Lessons For The Young Economist Manual PDF

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ECONOMI
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ROBERTP
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Lessons for the Young
ECONOMIST
Teacher’s Manual
The Ludwig von Mises Institute dedicates this volume
to all of its generous donors
and wishes to thank these Patrons, in particular:
Jeremy and Helen Davis

Scott Scharpen
Vijay Boyapati
David Atherton
Mary Diane Dolan
Lessons for the Young
ECONOMIST
Teacher’s Manual
ROBERT P. MURPHY
LvMI
Mises Institute
Copyright © 2012 by the Ludwig von Mises Institute.
Permission to reprint in whole or in part is gladly granted, provided full

credit is given.
For information write the Ludwig von Mises Institute

518 West Magnolia Avenue, Auburn, Alabama 36832. Mises.org
ISBN: 978-1-61016-204-3
Contents
PART I: FOUNDATIONS
1. Thinking Like an Economist . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Thinking Like an Economist . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Is Economics a Science? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
The Scope and Boundaries of Economic Science . . . . . . . . . . 7
Why Study Economics? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2. How We Develop Economic Principles . . . . . . . . . . . . . . . . . . 21

Purposeful Action versus Mindless Behavior . . . . . . . . . . . 21
The Social versus the Natural Sciences . . . . . . . . . . . . . . . . . 22
The Success of the Natural Sciences versus the
Social Sciences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
How We Develop Basic Economics . . . . . . . . . . . . . . . . . . . 23
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
3. Economic Concepts Implied By Action . . . . . . . . . . . . . . . . . . 39

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Only Individuals Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Individuals Have Preferences . . . . . . . . . . . . . . . . . . . . . . . . . 40
Preferences Are Subjective . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
Preferences Are a Ranking, Not a Measurement Using
Numbers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Different Individuals’ Preferences Can’t Be Combined . . . 42
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
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4. “Robinson Crusoe” Economics . . . . . . . . . . . . . . . . . . . . . . . . . 51

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
Crusoe Creates Goods With His Mind Powers . . . . . . . . . . 51
Consumer Goods versus Producer Goods . . . . . . . . . . . . . . 52
Land, Labor, and Capital Goods . . . . . . . . . . . . . . . . . . . . . . . 52
Income, Saving, and Investment . . . . . . . . . . . . . . . . . . . . . . . 53
Goods Are Valued Unit by Unit . . . . . . . . . . . . . . . . . . . . . . . 54
Pulling It All Together: What Should Crusoe
Do With Himself? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
PART II: CAPITALISM: THE MARKET ECONOMY

5. The Institution of Private Property . . . . . . . . . . . . . . . . . . . . 73
Society Requires Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
Capitalism: This Is Private Property . . . . . . . . . . . . . . . . . . . .73
The Market Economy and Free Enterprise . . . . . . . . . . . . . . 75
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
6. Direct Exchange and Barter Prices . . . . . . . . . . . . . . . . . . . . . 89

Why Do People Trade With Each Other? . . . . . . . . . . . . . . . 89
Direct Exchange / Barter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
How Prices Are Formed in Barter . . . . . . . . . . . . . . . . . . . . . . 91
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
7. Indirect Exchange and the Appearance of Money . . . . . . . 107

The Limitations of Direct Exchange . . . . . . . . . . . . . . . . . . . 108
The Advantages of Indirect Exchange . . . . . . . . . . . . . . . . . 109
The Advantages of Money . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
Who Invented Money? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
Contents | vii
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
8. The Division of Labor and Specialization . . . . . . . . . . . . . . 129

The Division of Labor and Specialization . . . . . . . . . . . . . . 129
Why Specialization Makes Labor More Productive . . . . . 129
Enriching Everyone By Focusing on Comparative
Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
9. Entrepreneurship and Competition . . . . . . . . . . . . . . . . . . . 145

Entrepreneurship . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
Competition Protects Customers . . . . . . . . . . . . . . . . . . . . . 146
Competition Protects Workers . . . . . . . . . . . . . . . . . . . . . . . . 146
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
10. Income, Saving, and Investment . . . . . . . . . . . . . . . . . . . . . . 161

Income, Saving, and Investment . . . . . . . . . . . . . . . . . . . . . . 161
Investment Increases Future Income . . . . . . . . . . . . . . . . . . 161
How Saving and Investment Increase An
Economy’s Future Output . . . . . . . . . . . . . . . . . . . . . . . . . . 162
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
11. Supply and Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177

Supply and Demand: The Purpose . . . . . . . . . . . . . . . . . . . . 177
Demand: Its Definition and Its Law . . . . . . . . . . . . . . . . . . . 177
Supply: Its Definition and Its Law . . . . . . . . . . . . . . . . . . . . 179
Using Supply and Demand to Explain the Market
Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
Using Supply and Demand to Understand Price
Changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193
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12. Interest, Credit, and Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197

Interest: It’s About Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
Savings, Investment, and Economic Growth . . . . . . . . . . . 198
Common Credit Transactions . . . . . . . . . . . . . . . . . . . . . . . . 198
The Pros and Cons of Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213
13. Profit and Loss Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . 217

Profit and Loss Guide Entrepreneurs . . . . . . . . . . . . . . . . . . 217
Interest Versus Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
The Social Function of Profit and Loss Accounting . . . . . 219
The Limits of Profit and Loss Accounting . . . . . . . . . . . . . . 219
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
14. The Stock Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235

The Stock Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
Why Issue Stock? (Debt versus Equity) . . . . . . . . . . . . . . . . 236
The Social Function of Stock Speculation . . . . . . . . . . . . . . 236
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
PART III: SOCIALISM: THE COMMAND ECONOMY

15. The Failures of Socialism—Theory . . . . . . . . . . . . . . . . . . . . 253
The Vision of Pure Socialism . . . . . . . . . . . . . . . . . . . . . . . . . 253
Socialism’s Incentive Problem . . . . . . . . . . . . . . . . . . . . . . . . 254
Socialism’s Calculation Problem . . . . . . . . . . . . . . . . . . . . . . 256
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
16. The Failures of Socialism—History . . . . . . . . . . . . . . . . . . . . 271

Economic Theory and History . . . . . . . . . . . . . . . . . . . . . . . . 271
Communism vs. Fascism . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272
Contents | ix
Socialism’s Body Count . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273

Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
PART IV: INTERVENTIONISM:

THE MIXED ECONOMY
17. Price Controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
The Vision of Interventionism . . . . . . . . . . . . . . . . . . . . . . . . 287
Price Ceilings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287
Price Floors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 290
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
18. Sales and Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305

Government Spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .305
How Government Finances Its Spending . . . . . . . . . . . . . . 306
Sales Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
19. Tariffs and Quotas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323

Mercantilism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
The General Case for Free Trade . . . . . . . . . . . . . . . . . . . . . . 324
Tariffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
Import Quotas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
20. The Economics of Drug Prohibition . . . . . . . . . . . . . . . . . . . 341

Drug Prohibition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341
Drug Prohibition Corrupts Government Officials . . . . . . 342
Drug Prohibition Fosters Violence . . . . . . . . . . . . . . . . . . . . 343
Drug Prohibition Reduces Product Safety . . . . . . . . . . . . . 343
x | Lessons for the Young Economist: Teacher’s Manual
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351

Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355
21. Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359

Money Inflation vs. Price Inflation . . . . . . . . . . . . . . . . . . . . 359
How Governments Make Prices Rise . . . . . . . . . . . . . . . . . . 361
The Danger of Government Price Inflation . . . . . . . . . . . . 362
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375
22. Government Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379

Government Deficits and Debt . . . . . . . . . . . . . . . . . . . . . . . 379
Government Debt and Inflation . . . . . . . . . . . . . . . . . . . . . . 380
Government Debt and Future Generations . . . . . . . . . . . . 380
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 387
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391
23. The Business Cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395

The Business Cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395
How Governments Cause the Business Cycle . . . . . . . . . . 395
The Inevitable Bust Following an Artificial Boom . . . . . . 397
The Causes of Mass Unemployment . . . . . . . . . . . . . . . . . . 398
Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
Answers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411
Preface
T
his is the Teacher’s Manual to accompany the student
text, Lessons for the Young Economist, published by the
Ludwig von Mises Institute. The student text is available
for free online, or it can be purchased as a physical book, at
this web address: http://mises.org/resources/5706/Lessons-
for-the-Young-Economist. The student text was designed with
junior high students in mind, but it is applicable for younger,
precocious students, and also even for adults who never got a
solid grounding in free-market economic principles.
This Manual is intended to guide the teacher through the
course, giving the broader context of the material in the stu-
dent text, as well as offering suggested test questions and fur-
ther activities. It can be used by classroom teachers, but is also
ideally suited to homeschooling instruction by parents who
may not be confident in their own economics knowledge.
Here’s how the Manual works: First, before introducing a
particular chapter (or Lesson), the teacher needs to read it in
the student text. Then, the teacher should read the accompa-
nying material in the Manual. For each section of each chapter,
the Manual may give the historical context, clarify the relation-
ship between what the student is learning from the text com-
pared to a typical college textbook, warn about possible confu-
sions the student may encounter, give links for the teacher’s
own edification (not necessarily to be assigned to the student),
and so forth.
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After walking through the main body of the student text in

a given chapter, the Manual then provides thorough answers
to the Study Questions found at the back of each Lesson. The
Manual then lists optional supplemental materials, which are
free online videos, audio lectures, and readings, along with
instructions as to their level of difficulty and relevance, help-
ing the teacher determine which (if any) to assign.
Next the Manual will list one or more Suggested Activi-
ties, which are applied ways to illustrate the concepts from the
chapter. Some of the activities will be suitable for classroom
use, while others will be more relevant for homeschooling
families where the teacher and student will be out in the “real
world” together on a regular basis.
Finally, each chapter of the Manual ends with a sample test,
which can be printed out (if the teacher is using a PDF ver-
sion) or copied (if using a physical book). The physical version
of the Teacher’s Manual also contains an answer key to the
sample tests, while the online PDF version only has the tests.
(This is to make it harder for students to look up the answers
beforehand.)
The sample tests for each chapter don’t follow a set format.
Sometimes there are true/false, sometimes multiple choice,
sometimes fill-in-the-blank, and there are also many short
answer questions. The idea is to give the teacher samples of
various styles, to help in the creation of a teacher’s own tests
based on the material.
Within the answer key, for each short answer question, the
Manual will give a sample “full credit” answer. The point here
is to show what a “model” answer would look like; the teacher
will have to decide what is actually worth full credit, because a
fair threshold might be far lower than what the Manual shows
as a great answer. The Manual will often (but not always)
also list ”partial” and ”no credit” answers, to help the teacher
understand the central concept of the question. Sometimes a
”no credit” answer will actually be a true statement, but it will
Preface | xiii
completely miss what the question is trying to elicit, showing

that the student didn’t grasp that section of the text.
In addition to the student text and Teacher’s Manual, the
Mises Institute also plans on holding recurring offerings of
Robert Murphy’s online Mises Academy class, covering the
main sections of the book. The current course listing is avail-
able at: http://academy.mises.org/.
It is the Mises Institute’s sincere hope that Lessons for the
Young Economist and this accompanying Teacher’s Manual fos-
ter a convenient introduction for young people to the fascinat-
ing and vital subject of free-market economic principles. Both
classroom and homeschool instructors are encouraged to relay
their feedback ([email protected]) on how they are using the
materials, and ways to improve future editions.
Part I
FOUNDATIONS
Lesson 1
Thinking Like an Economist
A
lthough most economists would endorse the themes
of the material in Part I: Foundations, there are several
areas where the views in the student textbook differ
from what is taught in a standard text. We will point these dif-
ferences out to you as we work through the book, and explain
the reasons for the disagreement.
One of the biggest differences is the simple fact that we
spend so much time on foundations in the first place. In most
texts, there is an urge to “jump right into the economics.” How-
ever, in this course we have adopted the admittedly old-fash-
ioned idea that you need to lay a foundation before building a
house. We hope that the approach in this course, including its
emphasis on understanding the nature and scope of econom-
ics, is intuitive and commonsensical. In contrast, many of the
problems in higher economics—as practiced at the most presti-
gious universities—can be traced precisely to its failure to pay
attention to these issues which are often derided as “philoso-
phy” rather than economics.
As with much of the material in this course, our approach
to economic foundations is based on the work of Ludwig von
Mises. If you want to read more of Mises’s views, you can
read the first chapter of Mises’s Epistemological Problems of Eco-
nomics, available at: http://mises.org/epofe.asp. However, you
3
4 | Lessons for the Young Economist: Teacher’s Manual
should be warned that Mises’s writing style can be difficult

at first, and you also need to know that for Mises, economics
is a branch of praxeology, his term for “the science of human
action.”
Some students will be more receptive to the material in Part
I, whereas others will be impatient to “get to the actual eco-
nomics.” Obviously we included the material in these opening
lessons because we deemed it important for a proper education.
However, for students who are impatient to learn something
“useful,” the first two chapters can be omitted without compro-
mising the material in subsequent lessons. But every student
should at least read Lesson 3, because Lesson 4 is where the
meat of the instruction begins, so it should be studied carefully.

In this section we are trying to get the student excited about
the subject, by explaining its relation to other disciplines. Some
economists engage in what has been called “imperialism” by
trying to apply economic logic to every facet of life, including
an “economic analysis” of dating.
In our view, there is a danger in overpromising the ben-
efits of economics, and that is why we have tried to place it in
its proper role among other disciplines. The principles or laws
that we develop in this course do apply to all situations where
people face scarcity and so must make choices that involve
tradeoffs. However, just because a particular economic “tool”
applies doesn’t mean that it is necessarily useful.
For an analogy, a physicist could make plenty of true state-
ments about the high school prom, involving conservation of
energy, the rotational inertia of dancing couples, and so forth.
But it would be ridiculous for physicists to start lecturing par-
ents and school administrators on the results obtained from
their study of the “physics of proms.”
Lesson 1: Thinking Like an Economist | 5
In the same light, in this course we focus on traditional top-

ics of economic analysis. We think it’s far more important to
educate students on matters such as minimum wage laws and
inflation, rather than racier (and perhaps more exciting) topics
that you will see covered by popular economics books on the
shelves at Barnes & Noble. Even so, if your student is eager for
a completely unexpected application of the tools being devel-
oped during the course, you can urge him or her to be patient
for the topic of drug prohibition covered in Lesson 20. In that
chapter, many students will be surprised by how easily they
can “make sense” of the stylized facts concerning black mar-
kets in drugs, using the apparently mundane tools that they
will have learned by that point.
Is Economics a Science?
In this section we adopt a definitely minority viewpoint,
so you should be aware of the controversy. Most economists
would agree with our take that economics is a science. How-
ever, many (perhaps most) economists would say that what
makes economics a science is its ultimate reliance on falsifiable
predictions.
The economists who adopt this view are (whether they
know it or not) following in the tradition crystallized by Mil-
ton Friedman in his famous essays on what is called “positive
economics.” If you want to learn more about this controversy,
you should first read the essays in the Supplemental Materials
for Lessons 1 and 2, and then for further discussion you should
listen to philosopher Roderick Long’s discussion of Friedman
versus Mises at http://mises.org/media/4006.
In a nutshell, the economists who follow Friedman adopt
the view of Karl Popper, who argued that in order for a state-
ment to be scientific, it had to be falsifiable. In other words, it
had to be at least possible in principle for the facts to turn out a
certain way, in order to render the statement false. If this were
not possible, then (according to Popperians and those econo-

mists who endorsed Friedman’s views on this matter) the state-
ment would not be scientific at all.
It is understandable why many academics, who wish their
work to be “objective” and free from personal bias, endorse the
Popperian view. If one’s model of the world can’t be proven
wrong, no matter what happens, then it seems to be a dogma
or “religion.”
However, Ludwig von Mises and those who follow his
views on this issue of the nature of economics, do not believe
economic theory is composed of testable propositions. This
recognition doesn’t therefore prove that economics is a mere
dogma; it rather (according to Misesians) shows that the Pop-
perian insistence on falsifiability is a bad criterion for science.
This is a deep philosophical controversy and your student
can skim through the material if it is too difficult. Just be aware
that standard textbooks would say that yes economics is a sci-
ence, but only because it relies on testable predictions. Ironi-
cally, the textbook will then go on to teach principles—such as
“People respond to incentives” and “All choices involve trade-
offs”—which are not testable! This was Mises’s whole point,
and it is the reason we have adopted his approach for this
course. It is a simple confusion to try to model economics on
physics or chemistry, and assume that in order to be scientific,
economics must consist of testable or falsifiable predictions.
As far as distinguishing economic science from other
human inventions that truly are unscientific—perhaps astro-
logical “forecasts” as reported in newspapers—we can simply
ask the reader whether he or she has a better understanding of
the world, after learning the material in this course. Geometry
too is “non-falsifiable” in the sense of Karl Popper, but it is not
merely a collection of arbitrary conventions and definitions.
There is a very real sense in which students understand the real
world better, after they have learned the basics of geometry. We
hope the same will be true after learning basic economics.
The Scope and Boundaries of

Economic Science
The material in this section is mostly offered for the benefit
of those students who like to be very organized and have a
solid understanding of what it is that they are about to begin
studying. It’s very important for the student to realize that
economics is not simply the study of business or money, even
though economics obviously does include these concepts.
If we are telling the student what economics is not, then we
ought to follow up by saying what it is. For the purposes of this
course, it is accurate enough to say that economics is the study
of exchanges.
Most economists would probably have no objection to
defining economics as the study of exchanges, but some of
them would take issue with our discussion of the hypothetical
“economic man.” In many textbooks and even popular exposi-
tions of economics, the authors will say that economists must
construct models of people “as if” they were (a) very selfish
and (b) capable of solving complicated mathematical problems
without ever making a mistake.
We reject that approach in this course. This difference goes
back to the more fundamental disagreement over the nature of
economics. Since we believe basic economic theory consists of
a (non-testable) way of viewing the world, we can’t anchor it
to (false) assumptions about human motivations and compu-
tational abilities.
In contrast, for those economists who think economics is a
collection of testable predictions, then there is nothing wrong
in making “simplifying assumptions” in order to yield crisp
predictions. They can justify their approach with analogies to
physics, where (for example) the scientist can make general
predictions about the path of a baseball without dealing with
complications such as the gravitational pull of a nearby but-

terfly.
For our purposes, it is enough that the student recognizes
that the principles or laws of economics as we develop them in this
course are not dependent on a particular view of man as being
an “egoist,” and they do not assume that people are superhu-
man calculators. On the one hand, this allows our principles
to be true for all people, but on the other we can only make
general statements about tendencies, rather than precise pre-
dictions which can then be measured experimentally.
Why Study Economics?

In this final section, we try to motivate the student to work
through the material in the coming lessons, some of which
will be difficult. If necessary, you should help your student
pace him or herself by warning that the true payoff may not
become apparent until Part III of the course. At that point, the
tools that we develop for understanding a market economy
can be used to explain why deviations from a market economy
lead to disastrous outcomes. Beyond the horrors described in
Part III, the material in Part IV should also prove very inter-
esting to students, as it will explain such “facts of life” as
unemployment and the business cycle, and show that they
are largely the result of government intervention.
However, in order for the student to fully appreciate these
later applications, he or she must first master the principles.
We encourage you to force impatient students through the
material in Part II before jumping into the “fun” material
later in the book.
If you want to pursue additional reading on the role of eco-
nomics in society—and in particular the duty of the average
citizen to learn basic economics—you should read Part Seven
of Mises’s masterpiece, Human Action, available at http://mises.
org/Books/HumanActionScholars.pdf.
Study Questions
1. Can economics make you rich?

In the text we have taken the position that basic economics per
se won’t guarantee financial success, but that being ignorant
of basic economics is a good way to ensure failure. An anal-
ogy might be the study of geometry and building a bridge that
can support traffic—studying geometry isn’t enough, but it’s
definitely necessary.
More generally, economists fall into two camps on this ques-
tion. The purists insist that even a trained economist doesn’t
have the ability to, say, predict stock price movements more
accurately than hedge fund managers. On the other hand,
many economists think that investors can outperform their
peers—especially in times characterized by heavy government
intervention—if they are guided by sound economics. For
example, several economists and investment advisors warned
of the housing bubble in the early and mid-2000s while there
was still time to “get out,” and they credited the business cycle
theory we will explain in Lesson 23 as their inspiration.
2. Is economics a science? Why or why not?

Of course the text’s answer is “yes,” so long as the student
understands that economics is not the same type of science as
physics or chemistry. However, the important point is to under-
stand the issue of logical versus empirical disciplines; we will
discuss this more in Lesson 2. If a particular student wants to
reserve the term science for those intellectual enterprises that
rely on falsifiable theories and experimental tests, then eco-
nomics is not a science. But to concede this point doesn’t mean
economics is arbitrary or has nothing to do with the real world;
mathematics doesn’t rely on experiments either, and so it too
would be “unscientific” using this criterion.
3. Does scarcity affect everyone?

Yes. The important point here is that scarcity is not the same
thing as poverty. We can imagine a world of fantastic mate-
rial wealth, where no one goes hungry or even gets sick. But
it would be difficult to even imagine a world without scarcity,
in which someone’s actions didn’t come with costs. If nothing
else, people would still have only a limited number of hours
per day in which to act. Even immortals with superfast space-
ships would still have to decide (say) whether to visit Galaxy
A first or Galaxy B.
4. Do the laws of economics still work inside a

maximum security prison?
Yes, the laws of economics (as developed in this course) do not
rest on particular assumptions. They are universal, as are the
laws of physics. However, in certain settings it might be diffi-
cult to apply or illustrate a particular economic law. For exam-
ple, the principles we develop for the Robinson Crusoe world
(in Lesson 4) apply to each person in a maximum security
prison, but because the environment is so different, it might
be hard to “see” certain effects. It’s still true that the prisoners
could (in principle) enhance their productive output by saving
and investing resources, but if the guards (or other prisoners)
would take anything they were working on, it would be point-
less for them to do so.
5. *Isn’t it just as important for the average

person to understand particle physics, since
much of the funding for this research comes
from government grants?
This is a difficult question because the student could take the
answer in several directions. We would say the answer is “no,”
*An asterisk indicates a more challenging question.

because government funding for particle physics would never

constitute the same impact on an economy as other govern-
ment programs that are based on faulty economic views. Also,
even a basic education in economics (such as the one provided
in this course) is enough to demonstrate the absurdity behind
most of the economic justifications for various government pol-
icies. In contrast, one would need to do much more research to
be able to decide how much physicists were exaggerating the
benefits of bigger government budgets for their pet projects.
Supplemental Materials
• Gene Callahan, Economics for Real People available at
http://mises.org/resources/2031, Chapter 1 and Appendix A.
Callahan’s book was commissioned and published by
the Mises Institute (the producers of this course). It is
intended as an introduction to Austrian economics,
which is the school of thought associated with Ludwig
von Mises. Callahan’s book, as well as the Lew Rockwell
essay listed below, provide an explanation for the term
“Austrian” and explain the relationship of the Austrian
School to others, such as the Keynesian or Chicago
School. For this course, the student doesn’t need to learn
the particulars of Austrian economics vs. other types of
schools. But in the Supplemental Materials, these terms
unavoidably come up and so the student will need to
know what they mean.
We should make it clear that most of the lessons in this
course do not depend on “Austrian” economics per se;
any professional economist who has an affinity for free
markets would endorse or at least sympathize with the
approach. The only chapters that owe an explicit debt to
the Austrian School are Lessons 15 and 23, because they
rely on the particular theories of Ludwig von Mises, the
dean of the Austrian School in the twentieth century.
• Robert Murphy, “The Core of What Economics Teaches,”

video available at http://mises.org/MediaPlayer.
aspx?Id=4988
Despite the official title of the lecture, this talk was
intended to give high school students a sample of the
insights that economics can give in unexpected settings.
It is self-explanatory.
• Lew Rockwell, “Why Austrian Economics Matters,”

available at http://mises.org/etexts/why_ae.asp
As we mentioned above, the course set out here (in
Lessons for the Young Economist) is not about Austrian
economics. It is a general introduction to economic
principles, coming from a free-market perspective.
However, everyone who worked on the course’s
development has an affinity for the Austrian School,
and this has undoubtedly influenced the presentation of
the material. In his essay, Lew Rockwell—the founder
of the Mises Institute—explains why a growing number
of academics and laypeople keep returning to the ideas
of a school of economic thinking that at one time was
considered a closed chapter in history.
• Nassau Senior, “An Introductory Lecture on Political Economy,”

available at http://mises.org/books/selected_writings_senior.
pdf.
Nassau Senior was a classical economist, meaning
that he wrote before the so-called Marginalist (or
Subjectivist) Revolution of 1871. (For an explanation see
Joe Salerno’s lecture at http://mises.org/media/4344).
We have included the lecture from Senior mainly to
give the interested student a taste of what economics
(or “political economy”) was like before the hyper-
mathematization of the twentieth century.
We emphasize that a modern economist would not
necessarily endorse everything Senior writes, just as a
modern political theorist wouldn’t agree with everything
in Aristotle’s works. For example, Senior assumes the
task of economics is to understand the accumulation of
material wealth, whereas modern economics no longer
focuses on that as its primary function. Some students
might find Senior’s work too difficult at this early
stage, when they have just been introduced to modern
economic principles as developed in this course. You
will have to decide whether the possible confusion
outweighs the benefit of seeing a historical document.
suggested
Discuss with the student
activities the various things that
every “well-rounded”
young adult should have
studied. For example, the list might include arithmetic and
algebra (but not necessarily calculus), famous works of
literature, key portions of world history, the major events
in the history of physics, and so on. The purpose of the
activity isn’t so much to come up with the list, but to discuss
what factors put something on the list (or keep it off).
After you have come up with a set of criteria for what puts
something on the list (or keeps it off), see if basic economic
principles should make the cut.
test — Lesson 1
True or False on Basic Ideas:

Write true if the statement is true or write false if the statement
is false.
1. The economic perspective is the most important one

in all situations involving people.
2. Economics is important only if you’re going to become

a businessperson.
3. At its core, economic theory cannot be tested.
4. Economic “laws” aren’t objective, but instead depend

on the tastes of the researcher.
Matching Essential Terminology:

Write the BEST answer on each line beside its description.
Social Science Tradeoffs Dilemma Barter

Scarcity Exchanges
5. The subject that economics studies.

6. A situation when traders exchange

goods or services directly for each other
without money.

7. The fact that making one choice means
that other choices become unavailable.

8. The fact that there are limited resources

but unlimited desires.
15
Short Answers (4 points each):

In one to three sentences, respond to the following prompts.
9. Explain how economics is indeed a science but not in the same sense
as physics or chemistry.
10. Describe a scene in which two people barter.

Test: Lesson 1 | 17
11. Explain why even phenomenally rich men and women need to
economize on their resources and choices.

Test answers have been deleted.
19

Lesson 2
How We Develop
Economic Principles
T
he material in this chapter would not be contained in
standard textbooks, and indeed (as we explained in the
previous chapter) many economists might not even agree
with some of its themes. Naturally we will be clear in the sec-
tions below to point out these areas of disagreement.
If a particular student cannot handle abstract thought very
well, Lesson 2 can safely be omitted. However, the material
in this chapter is important to truly understand what we are
doing when we use economics to understand the world.
Purposeful Action versus

Mindless Behavior
This section emphasizes the crucial distinction between
purposeful action and mindless behavior. It’s important for
the student to learn that the economist must “get inside the
head”—or more accurately, inside the mind—of the people
acting in a market.
Superficially, it appears that economics is about physical
things—dollar bills, tractors, factories, and television sets.
But economics is really about the (mental) decisions that
people make, concerning those physical things. A human
21
decision, or choice, is an intangible concept; it can’t be

weighed or otherwise measured.
The Social versus the Natural Sciences

In this section we simply reiterate the fundamental dis-
tinction between social and natural sciences. In the social sci-
ences we (typically) must rely not only on observable, physi-
cal things but also must rely on our interpretations of other
people’s mental activities.
To stress the point yet again, note that “mental activities”
does not mean “electrical activity in someone’s nervous sys-
tem.” It is a basic confusion at the outset to think that a descrip-
tion of someone else’s thoughts, feelings, and motivations is
the same thing as a description of that person’s physiological
processes. Now some researchers are making great progress
in showing the connection between physical states of the brain
and, say, feelings of aggression or creative thought. We are not
taking a stand on the deep philosophical issues of dualism and
the mind-body problem, if you are familiar with those con-
troversies. All we are saying is that talk of a person’s mental
“events” is on a different plane from talk of the operations of
his or her physical brain.
The reason we stress these points is that it will shed light
on the later sections, and why we argue that basic economics
is a logical, deductive framework rather than a set of empirical
propositions that need to be tested.
The Success of the Natural Sciences

versus the Social Sciences
In this section we remind people of the difference in reputa-
tion and prestige among the various sciences. It is undeniable
Lesson 2: How We Develop Economic Principles | 23
that the natural scientists seem much more . . . scientific . . .

than the social scientists. By now it should be clear why we
have spent so much time developing philosophical points
that (apparently) have little to do with an introduction to eco-
nomics. The techniques that lead to success and credibility in
the natural sciences do not seem to work as well in the social
sciences. Now we can see the role for an entirely different
approach to economics, as we explain in the next section.
How We Develop Basic Economics

