The Austrian Economics Wiki - User contributions [en]

Inflation

2010-12-27T21:56:51Z

Jmorris84: /* Limits */

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'''Inflation''' is a general increase in the [[money]] supply.<ref name="Hazlitt_inflation">Henry Hazlitt. [http://mises.org/story/2914 "What You Should Know About Inflation"], ''[[Mises Institute]]'', referenced 2009-06-07.</ref><ref name="Shostak_inflation">Frank Shostak. [http://mises.org/story/908 "Defining Inflation"], ''[[Mises Institute]]'', posted on 2002-06-03, referenced 2009-05-26.</ref>

One of the effects, that may accompany inflation (and is sometimes confused for it) is a rise in [[price]]s. A similar, but opposite effect in kind is [[deflation]].

{{See also|Inflations}}

==Definitions==
There are several ways to define inflation, with varying usefulness and ability to explain the phenomenon.

===Increase in money supply===
[[Price]]s do not stay constant, they are always rising and declining. An increase in the [[money supply]] - inflation, properly defined - has a tendency to raise them in general.<ref name="Rothbard_inflation">Murray N. Rothbard. [http://mises.org/rothbard/mes/chap12f.asp "11. Binary Intervention: Inflation and Business Cycles"], Chapter 12—The Economics of Violent Intervention in the Market, ''[[Man, Economy and State]]'', online version, referenced 2009-05-26.</ref>

<blockquote>When the supply of money is increased, people have more money to offer for goods. If the supply of goods does not increase — or does not increase as much as the supply of money — then the prices of goods will go up. Each individual dollar becomes less valuable because there are more dollars. Therefore more of them will be offered against, say, a pair of shoes or a hundred bushels of wheat than before. A "price" is an exchange ratio between a dollar and a unit of goods. When people have more dollars, they value each dollar less. Goods then rise in price, not because goods are scarcer than before, but because dollars are more abundant.<ref name="Hazlitt_inflation" /></blockquote>

An increased stock of [[commodity]] money will raise the standard of living by further satisfying nonmonetary demands for the commodity. New paper money does not demonstrably benefit some without injuring others.<ref name="Rothbard_inflation" />

===Overly large increase in money supply===
This has been a popular definition in the past. A large increase in the money supply would have the accompanying effects - like price increases. However, it is not clear how large exactly an increase has to be, making it a judgment call.<ref name="Goods">Ludwig von Mises. [http://mises.org/humanaction/chap17sec6.asp "Inflation and Deflation; Inflationism and Deflationism"], ''Chapter XVII. Indirect exchange'', [[Wikipedia:Human Action|Human Action]] online edition, referenced 2009-04-27.</ref>

===Unbacked money===
According to [[Murray N. Rothbard|Rothbard]], '''inflation''' is the process of issuing [[money]] beyond any increase in the stock of specie. In other words, new money substitutes are issued without backing of their specie. The great gain comes from the issuer’s putting new money into circulation. The profit is practically costless, because, while all other people must either sell goods and services and buy or mine gold, the government or the commercial banks are literally creating money out of thin air. They do not have to buy it. Any profit from the use of this magical money is clear gain to the issuers.<ref name="Rothbard_inflation" />

===Rising prices===
In a popular definition, '''inflation''' is an ongoing rise in the general level of prices.<ref name="White_inflation">Lawrence H. White. [http://www.econlib.org/library/Enc/Inflation.html "Inflation"], ''[[Wikipedia:Concise Encyclopedia of Economics|The Concise Encyclopedia of Economics]]'', referenced 2009-05-26.</ref>

However, this fails to explain why inflation is dangerous or exactly how does it cause its effects. "Why should a general rise in prices weaken real [[economic growth]]? Or how does inflation lead to the misallocation of resources? Moreover, if inflation is just a rise in prices, surely it is possible to offset its effects by adjusting everybody's incomes in the economy in accordance with this general price increase."<ref name="Shostak_inflation">Frank Shostak. [http://mises.org/story/908 "Defining Inflation"], ''[[Mises Institute]]'', posted on 2002-06-03, referenced 2009-05-26.</ref>

