hit”is willing to pay
more for corn than is Stephen. Because of this, he acquires six
bushels while Stephen only acquires three.
The demand we are speaking of is effective demand. In
order to take part in voluntary exchange, we must offer oth-
ers something that they value”we have to bring something to

the table. Demand at the point of a knife and demand that is
simply a wish for some good are altogether different from
demand in the market.
Although we will take up the topic of intervention in the
market process in Part 3 it will be instructive now to see if the
Richland town council could improve upon the market out-
come. Let™s say that the goat lobby persuades the council that
the corn price of goats is too low and is hampering the goat
industry. The council passes a law setting the price of goats at
four bushels of corn. The goat lobby is thrilled”now their
profits will soar! Stephen, who was only willing to sell one
goat at the previous price of three bushels, now is willing to
sell two for four bushels. Kyle, who was only willing to sell
two goats at the previous price, now is willing to sell three.
But if we consider Emma™s and Rachel™s demand for goats,
we see that the goat herders will be sorely disappointed,
because at the new, higher price, they will only want one
goat! Rachel, who in an unhampered market would have
bought two goats, only values the first goat more than four
bushels of corn. Emma, who would have bought one goat in
the unhampered market, now will not buy any. Kyle and
Stephen bring five goats to market, planning on “cleaning up,”
but instead go back home with four. There is now a glut of
goats and a shortage of corn: gluts and shortages are the result
of price-fixing.
In the regulated market, we can™t even be sure whether
Stephen or Kyle will get the corn. Although Kyle demands
corn more urgently than does Stephen, the new regulation
prevents him from outbidding Stephen. What™s more, in the
unhampered market there would be three exchanges, each of
which both sides consider to be beneficial. In the regulated
market only one exchange will take place. Although there is no
™ 79

way to calculate how much worse off the market participants
are in our regulated market than they would have been in the
unhampered market, we can use understanding to surmise
that they are worse off.


P words from the arenas of games and
war to describe the market. We hear that international
competition will result in some nations being “win-
ners” and others “losers.” We read a headline that some com-
pany has “crushed” its competition, or that the U.S. is at “eco-
nomic war” with Japan or OPEC.
Employed as loose metaphors, such terms are useful. But
the analogy does not extend very far. The key difference
between a game and the market process is that, in the market,
all participants gain from voluntary exchange. Kyle, Stephen,
Rachel, and Emma were all better off after completing their
trades than they had been beforehand.
Imagine that you and I open competing software compa-
nies. Over time, it becomes apparent that consumers prefer
your product. I close my business down, and you wind up hir-
ing me as your lead programmer. Now, in one sense, I lost
and you won. But in a much more important sense, everyone
won. I now have a role in fulfilling the needs of the con-
sumers to which I am better suited than previously, you have
a new lead programmer, and the consumers have a better soft-
ware company. This stands in sharp contrast to sports, where
the winner gets a “1” in the standings, the loser a “0,” and
everyone goes home. It is also very different from war, where

the winners may do what they want with the losers, including
annihilate them.
To take the metaphors of games and war too literally in
describing the market process is a misapprehension of its
nature. Market competition is different than sports and war in
crucial ways. It doesn™t exist to pick “winners” and “losers”: it
exists to allow everyone to find a place in the scheme of pro-
duction in which they can best satisfy the wishes of consumers.
It is just as mistaken to view international markets as pit-
ting one nation against another as it is to view the domestic
market as pitting employees against employers, or producers
against consumers. In a market economy, whether it is domes-
tic or international in scope, everyone™s standard of living can
rise at once. America has not lost if Japan or China should
become wealthier than the U.S. An increase in the standard of
living anywhere benefits all people who are economically
integrated with the area in question.
The discovery of the law of association was a great
achievement of the classical economists. It points the way
toward social harmony, showing that the powerful and the
weak have a better way to relate to each other than through
exploitation. The nature of the market as a network of volun-
tary exchanges means that each participant must feel he is
benefiting from a trade, or he would not enter into it.
With the basics of multiperson exchange under our belts,
we can move on to economic calculation, and the tool that
made it possible”money.

Money Changes Everything



A RICHLAND economy includes markets with
several buyers and several sellers of the same good, it is
hampered in two important ways. As we saw in the pre-
vious chapter, anyone who wants goats and grows corn must
find someone who wants corn and has goats. But it will not
always be easy to find someone who has the good you want
and wants the good you have. A great deal of time will be
spent looking for someone with whom to trade. And during
that time you need to keep feeding the goat, or keep the corn
from spoiling.
Second, although there are now a couple of hundred Rich-
landers, and their economy is growing more complex, they
still have no means of economic calculation. A tradesman, let™s
call him Marco, who is making fishing equipment, cannot use
a set of books to see whether his business is profitable or not.
All his books could record would be various quantities of
incommensurable goods. He might have, on the expense side
of his ledger, 1,000 fishhooks, 4 nets, and 20 fishing poles. On
the income side, he might have 4 hammers, 20 pounds of iron,


2 chairs, and 10 cords of wood. He has no way of determining
whether the net of these transactions yielded a profit. Is he
doing well enough that his operation will sustain itself and
keep him supplied, not only with a livelihood, but also with
the capital goods he needs to continue in business? What™s
more, he can™t say whether there was some other combination
of capital goods he should have purchased instead. Is he bet-
ter or worse off than if he had eight hammers, ten pounds of
iron, three chairs, and fourteen cords of wood? In order to
engage in accounting, as we know it, Marco needs a common
unit in which to enter these items in his books. In the Rich-
land barter economy, the best he can do is to use his intuition
as to whether he™s “doing OK” or not.
But humans are ingenious in their attempts to improve
their condition. In a barter market, some perceptive trader will
notice that certain goods are more marketable than others.
Let™s imagine that Richland has plenty of good grazing areas
for goats and that most residents keep a small herd. Marco has
fishhooks and wants corn. While he cannot find a corn farmer
who wants his fishhooks, he is able to locate a fisherman who
will trade him goats for fishhooks. Now, goats in tow, he is
able to find a corn farmer who is happy to acquire a few extra
goats. Marco has been able to exploit a profitable opportunity
that was not open to him through direct exchange. Employ-
ing indirect exchange, he acquired a good more marketable
than the one he originally had to sell, and used that good to
acquire the good he really wanted.
In a society unfamiliar with this practice, we can expect
that it will be adopted only gradually. At first, only the clever-
est traders will employ it. But others will notice their success
and begin to employ the same technique. Over time the most
marketable commodity comes to be used as a medium of


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