Finally the work of the prior sections yields the payoff,
where we now can explain the development of basic economic
principles or laws. We start with some basic truths or “axioms”
about purposeful action and then we logically deduce impli-
cations from these self-evident (or at least non-controversial)
building blocks.
The analogy with geometry is probably the best one avail-
able, because the student will be familiar with it and also
because there is no denying that geometrical proofs are impor-
tant truths about the “real world.” In other words, people
who would criticize the approach to economics adopted in
this course would be hard-pressed to apply their criticisms to
geometry.
If you are capable of presenting it, an actual proof of the
Pythagorean Theorem might drive home the point. There are
several proofs that you can survey at the Wikipedia article at
http://en.wikipedia.org/wiki/Pythagorean_theorem. Depend-
ing on the math skills of the student in question, one proof
might be easier to grasp than another. (For example, some are
quite intuitive, relying on a simple rearrangement of shapes,
while others rely on algebra.) The purpose of this exercise
would be to drive home the point of the power of a deductive
proof: Once the student really gets it and can see how the proof
of the Pythagorean Theorem works, he or she would realize

that it’s silly to go out and “test” the theorem on various right
triangles.
In addition to the Supplemental Materials, you can learn
more about this approach to economic principles by watch-
ing a lecture by economist Hans Hoppe at http://mises.org/
media/4347/Praxeology-The-Austrian-Method. Hoppe comes
from a philosophical background and has a thick accent, so
some viewers may find it difficult to follow. Roderick Long
discusses similar issues in a lecture discussing “a priorism
and positivism in the social sciences,” the audio is available
at http://mises.org/media/4017. (A priorism and positivism are
defined in Long’s lecture.)
Study Questions
1. If someone sneezes when pepper is thrown

in his face, is that a purposeful action?
The answer is no, because (presumably) sneezing is a reflexive

behavior. It’s important for the student to realize that the dis-
tinction between purposeful action and mindless behavior is
not simply the difference between human bodily movements
versus items in nature. As the example of lifting a leg in the
student text shows, human behavior can be classified as either
purposeful action or mindless behavior, depending on the cir-
cumstances.
2. Does “purposeful action” include mistakes?
Yes, it does. Purposeful action is intentional action; it is behav-

ior that serves a purpose to the thing doing the behaving.
People try to achieve certain outcomes and fail, all the time.
Yet they are still acting with purpose. In this course we do not
assume that people are flawless calculators, as some textbook
writers do.
3. *Are brain and mind interchangeable terms?
No, they are not. The brain is a physical organ of the body,
whereas the mind is an intangible concept that obviously bears
some relationship to the brain. (Note that someone can “lose
his mind” without losing his brain.) To repeat, we are not rul-
ing out particular theories of neuroscience that claim that cer-
tain mental states are caused by particular brain states. We are
making the very modest point that mental states or operations
(such as anxiety, happiness, long-range planning, multiplica-
tion, etc.) are different from brain states (such as firing neurons
and blood flow to the left hemisphere).
4. Can we perform controlled experiments to

test economic theories?
No, not in the same sense that we perform controlled experi-

ments in (some of) the natural sciences. There is an entire field
called “experimental economics,” in which researchers will
run experiments to test various issues that are important to
some economic researchers. For example, in one experiment
the subjects are grouped into pairs. The first subject is allowed
to divide up (say) $10 between himself and the other person in
his group. He can keep it all for himself, give $5 to the other
person and to himself, etc. Now the experiments have shown
that the method for determining who is first (and gets to split
the money) can affect the fairness of the split. If the first person
is chosen randomly, he or she tends to give a fairer split than if
the first person is decided by having the two people in the
group first play some type of competitive game. The theory to
explain this outcome is that the first person feels as if he or she
deserves more (or all) of the money if the power position is due
to “merit,” whereas the first person is more worried about
being selfish if his or her power is due to blind chance. (If you
want to pursue this topic a good summary is here: http://en.
wikipedia.org/wiki/Dictator_game).
Yet despite the growing field of experimental economics,
nonetheless the experiments conducted on human subjects are
not truly controlled, the way physicists can tinker with their
experiments on electrons. (At least, the physicists think their
experiments are very controlled. We ultimately don’t really
know.) There is always a great deal of “noise” in the results
of any experiment involving human subjects. Often times par-
ticular results of a strategic game will be thrown out because
“that subject obviously didn’t understand the rules” and so
forth. Indeed, one common finding is that students who have
studied economics tend to behave more selfishly in economic
experiments!
5. **Would you classify Intelligent Design

theory as a natural or social science?
There is no preferred answer to this question; we offer it merely
to provoke thought and discussion. The distinction we have
drawn in the student text between social and natural sciences
rested on the typical pattern that there are no “intentions” in
the natural sciences; it would be very unscientific to say that an
apple fell from a tree because it was afraid of heights. On the
other hand, it is perfectly reasonable and “scientific” to bring
talk of motivations and thoughts into analyses of people and
their actions.
Intelligent Design theory presents an interesting challenge
to this traditional dichotomy between the natural and social
sciences. The biologists and other “hard” scientists who vehe-
mently oppose Intelligent Design theory argue that it is just
as unscientific as explaining volcanic eruptions by reference to
angry gods. On the other hand, the proponents of Intelligent
Design theory say that it is just as reasonable as a homicide
detective looking at a murder scene and inferring that an intel-
ligence had been involved. No one would criticize the detec-
tive for being unscientific if he said, “This guy’s dead because
his wife was angry.”
To repeat, there is no preferred answer to this question, it is
offered merely to get the student to really think about the dif-
ferent approaches to exploring the world.
• Gene Callahan, Economics for Real People, Chapter 2.
This material should be self-explanatory. Callahan jumps
ahead to deal with some concepts that we will cover in
later lessons of this course.
• Gene Callahan, “What Is A Priori Science, and Why Does

Economics Qualify as One?” at http://mises.org/daily/2025
This is a good introduction to Mises’s methodological
views on economics. It is not necessary for students to
know this material for the present course, but if they
want to go deeper in this topic, they will need to grapple
with terms such as a priori.
• Robert Murphy, “Mises’s Non-Trivial Insight,” at

http://mises.org/daily/1304
This article spells out from scratch the difference
between the Misesian focus on human action, versus
the popular tendency to model economics after physics.
Often critics of Mises dismissed his attention on action
as trivial, but the article argues that it was a very deep
insight.
• Robert Murphy, “Psychology versus Praxeology,” at

http://mises.org/daily/1351
This final article should help distinguish the a priori,
deductive approach from an empirical, inductive
approach. Sometimes the emphasis on social versus
natural sciences confuses readers, because they know
that some social scientists—such as psychologists—
use experiments all the time. This article shows the
difference between experimental “laws” discovered
in psychology, versus deductive laws discovered in

economics. (Note that praxeology is Mises’s term for the
science of human action, which is a broad field that
includes economics as one of its components.)
It is not critical for the student to memorize the precise
details on these deep issues. The only really important
take-away lesson is that there is a large gulf between
viewing objects as mindless things, versus viewing them
as intentional beings. This difference goes a long way
toward explaining the varying prestige and credibility
enjoyed by “hard” natural scientists versus “soft” social
scientists. It also helps to explain the approach we take
in this course, where we don’t try to “prove” basic
economic principles by reference to experiments or
historical statistics.
suggested Get the student

comfortable with
activities the distinction
between purposeful
action versus reflexive (mindless) behavior by
working with extreme examples. For example,
does the sun “want” to rise in the east every
morning? Does a plant “want” to gradually move
its leaves toward the sunlight? Does a dog perform
a trick for a treat “on purpose”? Are the zombies
in movies using means to achieve ends?
test — Lesson 2
How We Develop
Economic Principles
Social or Natural Science:

Identify the following sciences as either social or natural.
A. Social Science B. Natural Science
1. Biology
2. Economics
3. Criminology
4. Astronomy

Write the appropriate term on the line beside its description.
Theorem Oxymoron Axiom
Freudian Keynesian Austrian
5. A school of economic thought that calls

for increased government spending
during times of economic decline.
6. A chain of deductive reasoning to

reach a conclusion from an initial set of
assumptions.
7. A school of economic thought that

blames faulty monetary policy for the
boom-bust cycle.
8. A definition or assumption from which

logical deductions are made.
31

9. List two examples of mindless behaviors and two examples of

purposeful actions.
Mindless behavior:
Mindless behavior:
Purposeful action:
Purposeful action:
Test: Lesson 2 | 33
10. Explain why the “scientific method” simply won’t do well in the realm
of social science.
11. Explain how economists derive economic principles or laws.

35

Answers — Lesson 2 | 37

Lesson 3
Economic Concepts Implied

By Action
Introduction
I
n Lesson 3 we illustrate the payoff of our attention to appar-
ently philosophical concerns in the previous chapter. The
general concepts we develop here would be ones endorsed
by most professional economists, and yet (as we’ll see) they are
all logical implications of the fact that humans act purpose-
fully. If a student is perplexed as to why we spent so much
time in Lesson 2 on the distinction between purposeful action
and mindless behavior, the answer is that purposeful action
provides a proper foundation for the basic principles shared by
all modern economists—even if those economists themselves
don’t know it!
Only Individuals Act

To say that every action requires an actor seems simple
enough, but it carries surprising implications. Much of the talk
in political analysis falls into the pitfall of assuming that col-
lectives can act, rather than focusing on the individual actions
that make up the combined effect.
It’s important to stress that this methodological focus on
the individual doesn’t take a stand on whether people are
39
“atomistic” or “social.” If a crowd gets riled up by a dema-

gogue and does something that none of the individuals would
do in isolation, that fact of “crowd psychology” is perfectly
consistent with what we are saying in this section. The impor-
tant point is that a “crowd” per se doesn’t do anything; it’s
always the people in the crowd who make conscious decisions.
For the present course, this emphasis on individual analy-
sis won’t seem to have profound implications. But at higher
levels of theory, the difference in focusing on “micro” versus
“macro” can be quite serious. For example, Keynesian econo-
mists diagnose recessions as shortfalls in aggregate spending,
and this leads them to certain recommendations. Austrian
economists try to trace their analysis of large “macro” events
back to individual decisions. This difference in approach partly
explains the diametrically opposed policy recommendations
that Keynesians and Austrians give in the midst of a recession.
(The Austrian view of recessions is laid out in Lesson 23.)
Individuals Have Preferences

In this section we introduce the concept of individual pref-
erences. This is the point at which standard textbooks would
normally begin the analysis. The groundwork up until now
has laid the foundation for this point. Our approach will hope-
fully give the student a better understanding of how econom-
ics actually works, by starting at an earlier stage rather than
jumping right into a discussion of preferences.
Preferences Are Subjective

This section deals with the subjectivity of preferences, which
is one of the most misunderstood components of modern eco-
nomics. As the text stresses, economists are not adopting ethi-
cal or moral relativism. There is nothing “uneconomical” in
Lesson 3: Economic Concepts Implied By Action | 41
someone condemning smoking as immoral; the point is that

if economists want to explain the price of tobacco, they obvi-
ously have to acknowledge the fact that many people prefer to
spend their money on cigarettes versus broccoli.
We did not bring it up for fear of overloading some stu-
dents, but the modern emphasis on subjective preferences
actually represents a revolution in economic theory. In classi-
cal economics—developed by people such as Adam Smith—
economists endorsed variations of the labor theory of value.
This was an objective (not subjective) approach to explaining
market prices. The modern, subjectivist value theory approach
(which we use in this course) is totally different from the clas-
sical conception. For a good introduction to this revolution in
economic thought, listen to Joe Salerno’s lecture here: http://
mises.org/media/1463.
Preferences Are a Ranking,

Not a Measurement Using Numbers
As with much of the material in these opening chapters,
the student may not understand why we are spending so
much time on apparently pedantic quibbles. Rest assured, the
emphasis on preferences being a ranking, not a measurement,
will make more sense in Lesson 6 when we explain the forma-
tion of barter prices. If the student gets the basic idea down
now, it will be easier for him or her to follow the discussion
later.
As the “An Alternate View” box explains, high-level main-
stream economics programs try to have it both ways on this
issue. On the one hand, incoming doctoral candidates will
learn that modern economic theory is based on preference
rankings. (So far this agrees with the approach in this course.)
But then after some mathematical fancy footwork, most prac-
ticing economists begin using “utility functions” that measure
people’s satisfaction or happiness. Although the mathemati-

cal footwork is correct, even so we think that most practicing
economists forget the lessons from their early schooling, and
do their research assuming that people’s subjective prefer-
ences can be captured quantitatively by a utility function.
For the student who won’t take further courses in econom-
ics, this tangent can safely be ignored. We are mentioning the
mainstream use of utility functions solely to help advanced
students relate other textbook presentations to what they are
learning in this course.
Different Individuals’ Preferences Can’t

Be Combined
In this final section we draw another implication, that pref-
erences from different people can’t be combined. We used the
popular example of taking a dollar from a rich man and giving
it to a poor man to motivate the idea, but the lesson applies to
much of the standard discussions concerning social policies.
Even many economists discuss ways of increasing “social wel-
fare” when the foundation for such a concept is dubious. It is
true that high-level economic theory can come up with a ratio-
nale for such language, but in practice many economists—let
alone people outside the profession—revert to the fallacy that
we can add up everybody’s level of happiness and then try to
maximize this number.
Study Questions
1. Why is it questionable to say, “Germany

attacked France”?
It’s inaccurate because what the statement really means is that
key officials in Germany’s government and military performed
actions that inspired other individuals to perform actions and
so forth. In some contexts this sloppiness of language is harm-
less, but in economic and political debates it can often be harm-
ful. For example, some people think that the “national debt”
(by which they mean the debt of the federal government) is
harmless because “we owe it to ourselves.” In Lesson 22 we
expose the flaw in such thinking.
2. Why do statements about a man’s actions

(implicitly) involve his beliefs as well?
To say that a man acts with a purpose, we are implying that the
man believes his action will achieve the result he desires. (If
we didn’t attribute such a belief to the man, then our descrip-
tion would make no sense.) This seems like a trivial point,
but much of the development of economics in the twentieth
century involved the growing realization among economists
that expectations were important. These developments lie out-
side the scope of this course, but the moral is that these “foun-
dational” issues really do have implications for cutting edge
research.
3. Can purposeful action be based on a faulty

belief? Give examples.
There are all sorts of examples of purposeful actions that are
based on false beliefs. For example, if we see a man on his
knee in a fancy restaurant in front of his dinner companion, we
might say, “He is proposing to that woman because he wants
to spend his life with her.” One of his beliefs that motivated
this action is that she will say yes. But she very well might say
no. Even in that case, the man’s action was still purposeful; he
just didn’t fulfill the purpose as he had expected. In business,
entrepreneurs make faulty forecasts all the time. Their actions
are still purposeful, and they still fall under the scope of eco-
nomic theory.
4. What does it mean when economists say

preferences are subjective?
This elementary observation simply refers to the fact that peo-
ple have different tastes. This is a much more straightforward
way of explaining market prices, than to assume that these
prices are the result of some “objective” facts (such as how
much labor went into the product, etc.). The emphasis on sub-
jective preferences will make more sense in Lesson 6 when we
explain barter prices.
5. *Does economics say you shouldn’t give

money to charity?
No! It is perfectly reasonable for an economist to donate
money to the poor. The discussion in the text was referring
to an illegitimate application of economic theory. Specifically,
some people learn the “law of diminishing marginal utility”
in standard economics courses, and then falsely conclude that
a dollar confers less utility on a rich man than on a poor man.
This talk is meaningless; economics says no such thing. Now if
we want to justify charity on the grounds of moral obligation,
that is consistent with economics. The only point here is that
standard utility theory does not justify wealth redistribution
the way many people think it does.
• Murray Rothbard, Man, Economy, and State, with Power
and Market (Scholar’s Edition, available at http://mises.
org/resources.aspx?Id=e8f5e0fa-d5bb-4844-9a4b-
831c6a090d9e), pp. 1–33.
This large volume is Rothbard’s grand treatise on
economic theory. The serious student who wishes to
really master modern Austrian economic thought at
some point will have to read Rothbard’s book, which is
surprisingly easy to read in spite of the complex subject
matter. For this course, we are including excerpts to
whet the advanced student’s appetite and also to give
longer discussions on certain points. Another benefit for
the advanced student is that Rothbard’s terminology
and discussion is more formal than the approach taken
in this course, and so will provide an easier transition
for those students who go on to study economics at
a higher level. If the student decides to slog through
large portions of Rothbard’s treatise, there is also a
dedicated study guide available at http://mises.org/
resources/3318/Study-Guide-to-Man-Economy-and-
State.
• Gene Callahan, “Choice and Preference,” at http://mises.org/

daily/1163.
In this article, Callahan responds to a famous (within
Austrian circles) critique of Austrian economics by
Bryan Caplan. The truly advanced student can first read
Caplan’s critiques (which are linked in the Callahan
article), and then read Callahan’s response. However,
Callahan’s article can stand on its own, because he
quotes enough from Caplan to get at the heart of the
dispute.
Specifically, Caplan had criticized the Austrian

approach to choice and preference, which is what we
have adopted in this course. Caplan is coming from a
mainstream perspective, but Callahan shows that his
criticisms misunderstand what the Austrians are saying.
This article should be helpful to clarify the relationship
between everyday, commonsense concepts and their
usage in economic analysis. For example, even though
we all know what it means to claim that (say) Mary’s
preference for vanilla over chocolate is stronger than
John’s, in economics this statement is meaningless. By
the same token, Caplan has focused on the perfectly
sensible term of indifference from everyday life, but
has applied it incorrectly in economics in the Austrian
tradition. It’s not important for the student to memorize
Caplan’s specific arguments and Callahan’s replies; the
important lesson is to understand the framework of
choice and preference that Callahan attributes to Mises
and his followers.
suggested
activities
Have the student
browse a newspaper
or watch the nightly
news, and note how many times a collective entity (such
as a country or government) is reported to have taken a
purposeful action.
test — Lesson 3
Economic Concepts Implied
By Action
Subjective or Objective:
Identify the following statements as either subjective or objective.
A. Subjective B. Objective
1. Pizza is a popular dinner choice amongst Americans.
2. Pepperoni pizza tastes better than just plain cheese

pizza.
3. Rap music is disgraceful and delivers a harmful message

to children.
4. No singer or band has sold more record units than Elvis

Presley.
Matching EssentialTerminology:
Quintessence Preferences Subjective Synthesis

Objective Utility
5. Ranked by people for decision-making.
6. An opinion or matter of taste.
7. A term used to describe how much

pleasure or satisfaction a person derives from
a particular situation.
8. A fact or precise measurement.
47

9. Keeping in mind the issue of individuals who act purposefully, rephrase

the following statement so that its meaning is more precise.
Germany invaded France in World War II.
10. Guess at Jordan’s preference and belief (two separate things) from
the following statement.
Jordan took some ibuprofen to ease her pounding head.
11. List your top three books or movies. In making the list, did you have
to measure how much enjoyment you got from each book or movie?
Explain.
(1)
(2)
(3)
49

Lesson 4
“Robinson Crusoe” Economics
Introduction
A
s the student text explains, the purpose of “Robinson
Crusoe” economics is to introduce economic concepts
in a simplified setting. After the student has mastered
the principles in an “economy” consisting of one person, we
then generalize it to a real economy with many people.
It used to be common for economics books to use examples
of Robinson Crusoe (or perhaps the Swiss Family Robinson)
to illustrate ideas, though the practice is rarer now. We have
retained the practice for two reasons. First, students seem to
respond well to the discussion. Second, the Robinson Crusoe
environment is perfect for showing the interaction of natural
resources, labor, and capital goods.
Crusoe Creates Goods With His Mind

Powers
This section introduces the concept of economic goods. The
two crucial points are: (1) goods are scarce, and (2) goods are
in the eye of the beholder. The first point refers to the fact that
there are plenty of conditions or factors in the world, which
are definitely useful to humans (gravity, oxygen, etc.). These
factors contribute to the satisfaction of people’s goals, just as
51
much (or even more so) than things like ladders and apples.
But because gravity, oxygen, etc., are (at least in most cases)
not scarce, they don’t have to be economized, and so don’t fall
under the umbrella of economic analysis. (Note that some texts
might refer to these things as free goods, to show that they are
still useful but not economic goods.)
The second point ties in with the modern subjective the-
ory of value. Economic goods are defined not by their physi-
cal attributes per se, but by the valuing human mind which
appraises them.
Consumer Goods versus Producer

Goods
This section breaks down the general category of goods into
consumer goods and producer goods. As with the definition of
a good in general, here too the distinctions between consumer
and producer goods are made in the mind of the beholder; the
same physical item can be a consumer good to one person, but
a producer good to another.
Land, Labor, and Capital Goods

This section takes producer goods and divides them into
finer categories, namely labor, natural resources (sometimes
called “land”), and capital goods. For the truly advanced stu-
dent, you could mention the technicality that capital goods
actually don’t need to have been produced by human beings.
The real criterion of a capital good—as opposed to a natural
resource—is its reproducibility by humans.
So for example, if Crusoe is planning on cutting down vines,
and notices a vine that is perfectly cut just as he would have
done himself—perhaps through some animal’s gnawing or a
Lesson 4: “Robinson Crusoe” Economics | 53
fortuitous lightning strike—then he can add that nature-given

vine to his stockpile, and consider it another unit of his capital
goods. It would be absurd if our definitions required Crusoe
to mentally keep track of which vine came from nature, and
which he had to transform with his labor and other tools, so
that (say) vines #1–14 and #16–27 were capital goods, but vine
#15 was a natural resource. If the cut vines are equally use-
ful for the goal Crusoe has in mind—tying sticks together to
make a long pole—then economics says they should be units
of the same good. The reason the nature-given vine in this case
would be a capital good, is that Crusoe can always make more
(identical for his purposes) vines if he wants. But we stress that
this is a very technical point, and you should only bring it up
for an advanced student who won’t be confused.
Income, Saving, and Investment

This section is perhaps the single most important one in the
entire course, so we encourage you to make sure the student
truly understands it. If necessary, you may want to have the
student write out the various numerical scenarios, showing
how Crusoe allocates his 24 hours for each successive day, how
many coconuts he gets to eat each day, and keeping track of his
growing stockpile of coconuts. Once Crusoe has accumulated
50 coconuts and begins constructing his pole, the student can
also map out what happens each day, to understand what it
means to say, “After saving, Crusoe invests his resources into
the construction of a pole.”
To underscore the importance of capital maintenance—in
other words, the importance of dealing with depreciation—
you might also have the student map out alternate timelines,
showing what happens to Crusoe if he doesn’t spend a fifth
hour each day working on gathering more vines etc., com-
pared to the timeline sketched out in the text, in which Crusoe
establishes a new equilibrium where he maintains the pole in
good condition. The student should find that Crusoe can enjoy
more leisure in the short run if he ignores depreciation, but
then when the pole deteriorates Crusoe faces a crisis and must
either sharply cut back on his coconut consumption, or begin
drawing down his stockpile. The lesson will obviously apply
to a modern economy that goes through a “boom and bust”
cycle, as we explain in Lesson 23.
Goods Are Valued Unit by Unit

This section teaches the principle of marginal utility. In
standard textbooks, they will often teach the related principle
of diminishing marginal utility, which states that the impor-
tance of the last unit of a good drops, as the supply of the
good increases. However, we have avoided that terminology,
because it can often “teach” the wrong lesson that utility is a
quantity of happiness, and that the “number of incremental
utils” goes down, as we add more and more units of a good
to a stockpile. We are taking pains to avoid this mentality, and
that’s why we merely describe the principle by saying goods
are valued “unit by unit.”
The diamond-water paradox is a familiar tool to illustrate
the difference between the classical approach to value, ver-
sus the modern approach in the wake of the 1870s Marginal-
ist Revolution in economic thought. (If you have not already
done so, we recommend again that you watch Joe Salerno’s
lecture at http://mises.org/media/4344.) However, you should
be aware that—as with most “revolutions” in any discipline—
the classical economists were fully aware of the role that sup-
ply and demand played in the different prices for water and
diamonds. The problem, though, was that their theoretical
framework was ill-suited to handle this complication; they had
to overlay the “obvious” facts about relative scarcity on top of
their other principles (such as a cost or labor theory of value).
The advantage of the modern, subjectivist (and marginalist)
approach to explaining economic value is that it more straight-

forwardly captures the essence of what drives all market prices.
(If you want to read a journal article dealing with the classical
vs. modern approach to pricing theory, try Robert Murphy’s
exposition here: http://mises.org/journals/jls/20_1/20_1_3.pdf.
The article eventually gets technical but the beginning will
give you a good understanding of how the classical econo-
mists explained market prices, and how the modern subjectiv-
ist approach is more elegant.)
Pulling It All Together:

What Should Crusoe Do With Himself?
In this final section, we draw together all the strands
of our discussion and argue that Crusoe tries to achieve his
more important goals, using the resources at his disposal. (Of
course these resources include his labor power.) Be sure that
the student understands that costs are fundamentally oppor-
tunity costs; they are not simply “how much money you have
to spend on something.” For example, if a woman decides to
marry one of several suitors, the true cost of her decision is not
simply the money spent on the wedding and reception. No,
the true cost to the woman of her decision includes the subjec-
tive value she places on her next-best alternative, which would
either be a different suitor, or deciding not to get married (at
that time).
For students who can handle the refinement, you should
also stress that costs are subjective, not objective facts. To con-
tinue with the wedding example, the money spent on the
reception is obviously not a “cost” to the bride, if her par-
ents are the ones paying. And even there, it’s not the bride’s
decision that “imposes costs” on the parents, but more accu-
rately it is the parents’ decision to follow tradition and kick
in the money to pay for their daughter’s wedding, once she
tells them the news. If her parents were originally planning

on using that money for a ski vacation, then the cost to them of
their decision would be the value each of them placed on going
to the vacation. (Note that each parent individually acts and
has individual valuations of the ski trip; we are lumping them
together for simplicity, to avoid getting into more details about
how the family finances are controlled.)
For an advanced student, you could also explain that some-
times the mistake occurs in the opposite direction, where peo-
ple erroneously conclude that the cost of an action is higher
than it really is, because of historical (and irrelevant) money
expenditures. For example, if a t-shirt vendor spends $1,000
printing up 500 shirts that say, “Yankees Win!” intending to
sell them in the parking lot after the final game of the World
Series, he will be devastated if the Yankees in fact lose. Some
people would say that he has to charge at least $2 for each shirt,
in order to “cover his costs.” But that $1,000 is gone, regardless
of what he does at this point. (This is typically referred to as a
sunk cost.) If the vendor finds he can sell the shirts for a dime
apiece—perhaps to disappointed fans or to gloating fans of the
true victors, who use the shirts in rude ways—that might be
his best use of them, in light of the new information. He would
probably prefer leaving the parking lot with $50 and no shirts,
rather than no money and 500 shirts that he can use as rags
at home. So the true cost of his decision to sell the shirts for a
dime apiece is not $950 ( = $1,000 - $50), but rather the subjec-
tive value the man would have received from having an addi-
tional 500 rags at home. That’s why it is still beneficial for him
to sell the shirts “at a loss,” because the decision at that point
confers higher benefits than costs. (These issues are explored
in the reading on marginality in the Supplemental Materials.)
Study Questions
1. Does economics assume that people act in

isolation from the rest of society?
No, the point of studying Robinson Crusoe is simply to keep
the analysis as simple as possible for the student. In the next
part of the book, we will explain the operation of a market
economy, which is composed of many people. However, the
same principles that apply to Crusoe also apply to individuals
in a market—the presence of other people is simply another
feature of the environment, as it were.
2. What does it mean to say Crusoe creates

goods with his “mind powers”?
Obviously we do not mean that Crusoe has magical powers
to conjure up coconuts through thought. What we meant by
this section title is that coconuts (or vines, sticks, etc.) are not
goods merely because of their intrinsic properties. In order to
become economic goods, someone (Crusoe in this case) has to
use his mind to classify them as scarce objects that can help him
achieve his objectives.
3. Can leisure be more physically demanding

than work?
Yes, as a footnote explained, it’s possible that Crusoe enjoys
swimming in the ocean as a leisure activity. This is much more
physically taxing than other chores such as gathering twigs for
a fire. Presumably Crusoe does not derive direct pleasure from
collecting twigs, and so this activity is work, not leisure.
4. Why does Crusoe need to worry about

depreciation of his capital goods?
If Crusoe ignores the wearing away of the pole, he will expe-
rience a sudden drop in his consumption. After going to the
trouble of investing in capital goods, Crusoe needs to maintain
them (by investing enough to offset depreciation) if he wants
to remain at his higher standard of living.
5. How do expectations affect someone’s

decisions?
The term expectations is simply economist jargon for fore-
casts. For every action, a person relies on his or her forecasts
of the future; that’s the whole point of acting, to try to influ-
ence future events. The text dealt with an example of Crusoe
building a raft, only to realize he couldn’t get out to the open
sea. But even more mundane actions rely on expectations. For
example, Crusoe “expects” that if he climbs a tree, he will be
able to knock coconuts down, and that the coconuts will not be
full of spiders when he cracks them open.
Callahan adapts the television reality show “Survivor”
for his own version of Robinson Crusoe economics.
• Robert Murphy, “What Does Marginality Mean?” at http://

mises.org/daily/1584.
Murphy lays out some of the implications of “thinking
on the margin.” There is discussion here of “sunk cost”
fallacies, which interest some students but are not
essential for the course.
• Murray Rothbard, Man, Economy, and State, pp. 42–72.

The material does not coincide perfectly with the layout
in this course, but the student who finds Rothbard
useful will eventually hit most of the same points if
he or she follows along with the pages as listed in the
Supplemental Materials outline.
• Murray Rothbard, “Introduction to Economics: Part I,” audio at

http://mises.org/media/4454.
Rothbard’s lecturing style leads him on many interesting
tangents that the beginning student need not pursue,
but even so this introductory lecture discusses Crusoe
economics and may be easier for some students to digest
than Rothbard’s formal treatise.
suggested
(1) Ask the student to think
activities of situations in which typically
non-scarce goods can become
scarce and hence subject
to economic analysis. For example, deep sea divers must
purchase tanks of oxygen, and we could imagine space
travelers buying gravity-generating devices for their ships.
(2) Ask the student to come up with scenarios in which

changing beliefs can alter which physical things are
considered scarce economic goods. For example, if a certain
root is believed to have medicinal properties, people will pay
others to collect it. But if it turns out that the man publicizing
the claims is a fraud, then the root might lose its status as a
good.
(3) The next time you and the student are at a store, ask
about the status of the items on the shelf, from the point
of view of the store owner and the customer. For example,
the student could say that all of the items on the shelves
are producer goods to the owner, because he or she
looks at them as a means of earning money. But from the
point of view of the customer, some of the items (such as
a loaf of bread) could be classified as a consumer good,
while others (such as a drill) could be classified either way,
depending on how the student frames the situation. (Note
that in one sense, a drill doesn’t confer direct happiness on
the consumer, except in a Tim Allen-macho-man fashion.)
Furthermore, even “obvious” consumer goods could be
classified as producer goods, depending on how the student
frames the issue. A woman might buy expensive clothes in
order to fit in with a certain group of people, for example,
even though she would rather wear sweatpants; in this
sense the items are a means to an end, i.e., producer goods.
(4) Have the student draw up a 7-day plan for Crusoe in the
new equilibrium, showing exactly how he allocates his hours
each day in a typical week, so that the supply of coconuts
never drops below 100. (A footnote in the text sketches the
answer.)
test — Lesson 4
“Robinson Crusoe” Economics
Producer or Consumer Good:

Identify the following as (most likely) producer or consumer
goods.
A. Producer good(s) B. Consumer good(s)
1. A glass of iced tea.
2. Robinson Crusoe’s coconuts.
3. Robinson Crusoe’s long stick.
4. A paring knife.

Economize Goods Land/Natural Resources

Labor Income Opportunity Cost
Saving Investment Equilibrium
Marginal Utility Capital Goods Equivocate
5. The subjective value placed on the next-best

alternative that must be sacrificed in any
choice.
6. The flow of productive services performed with

your body.
7. The evaluation of the importance of goods on

a unit by unit basis.
8. To use resources being mindful of their scarcity.
9. Factors of production that are created by

people.
63
10. Scarce items that can help a person achieve

his or her goals.
11. When someone consumes less than his or her

income.
12. When factors of production are devoted to

future income, rather than immediate
consumption.

13. Explain why an object only becomes a good when a person incorpo-
rates it into his plans.
14. Identify the distinction between a producer and a consumer good.