It is sometimes claimed, that a specific price increase - e.g. of oil - can increase all prices on average. But if people must spend more on oil, will not prices drop for the goods that they can no longer afford to purchase?<ref name="Casey_rising_prices">Christopher P. Casey. [http://mises.org/story/3482 "Only Criminals Use Honest Money"], ''[[Mises Institute]]'', posted on 2009-06-03, referenced 2009-06-3.</ref> (It is also impossible to establish an average of prices of different goods and services.<ref name="Shostak_inflation" />)

It is contended that the increase in commodity prices often occurs ''before'' the increase in the [[money supply]]. Immediately after the outbreak of war in Korea, strategic raw materials began to go up in price on the fear that they were going to be scarce. Speculators and manufacturers began to buy them to hold for profit or protective inventories. But to do this they had to borrow more money from the banks. The rise in prices was accompanied by an equally marked rise in bank loans and deposits. If these increased loans had not been made, and new money had not been issued against the loans, the rise in prices could not have been sustained. The price rise was made possible, in short, only by an increased supply of money.<ref name="Hazlitt_inflation" />

===Historical development of the definition===
The term "inflation" as defined by the [[British Currency School]] was used strictly to denote an increase in the supply of money that consisted in the creation of currency and bank deposits unbacked by gold. It became accepted in the English-speaking world from the mid-nineteenth century.

However, because the writers of the British Currency School neglected to consider bank deposits as part of the money supply, their policies as adopted in Great Britain failed to prevent inflation and the [[business cycle]]. The School’s doctrines and policies fell into profound disrepute by the late nineteenth century, and its definition of inflation was replaced by that of the opposing [[British Banking School|Banking School]], which saw inflation as a state in which the money supply exceeds the needs of trade. From there it was a short step to the currently prevailing definition of inflation as an increase in the price level.<ref name="Salerno_inflation_history">Joseph T. Salerno. [http://www.thefreemanonline.org/featured/money-and-gold-in-the-1920s-and-1930s-an-austrian-view/ "Money and Gold in the 1920s and 1930s: An Austrian View"], ''The Freeman'', Volume: 49, Issue: 10, October 1999. Referenced 2010-08-11.</ref>

==The process of inflation==
Historically, governments have often inflated by debasing [[coin]]s, but they found it is cheaper and faster by creating paper [[money]] on a printing press.

In the present is the method usually more indirect. As an example from the US, the government will sell its bonds or other 'IOUs' to the [[bank]]s. In payment, the banks create "deposits" on their books against which the government can draw. A bank in turn may sell its government IOUs to the [[Federal Reserve Bank]], which pays for them either by creating a deposit credit or having more Federal Reserve notes printed and paying them out. This is how money is manufactured.<ref name="Hazlitt_inflation" />

The value of money varies for basically the same reasons as the value of any commodity. Just as the value of a bushel of wheat depends not only on the total present supply of wheat but on the expected future supply and on the quality of the wheat, so the value of a dollar depends on a similar variety of considerations. The value of money, like the value of goods, is not determined by merely mechanical or physical relationships, but primarily by psychological factors which may often be complicated.

The value of a unit of money does not depend only on the present supply of money outstanding. It depends also on the expected future supply of dollars. If most people fear, for example, that the supply of dollars is going to be even greater a year from now than at present, then the present value of the dollar (as measured by its purchasing power) will be lower than the present quantity of dollars would otherwise warrant.<ref name="Hazlitt_inflation" />

===Limits===
If the government of a country is running a printing press, it may seem like a source of infinite wealth. But there are pragmatic limits on how much new money can be printed up each year. The more monetary inflation they sow, the greater the [[price]] inflation they will reap.

At some point, a government would actually make itself poorer in the long run by running the printing press too heavily in the present. For example, if the stock of money would be doubled in one year, the resulting price inflation could destabilize the economy and cause much needless [[capital]] consumption. The citizens would be less willing to invest in their businesses and retirement portfolios, knowing that their savings might be effectively confiscateed again through massive creation of new money. Foreign investors would be also wary of exposing themselves to this country if its fiat currency is too volatile.

Because of these considerations, the government would no doubt print new money every year, but wouldn't overdo it. He would aim for a moderate level of constant price inflation, with the purchasing power of his fiat currency slowly falling over time in a predictable manner. Each year, the new influx of money into the economy would represent a transfer of wealth from all other currency holders into the government's possession. If the government wants to spend more money than it receives via its taxes and new money from the printing press (inflation), it can still resort to old-fashioned borrowing.<ref name="Murphy_Limits">Robert P. Murphy. [http://mises.org/daily/4029 "The Fed as Giant Counterfeiter"], Mises Daily, February 01 2010, referenced 2010-02-02.</ref>

==Effects of inflation==
{{See also|For and against paper money}}

===Profit of money creators===
Increases in the money supply initiate an exchange of something for nothing. They divert real funding away from those, that generate wealth towards the holders of the newly created money. The general increases in prices, which follow, are a symptom of the erosion of money's purchasing power.<ref name="Shostak_inflation" />

===Rising prices===
The increase in the money supply will create a new level of [[price]]s, but it will not be the old level of prices, multiplied in all relations and quantities.

New money will change the spending habits of people. Also, some of them will make gains and losses and will alter their spending habits accordingly. Therefore, all prices will not increase uniformly. Some prices will rise more than others, therefore, some people will be permanent gainers, and some permanent losers, from the inflation.<ref name="Rothbard_inflation" />

==Further misconceptions==

===Velocity of money===
It is frequently said that the value of money depends not merely on its quantity but on the "velocity of circulation." Increased "velocity of circulation," however, is not a cause of a further fall in the value of the dollar; it is itself one of the consequences of the fear that the value of the dollar is going to fall (or, to put it the other way round, of the belief that the price of goods is going to rise). It is this belief that makes people more eager to exchange dollars for goods. The emphasis by some writers on "velocity of circulation" is just another example of the error of substituting dubious mechanical for real psychological reasons.<ref name="Hazlitt_inflation" />

''See also [http://www.mises.org/story/918 Is Velocity Like Magic?] by Frank Shostak.''

===Shortage of goods===
A rise in prices can be caused either by an increase in the quantity of money (inflation) or by a shortage of goods — or partly by both. Wheat, for example, may rise in price either because there is an increase in the supply of money or a failure of the wheat crop. But we seldom find, even in conditions of total war, a general rise of prices caused by a general shortage of goods. Even in the [[Wikipedia:Inflation in the Weimar Republic|Germany of 1923]], after prices had soared hundreds of billions of times, high officials and millions of Germans were blaming the whole thing on a general "shortage of goods" — at the very moment when foreigners were coming in and buying German goods with gold or their own currencies at prices lower than those of equivalent goods at home. Similarly, the rise of prices in the United States since 1939 was attributed to a "shortage of goods", while official statistics have shown a rising industrial production.

Nor is a better explanation to say that the rise in prices in wartime is caused by a shortage in civilian goods. Even to the extent that civilian goods were really short in time of war, the shortage would not cause any substantial rise in prices if taxes took away as large a percentage of civilian income as rearmament took away of civilian goods.<ref name="Hazlitt_inflation" />

===Rising commodity prices===
According to some economists<ref name="Bernanke_commodities">Chairman Ben S. Bernanke. [http://www.federalreserve.gov/newsevents/speech/bernanke20080609a.htm "Outstanding Issues in the Analysis of Inflation"], quote: "Inflation has remained high, largely reflecting sharp increases in the prices of globally traded commodities". Speech, At the Federal Reserve Bank of Boston’s 53rd Annual Economic Conference, Chatham, Massachusetts, June 9, 2008. Referenced 2010-06-22.</ref>, increases in commodity prices such as oil can be behind strong increases in the [[price]]s of goods and services.

If the price of oil goes up, and if people continue to use the same amount of oil as before, people will be forced to allocate more money to oil. If people's money stock remains unchanged, less money is available for other goods and services, all other things being equal. This of course implies that the average price of other goods and services must come down. (The term "average" is used here in conceptual form. We are well aware that such an average cannot be computed.)

Note that the overall money spent on goods doesn't change; only the composition of spending has altered, with more on oil and less on other goods. Hence the average price of goods or money per unit of good remains unchanged.