Test — Lesson 4 | 65
15. Explain why a person in Robinson Crusoe’s position would want, on

any given day, to harvest more coconuts than he or she planned on
consuming that day.
16. Water is necessary for life, but restaurants give it away for free.
Diamonds are mere décor, serving only vanity, but they cannot be had
cheaply. Explain this so-called “water-diamond paradox.”
17. Explain the following scenario.
Rory looked at the mess that the burglars had made, sat down on
the edge of his bed and wept. The thieves had made away with three
hundred dollars in cash, his laptop, his iPod, his Xbox 360, and all of his
games; but that’s not why he wept. More than any of those expensive
items, Rory most regretted the theft of his father’s class ring. It was only
ten carat gold, and the red center stone wasn’t even a real ruby. No
pawnshop would have given him more than fifty dollars for the ring, but it
was the loss of this ring that now left Rory emotionally distraught.
67


Part II
CAPITALISM:
THE MARKET ECONOMY
Lesson 5
The Institution of
Private Property
Society Requires Rules
T
o reinforce the connection between Lesson 4 and Part II,
you may want to stress this opening section. The general
principles we discussed regarding Crusoe still apply to
him, once he returns to civilization. In other words, it’s not that
the rules of Lesson 4 only work on tropical islands with one
inhabitant.
However, there is a problem once we recognize that in a
modern city, there are millions of Crusoes walking around,
appraising goods and trying to achieve their most preferred
goals. To settle conflicts, people assign property rights to
scarce goods. It’s not so much that the laws of economics need
to be altered to deal with a modern market economy. It’s more
accurate to say that the existence of property rights (with their
corresponding “rules of engagement”) provide a new form
of tradeoffs or constraints that each “Crusoe” must take into
account when making decisions.
To help the student see the big picture, make sure he or she
understands the layout of the text. Part I laid out the nature
and scope of economic theory, and then applied it (in Lesson 4)
73
to the case of an isolated individual. Part II sketches the oper-

ation of a pure market economy, in which everything is pri-
vately owned (and we simply assume people respect property
rights). Part III briefly describes the operation of pure social-
ism, in which the government effectively controls all natural
resources and capital goods. Finally, in Part IV we describe a
mixed economy, in which the government heavily intervenes
to influence the outcome of the underlying capitalist economy.
In an introductory course, we will rely on specific numerical
examples and hypothetical illustrations of particular concepts.
We are not trying to formally “prove” the validity of particular
laws or principles. Even so, it’s important that the student does
not get the impression that economic science “only works in
a capitalist system.” No, the underlying economic principles
apply to all people and all societies. But the institutional set-
ting can certainly influence the results of these fundamental
concepts, as we will see. For an analogy, it would be silly to
say that the principles of biology only apply to a planet that
receives as much sunshine as Earth does; obviously biology
doesn’t “assume” a particular amount of sunlight. Even so,
biology certainly can inform us that if all sunlight were sud-
denly blocked, then most life on Earth would quickly die.
Capitalism: This Is Private Property

Part II of the book sketches the operation of a pure capitalist
system, in which everything is owned by private individuals.
Note that there can still be group ownership under capitalism.
For example, business partners can jointly own the assets of
their company, and numerous shareholders can collectively
own a single corporation.
If there is any risk of confusion, you may need to clarify
that just because someone is the legal owner of a good, doesn’t
absolve him or her of all moral and religious obligations. For
Lesson 5: The Institution of Private Property | 75
example, even if someone owns his own body, and has the
legal right to shave his head or to get a vulgar tattoo, it may
still violate his religious beliefs to do so. It wouldn’t be a valid
argument against his religious peers to say, “I’m the owner so
you can’t tell me what to do with my hair!”
In an introductory course, we are not dealing with exotic
applications of private property, such as private ownership of
roads, or even private ownership of tanks and aircraft carri-
ers. This is not a course on political philosophy so we are not
addressing the important questions of the proper role of gov-
ernment in society. Rather, we are sketching the operation of
a pure market economy in order to show the student “raw”
capitalism in contrast to other institutional settings, and to
understand some of the economic effects of handling partic-
ular resources through private property, government owner-
ship, or a mixture of the two.
The Market Economy and Free

Enterprise
It is important that the student realize “the market” does
not refer to a place, even though he or she might have gone to a
“farmers’ market” at some point. In our context, “the market”
is shorthand for the market economy, which includes all of
the exchanges in a region. In modern times, most of the entire
world falls into one giant market (subject to heavy interference
from governments). Even though we often speak of the U.S.
economy, the Japanese economy, and so forth, strictly speaking
international trade connects almost all consumers and produc-
ers around the world into one nexus. If, say, Japanese factories
begin using more oil, that will lead to higher gasoline prices
for American motorists than would otherwise be the case.
You should stress the significance of free enterprise, for it
is a remarkable achievement that is taken for granted. At first
blush, it’s simply extraordinary that a capitalist system can

allow people the freedom to pick whatever jobs they want.
After all, what if not enough people become farmers, or engi-
neers, or doctors…? In later lessons we will explain how mar-
ket prices (especially wage rates and salaries) steer people into
occupations where they are needed, but for now you should at
least point out to the student that the very idea of free enter-
prise is extraordinary.
Study Questions
1. Did Crusoe need an institution of private

property?
No, the only conflict Crusoe had was with Nature. If he wanted
more coconuts to eat, he simply had to decide whether the ben-
efits outweighed the additional sacrifice of leisure. There were
no other intelligences who may have had their own designs on
the scarce goods.
2. Why does economic scarcity lead to

potential conflict in society?
Scarcity means that there aren’t enough units of a good (or ser-
vice) to satisfy everyone’s potential uses for it. In society, peo-
ple often have incompatible aims for the same unit of a good.
(If Jim eats a piece of pizza, Sally can’t eat the same piece.)
3. What are the three main institutional

settings we will study in this course?
Pure capitalism, pure socialism, and the mixed economy (as
defined in the student text and also above).
4. Is the sketch of a pure market economy a

realistic depiction of the United States?
Not at all! Historically, the United States was the closest to
a large, pure capitalist economy the world has ever known,
but the U.S. federal government has grown steadily since its
birth. Even though many people consider the United States
in the early 21st century to be an illustration of the operation
of capitalism, in our terminology it is most definitely a mixed
economy.
5. What does it mean when an economist says,

“We should let the market decide”?
Such a statement means that the government should not inter-
fere with the outcome of voluntary interactions among private
property owners. It’s important for students to realize that
letting “the market” decide something isn’t ceding decision-
making authority away from concerned individuals and into
the hands of a lifeless concept. On the contrary, “the market”
in this context refers to the decisions made by certain individ-
uals in the private sector, and any government involvement
would simply substitute the desires of government officials for
the people in the private sector. Decisions are always made by
individuals.
• Ludwig von Mises, Human Action (Scholar’s Edition, available at
http://mises.org/resources/3250), Chapter XV, Section 1, pp.
258–60, 264–70.
As should be clear by now, this course relies heavily
on the work of economist Ludwig von Mises.
Unfortunately, Mises’s writing can be quite difficult for a
newcomer, because not only is his language very formal,
but he also assumes that his readers are familiar with
a wide range of subjects. Even so, advanced students
should at least try to read the excerpts from Mises’s
magnum opus, Human Action. Assure them that even
professional Austrian economists can struggle with some
portions of the book, but it is worth sampling because
of its importance in the development of the modern
Austrian School. For students who want to jump in,
there is a study guide to the book at http://mises.org/
books/humanactionstudy.pdf.
• Thomas DiLorenzo, “Capitalism, Our Benefactor,” audio at

This is an easy-to-follow talk by an economist who
writes extensively on American history. Students
should enjoy the familiar historical episodes presented
(perhaps) in a radically new light.
• Ralph Raico, “Liberalism,” video at http://mises.org/

media/4358.
Historian Ralph Raico lays out the principles of classical
liberalism, referring to the program of capitalism,
reason, limited government, and peace among nations,
that Mises and others tried to defend in the twentieth
century against the competing ideas of socialism and
(what would now be called) progressivism. Note that the

modern term “liberalism”—to describe for example the
political views of the late Sen. Ted Kennedy—is not at all
the same as the classical liberalism that Raico describes.
suggested
activities (1) Especially if the
student is an animal
lover, you could ask
whether it’s really correct to say that Crusoe was the only
intelligent mind on his island, appraising the scarce goods.
For example, what if Crusoe’s activities destroyed bird
nests? There is no preferred answer here, but you should
point out the difficulties in actually assigning property
rights to birds, monkeys, etc. Note too that just because
someone has the legal right to use an object (i.e., is its
owner), doesn’t relieve him or her of moral or religious
responsibilities. For example, even if we can agree that
Crusoe is the effective owner of everything on the island,
we can still consider it deeply immoral for him to commit
wanton cruelty to the animals on it.
(2) One of the most difficult problems in applying

the concept of private property in the real world, is
understanding the boundaries between various property
rights. A discussion on these issues might be fruitful.
The classic expression of this idea is to say, “Your right
to extend your fist ends where my nose begins,” but
there are many other examples. For example, does a
homeowner have the right to throw a noisy party on his
own property at 3 a.m., or do his neighbors have the right
to exclude disturbing sound vibrations from entering their
property? These subtleties lie outside the scope of this
course, but they could provoke interesting discussions.
Murray Rothbard laid out a particular view of property
rights in his book The Ethics of Liberty, at http://mises.
org/rothbard/ethics/ethics.asp. Note that not all
libertarian or even Austrian scholars would necessarily
endorse Rothbard’s views, but the book at least provides
an example of a serious attempt to answer the question
of assigning actual property titles.
test — Lesson 5
T h e I n s t i t u t i o n o f P r i vat e
Property
Multiple Choice: Choose the best answer.
1. The capitalist system is based upon

A. trade protection.
B. trade surpluses.
C. private property.
D. government intervention.
2. Capitalism was originally a smear used by which socialist founder?

A. Adam Smith
B. Jean-Jacques Rousseau
C. Vladimir Lenin
D. Karl Marx
E. Paul Krugman
3. These were medieval associations of craftsmen designed to limit com-

petition in a certain trades.
A. guilds
B. temperance societies
C. inquisitions
D. labor unions
4. The system in which individuals may choose to enter any line of work
that they so choose is called
A. Crusoe economics.
B. mixed market.
C. free enterprise.
D. socialism.
83

Market
Free Enterprise
Guilds
Slavery
Private Property
5. An association of craftsmen that regulates com-

petition.
6. The institution assigning ownership of goods to

specific individuals.
7. The whole web of exchanges that individuals

make with their private property.
8. When some individuals have the legal right to

the bodies and services of other individuals.
9. Explain why the boundaries imposed by property ownership are abso-

lutely essential to a capitalist system.
10. Explain how property rights minimize conflicts.

87

Lesson 6
Direct Exchange and

Barter Prices
Why Do People Trade With Each Other?
O
ne of the most crucial principles in all of modern eco-
nomics is that both parties benefit from a voluntary
exchange. (Or more precisely, both parties expect to
benefit.) For the purists, note that technically we mean benefit
on net, or in other words, both parties expect the benefits to
outweigh the costs when they engage in a voluntary trade.
This is possible because preferences are subjective. For
example, it would not be possible for both parties in a trade
to walk away with a heavier object than each started out with.
That’s because weight is an objective fact, an intrinsic property
of an object. In contrast, value is in the mind of the beholder,
and that’s why two people can both feel they gave up some-
thing of lesser value, in exchange for something of greater
value, when they make a voluntary trade.
The text mentions the caveat that the parties expect to ben-
efit. This is because, after the fact, one or both parties might
regret the decision. For example, if someone sells a parcel of
land for a certain sum of money, and then later discovers that
there was a large oil deposit on the property, the seller will
probably regret the earlier decision.
89
Direct Exchange / Barter

Even though many textbooks jump right into a discussion
of exchanges against units of money, in this course we opt to
start with barter. There are several reasons for this. First, trad-
ing with money is simply a special case of the principles we
develop in this chapter; in other words, everything we say in
the analysis of barter prices is true for money, because units
of money are units of a (very special) good. Second, histori-
cally people must have traded with each other in barter, before
they began using money. Third, we want to show that money
emerged spontaneously through market exchanges—not from
the edicts of a government official—in Lesson 7. But in order
for that demonstration to make sense, the student will first
need to understand the formation of barter prices which we
develop in the current chapter.
Be sure that the student isn’t confused by the term direct
exchange, since we earlier defined a consumption good as one
that confers direct utility or satisfaction. As we point out in
the text, even though a producer good only confers indirect
utility or satisfaction (e.g., you can’t eat a tractor, but you can
use it to harvest more food), even so a producer good can still
be acquired through direct exchange. So the contrast between
direct and indirect means different things, in the context of
consumer versus producer goods, and direct versus indirect
exchanges.
Prices
The material in this section is fairly straightforward. Just
make sure the student understands that money is a good, and
why we can reverse prices as we normally express them to talk
about how many units of some other good (cars, bubble gum,
etc.) one needs to sell in order to “buy” one unit of money.
For example, if a car’s price is $15,000, then that is equivalent
Lesson 6: Direct Exchange and Barter Prices | 91
to saying that a car dealer needs to sell 1/15,000th of a car to

buy one dollar. If that seems too contrived because no one sells
fractional cars, you can use an example of a good that costs less
than $1. For example, if we are dealing with a pack of chewing
gum that sells for 50 cents, then the seller of the gum must sell
two packs in order to buy one dollar bill.
As we will make clearer in Lesson 7, one of the great virtues
of trading with money is that people only need to keep track
of one price for every good. In an economy with 20 goods (not
counting the money good), using money means that people
only need to stay up to speed with 20 different price ratios.
In barter, in principle they would need to stay aware of 190
independent ratios. This is because there are 20x19=380 total
arrangements of goods, taken two at a time. However, half of
those prices would be redundant, because if a trader knows
the banana:orange price ratio, he can simply use division to
obtain the orange:banana ratio.
How Prices Are Formed in Barter

As the text says in a footnote, the material in this section
might be too difficult for some students. However, we suggest
that you urge even hesitant students to at least work through
the section, even if they don’t fully absorb all the details. Once
the student understands how the tables work (which may
require help from you), the narrative should be fairly intuitive.
Notice that the explanation of barter price formation in this
section relies very heavily on the fact that preferences are rank-
ings, not measurements. Nowhere in this section do we use
“utility functions” or assign a total “enjoyment number” to a
particular combination of candy bars. All we need to assume is
that the siblings can rank various combinations of candy bars
in order of most to least preferred, and that is sufficient to dis-
cuss equilibrium barter prices.
Be sure the student understands the reason for making Alice

and Billy’s preferences identical. We are showing that differ-
ent initial endowments of candy can yield gains from trade.
In other words, it wouldn’t be so surprising if a Snickers-lover
could make mutually advantageous deals with a Milky Way-
lover. But the student might not have realized that because
goods are valued on the margin (or unit by unit), even people
with identical preference rankings can still gain from trade (if
they start with different combinations of goods).
To avoid confusion, you might want to tell the student that
there are no “rules” on preferences in the real world. In our
numerical examples, Alice, Billy, and Christy exhibit obvious
patterns in their preference rankings for candy bars. We did
this so as not to overwhelm the student, and also to crisply
illustrate the influence of different tendencies (such as desire
for more candy and for variety). In the real world, people don’t
have to justify or explain their preferences according to par-
ticular forces that “generate” them.
The student text should be self-explanatory, once one
knows how to read the tables. If necessary, you may need to
copy the relevant pages (or print them from the online version)
in order for the student to be able to refer easily back and forth
between the text’s discussion and the relevant table. Although
the process may seem tedious to some students at first, the
ultimate payoff should make it worthwhile. Many readers will
probably be surprised at the end of the chapter when they real-
ize they completely understand every aspect of the “market”
where Snickers are sold against Milky Ways (and vice versa).
The discussion quickly changes from some truisms about chil-
dren and candy bars, into general insights about markets.
For the advanced student, you should be clear as to exactly
what we have shown in this section. We did not prove that the
children had to exchange their candy bars according to one of
the described equilibrium scenarios. As the text explains, even
if the children really had the preferences we ascribed to them,
it would still be possible for them to fail to trade at all, because

of strategic miscalculations. It’s also possible that two children
could make a trade that the third party would have liked to
stop with a counteroffer, but failed to act in time. In that sense,
two of the children could regret a voluntary trade that one of
them made with the third child, even though the child making
the trade thought it was a good idea at the time.
Some textbooks might describe the equilibrium outcomes
as ones that would be likely to occur if the children showed up
day after day with the same preferences and the same initial
holdings of candy. However, even that isn’t quite right, because
then children might be tempted to engage in long-range stra-
tegic ploys, playing hardball in the first few rounds in order
to obtain better trading terms later on. We think it’s simplest
just to say that the equilibrium outcomes we’ve sketched are
the ones in which there are no further gains from trade, and
in which no one regrets the trades in light of new information
(such as a third child saying, “Why did you sell for such a low
price?!”).
Collapsing the Scope of Prices By Adding More Traders
The material in this final subsection is the hardest of the

chapter. If a student is lost, you can safely omit the discussion
concerning “knocking out” equilibrium prices with the arrival
of Christy. However, even for such a student you should at
least have him study the discussion of the equilibrium (with
all three children) where 1 Snickers trades for 2 Milky Ways, in
which Alice sells 2 Snickers and buys 4 Milky Ways, while Billy
and Christy each buy 1 Snickers and sell 2 Milky Ways. This
discussion ties all the strands together and shows a complete
market from a bird’s eye perspective.
Study Questions
1. How is it possible for both parties to benefit

from the same exchange?
Economic value is subjective.
2. *If a producer good only provides benefits

indirectly, can a producer good be obtained
via direct exchange?
Yes. The text discusses the example of a farmer trading away
bacon for tomato seeds, which are presumably a producer
good (intended for planting to yield tomatoes). So long as both
farmers intend on using the obtained goods themselves (rather
than trading them away yet again), the exchange is a direct
one. (The distinction between direct and indirect exchange will
be much clearer after you work through Lesson 7.)
3. Suppose the economy has only four goods:

apples, oranges, bananas, and grapes.
In barter, how many independent price
ratios would exist? (E.g., the apple:orange
ratio would not be independent of the
orange:apple ratio.)
There are 4x3=12 different pairs of goods, but only 6 if the order
is unimportant. So in a barter economy with four goods, trad-
ers would need to keep track of 6 different price ratios. Specifi-
cally, they are: apples:oranges, apples:bananas, apples:grapes,
oranges:bananas, oranges:grapes, and bananas:grapes. (If you
know that 1 apple trades for 2 bananas, then you automatically
know that 1 banana trades for half an apple. That’s why you
only need to keep track of 6 total exchange ratios in this small
economy.)
4. If Alice likes Snickers more than Milky Ways,

does that mean she would always choose
a Snickers over a Milky Way, if offered a
choice between one or the other?
No, because she might start out with more Snickers than Milky
Ways. For example, if Alice starts out with (2 Snickers and 0
Milky Ways), she would rather obtain one additional Milky
Way than one additional Snickers. The former gift would raise
her to the 14th spot on her preference ranking, whereas the
latter would raise her only to the 19th. (She would start at the
21st spot.) Note that in a sense, it’s inaccurate to say “Alice
likes Snickers more than Milky Ways” for this very reason, but
of course in everyday language we speak like this all the time.
5. *In what sense did Christy’s arrival “knock

out” some of the possible equilibrium prices
that could have formed between Alice and
Billy?
All we mean is that Christy would be willing to make
counteroffers to prevent some of the original equilibrium
trading outcomes from occurring. Intuitively, Alice wouldn’t
sell Snickers at such low prices to Billy once Christy enters
the scene with her stockpile of Milky Ways and her tendency
to prefer Snickers.
Callahan outlines the basics of direct exchange. Reading
his chapter 4 in conjunction with this course’s Lesson
6 may help the students to really grasp the material.
However, Callahan begins his chapter with a discussion
of the division of labor, a topic we won’t cover until
Lesson 8.
• Murray Rothbard, Man, Economy, and State, pp. 84–94,

103–26.
For advanced students who want a more thorough
treatment, the Rothbard excerpts provide a more
standard exposition based on the historical development
of the theory of barter pricing in economic thought.
However, you should be warned that Rothbard’s tables
do not work the same way as the ones in this course.
Rather than listing all possible combinations of goods,
Rothbard instead constructs preference rankings (or
“value scales”) based on the person’s original holdings.
Then he uses parentheses to indicate items that are not
yet in the person’s possession. The underlying principles
are the same, but some students may be confused by
the different technique for depicting preferences. The
advantage of the method we have adopted in this book
is that it quite clearly shows the ranking of various
hypothetical outcomes, but the advantage of Rothbard’s
approach is that he can handle larger quantities of goods
and thus give more realistic numerical examples.
suggested (1) If you have more

activities than one student, an
obvious activity would
be to create your own
market using candy bars (or some other goods that you
deem more appropriate). You could try to demonstrate
the effect of different initial endowments by conducting
the trials over several days. On Day 1, you might give
some students nothing but Snickers, while others are given
nothing but Milky Ways. Record who was given what, and
then record the outcome of their voluntary transactions.
On Day 2, you could reverse the initial distribution, and see
what difference it may have made. (Ideally you would use
the bite-size bars, and not give so many that the students
would carry them forward to the next day and possibly
disrupt the “experiment.”) Of course this wouldn’t be a truly
controlled experiment, because the students’ preferences
could change from day to day, and their bargaining
strategies could also evolve as they gain experience. Even
so, it might be interesting to document actual barter price
formation with goods that they really value. Implementing
the candy bar market for real would also drive home the
point that (with three or more students) you need to set
up procedures for how trades will be conducted. To keep
things as close to the text discussion as possible, you might
be an umpire and allow any student to offer a trade to
another, but then give all other students a chance to make
a counteroffer if they think allowing the announced trade to
go through would hurt their position.
(2) If you have at least four students, you could also try
conducting different trials in which the students are isolated
in smaller markets on Day 1, and then all lumped together
in a single market on Day 2. It would be very interesting to
see if the same Snickers:Milky Way price were established
in each of the smaller markets on Day 1, and (if not) what
price was established in Day 2 in the big market including
all students.
Test — Lesson 6
Direct Exchange and
Barter Prices
Short Answer:
On the lines provided, answer the questions in 1 to 3 sentences.
1. Explain how, at the moment of exchange, both parties in a voluntary

trade expect to benefit from it.
2. Suppose a farmer trades the metalsmith 10 pigs to obtain an axe that

the farmer will use to chop down trees. The metalsmith intends to keep
the pigs and eventually eat them. Is this a direct or indirect exchange?
Explain your answer.
99
3. How does subjective value make “gains from trade” possible?
4. In the Halloween candy example, what did we mean by an “equilibrium

position” or “equilibrium price”? Was the textbook saying that such an
outcome had to occur?
5. Do people need money in order for market prices to form? Explain.

103


Lesson 7
Indirect Exchange and the

Appearance of Money
F
or this chapter you should understand some technical
distinctions to place this material in context with other
books. Most economists use the term barter to refer to any
non-monetary exchange. Therefore, a “barter economy” under
this broad definition would still allow for people to use media
of exchange, that is, to engage in indirect exchanges.
For advanced students, you should therefore be careful in
the presentation of the material below, especially the first sec-
tion. There, we are showing the limitations of a world strictly
confined to direct exchange. Notice that this is more restrictive
than a world confined merely to barter. In other words, in our
considerations of “The Limitations of Direct Exchange,” we
aren’t just ruling out the use of money, we are going much fur-
ther and ruling out the use of any medium of exchange at all.
This is a harsher condition, because money is a very special
kind of medium of exchange, namely one that is accepted by
almost everyone in the community.
Then, in the middle of the lesson, we introduce generic
indirect exchange, but do not yet suppose that there is one
medium of exchange involved in every transaction. This is a
subtle point, but should help advanced students clarify their
thinking. (It is also related to the 5th study question.)
Finally, at the end of the lesson we explore an economy that
not only has indirect exchange (i.e., where people use media
107
of exchange, that is, where they accept some things in trade

with the intention of trading them away to a third party), but
goes further and uses money. To repeat, a monetary economy
is a very special case of an economy that practices indirect
exchange. So there are not three categories here, only two:
Direct and indirect exchange. Monetary exchange falls into the
latter category, but we can imagine indirect exchanges that do
not involve money.
The Limitations of Direct Exchange

It is common to explain the limitations of direct exchange
by citing its need for a “double coincidence of wants.” For
example, in order for a dentist to get bread, he has to find a
baker with a toothache. Most textbooks (if they even mention
this) drop the matter there, and assume the case for money has
been made.
However, the Austrian School economists tend to push
the analysis much deeper, showing that business production
itself would be impractical in a world of direct exchange. This
is partly due to the fact that Carl Menger, the founder of the
Austrian School, discovered the mechanism by which money
could spontaneously develop in a market originally limited to
direct exchange, and so Austrians are particularly suited and
eager to teach the mechanism to modern students. (We explain
this process later in the chapter.) The Austrian attention to
the categories of direct versus indirect exchange, and the spe-
cial case of money, is also attributable to the Austrian focus
on market processes, rather than the calculation of equilibrium
states or positions. Whatever the reason, it is undeniable that if
you read the excerpts from Murray Rothbard assigned for this
lesson, you will see a much more thorough discussion of the
limitations of direct exchange (and barter) than you will in any
standard textbook.
Lesson 7: Indirect Exchange and the Appearance of Money | 109
The Advantages of Indirect Exchange

For students who have difficulty keeping long chains of
reasoning crisp in their minds, you will probably want to have
them draw out the important elements of the narrative involv-
ing the farmer seeking shoe repair. The exercise will be useful
not only for this lesson, but also later on in Lesson 15 when we
discuss the problems of central planning. The students need to
get an idea of just how complex a modern economy is, and the
act of drawing out the sequence of trades necessary to achieve
shoe repair might help toward this goal.
To avoid confusion, you should reinforce the text’s clari-
fication that the table listing the preferences for the Cobbler,
Farmer, and Butcher has simplified the narrative in the body
of the text. Specifically, the table omits the Fisherman, because
a scenario involving three people was already complicated
enough.
Also, some students may not understand the connection
between the Cobbler’s leisure and the Farmer’s repaired shoes.
Obviously for a service (such as shoe repair), the seller is giv-
ing up leisure, while the buyer is receiving the product or ser-
vice. In other words, when it comes to the possible gains from
trade when one of the items is a service, the seller sacrifices
leisure but the buyer isn’t gaining the other person’s leisure.
The Advantages of Money

To recapitulate the layout of this chapter: First we showed
the severe limitations of an economy limited to direct exchange.
In the previous section, we relaxed that harsh assumption and
allowed for people to engage in indirect exchange.
However, there are still problems with generic indirect
exchange, in which people accept things in trade that they
intend to trade away in the near future, but where there is no
single medium of exchange that just about everyone treats this

way. In other words, we are here focusing on the limitations of
a world in which some people accept fish, butter, and bacon in
indirect exchanges, but other people don’t. Those other people
might only accept salt, milk, and tobacco in indirect exchanges,
which the first group of people would never accept in trade
(save for their possible direct desire to use these goods person-
ally in their own households).
When there is no “common denominator” in exchanges—
meaning when there isn’t a single good that participates on
one side of just about all transactions—then it is much more
difficult for people to keep track of “the market” and calculate
whether they are being offered a good price in a potential trade.
The use of money greatly simplifies the computations required.
(One of the Suggested Activities expands on this point.)
Who Invented Money?

The idea of spontaneous order is quite popular in some aca-
demic circles. In order to help the student grasp the concept
as it applies to the development of money, you may want to
introduce it in more familiar contexts, such as spoken lan-
guages or the natural sciences. (One of the Suggested Activi-
ties elaborates.) The crucial concept is that there are practices
and institutions that are clearly not “natural,” in the sense that
they were created by human beings, but at the same time their
whole scope wasn’t consciously designed by any one person
or group of people. Too often in political debates, people just
assume that a complex social institution must have been delib-
erately designed by someone, or at least that “experts” could
improve on something (the distribution of goods, for example)
if they tinker with it.
We emphasize it in the text, but be sure the student real-
izes that there is nothing that requires gold and/or silver to
be money. It is simply the case that in a true free market under

modern conditions, people would probably gravitate toward
these commodities which would blossom once again into
worldwide monetary goods, just as they did in the past.
Study Questions
1. What’s the difference between direct and

indirect exchange?
In direct exchange, both parties plan on using (either for con-
sumption or production) the item they obtain through the
trade. In indirect exchange, at least one of the parties plans on
trading away the item obtained through the trade.
2. Why would specialization be impractical in

a world limited to direct exchange?
A world limited to direct exchange would require a “double
coincidence of wants” before a trade could occur. It would be
impractical for someone to specialize in the production of ser-
vices or goods that were of high value but rarely needed, such
as (say) a heart surgeon or an orthodontist. In order to obtain
enough food, clothing, and other goods for a comfortable
living, the orthodontist would need to find—every week!—
someone with meat, bread, etc., who needed work done on his
braces, etc. In such a world, people would have to always be
ready to fall back on their own production for necessities, and
couldn’t spend time becoming a true expert in a specialty. Note
also that the orthodontist wouldn’t be able to accept, say, 100
chickens from a farmer in exchange for a lot of dental work,
because if the orthodontist then used some of the chickens to
obtain other items, it would no longer be direct exchange. (At
least some of the chickens would have served as a medium of
exchange for the orthodontist.)
3. How does indirect exchange facilitate the

strategy of “one step back, two steps
forward”?
With the possibility of indirect exchange, an individual can
“sell” her wares and receive something she doesn’t directly
desire, and in this sense has taken a step back in the goals she
can satisfy with her possessions. But if she can then trade away
the medium of exchange to obtain something she likes even
better than the original possession, she has taken two steps
forward.
4. What are the disadvantages of indirect

exchange without money?
Without money, various goods all trade against each other
directly. This makes it very difficult for someone to determine
the “best deal” when he wants to unload a particular good and
buy something else. He can quickly spot one way of doing so,
but it’s a very complicated problem to figure out if there is a
more lucrative way. (One of the Suggested Activities elabo-
rates on this idea.)
5. *Describe a society in which the people

practice indirect exchange, but have not yet
developed money.
If there is indirect exchange, it means that at least some people
in the society accept goods that they don’t directly want (for
production or consumption). So there are media of exchange.
However, if money has not yet developed, it means that there is
no one medium of exchange that everyone is willing to accept.
In other words, some members of the community accept
Medium of Exchange #1, while some others accept Medium of
Exchange #2, and so forth. In a monetary economy, (virtually)
everyone accepts the same medium of exchange.
• Doug French, “Money…” video at http://mises.org/media/4286.
French’s talk is aimed at high school students and
provides a very understandable introduction to the
Austrian view of money. He shows exhibits of different
types of money that should interest students.
• Robert Murphy, “The Origin of Money and Its Value,” at http://

This should be a fairly straightforward article that
formally lays out the Austrian view of money. It is
unavoidably technical at points because its purpose
is to explain the specific contributions of Carl Menger
and Ludwig von Mises to economic theory. However,
most students should be able to absorb at least the main
lessons.

Callahan covers much of the same territory that we
have in our treatment. He opens the discussion with a
list of attributes that money typically possesses, such
as ease of transport and divisibility. Be aware that
these are not requirements for something to qualify as
money. Something is money if it is a (nearly) universally
accepted medium of exchange. The attributes Callahan
discusses are factors that propel certain goods into
meeting the definition of money.