Likewise, the rate of increase in the prices of goods and services in general is going to be constrained by the rate of growth of money supply, all other things being equal, and not by the rate of growth of the price of oil.

It is not possible for increases in the price of oil to set in motion a general increase in the prices of goods and services without corresponding support from the money supply.<ref name="Shostak_commodities">Frank Shostak. [http://mises.org/daily/3018 "Commodity Prices and Inflation: What's the Connection?"], Mises Daily, July 2008, referenced 2010-06-22.</ref>

===Budget deficits===
A budget deficit is inflationary only to the extent that it causes an increase in the money supply. If it is fully financed by the sale of government bonds paid for out of real savings, it does not need to cause any inflation.

Inflation can occur even with a budget surplus if there is an increase in the money supply notwithstanding.<ref name="Hazlitt_inflation" />

===Wage price spiral===
Sometimes it is spoken of so-called "inflationary pressures" — particularly the so-called "wage price spiral."

If it were not preceded, accompanied, or quickly followed by an increase in the supply of money, an increase in wages above the "equilibrium level" would not cause inflation; it would merely cause unemployment. And an increase in prices without an increase of cash in people's pockets would merely cause a falling off in sales. Wage and price rises, in brief, are usually a consequence of inflation. They can cause it only to the extent that they force an increase in the money supply.<ref name="Hazlitt_inflation" />

==Inflation compared to counterfeiting==
Why is counterfeiting so bad if the government itself prints money? Suppose that Joe Doakes and his merry men have invented a perfect counterfeit. What would happen? In the first place, the aggregate money supply of the country would increase by the amount counterfeited; equally important, the new money will appear first in the hands of the counterfeiters themselves. Counterfeiting, in short, involves a twofold process: (1) increasing the total supply of money, thereby driving up the prices of goods and services and driving down the purchasing power of the money-unit; and (2) changing the distribution of income and wealth, by putting disproportionately more money into the hands of the counterfeiters.

[[Wikipedia:David Hume|David Hume]], in order to demonstrate the inflationary and non-productive effect of paper money, in effect postulated what Rothbard called the "Angel Gabriel" model, in which the Angel, after hearing pleas for more money, magically doubled each person's stock of money overnight. (In this case, the Angel Gabriel would be the "counterfeiter," albeit for benevolent motives.) While everyone would be happy from their seeming doubling of monetary wealth, society would in no way be better off: there would be no increase in capital or productivity or supply of goods. As people rushed out and spent the new money, the only impact would be an approximate doubling of all prices, and the purchasing power of the money would be cut in half, with no social benefit being conferred. An increase of money can only dilute the effectiveness of each unit of money.

In real life, the very point of counterfeiting is to constitute a process of transmitting new money from one pocket to another. Whether counterfeiting is in the form of making brass or plastic coins that simulate gold, or of printing paper money to look like that of the government, counterfeiting is always a process in which the counterfeiter gets the new money first.

In short, the early receivers of the new money in this market chain of events gain at the expense of those who receive the money toward the end of the chain, and still worse losers are the people (e.g., those on fixed incomes such as annuities, interest, or pensions) who never receive the new money at all. Monetary inflation, then, acts as a hidden "tax" by which the early receivers expropriate (gain at the expense of) the late receivers. As the earliest receiver of the new money is the counterfeiter's gain is the greatest. This [[tax]] is particularly insidious because it is hidden, few people understand the processes of money and banking, and because it is all too easy to blame the rising prices, or "price inflation/' caused by the monetary inflation on greedy capitalists, speculators, wild-spending consumers, or whatever social group is the easiest to denigrate. Obviously, too, it is to the interest of the counterfeiters to distract attention from their own role by denouncing any and all other groups and institutions as responsible for the price inflation.<ref name="Rothbard_counterfeiting">[[Murray N. Rothbard]]. [http://mises.org/books/fed.pdf The Case Against the Fed] (pdf), The Genesis of Money, p.12-15, referenced 2010-03-18.</ref>

==References==
{{Reflist}}

==External links==
* Wikipedia page on [[Wikipedia:Inflation|Inflation]]
* [http://www.econlib.org/library/Enc/Inflation.html Inflation] from The Concise Encyclopedia of Economics
* [http://mises.org/books/inflation.pdf What You Should Know About Inflation] (pdf), [[Henry Hazlitt]]
* [http://www.mises.org/story/2340 The Revolutionary War and the Destruction of the Continental] by Thomas E. Woods, Jr.
* [http://mises.org/books/inflationinfrance.pdf Fiat Money Inflation in France] (pdf) by Andrew Dickson White
* [http://libertarianpapers.org/articles/2009/lp-1-43.pdf The Definition of Inflation According to Mises: Implications for the Debate on Free Banking] (pdf) by Nicolás Cachanosky
* [http://mises.org/daily/3909 The Non-Mystery of Inflation] by Mark Spangler
* [http://mises.org/daily/4431 "Deficit Financing" and Inflation] by Ludwig von Mises and Bettina Bien Greaves
* [http://mises.org/books/inflation_primer_palyi.pdf An Inflation Primer] (pdf) by Melchior Palyi, 1962
* [http://mises.org/daily/3729 Gold vs Paper] by Ludwig von Mises, orig. published in July 1953
* [http://mises.org/daily/4654 How the Stock Market and Economy Really Work] by Kel Kelly, September 2010

[[Category:Money]]

Joseph Salerno

2010-12-27T21:44:33Z

Jmorris84:

'''Joseph T. Salerno''' is an [[Austrian School]] economist in the [[United States]]. He is a professor at [[Pace University]], an editor of the [[Quarterly Journal of Austrian Economics]], and Academic Vice President of the [[Mises Institute]]. Salerno is particularly active in [[banking]], [[monetary theory]], [[comparative economics]], and the history of economic thought.

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{{DEFAULTSORT:Salerno, Joseph}}
[[Category:Economists]]

List of libertarian websites

2010-12-27T18:54:42Z

Jmorris84: /* English */

List of websites that deal with libertarianism, sorted by language.
== English ==
* Mises Institute www.mises.org
* The Independent Institute [http://www.independent.org/ www.independent.org]

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Cost

2010-12-27T18:46:40Z

Jmorris84: /* Transaction costs */

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In [[action]], a less desirable condition is bartered for a more desirable. That which is abandoned is the [[price]] paid for the attainment of the end sought - and the value of the price paid are '''costs'''.<ref name="Mises_profit">Ludwig von Mises. [http://mises.org/humanaction/chap4sec4.asp "4. Action as an Exchange"], ''[[Human Action]]'', online edition, Chapter IV. A first analysis of the category of Action, [[Mises Institute]]. Referenced 2009-05-14}.</ref>

==Opportunity cost==
The '''opportunity cost''', when performing an action, is defined as the next best alternative foregone. In other words, it is what an actor has to give up to get something else.

===Introductory Example===
As an example, suppose Amy, an economic actor, wishes to purchase a chocolate bar. Her preferences are ordered as follows:

#Crunchie Bar
#Mars Bar
#Snickers

Should Amy choose to purchase a Crunchie bar, she gives up her second highest preference, the Mars Bar. Assuming these bars are priced equally, the opportunity cost of her decision to purchase the Crunchie Bar is the Mars Bar.

===Opportunity cost and trade===
''See also: [[Comparative advantage]]''

For example, Amy can produce either one hundred oranges or ten tires in a day while Chen can produce ten oranges or two tires in a day. It doesn't look like they have anything to gain by trading: Amy is much more productive than Chen.

But compare their opportunity costs. To produce one hundred oranges, Amy gives up the opportunity to produce ten tires. Her opportunity cost of an orange is one tenth of a tire, and her opportunity cost of a tire is ten oranges. Chen's opportunity cost of an orange is one fifth of a tire, and her opportunity cost of a tire is five oranges.

In terms of tires, it is cheaper for Amy to produce oranges because she only gives up one tenth of a tire to produce an orange while Chen has to give up one fifth of a tire. In terms of oranges, it is cheaper for Chen to produce tires because he only gives up five oranges to produce a tire while Amy gives up ten oranges to produce a tire.