The Rothbard excerpt analyzes the difference between
direct and indirect exchange a bit more formally.
• George Selgin, “The Private Supply of Money,” video at http://

Much of Selgin’s discussion is unnecessary for the
basic points of this lesson, but some students may find
his historical accounts fascinating. The overwhelming
majority simply assume that governments “had” to
create money, but Selgin shows the historical superiority
of private mints over their government counterparts.
• TIME article from 1933 discussing FDR’s gold

confiscation, at http://www.time.com/time/magazine/
article/0,9171,882486-1,00.html.
Almost immediately after his inauguration in the depths
of the Great Depression, Franklin Delano Roosevelt
ordered American citizens to turn in all of their gold
(except for rare coins, jewelry, and other non-monetary
items). Students may be surprised to learn that before
FDR’s confiscation, the government was contractually
bound to hand over a certain weight of gold to anyone
who presented it with U.S. dollars. (Specifically, $20.67
legally entitled the bearer to one gold ounce.) It was
because of its historical link to gold that so many people
used U.S. paper dollars in the first place.
• R.A. Radford, “The Economic Organization of a P.O.W. Camp,”

Economica vol. 12, 1945, available at http://www.albany.
edu/~mirer/eco110/pow.html.
The Radford paper is a classic among economists. Some
of it is a bit formal, but most students should still be
able to glean the general message. Radford was a P.O.W.
during World War II, and in this paper he explains how
cigarettes spontaneously evolved into money among the
prisoners.
suggested
activities (1) If appropriate for
the student, draw up
(or have the student
do so) a simulated economy on a sheet of paper, listing 5 –
10 different people and their offer prices for 3 – 5 different
commodities. (You should start on the low end of these
ranges and then increase them, to see how quickly the
complexity increases.) For example you might initially try
something like the following:
Alice Bob Charlie Dan Ed Frank

10 eggs for 0 eggs for 1 8 eggs for 2 apples for 1 egg for 2 0 apples for
1 pound of apple 1 pound of 1 egg apples 1 egg
bacon bacon
5 apples for 1 pound of 22 apples 1 pound of 1 pound of 1 pound of

1 pound of bacon for 50 for 1 pound bacon for 12 bacon for bacon for 11
bacon apples of bacon eggs 30 apples eggs

In the context of the above community, ask the student to
find the way to achieve the most eggs, starting with a pound
of bacon. If limited to direct exchange, the answer would
be obvious: Only Alice and Charlie are willing to offer eggs
for bacon, and Alice’s offer is better. So clearly—if limited to
direct exchange—the student should trade with Alice and
achieve 10 eggs for a pound of bacon.
However, with the possibility of indirect exchange, things
are not so simple. The student needs to check if there is
an indirect way to achieve more than 10 eggs, starting with
an initial pound of bacon. (Note that we assume that Alice,
Bob, etc., will trade as many units as the student wants, at
the posted price ratios.) For example, if the student trades
with Charlie, he or she can obtain 22 apples for the original
pound of bacon. Then the student can take those 22 apples
to Ed and obtain 11 eggs. Disregarding the extra hassle,

this indirect route yields 11 eggs for the original pound of
bacon, versus the 10 eggs using only direct exchange.
With only 5 other people and three commodities total, it’s
not too difficult to go through and quickly calculate the
most advantageous trading paths, for a specified starting
number of units of one good and a desired end good.
But by introducing more goods and people, the process
becomes very difficult very quickly. The point with these
exercises isn’t even for the student to find the correct
answer, but just to see how difficult it becomes without
money.
Once you have pushed the student as far as you plan in
terms of the complexity of scenarios like the table above,
introduce silver money and show how quickly the student
can find the best way to transform a pound of bacon into
eggs. (Note in the following table, the economy is not
necessarily equivalent to the economy depicted in the
above table; we are keeping things similar just to show
the difference that having a single medium of exchange
makes.)
Alice Bob Charlie Dan Ed Frank

1 ounce of 1 oz. of 1 oz. of silver 1 ounce of 1 ounce of 1 oz. of
silver for silver for for silver for 10 silver for silver for 2
1 pound of 100 apples ½ pound of eggs 8 apples pounds of
bacon bacon bacon
5 apples 1/10 pound 7 apples for 8 eggs for 1/3 pound 1 egg for
for 1 ounce of bacon for 1 ounce of 1 ounce of of bacon 1 ounce of
of silver 1 ounce of silver silver for 1 ounce silver
silver of silver
Using the above table, the first move is easy enough: The
student should sell his or her pound of bacon to Charlie,
in order to receive 2 oz. of silver. Because all transactions
work “through” silver—in other words, nobody is trying to
buy bacon with anything other than silver—the student
obviously puts him or herself in the most advantageous
position by selling the bacon to the person who offers the

most silver for it, namely Charlie.
Notice that already, the monetary economy has simplified
things for the student. With the previous table, the student
wasn’t sure which good to trade against in the first round,
whereas it is obvious when everyone sells everything for
the money commodity.
We have chosen the numbers in the table featuring silver,
such that the optimal second step is the “obvious” one
of using the 2 ounces of silver to buy 16 eggs from Dan.
Looking at the various offers of eggs per unit of silver,
clearly Dan offers the best terms.
However, there is a subtlety that you should point out
to the advanced student. Strictly speaking, after the
student has acquired his or her 2 ounces of silver
from Charlie, the next step would be to check for any
arbitrage opportunities. This would occur if there were a
“guaranteed” way to make money (i.e., silver) by taking
advantage of price discrepancies between buyers and
sellers. For example, look at the highlighted number 5 for
Alice. If Alice were instead willing to sell 12 apples for an
ounce of silver, there would be an arbitrage opportunity.
The student could take the 2 ounces of silver (obtained
from selling the bacon to Charlie), buy 24 apples from
Alice, and then sell them to Ed for 3 total ounces of silver.
Thus, the student would have transformed the original 2
silver ounces into 3 ounces. The source of this gain would
be the student’s observation that Alice is selling apples
at a price of 1/12 an ounce of silver each, whereas Ed
is buying apples at a price of 1/8 per oz. of silver each.
Since 1/12 < 1/8, the difference in prices offers a clear
speculative opportunity to “buy low, sell high.”
To be clear, there are no arbitrage opportunities in the
table above; we are simply showing what would happen
if the highlighted 5 had instead been a 12. It is easy to
check for arbitrage opportunities; the student can look to
see if any of the commodities (bacon, eggs, and apples)
are being sold on the bottom row for a lower unit price
than they are being purchased along the top row. Because
of the way fractions work, this is equivalent to checking
that the number of units of a good (apples, eggs, or
pounds of bacon) is lower in the bottom row, than it is
in the top row. For example, to check that there are no
arbitrage opportunities in apple investment, the student
just needs to verify that the 5 apples and 7 apples on
the bottom row (in Alice and Charlie’s columns) are lower
numbers than the 100 apples and 8 apples in the top row
(in Bob and Ed’s columns).
Although there is always the possibility of arbitrage—
buying low and selling high for a virtually “riskless”
gain—speculators are much more likely to spot such
opportunities and eliminate them in a monetary economy.
Just as it is straightforward for the student to check for
such opportunities, so too could Alice, Bob, etc., look
around and see if there were easy ways to make silver in
this fashion.
In summary, not only does the use of money greatly
simplify the first step for a trader—he or she knows to sell
wares to the person offering the most units of the money
good—but the use of money also makes it easier to see if
there is a speculative opportunity because of the pricing
among others in the community. Furthermore, in practice
average buyers and sellers wouldn’t even need to worry
about such possibilities, because savvy speculators would
most likely have already spotted the arbitrage opportunity
and whittled it away through buying and selling.
(To see how this works, consider that if Alice initially were
willing to give up 12 apples for an ounce of silver, while
Ed gave an ounce of silver for 8 apples, then traders
would make a silver gain by buying apples from Alice and
selling them to Ed. In principle, a speculator would want to
carry out this operation an infinite number of times. But in
reality, of course, eventually Alice would run low on apples,
and would be overflowing with silver. Ed, on the other hand,

would run low on silver and would be overflowing with
apples. So the arbitrage opportunity couldn’t last forever;
eventually Alice would lower the number of apples she
offered for an ounce of silver, while Ed would raise the
number of apples he required before giving up an ounce of
silver.)
(2) Motivate the concept of spontaneous order by

discussing more familiar examples. For instance, ask the
student “who decides” on the definition of the word red. If
the student says, “The people who write dictionaries,” then
ask what would happen if all of the new dictionaries next
year defined red as the typical color of ocean water. Would
everyone start saying the ocean is red, or would everyone
instead say, “The dictionary writers put the wrong definition
in for red!”? You can also ask, “Which group of people is
in charge of physics, or of women’s fashion this season?”
Of course there are particular people at any moment who
have far more influence than others, but it’s worth exploring
exactly how they achieved this position. The goal is for
the student to see that these clearly human “things”—the
definitions of words in the English language, the current
state of the field of physics, or what’s “in” for women’s
fashion this season—aren’t the result of a conscious plan
created by a single group of experts. These “things” are the
result of human action, but not (totally) of human design.
Much of the resulting patterns were not anticipated by
anybody, and it involved the interaction of millions of people.
Test — Lesson 7
Indirect Exchange and the
Appearance of Money
Short Answer:
1. Explain the advantages and limitations of direct exchange.
2. Explain how a community could use indirect exchange but not have
money.
121
3. Explain what economist Friedrich Hayek meant when he used the

term “spontaneous order” in reference to the origin of money.
Listing: For each commodity, list the attributes (you can put more than
one) of a good money that each has.
A. Very durable
B. Easily divisible
C. Easily transportable
D. Convenient market value (by weight)
E. Units very similar quality
4. House
5 Horse
6. Bananas
7. Gold
8. Silver
9. Aluminum
10. Plutonium
11. Emeralds
125


Lesson 8
The Division of Labor

and Specialization
The Division of Labor and Specialization
T
he material on the division of labor and specialization
is fairly standard. One difference is tying the concepts
to the use of money. Because most textbooks don’t dwell
much on a monetary vs. a barter economy in the first place,
they typically don’t explain that money allows a much greater
development of the division of labor.
It is a fairly basic point, but be sure the student sees the
connection between labor productivity and the standard of liv-
ing. The only way everyone can continue to consume more stuff
over time, is if everyone produces more stuff over time.
Why Specialization Makes Labor

More Productive
For the basic student, the important message of this sec-
tion is simply that specialization makes labor more productive.
For most students, this lesson can best be illustrated by imag-
ining a catastrophe in which most of the world’s population
is wiped out. Besides feelings of loneliness and despair, the
survivors would be in dire straits from a purely materialistic
129
viewpoint as well. Make sure the student understands that this

thought experiment illustrates the tremendous advantages of
the division of labor.
The more advanced student will benefit from trying to
break down the general superiority of specialization into spe-
cific causes. (Note that we are using the terms division of labor
and specialization interchangeably, but some writers might
make a subtle distinction in which specialization is a special
case of the division of labor, where people remain in one or
a few niche areas. In general, we could imagine a division of
labor in which everyone rotates jobs every day or week, so that
it wouldn’t necessarily be a case of “specialization.”)
Enriching Everyone By Focusing

on Comparative Advantage
Our earlier concentration on property rights and exchange
shows up in this section, as we mention that the benefits of
specialization can only be reaped when people are secure in
their property and can trade with each other.
The principles of absolute and comparative advantage are
bedrock in modern economics. In this course, we introduce
them in a simpler setting (namely a clothing store in the mall)
and defer the more traditional treatment—in the context of
international trade—until Lesson 19.
Historically, Adam Smith made a very strong case for free
trade (in his Wealth of Nations in 1776) but the argument relied
on absolute advantage. In other words, Smith showed that if
England could produce more mutton per hour of (English)
labor than France could produce per hour of (French) labor,
while at the same time France could produce more wine of a
certain quality per hour of labor than England could, then it
would make both countries richer if their governments allowed
Lesson 8: The Division of Labor and Specialization | 131
England to export mutton and import wine from France. This

is common sense once we spell out the situation.
However, later economists (such as James Mill and David
Ricardo) took the case further and showed that two nations
could become wealthier through trade, even if one of them had
the absolute advantage in both goods. The country with the
absolute advantage in both goods can still benefit by focusing
on producing (and exporting some of) the item in which it has
the relative, or comparative, advantage. In Lesson 19 we will
give a numerical example to illustrate the idea, but for now
you should at least understand the historical context of these
terms.
For this lesson, you simply need to make sure the student
understands that Marcia is better at both tasks. So it’s not as
obvious at first why Marcia would benefit from hiring John,
when she herself could do the job more quickly (and probably
better!) than John can. It’s obvious why a skilled dentist and
a skilled lawyer benefit from trading with each other, but it’s
not so clear in our example of Marcia and John. The reason, of
course, is that Marcia can focus her efforts on what she’s really
good at, by outsourcing the mundane work to John.
Study Questions
1. What’s the connection between

specialization and the productivity of
labor?
Specialization greatly increases the productivity of labor.
2. *If the world were filled with identical

people, would specialization still be useful?
Yes, because (among other reasons) people would still have

access to different climates and raw materials, and also because
initially identical people will develop different skills over time
if they specialize in different occupations.
3. Why is trade important for the division of

labor?
The division of labor only works when people produce more

than what they personally will use, and then trade their excess
or surplus with others. It does no good to produce ten times as
many oranges and steaks, if the farmer has to eat only oranges
and the butcher can only eat steak.
4. *Explain this statement: “The gains from

trade in a case of absolute advantage are
obvious, but they can be quite subtle in a
case of comparative advantage.”
If Joe is an expert lawyer while Sally is an expert dentist, it

is perfectly obvious that they benefit from Joe trading legal
services in exchange for Sally’s dental work. But in the text’s
hypothetical case of Marcia the storekeeper and John the hired
help, it’s not clear at first why Marcia benefits from hiring
someone to do a job she could more quickly herself.
5. Why is Marcia the storekeeper willing to

pay up to $40 to have someone clean her
store at the end of the day?
If Marcia has to clean the store herself, she sacrifices 30 minutes
that she could have spent pushing sales. Because it takes her an
average of 15 minutes to close a sale, that means Marcia loses
out on 2 typical sales if she doesn’t hire someone to clean for
her. Because the text assumes Marcia nets an average of $20 per
sale, her 30 minutes is worth $40 to her, and that is the most she
would be willing to pay someone else to do her cleaning.
• Leonard Read, “I, Pencil,” at http://www.econlib.org/library/
Essays/rdPncl1.html.
Read’s article is truly one of the most famous economics
pieces of all time. It is self-explanatory.
• Robert Murphy, “Superman Needs an Agent,” at http://mises.

org/daily/2242.
Another self-explanatory piece. Note the Suggested
Activity accompanying the Superman article.

In this chapter Callahan lays out Ludwig von Mises’s
conception of different economic roles or functions, as
distinct from actual people. For example, the economist
can contrast “the entrepreneur” with “the worker,”
without having in mind two specific people and
even disregarding the fact that all workers are (part)
entrepreneurs because they must make forecasts about
future career paths, etc. There are some technical terms
from Austrian economics (such as the “evenly rotating
economy”) that the beginner student can safely ignore.

213–31.
For the student who has been reading all the Rothbard
selections, the above excerpts will help round out the
material. However, Rothbard pursues several technical
tangents that are not directly needed to understand the
basics of the division of labor. Beginning students can
safely skip pages 213–31.
suggested
(1) Have the student
activities keep track of examples
of the division of labor
during the day, which
are not part of someone’s paid job. (E.g., the neighbors
tending to their yard, with the husband cleaning out the
gutters while the wife pulls weeds, as opposed to each
spouse pulling half of the weeds and cleaning out half of
the gutters.)
(2) Have the student keep track of examples of economies

of scale during the day, which are not part of someone’s
paid job. (E.g., someone running to get fastfood and asking
if anyone else wants anything. It doesn’t take twice as
much effort, gas, etc., in order to bring home two burgers
as it takes to bring home one burger.)
(3) Before reading the article from the Supplemental

Materials, have the student brainstorm and come up with
various jobs that Superman could perform. Try to estimate
the job that would yield him the highest income. See how
the analysis compares to Murphy’s.
Test — Lesson 8
The Division of Labor
a n d S p e c i a l i z at i o n
Short Answer:
1. What is the difference between absolute advantage and comparative

advantage?
2. Give an example—not from the textbook—involving two people and

two lines of production, where one party has the absolute advantage in
both lines, but it still obviously makes sense for each to focus on his or
her comparative advantage.
137
3. Identify a profession for which one might require a certain natural

aptitude, and explain why.
4. Identify a profession in which current practitioners don’t require much

of a natural aptitude but where extensive training / experience is neces-
sary.
5. Explain why, in a system with no division of labor, it is likely that most

people would be living in or on the edge of poverty.
6. Describe a scenario in which a doubling of inputs more than doubles

the output. What do economists call this phenomenon?
141


Lesson 9
Entrepreneurship
and Competition
Entrepreneurship
B
elieve it or not, many standard economics textbooks do
not even mention the role of entrepreneurs, let alone
describe them as the “driving force” of a market econ-
omy. Ludwig von Mises and other members of the Austrian
School naturally focus on entrepreneurship as the heart of a
market, because Austrians focus on processes rather than
equilibrium snapshots. In other words, economists who con-
centrate on how a market evolves over time will be very inter-
ested in the role that entrepreneurship plays.
Strictly speaking, entrepreneurs strive after psychic profit.
In other words, everyone seeks to improve his or her situation,
according to subjective preferences. This applies to Mother
Teresa as well as to Henry Paulson. However, at this level it’s
probably easiest to have students concentrate on the familiar
notion of a businessperson trying to “make money.” But to
remain technically accurate, we use the term monetary profit,
and take care not to make sweeping statements to the effect
that all entrepreneurs seek to generate monetary profits.
145
Competition Protects Customers

Be sure the student understands the significance of com-
petition in channeling the activities of businesspeople, “keep-
ing them honest.” Later on in the course, we will see that the
reason socialism and the mixed economy perform so poorly is
not that individuals become magically corrupt or evil under
those systems. Rather, the same people in a genuine free mar-
ket will tend to behave in ways that promote social cooperation
and harmony, whereas they will exploit their neighbors when
placed into a different institutional framework. (One of the
Suggested Activities follows up on this.)
Competition Protects Workers

In this section we have used phrases such as “fair price”
and “overpay.” Please be sure that the student understands the
limited scope of these terms. As we explain in the footnotes,
all transactions in a pure market economy are fair, in the sense
that they are voluntary exchanges of property. The point is that
competition promotes outcomes that most people have in mind
when they desire that economic activities be “fair.” In other
words, people who initially think that the government needs to
protect consumers and workers from greedy businesspeople,
probably don’t understand how markets actually work.
Depending on the student, you will have to decide how
deeply to push the analysis of labor productivity and wage
payments. There is an extensive treatment in Rothbard, but it
goes far beyond what the basic student requires. The one thing
you should stress to all students, however, is that all resource
owners receive payments based on these principles. In other
words, the owner of, say, a parcel of land or a snowblower,
can rent these out to businesses at prices determined by the
marginal product of those resources. We have focused on an
example involving labor services just because this is probably
the most interesting and relevant to the student.
Lesson 9: Entrepreneurship and Competition | 147
Study Questions
1. Why is the entrepreneur the “driving

force” of a market economy?
It is the entrepreneur who directly organizes economic affairs,
deciding how resources will be combined and which goods
will be produced in what quantities.
2. *In the real world, why are all capitalists

also entrepreneurs?
In textbooks we neatly isolate the various functions (entrepre-
neur, capitalist, laborer, landowner, etc.). However in reality,
an entrepreneur is ultimately someone who surveys the status
quo and takes risky or uncertain actions to strive for a better
future. Specifically, anyone who invests in a venture is acting
as an entrepreneur, because the capitalist must believe in the
project and stands to lose everything if the forecast is wrong.
3. What motivates and regulates

entrepreneurs in a market economy?
Competition.
4. How does the competitive process unfold

through “imitation and innovation”?
No entrepreneur starts from scratch. He or she first sees what
others are doing, and then tries to make improvements in
order to attract customers from others. Even someone who
starts a completely new business is still competing (ultimately)
against all other entrepreneurs, for the scarce dollars of poten-
tial customers. For example, a movie theater owner competes
not merely with other theater owners, but also with the owners
of amusement parks, and even the owners of restaurants and
gyms. Whenever a customer spends money at one business,

that is less money available for other shops.
5. How does competition protect workers?

If a particular worker is being paid less than his or her marginal
product, there is an opportunity for a competing entrepreneur
to offer a higher wage and pocket the (smaller) gap. The only
logical stopping point for this process is when all workers are
paid in line with how much they contribute.
• Jeffrey Tucker, “Technology and Social Change,” video at http://
mises.org/MediaPlayer.aspx?Id=4990.
Tucker’s talk is aimed at high school students and
provides a very good introduction to the idea of
competition as “imitation and innovation.”
• R.W. Grant, “Tom Smith and His Incredible Bread Machine,” at

http://www.fortwayne912.com/Incredible_Bread_Machine.
html.
This simple tale should illustrate the basic ideas behind
the fairness of the competitive process and letting
producers keep the fruits of their labors.
• Dom Armentano, “The Anatomy of Antitrust,” an interview

in The Austrian Economics Newsletter at http://mises.org/
journals/aen/aen398.asp.
For more advanced students, the discussion of
competition naturally includes the mainstream economic
notions of “perfect competition” and monopoly. In
this course we will not develop these topics because
beginning students often find it difficult to learn a
framework only to have it knocked down. Since we
think the mainstream understanding of competition
in very misleading, we do not discuss it in the main
text. However, advanced students should look to the
Armentano, DiLorenzo, and Rothbard discussions to
relate this chapter to more typical treatments.
• Thomas DiLorenzo, “Competition and Monopoly,” video at

A good introduction to the Austrian vs. the mainstream
economics view of competition.
• Thomas Woods, “Myths and Facts About Big Business,” audio

at http://mises.org/media/1887.
Woods’s discussion shows that much of the modern

understanding of the evils of unregulated big business is
actually due to faulty history. Contrary to popular belief,
the “robber barons”—to the extent that they operated
in the market, rather than getting privileges from the
government—actually served their customers with
higher quality and lower prices.
• Ludwig von Mises, Human Action, pp. 270–79.

In this excerpt Mises discusses the idea of “consumer
sovereignty,” in which competition and the desire for
profits causes entrepreneurs to obey the wishes of
the consumers. The basic idea is that even though the
owners of big businesses seem to be “in charge” to a
superficial observer of capitalism, in reality the “titans”
of business ultimately answer to the customer, the true
boss. This is a crucial aspect of Mises’s overall view of
capitalism.

636–75. (**)
We have placed two asterisks after the above excerpts,
because these selections from Rothbard can be quite
technical. We are only recommending them for the
advanced student who wants to read a sample of an
Austrian critique of mainstream monopoly theory. Even
the first excerpt, which focuses on entrepreneurship, is
filled with jargon such as DMVP (discounted marginal
value product) and ERE (evenly rotating economy)
which would only fully make sense for a student who
has read earlier sections of the treatise.
suggested
activities (1) Have the student
identify examples
where competition regulates behavior. For example, if one
grocery store begins offering carts designed as racecars
(for little kids to use while their parents shop), then others
usually follow suit. Or perhaps the student knows a
particular teenager who is quite rude in personal affairs,
but is a model of courtesy when working as a waiter at a
country club. (In this case, the student could explain that
the waiter is competing against other waiters for tips—in
other words, the diners will judge his performance based
on how it stacks up with other waiters’ performances—or
the student could say that the waiter is part of the whole
restaurant’s effort to compete against other businesses for
the customer’s dollars.) There are also examples that are
not so obviously tied to markets, for example athletes lifting
weights and watching their diets in preparation for a sports
season, or boys and girls buying expensive clothes and
otherwise grooming themselves in an effort to compete for
the most attractive dates.
(2) Discuss “outrageous” salaries with the student,

such as those earned by star athletes and movie stars.
Regardless of the ultimate ethical judgment, be sure the
student understands that these salaries are the result of
marginal productivity. For example, if a movie producer
adds George Clooney to the cast of a movie that originally
has no other household names, this decision will almost
certainly allow the producer to earn millions of dollars
more in revenue from the film. That is why Clooney can
command such a high salary. If the student thinks “no
one needs to make that much,” ask what the alternative
should be. For example, if Clooney’s presence increases
box office revenues by $3 million, but Clooney is limited to
a “reasonable” $500,000 paycheck, then does the movie
studio get to pocket the difference?
Test — Lesson 9
Entrepreneurship and
Competition

Entrepreneur Revenues Expenses Profit Competition
1. Protects the interests of both consumers

and workers.
2. The money earned from customers in

exchange for products and services.
3. Revenues minus expenses.
4. Anyone who starts a new business or

develops a new product.
5. The money a business pays to workers,

suppliers, landlords, etc.
Short Answer:
6. Explain how entrepreneurs are the driving force of a market economy.
153
7. Explain how an employer calculates the marginal productivity of a

worker.
8. Explain how competition protects workers.

9. Explain how competition protects consumers.

157


Lesson 10
Income, Saving, and

Investment
Income, Saving, and Investment
I
n terms of practical life lessons, this chapter is one of the
most important in the book. Be sure the student really
understands the power of compound interest, and that even
people with modest paychecks can become millionaires if they
begin saving early in their career.
Note that the possibly unfamiliar term dissaving refers to
someone who lives above his means—in other words, con-
sumes more than his income—but doesn’t borrow from out-
side lenders. Rather, the person finances his extra consumption
by drawing down previously accumulated savings.
Investment Increases Future Income

The tables should be self-explanatory to you, but make sure
the student understands how all the numbers fit together. A
very useful exercise (or test question) could involve your own
table (with some of the numbers altered) and a few of the cells
left blank. With a calculator or even just pencil and paper, the
student should be able to fill in the missing cells.
161
Retirement
Depending on your own views, you may want to tie in the
discussion of saving for retirement with a broader discussion
of the importance of thrift and self-reliance. In other words, one
doesn’t need to become a financial burden on the next genera-
tion if he or she has adequately saved during the prime work-
ing years. (More sophisticated students should learn about life
and health insurance policies as well.)
How Saving and Investment Increase

An Economy’s Future Output
In order to understand the business cycle theory presented
in Lesson 23, it’s necessary for the student to understand how
genuine savings and investment fuel an advancing economy.
In other words, the student should first learn how things can
go right (a sustainable expansion in the economy) before learn-
ing how they go wrong (an unsustainable boom period fol-
lowed by an inevitable bust or recession).
These issues will be covered in greater depth in the
Advanced Lessons 12 – 14, but for now make sure the stu-
dent understands two central ideas: First, the growing wealth
of a saver is not automatically “canceled out” by the growing
indebtedness of a borrower. Specifically, what can happen is
that the borrower (which can be a business firm) uses loaned
funds to expand production. So although it’s true that a grow-
ing corporation (for example) must take on debt if it wants to
borrow money to finance a new plant, the action is not really
comparable to an individual placing a trip to Tahiti on his
personal credit card. The new factory allows the business to
produce and sell more, earning higher revenues with which to
finance the interest payments on its higher debt.
Lesson 10: Income, Saving, and Investment | 163
The second important idea in this section is that the student

sees the physical underpinnings of economic growth through
saving and investment. In other words, people aren’t simply
wealthier because their bank balances rise exponentially over
time earning interest. Just as Robinson Crusoe’s standard of
living went up because of saving and investment (in a pole,
etc.), so too does a modern economy grow richer when its out-
put is focused more on capital goods and less on consumption
goods.
As a final caution, note that we are deliberately sidestep-
ping the issue of adjustment to a new configuration of spend-
ing. A Keynesian economist would worry that a sudden and
unexpected increase in saving by most people in the commu-
nity would lead to a recession. Some of the Supplemental read-
ings address these issues, but in the main text we wanted to
stick to the basic point that financial saving and investment
has a corresponding “real” component, in terms of the shift in
capital/consumer goods mix of output.
Study Questions
1. Can investment occur without saving?

No. The only way there are resources (whether financial or
physical) available for investment, is if someone has lived
below his or her means, i.e., saved.
2. What are the pros and cons of saving a high

fraction of your income?
The pros are a higher future wealth and income, the cons are
less consumption in the near term.
3. What’s the connection between saving and

retirement?
People can fund their own retirement lifestyle by saving
enough during their working years.
4. If someone borrows in order to buy today

rather than waiting to pay cash, is this an
example of uneconomical behavior?
No, it simply illustrates the person’s preferences. Just as one
person might be willing to pay $50 on a juicy steak, while
another person would regard this as absurd, so too might some-
one be willing to pay a high interest rate in order to consume
earlier rather than later. There is nothing intrinsically irratio-
nal or uneconomical about such a decision, which couldn’t be
applied just as well to other consumer decisions.
5. *Is it possible for every individual in the

community to accumulate assets for
retirement—or does one person’s rising
wealth translate into someone else’s rising
debt?
Yes, everyone in principle can accumulate financial assets to
fund retirement. It’s not the case that one person’s accumulat-
ing wealth translates into someone else’s growing indebted-
ness. (It’s true that various corporations and other entities must
be on “the other side” of someone else’s growing stockpile of
financial claims, but this need not reflect a growing danger to
the corporations, so long as they are using the loans produc-
tively.)
In this chapter Callahan spells out the Austrian view of
the structure of production. It is more advanced than our
discussion, but should still be quite accessible to most
students.
• Robert Murphy, “Cut Taxes for the Right Reasons,” at http://

Murphy points out that even many “free market”
commentators often fall prey to the same Keynesian
fallacies that they think they are debunking. Specifically,
tax cuts do indeed promote economic growth, but not
because they allow people to “spend more.”
• George Reisman, “Economic Recovery Requires Capital

Accumulation…” at http://mises.org/daily/3353.
The Reisman article was written in the wake of the
housing bust and the various “stimulus” efforts of the
Bush and Obama administrations. Students need not
read the entire article, but it may be interesting for
some because it applies our general lesson to a specific
historical situation.
suggested (1) Using Excel or

another spreadsheet
activities application, construct
your own table patterned
on the text’s example of
Frugal Freddy and Prodigal Paul. Print out portions of the
table, with some of the numbers hidden. Ask the student to
fill in the blanks.
(2) Using either a spreadsheet or online calculator (just

google “wealth accumulation calculator”), have the student
play with the numbers to see how long it would take to
achieve a desired target level of wealth. For example,
someone who earns $25,000, saves a constant 10% of
total income, and earns a tax-free return of 8% annually,
would accumulate almost $1 million after 30 years. The
point of course is not to encourage greed, but to show the
student the surprising power of compound interest—of
earning (new) interest on the built-up interest of the past—
and what Albert Einstein reportedly referred to as the “most
powerful force in the universe.”
(3) For the advanced student, discuss the idea that the
working generation must support the older (retired)
generation. In one sense this is always true; anytime a
retired person goes grocery shopping, she’s “skimming”
food from the harvest of current workers. However, so long
as the retired person is living off of previously saved wealth,
part of what’s happening is that the current workers are
more productive because of previous investments by the
now-retired person. So the total output of food is greater,
because there are more tractors, fertilizer, etc., due to the
years of abstinence and accumulation during the now-
retired person’s working years. For more on this idea (in the
context of debates over Social Security), see this article:
http://mises.org/daily/5658/Is-Social-Security-a-
Ponzi-Scheme.
Test — Lesson 10
I n c o m e , S av i n g , a n d
Investment

Income Savings Revenues

Expenses Borrowing Investment
1. The difference between income and

how much is spent on consumption.
2. Spending intended to generate more

income in the future.
3. How much can be spent on

consumption today, without impairing
future income.
4. A way to consume more than one’s

income during a certain time period.
Short Answer:
5. If you expect to live to at least 80 years old, why should you seriously
consider saving a large amount of your income and investing it while you
are young?
169
6. Respond to someone who says, “It hurts the economy when people
save too much, because if people don’t spend, then businesses can’t hire
workers.”
7. How does the accumulation of capital goods help workers who don’t
own them?
8. Respond to someone who says, “For every lender who grows rich,
there must be a borrower who grows poor.”
173


L e s s o n 11
Supply and Demand
Supply and Demand: The Purpose
T
he material in this lesson is standard. As the text explains,
supply and demand graphs are very useful to keep our
thoughts organized when we work through the effects of
a hypothetical change in the market. Even professional econo-
mists often start their basic analysis with some version of a
supply and demand graph.
For the advanced student, you should stress that there is
not a “theory” of supply and demand. All changes in market
prices can be “explained” by reference to movements of sup-
ply and demand curves or schedules. It is possible that future
economists will abandon the framework in favor of something
more convenient, but even if this occurs, it won’t be because
of some future empirical finding. Rather, future economists
might develop an alternative framework that provides a supe-
rior understanding of market prices.
Demand: Its Definition and Its Law