They can both have more oranges and more tires if they specialize and [[trade]]. Chen can offer Amy one tire in exchange for seven oranges. Chen would be better off because he would get seven oranges in exchange for one tire, while he would only get five oranges for one tire if he produced them himself. But this is attractive for Amy too, because she can get a tire for only seven oranges, which is fewer than the ten oranges she would have to give up if she produced tires herself. At any "orange price" of tires between five and ten, Amy and Chen are both better off.

The same logic is valid for countries - countries are also better off if they can specialize and trade.<ref name="Caden_Opportunity">Art Caden. [http://mises.org/story/3744 "Tire Trade Tirade"], Mises Daily, posted on Monday, October 12, 2009. Referenced 2009-10-13.</ref>

==Subjectivity of costs==
'''Costs''' are by nature subjective and not objectively measurable by an outside observer. An essential feature of [[Austrian School|Austrian economic theory]], unlike the [[Neoclassical economics|neoclassical theory]], is that cost is directly related to the act of choice. A summary of the implications follows:
# Most importantly, cost must be borne exclusively by the decision-maker; it is not possible for cost to be shifted to or imposed on others.
# Cost is subjective; it exists in the mind of the decision-maker and nowhere else.
# Cost is based on anticipations; it is necessarily a forward-looking or ex ante concept.
# Cost can never be realized because of the fact of choice itself: that which is given up cannot be enjoyed.
# Cost cannot be measured by someone other than the decision-maker because there is no way that subjective experience can be directly observed.
# Finally, cost can be dated at the moment of decision or choice.

Therefore, there can never be objectively measurable [[Wikipedia:Externality|external benefits]]. Costs (or benefits) are subjective and are inseparably tied to the act of choice. That is, an individual not involved in the economic decision or choice can never objectively measure another individual's costs (or benefits). Thus no statement about either the size or the very existence of external benefits can ever be falsified, and cannot be an argument for government [[intervention]].<ref name="Brownstein_Pareto">Barry P. Brownstein. [http://mises.org/journals/jls/4_1/4_1_6.pdf "Pareto Optimality, External Benefits and Public Goods: A Subjectivist Approach"] (pdf), Journal of Libertarian Studies, Vol. IV. No.1 (Winter 1980). Referenced 2010-05-27.</ref>

==Transaction costs==
Consider the classic example of the beekeeper adjacent to an apple orchard. The benefits accruing to the apple orchard from the beekeeper's production (pollination) are not considered by the beekeeper in determining his [[profit]] maximizing output level. Therefore, from the point of view of the apple grower the beekeeper is "underproducing." Many economists would agree that, since the costs of reaching an agreement are relatively small, this two-person case is not a problem for the government. The apple grower can simply bribe the beekeeper an amount up to the size of his perceived external benefits and thus induce the beekeeper to increase production.

As the number of beekeepers and apple growers increases, the costs of reaching an agreement on the size of the payment from the apple growers to
the beekeepers increase. If the '''transaction costs''' remain less than the possible gains from trading, an agreement will be reached. If, on the other hand, the transaction costs exceed the benefits from any trade, an agreement will not be reached. Under these circumstances many economists argue that the market has "failed" and that government intervention is therefore necessary. However, to argue for the government subsidization of the beekeepers is to ignore the fact that transaction costs are real costs which must be considered when making a trade. In the real world, when collective action does not take place, all that one can conclude is that the benefits of such action are smaller than the costs involved. In no way does this imply that the market has failed.

The existence of transaction costs explains why certain trades do not take place in the market. Asserting that the [[trade]] should have taken place is equivalent to stating that transaction costs are not real costs and somehow should not have been considered by the parties involved.