It is very important for the student to distinguish demand
versus supply, and to be able to analyze them separately. This
is the only way the student will be able to correctly answer
177
questions concerning the impact of particular changes in a

market.
Make sure the student understands that the demand sched-
ule is a list of hypothetical prices and that the schedule applies
at a particular moment in time. Strictly speaking, we do not
“observe” or “catalog” someone’s demand schedule by writ-
ing down how many gallons of gasoline she buys over the
course of several months (with different prices each day). The
demand schedule for each person in principle can change from
moment to moment.
As a footnote indicates, the Law of Demand is interpreted
differently by different economists. Some think that it is a logi-
cal deduction from rational action in the face of scarcity, and
that any apparent “violations” are really different goods. For
example, a woman with a taste for fine jewelry might buy
more units of a particular brand when they are more expen-
sive, because if the sale price were too low, the woman would
suspect the jewelry to be stolen or fake. But this wouldn’t vio-
late the Law of Demand if we insist that people’s subjective
perception of the good cannot be influenced directly by the
price, in order for the law to apply.
Other economists believe that the Law of Demand is merely
an empirical regularity, that could in principle be contradicted
by the facts. Note that strictly speaking, it would be impos-
sible to truly falsify the Law of Demand, because the under-
lying preferences (and hence demand schedule) could change
in between measurements. For example, if Sally buys 13 gal-
lons of gasoline at $2.50 per gallon on Monday, but she buys
0 gallons on Tuesday even though the price has dropped to
$2.45, that is obviously not a violation of the Law of Demand,
because on Tuesday Sally is still driving with a nearly full tank
of gas. If you understand this simple example, you can see how
it would be impossible to ever truly refute the Law of Demand
with an experiment.
Lesson 11: Supply and Demand | 179
If the student plans on taking standard economics courses

in the future, you should spend some time working with
demand (and supply) schedules and graphs, to make sure the
student truly understands how they work. However, if this
course is the last that the student is likely to take in economics,
the ability to translate numerical schedules into graphs is not
particularly important. The crucial skill is that the student can
use generic supply and demand curves to walk through the
impact of a stipulated change in market conditions, in order
to identify the direction in which price and quantity will move.
Supply: Its Definition and Its Law

Unfortunately the gasoline market is not the best illustra-
tion of the Law of Supply, because it may seem a bit contrived
as to why producers sell progressively larger quantities at
higher prices. (We chose the gasoline market because it is very
convenient for illustrating the demand side.)
The Law of Demand is fairly intuitive, but the Law of Sup-
ply may not be as obvious. Standard textbooks usually explain
rising supply curves as the result of rising cost curves. In other
words, at some point it becomes progressively more expensive
(per unit) to produce more units of a good, and so produc-
ers will need to charge more per unit in order to be willing
to operate at larger and larger levels of output. However, we
have not dwelt on this issue (even though it’s true as far as
it goes) because it reinforces the false idea that market prices
are caused by costs of production. In reality “costs” are simply
prices of labor and other resources, and so we haven’t really
provided a full explanation if we say that market prices are
caused by “costs.” If you haven’t already done so, you might
benefit from reading Robert Murphy’s discussion of classi-
cal versus modern price theory, at http://mises.org/journals/
jls/20_1/20_1_3.pdf.
One subtlety that might shed some light on the Law of Sup-
ply is that some producers drop out of the market altogether
below a certain price point. In other words, even if the stu-
dent has trouble seeing why a given producer would sell more
units at $100 rather than $99—if the producer still earns profit
at $99 per unit—the student should be able to understand that
producers are not identical, and so some of them might not be
able to turn a profit at a price of $99. Of course this analysis too
runs the risk of teaching the student the false theory that “costs
determine prices,” so you will have to decide whether to pur-
sue this train of thought.
Using Supply and Demand to Explain

the Market Price
Beyond understanding how market forces tend to eliminate
shortages and surpluses (or gluts), this material is important
because later in the course the student will learn how govern-
ment price controls lead to permanent shortages and gluts.
Using Supply and Demand to

Understand Price Changes
The central skill for this lesson is the ability to take a ver-
bal description of a change in a market, and use supply and
demand analysis to say which way price and quantity will
move. The five examples should be self-explanatory.
The most common pitfall for students in this setting is to
confuse a shift in demand (or supply) with a movement along
the demand (or supply) curve. College economics professors
are often quite adamant on this point, because it is so crucial
for clearly thinking through the impacts of a hypothetical
change. We encourage you to be mindful of this distinction,

and to correct the student if he says, “The price falls and so
demand increases,” when really he should say, “The price falls
and so the quantity demanded increases,” or, “The price falls and
so we move outward on the demand curve.”
Remember, the big picture here is that economists are try-
ing to separate out all influences on consumer and producer
behavior except those directly dealing with the price. So a
change in a good’s price will never shift the supply or demand
curves. (Be careful: The change in the price of one good can
shift the supply or demand curves of a different good. A change
in the price of oranges doesn’t affect the supply or demand
for oranges; on the contrary, we use the supply and demand
curves for oranges to explain the price of oranges! However, a
change in the price of oranges can certainly affect the demand
for apples, or the supply of orange juice.)
Study Questions
1. Why does the text say that supply and

demand can never be proven false?
The concepts of supply and demand are not “theories,” they

are instead tools of analysis. Future economists might stop
using them as tools if they find different ways of explaining
market prices that are more convenient or superior in some
other fashion.
2. Why does the text say that demand is a

snapshot in time?
A person’s demand schedule is an instantaneous relationship

between hypothetical prices and the corresponding quantity the
person would buy at each price. If time passes, the person’s
preferences or other factors might change, leading to a differ-
ent demand schedule.
3. How do you go from individual demand or

supply schedules, to market demand and
supply schedules?
At each price, the market quantity of demand or supply is the

summation of the individual quantities at that price.
4. Explain how the market process tends to

push prices toward their equilibrium levels.
If the price is above the equilibrium level, the quantity sup-

plied exceeds the quantity demanded, meaning there is a sur-
plus or glut. Because producers are trying to sell more units
than buyers wish to purchase, they tend to lower their asking
price. On the other hand, if the price is below the equilibrium
level, the quantity demanded exceeds the quantity supplied,
meaning there is a shortage. Because consumers are trying to

buy more units than producers wish to sell, producers have an
incentive to raise their asking price (or consumers bid higher
prices, depending on the mechanics of the particular market).
5. If supply increases while demand decreases,

what can we say about the change in
(equilibrium) price? What about the change
in (equilibrium) quantity?
The equilibrium price will definitely drop, because both
changes point in that direction. However, we don’t know what
will happen to the equilibrium quantity, because the sup-
ply shift tends to increase it, while the demand shift tends to
decrease it. Without more information we don’t know which
effect will dominate.
In this excerpt, Rothbard goes from individual
preference rankings to market demand and supply
curves. Remember that in Rothbard’s exposition, items
in parentheses refer to things that the individual does
not have in his or her possession.
suggested
(1) Look at the sample
activities test questions for supply
and demand graphing
exercises. Invent your own to give the student practice.
(2) Have the student read the newspaper or watch the

news looking for examples of confusion regarding price
movements. (Typically the confusion will occur when the
reporter mistakes a shift in the curve for a movement along
the curve.)
(3) Have the student take several different industries and

explain why producers would exhibit rising supply curves
(i.e., obey the Law of Supply). In other words, just as the
text gave a specific story to explain the motivations of
the three gasoline producers—and why they would sell
more units at higher prices—have the student come up
with similar explanations for why the producers in other
industries might do the same. For example, why would the
leaders of Saudi Arabia decide to pump more oil when the
price of oil is $100 per barrel rather than $70?
T e s t — L e s s o n 11
S u p p ly a n d D e m a n d
Multiple Choice:
Write the letter of the best answer.
1. Rebecca left for the store hoping to benefit from a huge sale on a
particular LCD TV. However, by the time she arrived, a sales clerk
informed her that the store had only stocked 10 of that particular TV,
and that they sold out of them within twenty minutes. And, of course,
there are no rain checks. How should we describe this situation?
A. glut
B. shortage
C. surplus
D. equilibrium
2. This principle states that lower prices of a good or service tend to

make people want either the same or a greater amount of that good
or service.
A. Law of Comparative Advantage

B. Law of Supply
C. Law of Demand
D. Murphy’s Law
3. Ryan worked furiously in his studio, sculpting little trolls from manure.
However, no matter how little he asked for a price, he could find no
buyers. Someone might have told Ryan that there was probably little
____________ for manure-based troll sculptures?
A. supply
B. equilibrium
C. cost
D. demand
187
4. The Law of Supply says that
A. a lower price will tend to lead a consumer to buy either the

same or a greater amount of the good or service.
B. consumers want to buy more units of something than produc-
ers want to sell at a particular price.
C. as the market price of a good or service rises, producers tend
to offer the same or a greater number of units.
D. producers are trying to sell more units of a good or a service
than consumers want to purchase at a particular price.
5. The Law of Demand says that
A. a lower price will tend to lead a consumer to buy either the

same or a greater amount of the good or service.
B. consumers want to buy more units of something than produc-
ers want to sell at a particular price.
C. as the market price of a good or service rises, producers offer
the same or a greater number of units.
D. producers are trying to sell more units of a good or a service
than consumers want to purchase at a particular price.
6. Another word for a surplus is a
A. glut
B. shortage
C. equilibrium
D. premium
Short Answer:
7. Define supply (not the Law of Supply).
8. Define demand (not the Law of Demand).

9. Why is it called an “equilibrium” price when quantity demanded equals

quantity supplied?
10. Explain how the demand for something can remain constant, but the
quantity demanded can decline.
11. Explain how a glut in the orange market can be bad news for the
producers of apples.
193


A d va n c e d L e s s o n 1 2
Interest, Credit, and Debt
Interest: It’s About Time
A
s the student text indicates, the theory of interest is
one of the most complicated areas in economics. Nat-
urally we are not going to reproduce or even allude
to the high-level debates among economists over the nature
and causes of interest. Most economists would agree with the
statements we make in this chapter, although some of them
might have included other claims—such as the idea that the
interest rate reflects the “productivity of capital”—that we are
consciously omitting because they are actually controversial in
certain camps.
The analogy between interest rates and currency exchange
rates is meant to help the advanced student. If a student is
struggling with the point, you can safely skip it. There is no
point in burdening the student with an extra concept (exchange
rates) just to shed light on the topic of interest.
It is important, however, that all students take away the
idea that interest rates in a free market help to coordinate the
actions of savers and investors. In particular, when the com-
munity saves more and frees up resources, (other things equal)
interest rates fall and give the signal to entrepreneurs to invest
resources in longer projects. The student will need to know
this in order to make sense of the business cycle theory pre-
sented in Lesson 23.
197
Savings, Investment, and Economic

Growth
The material in this section is fairly orthodox. The student
who plans on taking an undergraduate course in economics, or
who wants to view Roger Garrison’s PowerPoint presentations
(listed in the Supplemental Materials in Lesson 23), should
understand how to use basic supply and demand analysis in
the context of the loanable funds market.
The only real trick here is to understand the sense in which
the interest rate is the “price” of a loan. If it helps, you can
walk the student through and point out that we could just as
well say the price of borrowing $1,000 for a year is $80 (pay-
able at the time of repayment of the principal), in which case
the interest rate is 8%. If the student is confused about the use
of a percentage rather than an absolute dollar amount, you can
explain that the special thing about interest is that people are
renting the use of money. If a community used, say, tuxedos
as money, then the rental price of a tux (for a junior prom)
might be quoted in percentage terms too. But we use dollars as
money, not tuxedos, and so the men’s clothing store will quote
a price in dollar terms for the temporary use of a tuxedo, which
is why a percentage quote would make no sense. Yet in our
world it does make sense for a bank to give a percentage quote
on the price of a loan, since a loan is “renting money” and you
pay for the service with money.
Common Credit Transactions

You will have to decide whether to stress the point that
credit transactions per se do not increase the money supply.
In order to think about difficult questions such as the likeli-
hood of rising prices in the wake of the Fed’s bailouts of the
banking sector, it is crucial for the analyst to understand
Advanced Lesson 12: Interest, Credit, and Debt | 199
exactly how the money supply and credit interact with each
other. (There is a further complication in our fractional reserve
banking system, in which new bank loans do expand the quan-
tity of money.) However, this might be too subtle a point for
some students. For the truly advanced student who wants to
learn the accounting treatment of modern fractional-reserve
banking, consult this video lecture: http://www.youtube.com/
watch?v=6HAEPSt_12U.
Bonds
The concept of bonds can be very intimidating, so you
should make sure that the student understands it is simply
a formalized way of borrowing money. When a corporation
“sells” or “issues” a new bond, it is not producing something
like a TV. It is simply borrowing money, in exchange for a stan-
dardized IOU spelling out the terms of the loan. The advan-
tage of a bond issue (versus drawing up specific loan contracts
with different lenders) is that it’s very easy for the initial lender
to sell the bond to someone else, and thus transfer the iden-
tity of the person to whom the corporation owes the remaining
interest and principal payments.
Banks
Be sure the student understands the legitimate function that
credit intermediaries serve, in assessing and spreading risk.
Just as middlemen (and women) in physical products provide
a definite service when they (say) buy oranges at a low price
from Florida growers, and then sell them at a higher price in
New York, by the same token the banks perform a valuable
service when they borrow at a low rate and lend at a higher
rate.
The student text did not spell it out, but all parties—includ-
ing the lenders and the borrowers—benefit from the existence
of banks, at least if we assume that the banks do their jobs
properly and make sound loans. (This doesn’t always occur,
of course; the late 1920s and the late 2000s are great examples.
However many economists would argue that this poor perfor-
mance by the banks was caused or at least exacerbated by the
government and Federal Reserve.)
Credit Cards
In the student text we have tried to be neutral, as many par-
ents do not want their children ever using credit cards for obvi-
ous reasons. Economists must be able to explain the operations
of this market, just as they need to understand how farmers
and others fit into the cigarette market. Naturally the fact that
some people buy cigarettes doesn’t mean economists endorse
smoking.
The Pros and Cons of Debt

Again, we have tried to be as evenhanded as possible in
this section. Although few parents would glamorize high con-
sumption financed through credit cards, most people do not
have a principled objection to using mortgages to buy a starter
house, or buying a car at least partially on credit. Pushing it
even further, there would be far fewer doctors if no one were
willing to take out loans to pay for medical school.
Study Questions
1. Why is the first section titled, “Interest: It’s

About Time”?
Interest rates coordinate the actions of savers and inves-
tors. When people postpone consumption today, it frees up
resources that can begin producing the goods and services that
the savers will buy in the future.
2. *What is the connection between interest

rates and currency exchange rates?
Interest rates allow entrepreneurs to convert money units
from different years into a common denominator. Currency
exchange rates allow entrepreneurs to convert money units
from different countries into a common denominator.
3. Why does a low interest rate give a “green

light” to long production processes?
Entrepreneurs must buy inputs first, then sell the output later.
The lower the interest rate, the more valuable the future reve-
nue from customers will appear in today’s calculations. There-
fore, a given process with fixed dollar payments for inputs in
the beginning, and a fixed dollar payment by customers at the
end, will appear more profitable as the interest rate gets lower
and lower.
4. What is exchanged in a credit transaction?

The lender gives money in exchange for an IOU from the bor-
rower.
5. What is “productive debt”?

Debt that is used by the borrower in the hopes of increasing his
or her future income.
• Henry Hazlitt, Economics In One Lesson, Chapter VI.
Hazlitt illustrates the harmful outcome when
government uses credit to divert production. His
analysis shows, however, that credit provided
voluntarily by lenders on the free market leads to
the beneficial results desired by the proponents of
government loans to business.
• Thomas Woods, “Credit Diverts Production,” interviewed by Jeff

Tucker, audio at http://mises.org/media/4300.
Woods provides commentary on the Hazlitt chapter.

This excerpt contains Rothbard’s explanation for the
determination of the pure interest rate on a market
economy. It can be quite technical at times, and so only
the most advanced students should even attempt it. But
for those who have been following along with Rothbard,
it should provide a complementary discussion to the
much simpler presentation in the student text.
suggested
(1) For the truly
activities advanced student,
you could elaborate
on the tuxedo analogy
presented above. At
first it might seem impossible for a young guy to rent a
tuxedo on a Friday, and then return not only that same
tuxedo, but the “interest” payment of another tuxedo (or
a piece of one—maybe a vest) the following Monday. Yet
note that this is exactly what happens when we borrow
dollars from a bank—we are expected to return more
dollar bills than the bank originally handed to us. Remind
the student that by hypothesis, tuxedos are money.
So the loan could be a productive loan in the literal
sense, where (say) the borrower puts on the tuxedo
and performs a lounge singer routine, in exchange for
payment in the form of tuxedos. But it’s also possible
that the borrower uses the lent tuxedo to hire workers
to make something which he then sells to customers
for money (i.e., tuxedos), before paying off the loan plus
interest. The point of this rather silly thought experiment
is to drive home exactly what’s happening with loans
and interest, and why tuxedos would be an awfully
inconvenient money.
(2) If appropriate, you could go over a credit report or

the mortgage statement with the student, explaining the
various items. Many newcomers are shocked when they
first see how much of a mortgage or car payment goes
toward interest in the early years; it may be worthwhile to
explain this phenomenon. (In order to yield fixed monthly
payments at a fixed interest rate, the earlier payments
will necessarily involve more payment of interest and
less reduction of principal, compared to later payments.
The outstanding principal shrinks over time with further
payments, and so [at a fixed interest rate] it grows less
after each payment knocks it down ever further. The

process snowballs until the very last payment is devoted
almost entirely to principal reduction, and completely
pays off the loan.) You can google for “online amortization
calculators” if students want to play with various numbers,
to see for example the difference between buying a
given house with a 15-year versus a 30-year mortgage
at a given interest rate. (In the former case, the monthly
payments are much higher, but the house is paid off in
half the time and there are fewer “total dollars” going to
interest payments over the life of the mortgage, which
some people consider an important point although
many economists would say such a statistic is somewhat
misleading.)
(3) The student can experiment with the Federal

Reserve’s online database to look at various interest rates
on different types of corporate bonds: http://research.
stlouisfed.org/fred2/categories/119. You can
explain that the safer bonds—which are given a better
rating by the agencies—have a lower yield (interest rate),
because investors are less worried that the borrowing
corporation will default on the loan. Advanced students
should recognize that there isn’t “the” interest rate in a
market economy, but actually a whole suite of interest
rates based on the maturity time as well as the risk of the
loan. The student can see points on the “yield curve”—the
difference in interest rates even on debt issued by the
same U.S. government, depending on the length of the
loan—at this site: http://research.stlouisfed.org/
fred2/categories/115.
Test — Lesson 12
I n t e r e s t, C r e d i t, a n d D e b t
Multiple Choice:
Write the letter of the best answer.
1. This compensates lenders for giving up money available to them now,

in exchange for a promise to be paid back with money not available
until the future.
A. principal
B. credit
C. debt
D. interest
2. The __________ shows us exactly what the discount on future dollars

is, or (equivalently) what the premium on current dollars is.
A. exchange rate
B. maturities rate
C. market interest rate
D. commodities market
3. An _______________ rate is between currencies (e.g., U.S. Dollar vs.

Japanese yen).
A. interest
B. exchange
C. omninational
D. international
207
4. Interest is not the “price of money.” It is the “price of _____ money.”
A. borrowing
B. earning
C. saving
D. lending
5. Secured loans are backed by
A. the government
B. collateral
C. credit history
D. credit intermediaries
6. Debt incurred by an entrepreneur for the purpose of expanding his or

her business operations is called
A. secured debt
B. unsecured debt
C. collateral debt
D. productive debt
Short Answer:
7. Justin forgot his lunch money at home. To make matters worse, it

was pizza day at school, and Justin loves pizza. However, his friend, Vraj,
always has money, so Justin asks if he can borrow $2.00. Vraj agrees,
but insists upon being paid back $2.50 the next day. Calculate the (daily)
interest rate of Vraj’s loan.
8. Explain why the deal between Justin and Vraj was mutually beneficial.
9. Other things equal, an increase in interest rates will have what effect
on the quantity demanded of loans?
10. Identify what happens to interest rates when a community saves more
in general, and generalize the signal that this sends to entrepreneurs.
11. When a company sells a bond, what is it essentially doing?
12. What is the economic benefit of a credit intermediary such as a

bank?
13. Discuss this statement: “Getting rid of all records of credit histories
and credit reports would help borrowers.”
14. Explain why the interest rates on unsecured loans tend to be higher
than those on secured loans.
213


Profit and Loss Accounting
Profit and Loss Guide Entrepreneurs
T
his section contains one of the most important insights
in the entire course. Most people do not understand that
the economy is a dynamic system in which people must
always respond to changing conditions, be they unexpected
weather, changes in consumer tastes, or a new invention.
Make sure the student really understands how profits and
losses guide entrepreneurs. There is no objective “right way”
to run a business in a particular industry; entrepreneurs need
to discover this through competition. (The Hayek reading in the
Supplemental Materials elaborates on this important point,
though it may be too difficult reading for some students.)
As a consequence, when we see businesses in the real world
earning “excessive” profits, that isn’t a signal that the owners
are ripping people off. On the contrary, it’s a signal that the
owners are adjusting serious imbalances (or “false prices”) in
the market.
Interest versus Profit

You will have to determine how far to push this section,
based on the ability of the student. The most basic point is that
217
a company is not necessarily using resources efficiently just

because it takes in more total dollars in sales than it pays out
in expenses. Even if a business “turns a profit” in the every-
day sense of the term, it might be suffering an economic loss
once the implicit interest on the invested capital is taken into
account.
For the more advanced student, there is a related point:
It’s actually not true (as we implied in Lesson 9) that competi-
tion among entrepreneurs drives the “markup” to zero. This is
because in a typical industry, there is a time delay (often siz-
able) between the payment of wages and other expenses, ver-
sus the receipt of the revenues from customers. Competition
will still tend to bid up wages for workers, and push down
prices for the final products, until the workers get paid the full
value of their marginal contribution to the firm’s revenues.
However, the “full value” needs to take into account the time
value of money. If a worker digs a ditch in the year 2010 for a
shopping mall that won’t be open to customers until the year
2012, then the entrepreneurs who pay the worker will take into
account the fact that his wages are in 2010 dollars, which are
worth more than 2012 dollars. So even if the worker ultimately
contributes, say, $15 in revenues for every hour he spends dig-
ging the ditch, he will only be paid (say) $13.61 per hour in
2010, if the interest rate is 5%. (Note that $13.61 x 1.05 x 1.05 =
$15.)
This latter point is rather subtle, and you can safely skip
it entirely for the beginning student. But more advanced stu-
dents should recognize that competition doesn’t actually
whittle away “markups” to zero, in production processes that
involve long periods of time. In a sense the markup really does
get driven toward zero, once we convert dollars from differ-
ent time periods into a common denominator; but still this is
a subtle point that many people never think about, and you
should clarify it for the advanced student.
Advanced Lesson 13: Profit and Loss Accounting | 219
The Social Function of Profit and Loss

Accounting
The Austrians are rare among economists because they can
really explain the social function of profit and loss accounting.
Mainstream economists focus on equilibrium states in which
there are no profit opportunities; they take up the analysis at
the point where competition has already eliminated any price
discrepancies. For the Austrian, this is to ignore the heart of the
market economy, when entrepreneurs make adjustments in an
attempt to better satisfy the consumers.
The material in this section follows the presentation by
Robert Murphy (listed below in the Supplemental Materials).
However, that discussion can become somewhat technical in
the second half.
The Limits of Profit and Loss Accounting

Be sure that the student doesn’t draw the wrong conclusion
from this chapter. We are not saying that entrepreneurs need
to do whatever makes the most profit. All we are saying is that
the profit and loss system provides a mental aid to entrepre-
neurs as they run their businesses, buying resources from one
group of people, turning them into products and services, and
then selling the output to other people. Without market prices
for each component in this complicated process, the entrepre-
neurs would be “groping in the dark,” as Mises says. It’s cru-
cial for students to understand this point now, in order to make
sense of the chapters on socialism later on.
But just because something is necessary for guidance,
doesn’t mean that it should be the master. For an analogy, if
a family goes to Disneyland for the first time, they will surely
want to obtain a map of the park. The map doesn’t force the
family to visit rides in a particular sequence, but it provides

crucial information for the family to make its decisions. With-
out the map, they would be “groping in the dark,” stumbling
from one ride to the next and having no idea if they were
spending their hours (and leg muscles) in the best way, given
their own desires and the physical layout of the park.
Study Questions
1. Explain: “Entrepreneurs do not respond

to particular prices but rather to the
difference between certain prices.”
Most entrepreneurs are not out to maximize revenues, but

rather to earn profits. Monetary profit is the difference between
the revenues from customers and the expenditures on inputs.
Just because a particular price is very high doesn’t automati-
cally mean that entrepreneurs rush to produce the item in
question; the expenses involved in producing the item might
be really high too.
2. Explain: “In a market economy with

open competition, there is a tendency for
monetary profits and losses to be whittled
away over time, as entrepreneurs adjust to
the situation.”
If the prices in a certain industry allow the firms to reap large

monetary profits, this will tend to attract competitors. By pro-
ducing more of the finished good (or service), they push down
its price, and by buying more of the inputs needed to produce
it, they push up the costs of production. Thus the overall profit
margin shrinks. The reverse happens in an industry suffering
from monetary losses.
3. *How does interest relate to profit,

specifically the difference between
accounting and economic profit?
In everyday language, and even in terms of standard account-

ing, “profit” refers to the excess of money receipts over money
expenditures. But this figure includes the interest payment
on the invested capital in the business. In other words, out of
the gross or accounting profit we need to subtract the interest

payment reflecting the fact that the investors’ capital was tied
up for a certain period when it could have been “at work” in
another project.
4. In what sense do consumers—rather than

the “captains of industry”—guide the
production decisions in a market economy?
With their spending decisions, consumers provide guidance to
entrepreneurs, to the extent that they allow themselves to be
steered by considerations of (monetary) profit. It is the spend-
ing of smokers that leads farmers to plant tobacco.
5. Does a market economy force entrepreneurs

to do whatever makes the most profit?
No, in a market economy the owner determines the fate of a
particular unit of resources (including labor services). No mat-
ter how high the price of cigarettes, a farmer doesn’t have to
plant tobacco if he doesn’t want to. But market prices do allow
resource owners to make informed decisions. They get a sense
of how much other people want to encourage them to use their
resources in a particular way.
• Ludwig von Mises, “Profit and Loss,” Sections 1–5, at http://
mises.org/story/2321.
Although Mises’s writings are always formal, this is
actually an accessible introduction to Mises’s views on
profit and loss. His analysis covers much of the same
ground as our (simplified) student lesson.
• Joe Salerno, “The Theory of Profit, Loss, and Entrepreneurship,”

audio at http://mises.org/media/1027.
Salerno provides an introduction to the Austrian
understanding. Although other schools of economic
thought give a cursory nod to the role of the
entrepreneur, the Austrians emphasize entrepreneurship
probably more than any other school. This relates to
the relatively narrow importance Austrians ascribe
to the analysis of equilibrium states, focusing instead
on the process by which an economy moves toward
equilibrium.
• Robert Murphy, “Consumer Sovereignty and the Production

Process,” audio at http://mises.org/media/4004.
In this lecture Murphy first explains Mises’s
endorsement of the notion of “consumer sovereignty”
and why a market economy usually satisfies this
principle. Then Murphy explains the Rothbardian
critique of the concept. Part of the discussion involves
monopoly theory, which the student can safely omit.
(Murphy has also written articles on these topics,
available at http://mises.org/daily/1364 and http://
mises.org/daily/1379.)
• Friedrich Hayek, “Competition as a Discovery Procedure,” at

https://mises.org/journals/qjae/pdf/qjae5_3_3.pdf.
This is a classic Hayek paper but it is formal. Even if
they can’t understand all of it, most students should
probably be encouraged to at least try reading it.
suggested Look through a

activities newspaper or online
financial website to see
discussions of earnings
or “profits” of major
corporations. Explain that these are accounting
profits. Investors who leave their money tied up in
a corporation must look at their return (whether
measured in dividend payments or increase in the
stock price) and compare it with other places they
could have invested their money during the same
time period. It’s not enough to know, for example,
that the Acme Corporation took in $1 billion in
revenues and paid out $990 million in expenses.
That $10 million in profits could be wonderful if
Acme is a lemonade stand company with just the
labor of the thirteen-year-old owner being the
non-compensated input. (The $990 million paid for
an enormous amount of lemonade mix, disposable
cups, etc.) On the other hand, if Acme runs an
offshore oil rig that took $5 billion of investments
to construct, then having a particular year—once
it’s in full operation—where revenues were only
$10 million higher than out-of-pocket expenses
is probably disastrous, compared to other, safer
investment opportunities. (This is because the
investors would only be earning a 2% return on
their $5 billion investment, when they probably
could have earned a higher rate of return by
investing in bonds or other lines that were safer
than an offshore oil rig. We aren’t even considering
the fact that the oil rig would take a long time to
construct, a period during which the rate of return
on investment would be zero.)
Test —Lesson 13
Profit and Loss Accounting
Short Answer:
1. Explain why, generally speaking, activities that generate high (mone-

tary) profits will attract more entrepreneurs, while those that cause losses
will repel entrepreneurs.
2. Explain the distinction economists often make between interest and

profit.
227
3. Does the profit and loss system force movie theaters to stay open on
Christmas? Explain.
4. Explain how the profit and loss system communicates the desires of
consumers to resource owners and entrepreneurs.
5. If smoking is bad for you, then why do farmers grow tobacco?