As an example, all of us have wished many times in our lives that we could be instantaneously transported to our destination, be it for work or recreation. Many times the existence of transportation costs (time and money) has led to a decision to stay at home. However, the existence of transportation costs explains why people make certain decisions, and by no means can be used as an argument for government intervention on the grounds of high transportation costs. That is, it would be incorrect to argue that resource allocation is not optimal because of the existence of these transportation costs. On the contrary, any subsidy payments would alter the pattern of resource allocation, making one course of action seem cheaper than it formerly did.<ref name="Brownstein_Pareto" />

==References==
{{Reflist}}

==External links==
* [[Wikipedia:Cost|Cost]] on Wikipedia
* [http://mises.org/journals/scholar/Thornton8.pdf Richard Cantillon and the Discovery of Opportunity Cost] (pdf) Mark Thornton
* [http://mises.org/journals/rae/pdf/RAE3_1_9.pdf Subjective Cost Revisited] (pdf), by William Barnett II
* [http://libertarianpapers.org/articles/2009/lp-1-39.pdf Austrian Economics and the transaction cost approach to the firm] by Nicolai J. Foss and Peter G. Klein
* [http://www.econlib.org/library/Buchanan/buchCv6c0.html#Preface Cost and Choice: An Inquiry in Economic Theory], Preface, by Buchanan, James M., 1969
* [http://mises.org/daily/4901 What's Cost Got to Do with It?] by Joseph T. Salerno, December 2010
[[Category:Economic concepts]]

Cost

2010-12-27T18:41:56Z

Jmorris84: /* Subjectivity of costs */

{{Stub}}

In [[action]], a less desirable condition is bartered for a more desirable. That which is abandoned is the [[price]] paid for the attainment of the end sought - and the value of the price paid are '''costs'''.<ref name="Mises_profit">Ludwig von Mises. [http://mises.org/humanaction/chap4sec4.asp "4. Action as an Exchange"], ''[[Human Action]]'', online edition, Chapter IV. A first analysis of the category of Action, [[Mises Institute]]. Referenced 2009-05-14}.</ref>

==Opportunity cost==
The '''opportunity cost''', when performing an action, is defined as the next best alternative foregone. In other words, it is what an actor has to give up to get something else.

===Introductory Example===
As an example, suppose Amy, an economic actor, wishes to purchase a chocolate bar. Her preferences are ordered as follows:

#Crunchie Bar
#Mars Bar
#Snickers

Should Amy choose to purchase a Crunchie bar, she gives up her second highest preference, the Mars Bar. Assuming these bars are priced equally, the opportunity cost of her decision to purchase the Crunchie Bar is the Mars Bar.

===Opportunity cost and trade===
''See also: [[Comparative advantage]]''

For example, Amy can produce either one hundred oranges or ten tires in a day while Chen can produce ten oranges or two tires in a day. It doesn't look like they have anything to gain by trading: Amy is much more productive than Chen.

But compare their opportunity costs. To produce one hundred oranges, Amy gives up the opportunity to produce ten tires. Her opportunity cost of an orange is one tenth of a tire, and her opportunity cost of a tire is ten oranges. Chen's opportunity cost of an orange is one fifth of a tire, and her opportunity cost of a tire is five oranges.

In terms of tires, it is cheaper for Amy to produce oranges because she only gives up one tenth of a tire to produce an orange while Chen has to give up one fifth of a tire. In terms of oranges, it is cheaper for Chen to produce tires because he only gives up five oranges to produce a tire while Amy gives up ten oranges to produce a tire.

They can both have more oranges and more tires if they specialize and [[trade]]. Chen can offer Amy one tire in exchange for seven oranges. Chen would be better off because he would get seven oranges in exchange for one tire, while he would only get five oranges for one tire if he produced them himself. But this is attractive for Amy too, because she can get a tire for only seven oranges, which is fewer than the ten oranges she would have to give up if she produced tires herself. At any "orange price" of tires between five and ten, Amy and Chen are both better off.

The same logic is valid for countries - countries are also better off if they can specialize and trade.<ref name="Caden_Opportunity">Art Caden. [http://mises.org/story/3744 "Tire Trade Tirade"], Mises Daily, posted on Monday, October 12, 2009. Referenced 2009-10-13.</ref>

==Subjectivity of costs==
'''Costs''' are by nature subjective and not objectively measurable by an outside observer. An essential feature of [[Austrian School|Austrian economic theory]], unlike the [[Neoclassical economics|neoclassical theory]], is that cost is directly related to the act of choice. A summary of the implications follows:
# Most importantly, cost must be borne exclusively by the decision-maker; it is not possible for cost to be shifted to or imposed on others.
# Cost is subjective; it exists in the mind of the decision-maker and nowhere else.
# Cost is based on anticipations; it is necessarily a forward-looking or ex ante concept.
# Cost can never be realized because of the fact of choice itself: that which is given up cannot be enjoyed.
# Cost cannot be measured by someone other than the decision-maker because there is no way that subjective experience can be directly observed.
# Finally, cost can be dated at the moment of decision or choice.

Therefore, there can never be objectively measurable [[Wikipedia:Externality|external benefits]]. Costs (or benefits) are subjective and are inseparably tied to the act of choice. That is, an individual not involved in the economic decision or choice can never objectively measure another individual's costs (or benefits). Thus no statement about either the size or the very existence of external benefits can ever be falsified, and cannot be an argument for government [[intervention]].<ref name="Brownstein_Pareto">Barry P. Brownstein. [http://mises.org/journals/jls/4_1/4_1_6.pdf "Pareto Optimality, External Benefits and Public Goods: A Subjectivist Approach"] (pdf), Journal of Libertarian Studies, Vol. IV. No.1 (Winter 1980). Referenced 2010-05-27.</ref>

==Transaction costs==
Consider the classic example of the beekeeper adjacent to an apple orchard. The benefits accruing to the apple orchard from the beekeeper's production (pollination) are not considered by the beekeeper in determining his [[profit]] maximizing output level. Therefore, from the point of view of the apple grower the beekeeper is "underproducing." Many economists would agree that, since the costs of reaching an agreement are relatively small, this two-person case is not a problem for the government. The apple grower can simply bribe the beekeeper an amount up to the size of his perceived external benefits and thus induce the beekeeper to increase production.

As the number of beekeepers and apple growers increases, the costs of reaching an agreement on the size of the payment from the apple growers to
the beekeepers increase. If the '''transaction costs''' remain less than the possible gains from trading, an agreement will be reached. If, on the other hand, the transaction costs exceed the benefits from any trade, an agreement will not he reached. Under these circumstances many economists argue that the market has "failed" and that government intervention is therefore necessary. However, to argue for the government subsidization of the beekeepers is to ignore the fact that transaction costs are real costs which must be considered when making a trade. In the real world, when collective action does not take place, all that one can conclude is that the benefits of such action are smaller than the costs involved. In no way does this imply that the market has failed.

The existence of transaction costs explains why certain trades do not take place in the market. Asserting that the [[trade]] should have taken place is equivalent to stating that transaction costs are not real costs and somehow should not have been considered by the parties involved.

As an example, all of us have wished many times in our lives that we could be instantaneously transported to our destination, he it for work or recreation. Many times the existence of transportation costs (time and money) has led to a decision to stay at home. However, the existence of transportation costs explains why people make certain decisions, and by no means can be used as an argument for government intervention on the grounds of high transportation costs. That is, it would be incorrect to argue that resource allocation is not optimal because of the existence of these transportation costs. On the contrary, any subsidy payments would alter the pattern of resource allocation, making one course of action seem cheaper than it formerly did.<ref name="Brownstein_Pareto" />

==References==
{{Reflist}}

==External links==
* [[Wikipedia:Cost|Cost]] on Wikipedia
* [http://mises.org/journals/scholar/Thornton8.pdf Richard Cantillon and the Discovery of Opportunity Cost] (pdf) Mark Thornton
* [http://mises.org/journals/rae/pdf/RAE3_1_9.pdf Subjective Cost Revisited] (pdf), by William Barnett II
* [http://libertarianpapers.org/articles/2009/lp-1-39.pdf Austrian Economics and the transaction cost approach to the firm] by Nicolai J. Foss and Peter G. Klein
* [http://www.econlib.org/library/Buchanan/buchCv6c0.html#Preface Cost and Choice: An Inquiry in Economic Theory], Preface, by Buchanan, James M., 1969
* [http://mises.org/daily/4901 What's Cost Got to Do with It?] by Joseph T. Salerno, December 2010
[[Category:Economic concepts]]