231


The Stock Market
The Stock Market

There is an entire field of financial economics that studies
issues such as the pricing of corporate stock, the relative merits
of issuing debt versus equity, and so on. In this introductory
course we are obviously not going to cover such controversies
and rival theories. Rather, we are trying to give the student a
basic understanding of what the stock market is and how the
principles of previous chapters apply in this setting.
If you take a course in financial economics at a highly ranked
university, it will be extremely quantitative, more so than most
other areas of economic theory; in this respect typical financial
economists are very different from the typical Austrian econo-
mist. However, many of the practitioners in this field are very
sympathetic to free-market principles and recognize the harm
of government intervention in financial markets. For whatever
reason, there is a large body of academics who recognize the
benefits of unfettered entrepreneurship in the narrow realm
of stocks and bonds, whereas these same academics might be
more skeptical of laissez-faire in the market for teenage labor
and electricity.
235
Why Issue Stock? (Debt versus Equity)

The ostensible purpose of this section is to compare two dif-
ferent methods of raising funds, namely issuing debt versus
equity. However, this particular question isn’t very important
for our purposes. Rather, we are going through this discussion
because it offers a concrete, real-world problem that gives us
an opportunity to introduce new concepts that are relevant to
this chapter.
In other words, the student shouldn’t get bogged down
trying to memorize the pros and cons of debt versus equity.
Rather, the student should grasp the essence of what debt and
equity are, and we hope that framing the issue in terms of a
corporation trying to raise money will be interesting to the stu-
dent.
The Social Function of Stock Speculation

One of the most hated figures in the world is the specula-
tor, in particular a financial speculator. To some people, some-
one who makes money by, say, betting against a Latin Ameri-
can currency is the lowest form of evil. Whenever speculators
“attack” the currency of a profligate government that has run
up an excessive debt and has printed too much money, the
government officials naturally claim that the speculators are
the cause of the weak currency.
As this section demonstrates, successful speculators actu-
ally reduce the volatility of an asset, in the following sense: If
a speculator buys low and sells high, then his very actions
tend to push up the price when it was initially low, and push
down the price when it becomes high. Thus the speculator
reduces the gap in prices that otherwise would have existed.
Depending on the student, you may want to elaborate
and explain that this explanation is a bit too simplistic. In the
Advanced Lesson 14: The Stock Market | 237
real world, we can imagine speculators initially being suc-

cessful by starting an “asset bubble.” For example, if specula-
tors begin a mass buying spree of houses, this may set into
motion a self-fulfilling prophecy where further speculative
buying pushes up the price still further, and apparently jus-
tifies the initial round of buying. However, if the “funda-
mentals” do not support this higher price, then eventually
the bubble pops and the last speculators holding the bag suf-
fer huge losses. In such a scenario, one could argue that the
initial speculators—even though they made money—were
harmful to society by pushing prices above their “correct”
level. This is a deep issue and not all economists—not even
all Austrian economists—agree on how to frame the matter.
(The last reading in the Supplemental Materials elaborates on
these matters.)
Study Questions
1. If Jim owns 200 shares of a corporation,

can we figure out how much of the
corporation Jim owns?
No, we need to know the total number of shares as well, in

order to calculate Jim’s percentage. The point of this question
is to make sure the student realizes corporations have different
amounts of stock shares.
2. What are the two basic options a

corporation can take to raise new funds?
The corporation can issue debt (i.e., sell bonds) or equity (i.e.,
sell new shares of stock).
3. Who gets first dibs on the earnings of

a corporation—the bondholders or the
stockholders?
The bondholders. The stockholders are residual claimants,

meaning they are only entitled to the assets of the corporation
after everyone else (suppliers, lenders, laid-off employees fil-
ing a lawsuit, customers demanding a refund, etc.) has been
satisfied.
4. If a corporation is highly leveraged, will

its stock be more likely to appeal to a
conservative or an aggressive investor?
The “correct” answer is the aggressive investor. In reality even

a conservative investor might own a small portion of a highly
leveraged company, so long as the investor diversifies his
holdings across many corporations. But in this basic question
we are just trying to get the student to understand that—other
things equal—more leverage tends to magnify potential gains

and potential losses.
5. *How do successful speculators reduce the

volatility of stock prices?
A stock price is volatile when it bounces around a lot, rather
than moving within a narrow band. Stock speculators, if they
are profitable, tend to reduce the band in which a stock price
moves. If a stock price is above where it “should” be, the astute
speculator will sell it, pushing down the price. If the price is
originally too low, the astute speculator will buy the stock,
pushing up the price.
• Robert Murphy, “The Social Function of Stock Speculators,” at
http://mises.org/daily/2381.
This is a slightly more formal exposition of the material
in the student text.
• Robert Murphy, “A Man, A Plan, and a Short-Selling Ban,”

at http://www.econlib.org/library/Columns/y2008/
Murphyshortsell.html.
In the midst of the financial crisis, the SEC under the
Bush administration made it temporarily illegal to “short
sell” stock in certain vulnerable companies. This article
explains the harm of such a policy.
• Robert Murphy, “Bursting Eugene Fama’s Bubble,” at http://

This article is only intended for advanced students. It
criticizes famous Chicago economist Eugene Fama’s
use of the “efficient markets hypothesis” in light of the
crash in housing prices around 2007. The material in
the student textbook should not be taken to endorse all
speculative activity, as the article on Fama makes clear.
We are not claiming that speculators are always right,
we are merely claiming that there are incentives for
speculators to correctly anticipate price changes, and
that successful speculation does indeed help others.
suggested
activities (1) One popular
exercise is to have
students assemble a
“fantasy stock portfolio”
(analogous to “fantasy football teams,” etc.). Especially if
you have multiple students, you can allocate each student
an initial sum of money and have him or her spend it on
blocks of stock from various corporations. You can then
use a simple Excel file to track the movements of the total
market value of each student’s stock portfolio by plugging
in the prices from a site such as http://www.cnbc.
com/. (The student can enter the stock ticker in the search
engine at the top of the main page.)
(2) You can have the student read financial articles either
online or in a print newspaper such as the Wall Street
Journal. The goal is not to have the student grapple with
the opinions that are offered, but just to understand
the basic terms used in a typical financial news story.
For example, a stock price can go up even when the
corporation reports losing money, just so long as “the
market” had been expecting an even worse report.
Fair warning: Much of the mainstream financial press
is economically illiterate, as judged by the economic
principles in this course. The student is not looking to the
press to learn economics by any stretch. But a complete
novice can start learning about the business world by
occasionally watching CNBC or reading the Wall Street
Journal.
(3) You can work through a simple numerical example

to illustrate the effect of leverage. For example, suppose
the managers of a corporation spot an opportunity to
buy trinkets from an archeological dig in Peru at $10 and
sell them to collectors in the U.S. a month later at $15.
Unfortunately the company only has $10,000 in cash that

it can devote to this project. If the company spends all of
its cash on this project, it will earn $5,000 total—a 50%
return on its investment of $10,000—if the trinkets really
can be sold for $15 apiece to collectors in the United
States. On the other hand, if the trinkets turn out to be
worthless, the corporation could lose up to $10,000 on
the deal—a complete loss of 100%.
Now suppose the managers are extremely confident in

the success of the project. They issue $10,000 worth
of new corporate bonds, which mature in one month
at which time the corporation will have to pay back
the lenders a total of $10,100. Armed with these extra
funds, the corporation initially buys 2,000 trinkets from
the archeological dig site at $10 apiece. If they can turn
around and unload them (as they expect) for $15 each in
the U.S., then their total revenues will be $30,000. Out of
that, they must pay $10,100 to the bondholders, leaving
them with $19,900. Since they started out with $10,000
of their own money, their total monetary profit is $9,900,
a return of 99%. (Compare that to the 50% return in the
original scenario.) This is the advantage of leverage: when
things go well, it magnifies the positive return.
On the other hand, suppose the trinkets cannot be sold

for any money. In this case, the corporation is out not only
its original $10,000, but also still owes the bondholders
$10,100. In this case the total loss on the project would
be $20,100, based on an original investment of the
corporation’s money of $10,000. That works out to a loss
of 201%! With no leverage, the worst the corporation
can do is lose everything on a deal, i.e., a loss of 100%.
But with leverage—i.e., speculating with other people’s
money—the corporation can lose even more than that.
In the real world, corporations very rarely buy an asset

only to see its price literally plummet to $0. However, in
the real world many corporations are highly leveraged,

sometimes as much as 30-to-1, meaning that they
have borrowed $30 for every $1 in owners’ assets
involved in the corporation’s operations. In such a
position, even a slight reduction in the market value of
the corporation’s assets can spell bankruptcy.
(4) For a sufficiently advanced student, you could apply

the discussion of debt versus equity to the problem of
the financial crisis which began in the late 2000s. Many
commentators have derided the low-interest policies of
the Federal Reserve, saying, “The banks have plenty of
liquidity. Their problem is that they are undercapitalized;
they need the government to buy shares of stock, not
make cheap loans.” For students who have a basic
understanding of accounting, our discussion of debt
versus equity will shed light on this controversy over how
to jump-start ailing banks. (Of course, we are neglecting
the negative consequences of government intervention
in the banking sector—our point here is to note the
relevance of our abstract discussion in the student text
to real-world controversies.)
test — Lesson 14
The Stock Market

Stock exchange
Stock brokerage
Bonds
Dividend
Leverage
Speculator
1. The size of a company’s debt relative to

the equity held by the owners.
2. Where purchases and sales of (some)

stock shares occur.
3. A sum of money (from revenues) paid to

shareholders.
4. Someone who buys a particular stock

because he looks to sell it at a profit in
the near future.
5. Companies that buy and sell stocks for

people.
6. What companies can sell to raise

money, if they do not want to share
ownership with others.
245
Short Answer:
7. Explain why companies might want to raise outside funds, rather than
financing any desired spending out of profits.
8. Discuss the distinction between a corporation raising new funds by

issuing debt versus stock.
9. Explain how speculators actually regulate the stock market in a healthy

and non-interventionist way.
10. In common discussions, what is the difference between an investor

and a speculator in stocks?
249

Part III
SOCIALISM:
THE COMMAND
ECONOMY
Lesson 15
The Failures of
Socialism—Theory
The Vision of Pure Socialism

One of the greatest accomplishments of the Austrian School
of economics was the critique of socialism developed by Lud-
wig von Mises in 1920, and elaborated by his follower Fried-
rich Hayek. (For a brief summary of the “socialist calculation
debate” see the beginning of Robert Murphy’s article available
at http://mises.org/journals/qjae/pdf/qjae9_2_1.pdf.) Although
every free market economist is familiar with the incentive
problem of socialism, not all of them are aware of the calcula-
tion problem. We handle these different problems in the sec-
tions below.
We are assuming that the “vision of pure socialism”
involves the government taking ownership of all factors of
production. As we note in a footnote in the student text, some
self-described socialists would not endorse this strategy. They
reject government control of resources, but they do not endorse
private property either. To such theorists, the system of capital-
ism itself represents an unjust concentration of power into the
hands of an elite group. If the student is interested and wants
to read more on the cutting-edge theoretical arguments from
people who reject private property, a good starting point is this
253
website: http://www.infoshop.org/page/AnAnarchistFAQ. (Note

that for these writers, “anarchism” is not compatible with
“capitalism.”)
Socialism’s Incentive Problem

To be clear on the outline of our presentation: In Part II of
the student text, we described the operation of a pure market
economy. In Part III we (more briefly) explain the problems
with a pure command economy. In Part IV we will explain the
undesirable consequences of limited government interven-
tions into a market economy—i.e., we will describe what hap-
pens in a so-called mixed economy.
Breaking down the outline even further: In the present
chapter (Lesson 15), we are discussing the theoretical problems
with socialism. In the next chapter (Lesson 16), we will look at
the actual historical experience of socialist governments.
And to break down the outline one more step: In the pres-
ent chapter, we divide the theoretical critique of socialism into
two components. First, in this section we discuss the incentive
problem, which shows that total output will likely fall with the
move to socialism, and also that the composition of output will
likely be worse from the consumers’ point of view. Then, in the
next section we discuss the calculation problem, which is com-
pletely distinct from the incentive problem. In other words,
even if the socialist reformers were correct, and people born in
a socialist community were not selfish or abusive (so we didn’t
have to worry about the incentive problem), the central plan-
ners would still face the calculation problem.
Who Picks Up the Garbage?

This subsection makes two main points. First, once we
depart from the market economy’s principle of paying a worker
Lesson 15: The Failures of Socialism—Theory | 255
in proportion to his or her marginal product, we encounter the

problem of getting people to do “dirty work.” If it weren’t for
differences of pay, most people would prefer to pick up golf
balls (at a driving range) rather than pick up trash cans (on a
garbage truck route). Yes, there are other changes the social-
ist planners could make, in order to get more volunteers for a
particular job, but then these changes would impact the output
in other sectors. (One of the Suggested Activities relates to this
issue.)
The second main point of this subsection is that even if the
socialist planners were willing to use punishments to get the
required number of “volunteers” in each occupation, they still
wouldn’t be able to mimic the outcome of a market economy.
This is because you can’t tell from simple inspection which
workers are capable of genius. By definition, no one knows
what amazing invention or discovery a person is capable of,
until he or she invents or discovers it. So although the plan-
ners wouldn’t need to worry about getting people to pick up
the garbage—if they were willing to threaten workers who
refused to do the dirty work—they still wouldn’t be able to
motivate everyone to perform the same as they would under a
system of private property.
For the advanced student, you should make clear that the
argument isn’t simply that a potential genius needs the pos-
sibility of earning millions before he or she is willing to tinker
in the laboratory. That observation is probably true for a large
number of the practical inventions and discoveries made every
year in a market economy, but it isn’t necessary for our point.
There are some tasks that slaves simply cannot do, and in a
very real sense, the workers in a system of State-run socialism
are all property of the government. To give a vivid example,
suppose the planners unwittingly take the next Einstein or
Edison and assign him to garbage truck duty! The physical
labor and loud noises (if in a big city) might prevent would-be
geniuses from ever contributing beyond their assigned tasks.
Allocating “Capital” to New “Firms”

All students should grasp the standard incentive prob-
lem discussed in the prior subsection. In this subsection, we
explore a subtler but perhaps far more significant problem. It is
hard enough to explain how a socialist system could match the
performance of a market economy if things stayed the same,
but once we realize that conditions constantly change, then
the case for a market economy is even stronger. If the student
understood the earlier discussion of the role of entrepreneur-
ship and the stock market, then he or she should understand
the immense disadvantages confronting a socialist system.
One Giant Monopoly

The “incentive problem” of socialism is typically used to
denote the problem of workers who shirk when their pay is
not directly tied to performance. However, in this subsection
we spell out the problems on the other end, where the people
in charge have little incentive to ensure customer satisfaction.
(There is a Suggested Activity related to this subsection.)
Socialism’s Calculation Problem

In this section we are scratching the surface of the “calcula-
tion argument” developed by Ludwig von Mises and Friedrich
Hayek. This is one of the seminal contributions of the Austrian
School and students who wish to learn more should follow up
with the Supplemental Material.
The advanced student might notice that there is a partial
overlap between the problem of allocating capital as discussed
above (as part of the “incentive problem”) and the more gen-
eral calculation problem. The way to distinguish the two is
the following: There is definitely an incentive problem when

it comes to the central planners deciding upon various proj-
ects to fund, because they aren’t experts in each field and so
can’t be sure if some of the promoters are lying or exagger-
ating in order to get resources for their own ideas. But even
if we assume all of this away, and pretend that none of the
promoters would do anything except render his or her honest
judgment on all of the technical issues, nonetheless the central
planners still wouldn’t be able to calculate the economically effi-
cient projects that deserved funding.
Solving the Calculation Problem?

In this subsection we repeat the rhetorical device used ear-
lier, and show that in order to solve the problems of socialism,
the central planners are led step by step back toward a market
economy. This isn’t attacking a strawman, incidentally: If you
read the historical overview of the socialist calculation debate
in the Murphy article in the Supplemental Materials, you will
see that the socialist theorists introduced various forms of
“market socialism” to deal with Mises’s critique.
Study Questions
1. Explain the term command economy.

The term refers to the fact that under (State) socialism, a group
of a few (or one) political authorities controls all productive
resources, including labor.
2. What is the incentive problem inherent in

the slogan, “From each according to his
ability, to each according to his needs”?
The policy of this slogan severs the connection between work
and reward. It is unlikely that workers would contribute as
much to the pile of total output, if the amount they got to con-
sume (or give to their family) had nothing to do with their con-
tribution.
3. Could a socialist government use

punishment to overcome the problem of
shirking among workers?
For certain, simple tasks—such as garbage collection and
painting barns—a socialist government could use punishment
to get workers to carry out their assigned duties. But many jobs
require creativity and other unobservable aptitudes. A market
economy allows workers to choose their own occupations and
discover the fields where they can contribute the most. Even
with the use of punishment, socialist officials wouldn’t be able
to force their subjects to produce the same output. (Could you
really use a whip to force someone with nimble hands to spend
years training to become a brain surgeon?)
4. What do beer companies and electric

utilities have to do with socialism?
The argument in the text is that during summer months, com-
panies that enjoy government-granted monopolies such as
electric and water utilities often restrict their service, whereas
private companies in open competition (such as beer and soda
producers) welcome the boost in demand for their products.
5. *Why doesn’t a market economy suffer from

the same calculation problem that plagues
the socialist planners?
The market overcomes the calculation problem because no one
group is “in charge” who needs to decide everything. The deci-
sions are instead dispersed among all the owners of producer
goods (including labor). The profit and loss test, as revealed
by market prices, guides the owners when they decide how to
deploy their resources.
• Gene Callahan, Economics For Real People, Chapter 10.
Callahan covers much of the same territory in his
chapter, as we have done in the student text (though
in a different order). One thing to note is that the
“knowledge problem” is very similar to the “calculation
problem”; they both flow out of the writings of Mises
and Hayek in their debate against the socialist theorists.
(Specifically, the knowledge problem refers to the
inability of central planners to actually assemble all
the information they would need in order to rationally
design the economy, whereas the calculation problem
in its purest form takes this information as given and
still says that the planners would not know how best to
deploy resources.) The knowledge/calculation problems
are completely distinct from the incentive problem of
socialism.
• Joe Salerno, “Calculation and Socialism,” video at http://mises.

org/media/4366.
Salerno provides a good introduction to the calculation
problem. His presentation doesn’t assume too much
on the part of the viewer, but the presentation is more
formal than Callahan’s discussion.
• Mateusz Machaj, “The Nature of Socialism,” at http://mises.

org/daily/4066.
Machaj’s article is the most formal of the three selections,
and beginner students should probably skip it. The
article is part of a collection in honor of Hans Hoppe,
and thus it is geared toward an academic audience.
Even so, it is easier reading than the actual articles
in the historical calculation debate, and provides an
intermediate stepping stone for the advanced student
who may wish to jump in.
suggested
activities (1) Have the student
identify appealing
versus distasteful
jobs that require
comparable skill levels. (For example, serving food in
Disneyworld versus serving food to the workers at a
chicken slaughterhouse.) If the central planners are not
allowed to pay more for the distasteful occupations,
what other incentives could they use to prevent
everyone from volunteering for the appealing jobs
and no volunteering for the distasteful ones? (For
example, the planners could insist that everyone who
volunteers to work at Disneyworld first pass a difficult
trigonometry exam, or that anyone who volunteers at
the slaughterhouse gets to have lunch with a movie
star once per year.) Have the student think through the
implications of these changes.
(2) Have the student keep track of differences in the

attention to customer satisfaction when it comes to
private businesses versus government agencies or
private agencies that enjoy a government-granted
monopoly. (This last category includes the Post Office
and many local utilities.) The differences could include
items such as ease of finding a parking spot, hours
of operation (e.g., check out the hours of your local
“public” library and compare them to hours of a book
store or video rental business), time spent waiting in line,
and friendliness of staff.
test — Lesson 15
T h e Fa i l u r e s o f
Socialism—Theory
Multiple Choice:
Write the letter of the best answer to each question.
1. In a command economy, resources are owned and controlled by

A. capitalists.
B. the people.
C. the government.
D. producers.
2. Capitalism is to market economy as __________ is to command

economy.
A. anarchism
B. socialism
C. egalitarianism
D. monarchism
E. Obamism
3. Which economist systematically laid out the calculation objection to

socialism?
A. Karl Marx
B. Adam Smith
C. David Hume
D. Ludwig von Mises
263
Short Answer:
4. What is the incentive problem for workers under socialism?
5. Describe socialism’s “calculation problem” (which is NOT the same as

the incentive problem).
6. What is ironic about the various schemes that can be implemented to

“cure” socialism of its problems?
7. Explain why you probably receive better service at Walmart than at the
Department of Motor Vehicles.
8. Contrast the very worst that a capitalist “tyrant” can do to you (as a
malcontented worker or an obnoxious customer) versus what a socialist
tyrant can do to you.
267


Lesson 16
The Failures of
Socialism—History
Economic Theory and History

We are trying to walk a fine line in this chapter. On the
one hand, it is important for the student to learn the histori-
cal record of many socialist governments. Conventional treat-
ments (at least in the United States) typically focus on the
atrocities of the African slave trade and the Jewish Holocaust
under Nazi Germany, while completely omitting the atrocities
committed by “leftist” governments.
On the other hand, we do not want to reinforce the com-
mon misconception—which we took great pains to dissect in
Part I of the student text—that basic economic theory must be
tested through empirical observation. Strictly speaking, eco-
nomic theory by itself does not say, “If the government of a
large country abolishes private ownership of the means of pro-
duction, then millions of people will die.”
Rather, economic theory claims that other things equal, aboli-
tion of private property will cripple the coordinating mecha-
nism of market prices and the profit and loss test, and will also
put great power in the hands of potentially wicked people. In
271
principle, other factors could intervene, counteracting these

forces. To give a silly example, Martians could show up and
provide humans with solar-powered machines that produce
consumer goods at the touch of a button. In this case, people’s
standard of living might rise after the switch to socialism,
though it would be in spite of the switch, not because of it.
We are stressing this seemingly pedantic point because one
of the standard arguments in favor of a mixed economy (as
opposed to a command economy) is that the standard of living
is obviously higher in the late twentieth century in Western
countries compared to the late 19th century. The proponents
of government intervention claim that this prosperity was the
result of regulations imposed on a much more laissez-faire
economy of the past. In other words, they argue that the growth
of “big government” in the United States and other democratic
nations went hand in hand with a growing economy. The pro-
ponent of free market economies would of course reply that
20th century economic growth would have been even greater
had the Western governments limited their taxation and regu-
lation.
If you want to learn more about the approach Mises took to
economic theory and history, David Gordon’s lecture (http://
mises.org/media/3978) is an excellent starting place.
Communism versus Fascism

This is a course in economics, not political science or history.
However, from an economic standpoint the standard political
classification of various historical regimes is inadequate. Far
from being polar opposites, the “far left” government of Stalin-
ist Russia and the “far right” government of Hitler’s Germany
were very similar. Moreover, as we tried to explain in the last
chapter as well as the current one, we can’t compartmentalize
“economic” and “personal” freedoms. If the government is the
Lesson 16: The Failures of Socialism—History | 273
sole employer, then it has tremendous power over the indi-

vidual. It’s little consolation to have even a constitutionally
protected “freedom to protest” if the government can assign
you to work in Siberia and also controls all the media.
Socialism’s Body Count

We do not want to commit the opposite mistake and give
the impression that governments in countries that officially
embrace capitalism are innocent of any wrongdoing. We have
tried to be neutral in mentioning events from U.S. history, as
some would defend (say) the atomic bombings of World War
II as acts of self-defense which precluded even more deaths.
The student should be aware, however, that modern socialists
view capitalism as inherently imperialistic, and cite the fre-
quent military actions of the United States as prime evidence.
The Broad Numbers

The Black Book of Communism is well-respected in academic
circles and comes from Harvard University Press. We have
opted for a small sample to give the student just a taste of the
evidence of the brutal death toll of communism in the twenti-
eth century.
Close to a Controlled Experiment

Again in this section, we explain that in the social sciences
there can be no controlled experiment. But guided by our theo-
retical understanding of market versus command economies,
the evidence seems compelling that State socialism is an inef-
ficient economic system.
Study Questions
1. *Does the historical record prove that

socialism is a flawed economic system?
No, because we can never know how history would have
unfolded in an alternate timeline where socialism hadn’t been
implemented. (For an analogy, if someone has a headache
and takes an aspirin, and then the headache gets worse, that
doesn’t prove that “aspirin makes your head hurt.” It’s prob-
ably the case that the headache would have gotten really bad
had the person never taken an aspirin.)
2. What is wrong with the conventional “left /

right” spectrum on which Stalin is the polar
opposite of Hitler?
The problem is that economically speaking, the regimes of Sta-
lin and Hitler were quite similar. Both involved heavy govern-
ment involvement in the use of property, meaning that both
regimes were the polar opposites of a pure market economy.
3. Do governments that officially support

capitalism ever kill innocent people?
Yes, there are numerous examples of “anti-communist” author-
itarian regimes that imprisoned and killed political opponents.
If we broaden the category to include deaths of civilians living
outside of the country, then the Western democracies (espe-
cially the United States and Great Britain) killed hundreds of
thousands of civilians during the two world wars.
4. According to the text, which government

massacred the largest number of civilians?
The Communist Chinese government.
5. *Explain this subsection title: “Close to a

Controlled Experiment.”
There can never be a truly controlled experiment in the social
sciences, because people learn from experience; thus the origi-
nal experiment cannot be recreated, save for one minor adjust-
ment. (This is the hallmark of a controlled experiment.) Even
so, the examples of East and West Berlin, and especially North
and South Korea, cast considerable doubt on the efficiency of
socialism as an economic system.
• Yuri Maltsev, “What Soviet Medicine Teaches Us,” at http://
Maltsev earned his Ph.D. in economics in Moscow and
served on a team of Soviet economists working on
President Mikhail Gorbachev’s policy of perestroika,
before defecting to the United States. Maltsev is a
champion of the market economy, and has powerful
first-hand experience to justify his views. In this article
he warns of government “solutions” to health care.
• Yuri Maltsev, “Farewell to Aleksandr Solzhenitsyn,” at http://

In this article Maltsev explains the personal life and
literary achievements of the Soviet dissident and Nobel
laureate Aleksandr Solzhenitsyn, author of The Gulag
Archipelago.
suggested
(1) Have the student
activities scour news accounts
of “right wing” and “left
wing” governments or
guerrilla groups, and
try to isolate what the difference is supposed to
be. Typically, both groups are in favor of having
the government control property, it’s just that the
“right wing” groups want to redistribute wealth to
the owners of multinational corporations, whereas
the “left wing” groups want to redistribute wealth
to rural peasants.
(2) Have the student peruse standard history

texts or check the documentaries on the History
Channel. There will probably be extensive
coverage of the crimes of Nazi Germany, with
relatively little (if any) attention paid to the much
larger death toll at the hands of communist
dictatorships.
test — Lesson 16
T h e Fa i l u r e s o f
Socialism—History
Communist or Fascist? Place the letter of the correct conven-

tional label next to each (in)famous government ruler.
A. communist B. fascist
1. Adolf Hitler 2. Pol Pot
3. Mao Tse-Tung 4. Vladimir Lenin
5. Benito Mussolini 6. Joseph Stalin
Multiple Choice. Write the letter of the best answer to each

question.
7. A system that seeks to establish government ownership over the

means of production through a revolution in the working class.
A. socialism
B. communism
C. capitalism
D. fascism
8. A system that seeks to establish government control over the means

of production while retaining the institution of private property.
A. socialism
B. communism
C. capitalism
D. fascism
279
9. Communism and Nazism are both forms of

A. anarchism
B. socialism
C. entrepreneurism
D. capitalism
10. Pol Pot’s Khmer Rouge communist regime killed up to 25% of its own
people in which country?
A. Vietnam
B. China
C. North Korea
D. Cambodia
11. “[O]ne particular feature of many Communist regimes [was] their sys-
tematic use of _____ as a weapon.”
A. famine
B. gas
C. poison
D. disease
E. Kalishnikovs
12. By far, which country’s experience with communism cost the most
lives?
A. U.S.S.R
B. North Korea
C. People’s Republic of China
D. Vietnam
13. Post WWII, where in Europe was the contrast between relative capital-
ism and communism the starkest?
A. Paris
B. Berlin
C. Warsaw
D. Moscow
14. In nighttime satellite photographs, this communist country is distin-

guished by its darkness and its neighbors’ brightness.
A. North Korea
B. People’s Republic of China
C. Japan
D. Ukraine
Short Answer:
15. Compare and contrast communism and fascism.

16. Explain how the conventional “Left Wing/Right Wing” dichotomy (or
Left/Right Spectrum) with communists on the left and fascists on the right
makes little sense in terms of economics.
17. Does the material in this chapter show that we prove economic
theory with experimental evidence?
283

Part IV
INTERVENTIONISM:
THE MIXED ECONOMY
Lesson 17
Price Controls
The Vision of Interventionism
I
n this final portion of the book, we focus on major compo-
nents of the “mixed economy.” Most intellectuals recognize
(at long last, in some cases) that pure socialism doesn’t work.
However, they are still unwilling to embrace a society with
complete private property rights. They reject both pure social-
ism and pure capitalism, and opt for a third way, an interven-
tionist system that (allegedly) avoids the unseemly excesses of
a pure market while stopping short of outright central plan-
ning.
Much of the analysis in this section of the book is compa-
rable to what is found in mainstream textbooks, though the
emphasis would be different. In a standard text, for example,
much space would be devoted to diagrammatic expositions of
the “welfare losses” arising from interventions such as tariffs.
In this course we do not dwell on the graphs, which leaves us
more space to analyze the various topics in greater detail.
Price Ceilings
The analysis in this section is fairly straightforward. We
offer just a few comments to help you allocate your time.
287
Immediate Shortages
Immediate shortages are the most critical consequence of
price ceilings. For students wishing to go on in economics,
make sure they know how to use supply and demand curves
to illustrate the shortage.
Lower Supply in the Long Run

In addition to an immediate reduction in the quantity sup-
plied in the short run, price ceilings also reduce the supply in
the long run. For advanced students, you can point out the
subtlety here: The price ceiling moves output along the original
supply curve to the bottom left (yielding a smaller quantity
supplied), but it actually moves the entire supply curve to the
left over time, relative to where the supply curve would have
been in the absence of the price ceiling.
To give an exaggerated illustration: If the government sud-
denly declared that apartments could only rent for $1 per
month, the quantity supplied would fall sharply. Most own-
ers would only “rent” to their friends and out-of-town rela-
tives, and would use their remaining rooms as storage. (They
might rent it out as storage space if this evaded the rent control
law.) Some might be more philanthrophic and allow tenants to
move in who had passed some other test of merit, such as reha-
bilitated drug abusers or ex-cons trying to get back on their
feet. However, if the government removed the price control
after only a few months, the quantity supplied could quickly
snap back to its original level, just as soon as the contracts for
the existing tenants expired.
On the other hand, if the government kept the $1 price ceil-
ing in place for a few decades before removing it, the quan-
tity supplied would not quickly return to its original level (let
alone the level it would have achieved if there had been no
price ceiling in the intervening decades). This is because the
Lesson 17: Price Controls | 289
landlords would not have replaced their deteriorating build-

ings. In fact, once they were sure the rent control law was
going to last, many landlords would have had their apartment
buildings bulldozed and replaced them with stores or park-
ing garages. The lesson is that the absurd price ceiling of $1
per month would initially suppress the quantity supplied, but
eventually it would also restrict the entire supply curve. After
having an absurd $1 per month ceiling in place for decades,
if the government suddenly removed the control and allowed
the market to set prices, there wouldn’t be many physical
apartment units in existence at that moment, no matter how
high the market price soared after the removal of the ceiling.
Non-price Rationing
One of the functions of the (undisturbed) market price is
that it rations the available supply of a good among the com-
peting demands for it. In essence, if someone wants more units
of the good, he has to bid more dollars for it. This of course
strikes many observers as unfair, since it gives an obvious
advantage to the wealthy.
However, by placing a cap on the price, the government
doesn’t eliminate the fact of scarcity; there are still more people
who want to use the good, than there are units of the good to
go around. All that happens is that the rationing must occur
through non-price mechanisms. This actually might end up
being more distasteful to the proponents of the price control,
than the original price rationing.
For example, under rent control landlords can be much
pickier in which tenants they select for their available apart-
ments. They might insist on seeing several months’ worth of
paycheck stubs, run a background check on the applicant,
and require letters of reference from previous landlords. They
might also prefer tenants who travel in the same social circles,
or come from the same ethnic group, whether from outright
bias or because they subconsciously feel more comfortable let-

ting someone move into the building when (say) he goes to the
same church. In such an environment, ethnic minorities and
recent immigrants—especially if they don’t speak the native
tongue—will be at a huge disadvantage, and may find it very
difficult to find a place to live. This outcome is the exact oppo-
site of what most proponents of rent control desire.
Drop in Quality
Be sure the student understands that even the ostensible
winners from price ceilings are not as lucky as the first stage
of the analysis suggests. In other words, even the tenants who
receive a break on their rent may end up with lousier service
from the landlord.
Price Floors
As with the previous section, the analysis here is straight-
forward.
Immediate Surplus (or Glut)

Be sure the student understands that price floors cause
immediate surpluses (or gluts); this is the most important con-
sequence. The student planning to go on in economics should
also be able to graphically illustrate a price floor and the cor-
responding surplus.
Lower Demand in the Long Run

The analysis here is the mirror-image of the effects of price
ceilings on supply. In the case of price floors, the immediate
effect is a restriction in the quantity demanded. That is, the
artificially high price moves along the original demand curve
(up and to the left). But over time, the price floor (and the asso-
ciated higher-than-equilibrium price) leads the buyers to adapt
by reducing their dependence on the good or service in ques-
tion. The result can be a leftward shift in the entire demand
curve, so that even if the price floor were suddenly removed, a
wage (price) at the original, lower level would not draw forth
the same quantity demanded.
Non-wage Competition
One way of illustrating the consequences in this subsection
is to point out the different unemployment rates based on vari-
ous demographics. (As of this writing, the Bureau of Labor Sta-
tistics has links to such data at the bottom of this link: http://
www.bls.gov/cps/#data.) The very groups who are the most
economically vulnerable tend to have the highest unemploy-
ment rates, and one of the explanations is that these groups
are legally forbidden from underbidding other workers who
are earning the minimum wage. Proponents of the legislation
would argue that it is indecent for someone to make less than
the minimum wage, but it’s arguably more indecent for some-
one to be willing to work but unable to find a job.
Drop in Workplace Quality

By forcing employers to pay more per hour, and by ensur-
ing a long line of willing workers ready to replace anyone who
quits, minimum wage laws reduce the incentive for employers
to make jobs attractive in other dimensions. For example, the
employer might reduce break times, stop providing free food
in the lunch room, and set the thermostat higher in the sum-
mer and lower in the winter. The employer might be slower to
replace overhead fluorescent bulbs, and (in an office environ-
ment) might spend less money on office furniture. Perhaps the
bathrooms will be stocked with very cheap toilet paper and
clinical-smelling hand soap.
Study Questions
1. What is “mixed” in the term mixed

economy?
A mixed economy combines features of both capitalism and

socialism, namely private ownership and government direc-
tion.
2. How can the quantity supplied of

apartments fall, even in the short run? Isn’t
there a fixed number of apartment units at
any given time?
Remember that the quantity supplied means the number of

apartment units offered for rent. As the legally permissible price
falls, more and more owners won’t find it worthwhile to go
through the hassle and risk of renting their physically avail-
able rooms to total strangers.
3. How might price ceilings on gasoline impede

the evacuation of a city in the path of an
oncoming hurricane?
At any given time, gasoline stations in a typical city don’t have

enough fuel in the underground tanks to withstand a mass
exodus of the entire population, with every motorist filling up
before leaving town. If the authorities impose price ceilings to
prevent “gouging” after the news breaks, the stations will run
out of gas before everyone has had a chance to refuel. Con-
sequently some motorists will be stranded on the interstates,
impeding traffic flow.
4. *How can minimum wage laws reduce

the long-run demand (not just short-run
quantity demanded) for labor?
Business owners may respond to a minimum wage law by buy-
ing more machines and redesigning their workplaces to oper-
ate with a fewer number of higher-skilled employees. Once
businesses have adapted in this fashion, the demand curve for
labor will have shifted to the left, because even at the original
wage level, businesses would now demand a lower quantity.
5. How can a minimum wage actually hurt

even the workers who stay on the job?
Employers could reduce workplace amenities and other perks
to compensate for the higher labor expenses. It is possible that
employees would actually prefer the original combination of
pay and other benefits to the combination they receive after the
imposition of the minimum wage.
• Henry Hazlitt, Economics In One Lesson, Chapters XVIII and
XIX.
As with all of Hazlitt’s chapters, these provide a
wonderful yet succinct analysis.
• Gene Callahan, Economics For Real People, Chapters 11–12.

Callahan provides a good exposition on the problems
with price controls, from an Austrian perspective.
• Robert Murphy, “The Gas-Line Quagmire in Iraq,” at http://

Murphy applies the lessons of economic theory to the
real-world example of long gas lines in post-invasion
Iraq.
• Bloomberg story on Hugo Chavez imposing price controls after

devaluing the currency: http://www.bloomberg.com/apps/ne
ws?pid=newsarchive&sid=aTtr11jqdrdM
This news story actually combines two different issues.
Hugo Chavez first devalued Venezuela’s currency on
certain foreign transactions, so that the bolivar would
exchange for fewer U.S. dollars. (Many speculate that
Chavez’s motivation was to earn more revenue—when
quoted in bolivars—from selling Venezuela’s surplus
oil on the world market.) The devaluation meant that
Venezuelan merchants who relied on foreign imports
of the affected goods saw their expenses instantly rise.
Yet Chavez declared it illegal for the merchants to raise
the prices they charged their customers in turn. (You
could ask the student to do some online research to see
if any shortages were reported in Venezuela following
Chavez’s new policies.)
• Peter Schiff on Samoan price controls: http://www.youtube.

com/watch?v=_LaPGIIAyk4
Investment manager Peter Schiff is considered a
hero in certain circles for his uncanny predictions of
the housing collapse. (A compilation of some of his
TV forecasts can be seen at http://www.youtube.
com/watch?v=Z0YTY5TWtmU.) In the above clip he
discusses the interesting example of Samoan price
controls and how they destroyed an industry.
• Walter Block, debate on minimum wage against Jared

Bernstein, audio at http://mises.org/media/2452.
Austrian economist and libertarian writer Walter Block
debates the minimum wage on a radio program with
progressive economist Jared Bernstein.
• Joe Salerno, “Case Studies in Price Controls,” audio at http://

Salerno provides interesting historical examples to
illustrate the theoretical points in this chapter.
suggested (1) Often a good

way to introduce
activities the problems with
the minimum
wage—especially
with someone who
initially thinks it’s a good idea—is to ask, “Why not set a
minimum wage of $100 per hour, so everyone would be
rich?” (The same thing could be done for rent control
of $10 per month.) Another way to approach the issue
is to ask, “Why doesn’t every worker—including brain
surgeons and star quarterbacks—get paid the minimum
wage?”
(2) While on an interstate road trip, have the student

find out the minimum wage levels applicable in each
state along the route using Wikipedia: http://en.wikipedia.
org/wiki/List_of_U.S._minimum_wages. Then pay
attention to how many workers the various restaurants
have along the way, trying to hold other factors constant
(such as time of day, weekday versus weekend, size
of the crowd, etc.). For example, as of this writing the
minimum wage in Washington state was $8.55 for
workers 16 and older, whereas in adjacent Idaho it was
only $7.25. Other things equal, we would expect to see
fewer workers at fast-food restaurants in Washington.
(Be careful if stopping at a fancier restaurant, because
minimum wage laws usually make exceptions for
workers who earn tips.)
test — Lesson 17
Price Controls
Short Answer:
1. Explain how interventionists vie for “the best of both worlds.”
2. Why would someone support a price ceiling?
297
3. The textbook claims that price ceilings (a) cause immediate short-
ages and (b) lower long-run supply. What’s the difference? Use a specific
example to illustrate.
4. Explain why minimum wage laws lead to higher unemployment rates.

5. Explain how the poorest and most desperate are actually hurt by mini-
mum wage laws.
6. Explain how minimum wage laws might lead to a decline in workplace

quality.

301


Lesson 18
Sales and Income Taxes
Government Spending
I
n the introduction to this lesson, we adopt the position of
Ludwig von Mises when it came to the “value-free” analysis
of government intervention: Mises believed that economic
science per se was objective and dispassionate; it could not say
whether a sales tax was a good thing or a bad thing. However,
in order for citizens to make informed decisions regarding
important issues such as taxes, they needed economics to show
them the full consequences of their decisions.
For some reason, standard economics texts do not typically
discuss the obvious point that government spending necessar-
ily diverts resources into channels where they otherwise would
not have gone. In contrast, standard texts will devote inordi-
nate amounts of time to discussing the “incidence” of particu-
lar taxes, depending on the relative elasticities of supply and
demand. (For example, if the government levies a sales tax on
cigarettes, the consumers will end up bearing the brunt of the
tax, whereas a comparable sales tax on Pepsi would probably
fall heavily on the company, as Pepsi drinkers would shift into
Coke.)
305
But when it comes to the issue of what governments do with

their tax revenue, most economics books fail to mention the
points we make in this opening section. Our observations here
are not unique to the Austrian School; other free market econo-
mists have made them as well. For example, Milton Friedman
said that the true burden of government should be measured
by how much it spends, not how much it taxes. Friedman’s
observation is very relevant to the discussion here.
To clarify the examples in the student text: We bring up the
example of Disneyland to make sure the student understands
the way firms in the private sector overcome the problems we
are attributing to political programs. In other words, we are
showing why private spending by businesses doesn’t misdi-
rect resources—or rather, why there is a built-in penalty for
private misdirection—the way government spending does.
How Government Finances Its Spending

It is a staple of the free-market economics tradition that
government revenues must come from taxation, deficits (bor-
rowing), and/or inflation. So be sure that the student under-
stands these three methods, and sees how the public ultimately
ends up paying for government spending regardless of how it
is financed. (The appeal of borrowing and inflation is that the
politicians can appear to deliver popular spending programs
today, without a corresponding expense. But this appearance
is deceptive.) Note that the discussions of deficits and inflation
are deferred to later lessons in the book.
We stress this in the text, but it bears repeating here: The gov-
ernment distorts the private economy twice, first when it sucks
out revenue, and second when it spends its funds. The exagger-
ated example of a 200% income tax tries to isolate the two effects.
At such an absurd tax rate, the government would raise little if
any tax revenue, and if it limited itself to spending tax revenues,
Lesson 18: Sales and Income Taxes | 307
even government spending would be very small. Yet it would

be wrong to conclude that this hypothetical government didn’t
distort the economy very much; the draconian 200% income
tax rate would virtually wipe out the official economy and
drive productive activities either out of existence or into the
black market. (Note that in this example, Friedman’s sugges-
tion of focusing on government spending as the measure of
government’s burden would be misleading.)
Sales Taxes
To repeat, in a standard undergraduate economics text, they
will typically analyze sales taxes with the aim of understand-
ing the “incidence,” meaning whether the consumers or the
producers bear the brunt of a new tax. In these standard text-
books, there is a discussion of the general loss to the economy
in the form of a “deadweight loss.” The idea here is that when
the government makes goods and services artificially expen-
sive, potential trades do not occur, so that the gains from trade
among producers and consumers are reduced. We have tried
to get across the same idea in the student text, without using
the actual term deadweight loss and without recourse to supply
and demand graphs.
Income Taxes
Depending on your own judgment, you may wish to spend
more or less time on the issues of tax brackets, tax-deductible
expenses versus tax-exempt income, and so forth. For many
students, these are vague phrases that don’t really become sig-
nificant until they purchase their own houses and the tax code
has personal consequences. It is probably worth clearing up
two common misconceptions, which are: (1) people can alleg-
edly be hurt by a pay raise because it puts them in a higher tax
bracket, and (2) businesses don’t mind buying things that are
“tax writeoffs.” These views are false, though there is a grain
of truth to them. (Specifically, a pay raise is not as advanta-
geous when the marginal dollars are taxed at a high rate, and a
business will not watch its expenses as carefully if they are tax
deductible. But this is different from saying a person literally
is hurt by a pay raise, or that a business actually makes money
by increasing its expenses.)
The final example in the text illustrates the point that incen-
tives do affect behavior. High income tax rates definitely distort
the labor market. The distortion is not necessarily that highly
productive people leave the labor market, but rather that they
are guided more by non-pecuniary factors and in that respect
the guidance provided by other people’s spending is muted.
Study Questions
1. *Does economics conclude that government

spending is bad?
No, economics simply points out that resources will be directed
to different projects when the government spends money. The
goods and services produced because of government spend-
ing come at the expense of other goods and services that now
will never exist. Economics per se can’t say that one pattern of
output is better or worse than the other, but it reminds us that
there is a tradeoff, an opportunity cost to the government’s
actions.
2. How do we know that government

spending diverts resources from the private
sector? Does it matter how the government
obtained its funds?
We know government spending diverts resources, because we
can see that actual resources are consumed (or at least devoted
to a specific end) when the government spends money. Those
resources can’t physically be used for private projects (at least
in most cases). At this level of analysis, it doesn’t matter how
the government obtained its funds; its spending necessarily
commits resources to particular projects and thereby makes
them unavailable for entrepreneurs in the private sector.
3. **If the government builds a library, do we

know that the private sector wouldn’t have
built a library instead?
This is a subtle question. Generally speaking, we can say that
the government directs resources in different ways from how
the private sector would; otherwise, there would be no point to
government programs. However, it doesn’t follow that entire
categories of government services (such as old-age pensions or

“free” libraries) exist in a vacuum left by the private sector. If
the government didn’t build any libraries—and especially if it
lowered taxes accordingly by the amount it currently spends
on libraries—then charitable groups would probably develop
an alternative in the voluntary market sector. The market-pro-
duced “free” libraries would probably be much more modest
in terms of the physical structures, especially in urban areas
with high real estate prices, but it’s likely that they would be
more useful to their actual customers. At the very least, they
would provide more useful services per dollar spent.
4. If the government raises a modest amount

of money through taxation, do we know
that the tax burden is light?
Not necessarily, as the example of a 200% income tax shows.
5. As long as people continue working, does

the income tax have little effect on the
economy?
Not necessarily, as the example of a worker considering a job
in New York City shows.
• Thomas DiLorenzo, “Rothbard’s Economics of Taxation,” audio
at http://mises.org/media/1324.
This is a self-explanatory lecture. If the student is going
to read Rothbard’s selection below, he or she would
definitely benefit from first listening to DiLorenzo place
the material in context.
• Hans Hoppe, “The Economics of Taxation,” first two sections, at

Hoppe’s treatment is compatible with the discussion in
the student text. He shows that the classical economists
(such as J.B. Say, after whom “Say’s Law” is named)
understood that one of the essential characteristics of
taxation is its coercive nature. Ironically, most modern
economics texts do not really dwell on this difference
between taxation and, say, income earned voluntarily
in the private sector. The point is not simply one of
morality; we are not making a “mere” value judgment.
As Hoppe shows, there are definite implications from
organizing resource allocation on the basis of voluntary
exchanges versus coercive transfers from citizens to the
government. Part of the difference in perspective is no
doubt due to the Austrian focus on the institution of
private property and the role it plays in society.

Rothbard spells out the basics for a praxeological
analysis of taxation. In other words, Rothbard uses the
same theoretical framework that Mises had developed
for the study of purposeful action when restricted to a
market economy, and Rothbard applies it to the study of
purposeful actions involving coercion. In this selection
Rothbard looks at the specific category of coercion
involving “binary interventions,” meaning cases where

one party takes resources from another. (In contrast
a price control would involve more than two parties,
since the government official interferes with exchanges
between two other people.) Taxation is just such a binary
intervention.
suggested
(1) The next time you
activities are at a gas station, point
out the sign indicating
that the posted price
includes all applicable
sales taxes. Ask the student to guess how much of the
pump price is due to federal and state sales taxes. Then
show the actual answer here: http://tonto.eia.doe.
gov/energyexplained/index.cfm?page=gasoline_
factors_affecting_prices.
(2) Explain to the student that the current incarnation of

the federal income tax was enacted in 1913 through the
Sixteenth Amendment: http://en.wikipedia.org/wiki/
Sixteenth_Amendment_to_the_United_States_
Constitution. Explain that when the tax was first enacted,
the top rate was 7.0%, applicable to people earning
$500,000 or more. (Note that this much income in 1913
would be equivalent to more than $10 million in income
in 2010.) Point out to the student that obviously, tax rates
have increased since the income tax was first enacted.
Ask the student to guess (a) the top tax rate on income
in U.S. history and (b) what the top tax rate was in 1918,
five years after the initial 7% rate. Then have the student
examine the actual history here: http://taxfoundation.
org/taxdata/show/151.html#fed_individual_rate_
history-20091231. (Start at the bottom of the document
and scroll upward.)
test — Lesson18
S a l e s a n d I n c o m e Ta x e s
Short Answer:
1. Discuss the difference in economic efficiency between Disney spend-

ing $10 million to improve Disneyland and the government spending $10
million to build a bomber.
2. Explain why political authorities in an interventionist economy cannot

objectively measure how much their citizens benefit from their expendi-
tures.
315
3. Sometimes the government spends money to build something (e.g.,

a library) because entrepreneurs won’t do it themselves. Does this prove
that the government spending is a good thing?
4. Identify the three typical methods by which governments raise money.

5. Explain why high sales tax rates fuel black markets.

6. Suppose that there are two income tax brackets. Income up to

$100,000 is taxed at 10 percent, while income higher than that is taxed
at 2%. Mary originally earns $99,000, but then gets a raise and now
earns $101,000. How much total tax does Mary owe the government in
each scenario? Has the raise pushed Mary into a higher tax bracket? If
so, is she worse off (assuming she only cares about her take-home sal-
ary)?

319


Lesson 19
Tariffs and Quotas
Mercantilism
T
he case for free trade is simultaneously one of the most
difficult to convey to skeptics, and yet endorsed by the
vast majority of economists. Not merely “free market
economists,” but even many otherwise interventionist econo-
mists, understand the mutual benefits when countries reduce
trade barriers and liberalize imports and exports.
There is a vast literature for the non-expert on the topic of
free trade. Obviously we could not summarize every argument
in the student text, and we couldn’t cite every relevant read-
ing below in the Supplemental Materials. But if the student is
interested, you can pursue the topic much further than some of
the other ones in this course. The case for free trade is crucial to
understanding markets generally, and so extra time spent on
this topic will not be wasted.
We open the discussion by explaining mercantilism. Make
sure the student recognizes that although mercantilism as an
official doctrine has long been discredited, it obviously sur-
vives in both government policies and the popular under-
standing of trade. The only real change over the centuries is
323
that nowadays, the emphasis is not on the accumulation of

gold and silver, but instead on domestic “job creation.”
The General Case for Free Trade

The arguments in this section should be self-explanatory. To
help you explain some of the nuances, here are two clarifying
notes:
First, you should realize that Adam Smith didn’t present
the modern case for free trade. What Smith really did was
show that if two countries have absolute advantages in differ-
ent goods, then both countries grow richer by specializing in
those goods and trading with each other. The more general
case, in which even a country that has the absolute advantage
in everything can still gain from trading with a less productive
neighbor, is typically credited to David Ricardo (though some
historians of economic thought question whether he invented
the idea). (There is a numerical illustration in the Suggested
Activities below.)
Second, you should be aware of the distinction between a
trade deficit and a current account deficit. This distinction will
probably not be important for most students, but especially if
you try to make analogies between individual households and
countries, knowing the distinction may help you keep things
straight (at least in your own mind). A trade deficit occurs
when Country A buys more goods and services from Country
B than vice versa. People often describe this situation by say-
ing that Country A is “living beyond its means.”
However, this can be inaccurate because a current account
deficit occurs when Country A spends more on goods and ser-
vices sold by Country B, than Country A earns in income from
the people in Country B. Now if the only source of income were
through current sales of goods and services, a trade deficit and
a current account deficit would be equivalent. But in the real
Lesson 19: Tariffs and Quotas | 325
world, what can happen is that, say, people in Country A in the

year 2010 buy $1 billion worth of stock in corporations located
in Country B. Then in the year 2011, those corporations issue
$50 million worth of dividends to the stockholders who live
in Country A. These stockholders can then spend the money
on goods and services produced in Country B, and in a sense
will just “recycle the money” back to Country B. If these were
the only transactions, Country A would still have a $50 mil-
lion trade deficit with Country B, but it would have a $0 cur-
rent account deficit. There would be nothing “unsustainable”
about the people in Country A receiving an annual influx of
goods and services from Country B, which would represent
their annual earnings on the $1 billion investment made back
in the year 2010.
These nuances are probably beyond the scope of most stu-
dents’ abilities, but you should be aware of them. For example,
if you try to explain that a country running a trade deficit is
analogous to a household that consumes more than it pro-
duces, you should realize that a retired person doesn’t produce
anything. Yet if he has saved up enough during his working
years, he can comfortably run “trade deficits” with the rest of
the community for decades after he has quit working. It’s even
possible that his net worth continues to grow after retirement,
just so long as he consumes less than the investment earnings
each year. To sum up, just as a retired person can derive an
income from previous investments, and thus he “consumes
more than he produces” year after year, so too can Country A
run perpetual trade deficits with Country B, so long as Coun-
try A is using the income it earns from previous investments in
assets located in Country B.
(Note that the distinction we have drawn between income
earned by “producing” with one’s labor versus income earned
from financial assets is arguably spurious; the successful stock
speculator is a “producer” just as much as the farmer, from a
certain point of view. We are just warning you that the way
trade statistics are calculated, a “trade deficit” narrowly refers

to cross-country exchanges of conventional goods and ser-
vices, rather than capturing every conceivable way a person
in Country A could earn income from a person in Country B.)
Tariffs
There are numerous ways that free-market economists have
tried to show the flaws of protectionism, i.e., the philosophy
of using tariffs (or other trade barriers) to “protect” domestic
workers. You may want to first read all of the Supplemental
Materials before teaching this topic, to familiarize yourself
with the various arguments and styles.
As we stated in the student text, it actually concedes too
much to the protectionist position to “follow the money”; it’s
a bad habit that often leads to faulty conclusions. Yet Hazlitt
and others have focused on dollar expenditures simply to pin-
point precisely where the protectionist goes wrong. In other
words, if no one had ever uttered fallacious protectionist argu-
ments, we probably wouldn’t even talk about dollars going
into different sectors. Rather, we would explain that trade bar-
riers divert resources into less efficient sectors, and lower total
output. Therefore trade barriers make everyone in the world
poorer, on average.
Import Quotas
As the text explains, tariffs and import quotas can be quite
similar in their broad effects on domestic employment and
consumers. (One difference is that under a tariff, government
collects more revenue, whereas under a quota the foreign pro-
ducer can keep the higher earnings on the artificially restricted
number of units sold in the country.)
The last point we make in the text is that a quota can poten-
tially cause far more damage than a tariff, simply because the
government could impose a draconian quota without it being
as obvious as if the government imposed a comparable tar-
iff. Especially with the passage of time, the effects of a quota
become harder to gauge, since we would have to know what
the free-trade level of imports would be. For example, if Coun-
try A originally imported 100,000 cars from Country B, and
then Country A’s government imposed a 90,000-vehicle quota,
that would probably be equivalent to a significant but not out-
rageous tariff rate. However, as the years passed, the original
90,000-vehicle quota would become more and more onerous.
This is because, in the absence of the quota, the number of
imports would probably have grown over the years.
Study Questions
1. *Could every government successfully

implement mercantilist policies?
No, because it’s impossible for every country to run a trade
surplus with every other country. In contrast, the argument
for free trade can apply to all countries; every government can
consistently enrich its own citizens by enacting free trade poli-
cies.
2. What historical role did Adam Smith play

with respect to mercantilism?
Adam Smith showed that a country impoverishes itself if it
tries to produce at home, what could be purchased abroad
more cheaply. Smith’s arguments focused on the logic of abso-
lute advantage, where each country was best at producing at
least one particular good. In that setting, it naturally made
sense for all countries to specialize in those goods in which
they had the absolute advantage.
3. Explain the meaning (not the cause) of this

statement: “The U.S. ran a trade deficit
with Japan last year.”
During the course of the previous year, people in the United
States spent more money on goods and services produced in
Japan, than the people in Japan spent on goods and services
produced in the United States.
4. Explain: “The economic case for free trade

is unilateral.”
If Country A and B initially have tariff barriers erected against
each other, Country A grows richer by lowering its own tariffs
even if Country B doesn’t reciprocate. In other words, the ben-

efit of a free trade agreement is not simply that lowering your
own barriers gives your diplomats leverage when they try to
convince other governments into reducing barriers against
exports from your own country.
5. Explain: “A tariff doesn’t increase

employment, it just rearranges it.”
So long as wages are allowed to adjust, workers can always
find employment in the market economy. When a tariff causes
employment to expand in a particular sector, therefore, this
doesn’t “create jobs” on net, but merely sucks workers out of
other sectors.
• Frédéric Bastiat, “Petition of the Candlemakers,” at http://
bastiat.org/en/petition.html.
This is one of the most famous economics essays of
all time. It is (of course) a satirical play on standard
mercantilist arguments. Bastiat “proves” that shutting
out “unfair” competition from the sun would be a great
boon for industry.
• Henry Hazlitt, Economics In One Lesson, Chapters XI–XII.

Hazlitt continues in the great tradition of economists
showing the absurdities of protectionist arguments.
Hazlitt picks apart the standard case for trade barriers
and shows the importance of focusing on the “unseen.”
• Robert Murphy, “People Can Just Get Along,” at http://mises.

org/daily/1684.
A self-explanatory essay on the gains from trade, as well
as a treatment of some modern objections.
suggested
Especially for the student
activities who will study economics
at higher levels, you
may wish to go over
the following numerical
example which illustrates comparative advantage in the
case of international trade. (This example was drawn from
the class notes for an introductory undergrad class in
macroeconomics.)
Suppose that the following table summarizes the physical
productivities of U.S. and Mexican workers in two different
industries:
U.S. MEXICO
2 TVs / worker day 1 TV / worker day
5 DVDs / worker day 2 DVDs / worker day

The U.S. workers have the absolute advantage in both

lines, because 2 > 1 and 5 > 2. However, the U.S. workers
have the comparative advantage only in DVD production,
because (5/2) > (2/1). To see it another way, the U.S.
workers can make twice as many TVs per day as their
Mexican counterparts, but can make more than twice as
many DVDs per day.
Intuitively, we know (recall our discussion of comparative
advantage in the case of Marcia and John in Lesson 8)
that if the U.S. specializes in DVDs and Mexico in TVs,
the people of both countries will have more consumption
opportunities and hence will be better off in material terms.
But in order to drive home the point, let’s pick some simple
numbers to illustrate the process from the point of view
of individual firms and workers. Note that these numbers
are illustrative only; there is nothing magical about these
particular values, they are serving as examples to give a
concrete illustration of the general principle.
U.S. IN AUTARKY (BEFORE TRADE)

TV price is $50 each, DVD price is $20 each, and workers
get paid $100 / day.
Note that this is consistent with the table above. A U.S.
worker can make 2 TVs per day, thus earning $100 in
revenue for his employer. In a competitive labor market,
the worker therefore earns $100 per day. Or, if the worker
goes to the DVD plant, he cranks out 5 units per day, again
yielding $100 in revenue for his employer.
MEXICO IN AUTARKY
TV price is $10 each, DVD price is $5 each, and workers get
paid $10 / day.
Note that these numbers are also consistent with the
table above. A worker can yield his employer either $10
in TV production (1 per day @ $10 each) or through DVD
production (2 per day @ $5 each).
U.S. AND MEXICO AFTER UNFETTERED TRADE

TV price is $22 each, DVD price is $10 each.
U.S. workers get paid $50 / day.
Mexican workers get paid $22 / day.
Check that these numbers are also consistent with the

table, assuming unrestricted trade between the countries.
The U.S. workers just make DVDs, and so earn $50 per
day. The Mexican workers just make TVs, and so earn $22
per day.
U.S. TV manufacturers can’t stay in business under these
circumstances; they can only charge $22 per TV (due to
“cheap imports” from Mexico) but the U.S. worker can only
make 2 TVs per day. So that means the U.S. TV producer
could only pay his or her workers $44 / day, yet the DVD
producers are offering $50. So no U.S. worker would
continue going to the TV factory.
By the same token, the previous Mexican producers of DVDs
can’t compete with the “overly productive” U.S. workers.
Even though DVD prices in Mexico have risen to $10 each,
nonetheless the Mexican DVD producer can only pay his
workers $20 per day (since each Mexican worker can only
make 2 DVDs / day). No Mexican worker would accept that
job, since the TV factory is paying $22 / day.
Finally, notice that all workers are richer in real terms than
under autarky. The U.S. worker has experienced a reduction
in nominal wages, but his smaller paycheck can now buy him
either 5 DVDs or more than 2 TVs. Similarly, the Mexican
worker’s wages can now buy him either 1 TV or more than
2 DVDs.
This makes perfect sense: If the worker in either country
wants to spend all of his or her paycheck on the good still
produced domestically, then he or she is unaffected by
trade. But if the worker wants to buy the product that is
now imported, the worker can buy more units than under
autarky. That’s the whole point of trading, after all. You
import things from foreigners when this is cheaper than
making it yourself.
In summary, make sure you understand the purpose of the
example: We are showing that the workers in the United
States benefit from free trade with Mexico, even though the
Americans’ labor is more productive in every line.
The example also shows (though this isn’t the crucial point)
that some Mexican firms would be unable to compete
with American imports, if all trade barriers were removed
between the two countries. Many people in discussions
of free trade seem to think that the country with cheaper
labor has a competitive edge in every industry, but they are
mistaken. In our example above, the Mexican firms couldn’t
compete with American DVD manufacturers, even though

Mexican labor costs were lower, because the American
workers’ productivity more than compensated for the wage
differences.
test — Lesson 19
Ta r i f f s a n d Q u o ta s
Multiple Choice:
Write the letter of the best answer to each question.
1. An economic philosophy/doctrine which holds that a country grows

rich by encouraging exports and discouraging imports.
A. communism
B. capitalism
C. mercantilism
D. socialism
2. Goods and services sold to foreigners are called

A tariffs.
B. exports.
C. quotas.
D. imports.
3. Goods and services bought from foreigners are called

A. tariffs.
B. exports.
C. quotas.
D. imports.
4. Taxes placed on goods and services bought from foreigners are called
A. tariffs.
B. exports.
C. quotas.
D. imports.
335
5. Limits on the total amount people can buy from foreigners are called
A. tariffs.
B. exports.
C. quotas.
D. imports.
6. Who destroyed the intellectual justification for mercantilist policies?

A. Thomas Jefferson
B. Adam Smith
C. Lord Acton
D. Thor
7. When applied to trade or trade policies, this adjective suggests mod-

ern-day mercantilist sentiment.
A. strict
B. obstructionist
C. deregulated
D. protectionist
8. Which 1776 book most famously demolished mercantilism as an idea

and began to build the case for free trade?
A. The Rights of Man
B. The Declaration of Independence
C. The Wealth of Nations
D. Harry Potter and the Laissez-Fairy
True or False:
Write true if the statement is true or write false if the statement
is false.
9. Most economists think that tariffs make trade fair.
10. Trade with Chinese companies benefits American

consumers.
11. Free trade only benefits a country if other countries

also practice free trade.
12. A government can make its own people (on average)

richer by removing trade barriers.
Short Answer:
13. Could every country successfully implement mercantilism? What

about free trade?
14. Explain how tariffs are taxes on domestic citizens, not foreign compa-
nies.
15. Explain how penalizing U.S. imports simultaneously penalizes U.S.

exports.
339

Lesson 20
The Economics of
Drug Prohibition
Drug Prohibition
The material in this chapter may be sensitive for obvious
reasons. We have tried to present it in a neutral fashion, without
glorifying drug use or otherwise condoning particular prac-
tices. However, when contrasting the outcome of a free market
in which people voluntarily exchange property titles, versus
an interventionist economy where the government coercively
overrides property rights, drug prohibition is one of the major
vehicles in today’s world. It is also an excellent illustration of
what is called “the law of unintended consequences,” because
many of the alleged problems of drug use are actually caused
by drug prohibition. We emphasize the point that just because
something is legal, doesn’t mean it is ethical or moral. (If some-
one thinks it would be a bad idea for the government to throw
cheating spouses in jail, that doesn’t mean the person is “for”
marital infidelity.)
341
Drug Prohibition Corrupts

Government Officials
Depending on your policies regarding R-rated movies,
you may suggest that the student watch certain films to better
understand the scope of corruption even in the U.S. govern-
ment. For example, Serpico (starring Al Pacino) and American
Gangster (starring Denzel Washington and Russell Crowe) are
both excellent films from a cinematographic standpoint, but
they also are based on true stories depicting the incredible
degree of police corruption necessary for the large-scale drug
trade to occur. In order to understand “how the world works,”
the student ultimately needs to realize just how pervasive drug
corruption is among certain American police departments.
The Significance of “Victimless Crimes”

In this section we point out the significance of the govern-
ment criminalizing activities between consenting parties—
often called “victimless crimes.” Whether or not the outsider
agrees that a mutually beneficial trade is occurring, the fact is
that the parties themselves believe it to be so. This fact has con-
sequences, making it much more difficult for the government
to stamp out “victimless” crimes as compared to crimes where
one party does not consent to the activity. Because “victimless”
crimes are commercial transactions, the scope for corruption
is much larger than for more traditional crimes. This observa-
tion shows that the typical objection to drug legalization argu-
ments—namely, someone who says, “Well I guess we should
just legalize murder too, right?”—obscures some important
differences between the two classes of crimes.
Corruption as Cause and Consequence

Keep the material in this subsection in mind, when going
over the standard supply and demand treatment of drug
Lesson 20: The Economics of Drug Prohibition | 343
prohibition. Specifically, when the supply curve (for a good

such as heroin or cocaine) shifts to the left after the introduc-
tion of stiff legal penalties, the possibility of corruption damp-
ens the move. In other words, producers don’t actually say to
themselves, “If the price is $1,000 per gram, how many grams
of cocaine do I want to sell, knowing that I will spend 20 years
in jail?” Rather, the big-time producers say, “If the price is
$1,000 per gram, how many grams of cocaine do I want to sell,
knowing that I will have to spend such-and-such dollars per
week paying off various vice squads and judges, to minimize
the chance that I’ll spend 20 years in jail?”
Drug Prohibition Fosters Violence

The individual points in this section are self-explanatory.
But to step back and give the overall theme: We first note the
undeniable connection between drug prohibition and crime;
the historical example of alcohol—with its gangland killings
during the Prohibition era—makes this clear enough. How-
ever, many economic discussions do not really explain why
prohibition leads to more violence. Worse still, some econo-
mists blame the increase in violence on the lack of police pro-
tection for drug dealers. (We explain in the text why this is a
poor explanation.) In the text, we show that prohibition raises
the marginal benefits of violence, and that it lowers the mar-
ginal costs. If a government policy raises the benefits and low-
ers the costs of a particular action, we shouldn’t be surprised
when people engage in more of it.
Drug Prohibition Reduces Product

Safety
In this section we explain how drug prohibition reduces prod-
uct safety. For example, you may recall the national discussion
on the dangers of drug use when promising basketball star

Len Bias died in 1986 from a cocaine overdose soon after being
drafted to the Boston Celtics. Although the obvious message to
kids was, “Don’t ever experiment with cocaine!” a less obvious
implication was, “When the government tries to keep people
safe by banning certain products, the results often backfire.”
(In other words, using cocaine is more dangerous, when it
must be purchased from a black market dealer, as opposed to
buying it from a name-brand manufacturer.)
The last example in the student text concerns a hypothetical
ban on shrimp. We explain that in the black market for shrimp,
there would probably be a shift toward “jumbo” shrimp, rela-
tive to the original market outcome. What we have in mind is
something like the following: Typically jumbo shrimp sells for
a higher price per pound than conventional shrimp. So if the
government for some reason placed large penalties on the sale
of all shrimp, presumably some entrepreneurs would still sell
it, covertly. But because they would have to hide their stash of
shrimp in, say, portable coolers filled with ice, the volume they
had for storage would be at a premium. Rather than stuffing
a cooler full of regular-sized shrimp that had a black market
price of $100 per pound, it would be more lucrative for the
illegal shrimp dealer to only carry jump shrimp that sold for
$150 per pound. In the unregulated market, it doesn’t neces-
sarily follow that producers will only carry the type of shrimp
commanding the highest price per pound, because it can be
profitable to carry both types and simply buy a bigger cooler to
store larger quantities of the cheaper (per pound) shrimp. But
in a black market where storage space is at a high premium,
that option may no longer make sense.
If you can understand the logic of the shrimp example, then
you can see why drug dealers would shift to “harder” items in
a prohibited market. Going the other way, this analysis sug-
gests that if drugs were legalized, consumers would actually
end up consuming “softer” drugs on average, compared to
what they currently buy in the heavily regulated market. This

is a very important consideration, to the extent that protecting
people from their own bad decisions is one of the primary jus-
tifications for drug prohibition.
Study Questions
1. What role does economic science play in the

analysis of drug prohibition?
Economics cannot say whether drugs should be prohibited or
legal, but it can objectively point out some of the (often unfore-
seen) consequences of drug prohibition. Many of these conse-
quences are blamed on the drugs themselves, when in fact it is
the government’s prohibition causing or at least exacerbating
the problem (gang warfare, drug overdoses, kids becoming
drug dealers, etc.).
2. In what sense do cocaine dealers (under

drug prohibition) earn hazard pay?
Under prohibition, cocaine dealers operate in a very risky pro-
fession. They are at constant risk of going to prison for a very
long time, and typically they are more likely to be violently
killed than members of other professions. These factors reduce
the supply curve of cocaine, driving up the monetary returns
until enough producers are willing to tolerate the high risks
and operate in the industry.
3. *What is the connection between corruption

and a “victimless crime” such as cocaine
distribution?
Unlike traditional crimes such as robbery and murder, when
it comes to commercial drug transactions there is a customer
who wants to give his money to the dealer in exchange for
the product. Because there is so much more money involved,
and such a huge potential market, illegal drug dealers have
the ability to funnel very large bribes to government officials.
Also, it is more understandable that police would look the
other way when people are consensually breaking laws, as
opposed to criminals who are violating the property rights of

others through theft or bodily assault.
4. How does drug prohibition raise the

marginal benefits of using violence for drug
dealers?
The “hazard pay” (see question 2) aspect of illegal drug deal-
ing raises the monetary payoffs to producers. This means that
in most cases, a given drug dealer can earn a much larger
monetary income (without a corresponding increase in risk of
imprisonment, etc.) from expanding his customer base, rela-
tive to other industries. Also, the nature of drug trafficking
means that there will be many opportunities where the use
of violence would allow someone to acquire a suitcase full
of cash. These situations don’t often arise in other industries,
where transactions occur in public view inside buildings.
5. How might drug prohibition contribute to

fatal overdoses?
The nature of a prohibited drug industry attracts people who
are skilled in police corruption and violence. This is a different
type of person from the one who would thrive in a free mar-
ket. Furthermore, even among the fraction of entrepreneurs
who enter the illegal drug industry and are excellent pharma-
cologists, etc., they cannot earn brand name loyalty as easily
as firms in a free market. It is much harder for consumers to
seek out and patronize “safe” drug producers in a prohibited
market. Finally, the incentives of a prohibited market lead
producers and consumers to shift toward “harder” products,
increasing the dangers of overdose from consumer error and/
or product impurities.
• Mark Thornton, “The Economics of Prohibition,” at http://mises.
org/daily/2269.
Austrian economist Mark Thornton is an expert on the
topic. This article provides a good introduction to his
views.
• Walter Block, Channel 6 WDSU debate on drug legalization,

video at http://mises.org/media/1963.
This debate features Austrian economist and libertarian
theorist Walter Block against an official from the Drug
Enforcement Agency. (There is an introductory news
feature setting up the context of drug problems in
New Orleans, and then the debate begins at the 4:05
mark.) We should point out that strictly speaking, there
is no connection between Austrian economics and
drug legalization. However, in practice most Austrian
economists do favor drug legalization because they also
tend to hold libertarian values, and because they see
much of the tragedy related to drug use as stemming
from prohibition.
• Short film, “The Incredible Bread Machine Film,” at http://

mises.org/MediaPlayer.aspx?Id=4996.
This is a half-hour film made by a group of young
people in the 1970s. It is something of an underground
classic in libertarian circles. It touches on various
examples of government interference with citizens’ lives,
including drug prohibition.
suggested
(1) For students interested
activities in history, you could ask
them to explore the
origins of the current drug
prohibition regime. In
other words, it was not always the case in the United States
that someone selling cocaine could be sent to prison for
decades. (Some proponents of drug legalization point out
that hemp was used for commercial purposes in colonial
times. They even claim [perhaps apocryphally] that the
original U.S. Constitution and U.S. flag were made of hemp.)
(2) If the movie versions would be inappropriate, reading

the book Serpico by Peter Maas may be an acceptable
substitute. The author relays the real-life story of a New York
City police officer (Frank Serpico) who refuses to accept
“dirty money.”
test — Lesson 20
The Economics of
Drug Prohibition
Short Answer:
1. Contrast drug prohibition with “sin taxes” on liquor and cigarettes.
2. Does it make sense for someone to support drug legalization, while

opposing drug use?
351
3. How might drug prohibition raise the financial marginal benefits of

violence for drug dealers? (Hint: This question is NOT asking about the
marginal costs of violence.)
4. Define “victimless crime,” and list two different examples.

5. Although it is illegal, the drug trade is still a business. Explain.
6. Explain how drug prohibition reduces product safety.

7. Explain this statement: “Most of the problems that people blame on

drug use are actually caused by drug prohibition.”
355



Lesson 21
Inflation
Money Inflation versus Price Inflation
T
here are some free market enthusiasts who are very par-
ticular about the careless use of the term inflation and so
be sure the student understands the two distinct mean-
ings.
Also note (as we explain in a footnote) that we have deliber-
ately used the term stock of money rather than the more familiar
money supply. Often when people discuss price inflation they
will say, “The supply of money rises, and so does the price
level.” This may confuse the student since we took such pains
earlier in the course to distinguish between “supply” (mean-
ing the supply schedule, as represented by the entire supply
curve) versus the quantity supplied. In most cases, when peo-
ple say, “The supply of money rises, pushing up prices,” they
are not referring to the supply (schedule) of money but rather
the actual quantity of money in existence.
We have not included selections from Milton Friedman
in the Supplemental Materials because of copyright issues.
However, for a well-rounded education in free market eco-
nomics, the student should be familiar with Friedman’s views
on money. A very simple introduction to Friedman’s overall
worldview is Free to Choose, whereas a more advanced book is
359
Capitalism and Freedom. A more technical—though still acces-

sible to the lay reader—book focusing on money is Money Mis-
chief. (We should stress that Friedman’s views do not necessar-
ily overlap with the presentation of this course.)
There is nothing magical about the particular charts we
chose in this chapter; we are simply trying to introduce the stu-
dent to the various concepts—while warning against common
pitfalls—and also warming the student up to working with
economic data. As we have stressed throughout this course,
basic economic principles do not stand or fall on empirical
testing. However, in order to hone one’s understanding of the
economy (and more narrowly the financial sector), it is nec-
essary to familiarize oneself with various historical patterns.
(In the Suggested Activities we explain how to generate these
types of graphs yourself.)
Note that the Consumer Price Index (CPI) is maintained
by the Bureau of Labor Statistics. They explain the index here:
http://www.bls.gov/cpi/#faq.
When the media report the latest inflation number, what
they are usually referring to is the increase in the seasonally-
adjusted Consumer Price Index. (In recent years they have
slowly shifted the focus more and more to the “core” CPI, which
is the standard CPI with food and energy prices removed. The
official justification for this procedure is that food and energy
prices are more volatile than some of the other constituents
of the CPI, and so by focusing on the “core” analysts can see
the underlying trends. However, many cynics think this is sim-
ply a government ruse to mask the true increase in prices due
to poor monetary policy. After all, consumers think food and
energy are rather important parts of their budgets.)
The “pitfall” we are trying to guard against in this section is
the erroneous belief that prices follow movements in the stock
of money in a mechanical fashion. In other words, some people
think that if the number of dollar bills goes up by 20%, then
prices rise by 20% (perhaps after a lag). This is wrong for two
Lesson 21: Inflation | 361
reasons. First, not all prices rise by the same amount; we know
this because relative prices bounce around all the time. (For
example, the price of a gallon of gas divided by the price of a
Big Mac, does not always yield the same ratio.) Second, it’s not
even true that on average prices must rise by the same percent-
age as the stock of money, even if we adjust for the increase in
production of real goods and services. The reason is that the
demand for money can change as well. Too often proponents of
free market economics focus on the supply side of the “money
market” while completely ignoring the demand side. But as we
know, the market price of something—including the exchange
value of units of money—is determined by the interaction of
supply and demand.
How Governments Make Prices Rise

Many people find it easier to understand modern currency
“debasement” by first learning of the ways in which political
rulers used to literally introduce base metals into coins. For a
fascinating theory linking the fall of Rome to various govern-
ment interventions, read Mises’s short explanation on pages
761–763 of the Scholar’s Edition of Human Action (available at
http://mises.org/Books/HumanActionScholars.pdf).
The Rise of Fiat Money

This subsection provides a short historical background to
the topic of government inflation. For more of this history
(from an American perspective), see the Rothbard pamphlet in
the Supplemental Materials.
The Price of Money Set By Supply and Demand

The important take-away message from this subsection is
that the “price” is its purchasing power. In other words, if one
unit of the money good sees its “price” rise, this means that
people must offer more units of goods and services in order to
acquire a unit of money. This is the opposite of how we nor-
mally think of money and prices, because we usually quote
prices in terms of money. For example, if the price of a car rises
from $10,000 to $15,000, this actually reflects a falling price of
money. In other words, the purchasing power of money falls,
when the prices of all non-money goods and services go up.
What the average person means by (price) “inflation” is a gen-
eral rise in the prices of most goods and services. This is the
same thing as saying the general purchasing power of money
has fallen.
At the end of this section we discuss the case of the U.S. in
the mid-1980s, when the stock of money (at least as measured
by the aggregate M1) began rising much more quickly than the
CPI. Again, we are trying to make sure the student realizes that
there are no mechanical formulas in economics; people’s sub-
jective valuations ultimately determine the objective prices we
see in the market. For various reasons (probably involving the
sharp income tax rate cuts and the collapse in price inflation
rates) the world demand for U.S. dollar-denominated assets
rose quickly in the mid-1980s, so that the sharp increase in the
money stock did not coincide with large U.S. price inflation.
The Danger of Government Price

Inflation
This section spells out the basic reasons that price infla-
tion is dangerous, especially when the price inflation is severe
and erratic. In a subsection we deal with the common retort
that people can protect themselves from government inflation
through various countermeasures and “hedging” strategies. If
necessary, remind the student of the function of money in the
first place, and point out that this function is crippled to the
extent that the purchasing power of money varies in large and

unpredictable ways.
The last point of the lesson reminds the student that gov-
ernment spending always diverts resources out of private
hands and into politically-directed projects. Therefore, when
the government relies on inflation to finance its programs,
there is a definite transfer of wealth out of private hands and
into government control. This is true, whether or not official
price indices show “inflation.” In cases like this, what may be
happening is that the government inflation is offsetting a fall in
prices that otherwise would have occurred.
Study Questions
1. What are the two meanings of the term

inflation?
Monetary inflation refers to the increase in the amount of

money (and possibly the amount of credit), whereas price
inflation refers to a general increase in (most) prices.
2. Is there a strict connection between money

growth and price increases?
No. All large-scale price inflations have been preceded by a

large-scale monetary inflation, but there is no strict formula
connecting the two. Especially over short time spans, the two
can even move in opposite directions.
3. Why do workers sell their labor hours in

exchange for intrinsically useless pieces of
fiat money?
People accept money in their exchanges because they expect

other people to do the same in the future. (In other words,
money has purchasing power now because people expect it to
have purchasing power in the future.) This can be true even for
fiat currency.
4. If the stock of money increases, what

happens to the “price of money,” other
things equal? What does this imply for the
prices of goods and services?
As the stock of money increases, the price of money decreases,

holding the demand for money constant. But a falling “price
of money” translates into rising prices for other goods and ser-
vices, i.e., price inflation.
5. What is the harm of government price

inflation?
Price inflation reduces the effectiveness of a medium of
exchange. It becomes more difficult for people to make long-
term financial decisions when the market value of the currency
itself becomes volatile.
• Henry Hazlitt, Economics In One Lesson, Chapter XXIII.
Hazlitt deploys his characteristically snappy writing to
explain inflation.

Callahan explains the Austrian take on money and
(price) inflation. He also refers to mainstream economics
(such as the famous “equation of exchange,” MV = PT)
more than we have done in the student text.
• Murray Rothbard, What Has Government Done to Our Money?,

at http://mises.org/money.asp.
This is an entire pamphlet, and the student need not
read all of it. However, it is a classic introduction to
money, banking, and inflation. The student can also
learn more about the gold standard in U.S. history from
this pamphlet.
• George Reisman, “The Economics of Inflation,” audio at http://

For those who prefer audio to written materials,
Reisman provides a good introduction to this topic. His
audience was undergraduates who had an interest in
Austrian economics.
suggested This lesson is a good time

activities to introduce the student
to the wealth of data (and
easy charting options)
at “FRED,” a database
maintained by the St. Louis Federal Reserve Bank. The URL
is: http://research.stlouisfed.org/fred2/.
We’ll walk you through the re-creation of the chart in the

student text. After learning this, you (and the student)
should be able to construct your own charts. (Note that
this description was written in the fall of 2011. FRED
occasionally revamps its website and so the following
description may eventually be obsolete.)
The chart in the text shows CPI versus M1. The specific
series titles are “CPIAUCNS” (which stands for “Consumer
Price Index All Urban Consumer Non-Seasonally adjusted”)
and “M1NS” (which stands for “M1 Non-Seasonally
adjusted”). In order to graph this, we need to first tell FRED
which series we want.
From the main FRED page, click on the “Prices” category

(which is in a list on the right side of the page). On the next
screen click on “Consumer Price Indexes.” If you then scroll
down, you will see a list of the actual data series. The series
we want (i.e., CPIAUCNS) is the second in the list (as of this
writing). Click on CPIAUCNS.
Now FRED shows us information about this particular

series, as well as the default chart. The dates are not the
ones we used in the student text, so we will have to adjust
those. But first we’ll add the M1 series, then worry about
formatting the chart dates.
To add M1NS, click “Edit Graph” which is immediately

below the default graph. This brings up a new page. If you
scroll down a bit, you will see a green arrow with the
option to “Add Data Series.” After you click this, a box will
appear allowing you to type in a search term. Or, you can
click on the “Browse” (to the right of the search box) to
look for the next data series you want to add. Go ahead
and click “Browse.”
When you click “Browse,” a new window pops up,

showing the list of data categories. M1 is a monetary
aggregate, so click “Monetary Aggregates.” From the new
menu, click “M1 and Components,” and then scroll down
to find “M1NS.” (As of this writing, it is 5th from the top.)
After you click M1NS, FRED should update the chart so

that it now shows the entire history of the CPI and M1
series. (Note that CPI goes back to 1913, whereas M1
only starts in the late 1950s.) We now want to trim the
dates to match the timeline of the chart in the student
text.
Currently “Line 2” of your FRED chart should be “open.”

(If it isn’t, click on the green arrow on the left side of the
line, and that should expand the M1 line and allow you
to tweak its settings.) One of the options is “Observation
Date Range.” Change the start date to “1960–01–01.”
Then click on the green arrow next to the CPI “Line 1,”
and update the starting date for this series as well.
By clicking the button “Redraw Graph” on the bottom left,

you can see the chart with the smaller timeline. However,
it still doesn’t look the same as the chart in the student
text. The problem is that the current graph (on your
FRED window) is using different units for the two series.
(Specifically, it is showing M1 measured in billions of
dollars, whereas it is showing CPI as an index where 100
is the average value of the CPI from 1982 to 1984.) We
need to change the units so that both series are graphed
as an index, and we want to start them at the same point

so that we can observe proportional changes in their levels
over time.
For each line (i.e., Line 1 and then Line 2), select the
Units pull down menu. Then pick the last option “Index
(Scale value to 100 for chosen period)”. Finally, type in
“1960–01–01” where FRED prompts you to “Or Enter An
Observation Date”.
After you have done this for both CPI and M1, click “Redraw
Graph” and you should now see the same graph (except
perhaps for a later ending date) as the one appearing in the
student text.
test — Lesson 21
I n f l at i o n
Short Answer:
1. Explain how the Caesars quite literally debased their currency, and
discuss the consequences.
2. If U.S. paper money is really intrinsically worthless, why do people

work, steal, and kill for it?
371
3. Does fiat money have whatever value the government assigns to it?
4. How does a gold standard place a limit on inflation?

5. When prices of most goods and services, measured in dollars, go up,

what is happening to the market value of the dollar? Explain.
6. Explain how large and variable price inflation partially defeats the
purpose of using money in the first place.

375


Government Debt
Government Deficits and Debt
A
s this is an Advanced Lesson, it pursues certain trains
of thought more deeply than the typical chapter in this
course. You will have to adjust the difficulty to the stu-
dent. Of course the most basic point is that government deficit
spending leads to higher debt, which entails future interest
payments to service the debt.
Interest on the “National Debt”

The purpose of this subsection is to drive home the point
that government debt requires interest payments, which can
consume a growing portion of tax revenues. In the FINANC-
ING sections, the student can see exactly how the interest
payments manifest themselves. Specifically, the government
receives a lower amount when it first sells a bond, than when
the bond is redeemed the following year. This is why simply
rolling over the bonds—in order to keep the outstanding debt
level constant—will “lose” money, which is made up for by
interest payments out of general tax revenue.
As we explain in a footnote in the student text, in the real
world the federal government issues debt of various maturities
379
(3-month, 6-month, 5-year, etc.). Also, longer-term U.S. gov-

ernment bonds may pay interest through coupon payments, in
which case the lender hands over the full face amount in the
beginning. For example, if an investor buys a 5-year, $10,000
bond with a coupon rate of 5%, then the investor hands over a
full $10,000 upfront to the U.S. Treasury. Then every 6 months
the investor “clips a coupon” and gets a $250 payment from
the Treasury. (Note that $10,000 x 5% = $500 per year = $250
per 6 months). Then after doing this for 5 years, the investor
receives his original principal of $10,000 back. With coupon
payments, the investor receives his interest payments sepa-
rately, and so there is no need to discount the original sum lent
to the government.
Government Debt and Inflation

In this section we explain that the popular understand-
ing of government debt and inflation is largely correct, but
the underlying mechanism is much subtler than most people
realize. We have taken pains to spell out these nuances not so
much because the question warrants this much attention, but
rather because the discussion provides a good illustration of
various principles we have already covered in the course.
If you and/or the student wish to read further on how the
Federal Reserve effectively monetizes (some of) the federal
government’s debt, start with this article from Robert Murphy:
Government Debt and Future

Generations
The approach in this section is similar to the previous one.
Officially we are exploring the subtle truth of the popular belief
Advanced Lesson 22: Government Debt | 381
that government deficits impoverish future generations—the

claim is true, but not for the reasons that most people think.
The reason we spend so much time on the issue, however, is
that it provides a good reinforcement of the concepts we are
trying to teach.
Be sure that the student doesn’t take away the wrong lesson
from this final section. We point out that government indebt-
edness goes hand in hand with increased assets (in the form of
government bonds) in the possession of the public. Our point
here is not to say, “It’s a wash, the government debt is no bur-
den because we ‘owe it to ourselves.’”
Yes, government debt is a burden, and makes the next
generation poorer than it otherwise would be. But the reason
it is a burden isn’t merely that the government accumulates
financial obligations. To prove that this fact per se is not deci-
sive, we brought up the counterbalancing fact of larger private
assets (in the form of government bonds). No, future citizens
are impoverished because government deficit spending today
leads to lower private capital formation, meaning that there
are fewer machines, fewer factories, smaller stocks of inven-
tory, etc., for future workers to use. So that’s the real reason
a government accumulating debt will ultimately make future
generations poorer.
The other important lesson is that once we understand
exactly why deficit-spending is bad, we see that tax-financed
spending is just as bad or even worse. So it is absurd when
“deficit hawks” think that the “responsible” thing to do is raise
taxes on the current generation, as if that will spare future gen-
erations from the consequences of a profligate government.
Study Questions
1. *Explain: “The government deficit is a flow

variable, while the debt is a stock variable.”
It only makes sense to measure the deficit in reference to a cer-
tain duration of time. For example, we can talk about the deficit
during fiscal year 2010, or during the first three months of cal-
endar year 2009. In contrast, the debt is a measure that applies
at a particular moment in time. For example, we can talk about
the debt as of December 31, 2009. (To understand the flow/
variable distinction, an example of water might help. If some-
one is using a hose to fill a backyard pool, the rate at which the
water shoots out of the hose—say, 5 gallons per minute—is a
flow variable. On the other hand, the depth of the water in the
pool—say, 3 feet—at any given time is a stock variable.)
2. When the government spends more than it

collects in tax revenues, what can we say
about the budget?
The budget is in deficit.
3. *Is it possible for the government to sell

new bonds in a given year, even if the
budget is in surplus?
Yes. If the government carries forward an existing debt that is
larger than the surplus, then the government ends the period
with a debt (though a lower one). If some of the carried debt
had to be “rolled over” into new bonds, then the government
would have issued new bonds to replace the maturing ones
(which were not being paid off with the surplus). For example,
in the student text’s table, in the year 2012 the government
runs a $25 billion surplus, but also (re)issues $75 billion worth
of new bonds.
4. Are government budget deficits directly

inflationary?
No, because by itself a budget deficit doesn’t create new money.
5. *Does it help future generations by raising

taxes now to close a budget deficit?
No, because the actual mechanisms through which govern-
ment budget deficits impoverish future generations—lower
capital formation, distortions to the future economy when
taxes are raised, etc.—are applicable to present tax hikes.
• Robert Murphy, “Government Debt Has No Upside,” at http://
This essay covers some of the same ground as the
student text, but it also deals with two popular notions
that the student has probably heard. The first is the
view of Alexander Hamilton that a large national debt
is good because it gives people an incentive to support
the government, and the second is the claim that the
national debt is no real burden because “we owe it to
ourselves.”
suggested
activities (1) Use the table in
the student text as a
template, but change
the numbers. Leave
some of the cells blank and then see if the student
can fill them in. For example, you may want to chart
out the next three years of the hypothetical scenario
in the student text. In the year 2013, you could leave
the Interest payment cell blank, because that is already
pinned down by the debt level of $75 billion carried
forward from the year 2012. (The answer will be $3.75
billion in interest payments in the year 2013.)
(2) Have the student review the history of U.S. federal

government budget revenues and expenses to get a
sense of the magnitudes (and how they’ve exploded in
recent decades). They are conveniently summarized at
the Statistical Abstract here: http://www.census.gov/
compendia/statab/cats/federal_govt_finances_
employment/federal_budget--receipts_outlays_
and_debt.html.
test — Lesson 22
Government Debt
Matching:
Write the letter of the correct term beside each concept.
A. Flow variable B. Stock variable
1. Weight 2. Age 3. Batting average
4. Speed 5. Income 6. Price
Short Answer:
7. Could a government run a budget surplus while still having a large

debt? Explain.
387
8. If the government retires some of its outstanding bonds during the

year, does that mean it’s necessarily running a budget surplus? Explain.
9. Explain the accurate sense in which government deficits today make

our grandchildren poorer.
Complete the Table.

Fill in the appropriate numbers, using the table in Lesson 22 as
a guide. (Assume the annual interest rate on government debt is
5%.)
2010 2011 2012

Tax Rev: Tax Rev: Tax Rev:
$1 trillion $1 trillion $1 trillion
Expenditures: Expenditures: Expenditures:

$1.2 trillion $1.3 trillion $800 billion
Deficit: Q#10 Deficit: Q#13 Surplus: Q#15
Debt at start: Debt at start: Debt at start: Q#16

$0 $200 billion
Debt at end: Q#11 Debt at end: Debt at end: Q#17

$500 billion
EXPENDITURES EXPENDITURES EXPENDITURES
Military: Military: Military:

$400 billion $350 billion $300 billion
Social: Q#12 Social: Q#14 Social: Q#18
Interest: Interest: Interest: Q#19

$0 billion $10 billion
391


The Business Cycle
The Business Cycle
T
his final chapter is the culmination of the entire course. It
draws on several tools developed in previous lessons, and
has a very ambitious scope. Without calling it by name,
we have laid out the Austrian business cycle theory, or what
is also called the Mises-Hayek trade cycle theory. In addition
to the Supplemental Materials, for further reading you can try
the pamphlet, The Austrian Theory of the Trade Cycle and Other
Essays available at: http://mises.org/tradcycl.asp.
How Governments Cause the

Business Cycle
In this section we follow the advice of Friedrich Hayek,
who said that in order to understand how things can go wrong
in a market, we first need to understand how they could ever
go right. What Hayek meant was that it’s actually something
of a miracle that the economy can generally grow from year to
year, with entrepreneurs anticipating customer demands and
395
matching resources to preferences in a smooth way, so that

people only notice something is wrong every few years. This
is why we first remind the student what we have already stud-
ied in previous lessons, concerning sustainable, market-driven
growth. (Roger Garrison in his PowerPoint show—discussed
in the Supplemental Materials—follows the same pedagogical
strategy.)
Sustainable, Market-Driven Economic Growth

The crucial point here is that sustainable economic growth
involves a tradeoff, where current consumption drops so that
future consumption may increase. This is obvious in the world
of Robinson Crusoe, but the same principle applies in a mod-
ern economy with millions of people.
Unsustainable, Government-Driven Economic Growth

There is a great deal of information packed into this subsec-
tion; you will need to tailor it to the student. The basic story is
that when the government artificially lowers the interest rate,
it gives the appearance of the prosperity that would accom-
pany a genuine influx of new savings, but this apparent pros-
perity can’t be genuine since it is fueled by nothing more than
pieces of paper (fiat money).
For the more advanced student, you can elaborate on the
complication that the “illusion” can be quite effective, since
everybody really can enjoy an increased standard of living at
least for a few years. In other words, during the artificial boom
period, the vast majority of workers can get higher paychecks
and spend them on real goods and services, and the vast
majority of businesses can see a surge in their sales and docu-
ment great profits on their books. This is all made physically
possible because of capital consumption, which is the opposite
of (net) investment. In effect, during the artificial boom period
Advanced Lesson 23: The Business Cycle | 397
people increase their consumption in the present, exploiting a

tradeoff of lower consumption in the future.
In a footnote we point out an extremely subtle point, but
one which may interest the very advanced student: Techni-
cally, it’s not correct to say that the economy can finance an
increase in output of both consumption and capital goods, by
ignoring depreciation. This is because the way the economy
deals with depreciation is to produce more capital goods. For
example, if a particular entrepreneur engages in maintenance
on his factory by buying ball bearings and lubrication oil, and
by slowly building up a new machine to replace his current
one once it wears out, then these actions are all acts of invest-
ment in the creation of new capital goods. So really what hap-
pens during the unsustainable boom period, is that entrepre-
neurs produce the wrong kinds of capital goods, and yet they
erroneously think that their total output has increased.
The Inevitable Bust Following

an Artificial Boom
To illustrate his theory of the boom-bust cycle, Mises would
often invoke the analogy of a master builder who is drawing
up blueprints for a new house. In order to design the “opti-
mal” house, the builder obviously needs to know how many
nails, two-by-fours, workers, etc., are at his disposal. Now if
for some reason the master builder thinks he has more bricks
to work with than he really does, he will draw up blueprints
for a house that are too ambitious.
At some point, the builder would realize his mistake, even
if it occurs when he runs out of bricks and yet his blueprints
still expect him to use another 1,000 bricks (say) to finish the
design. Note that the sooner the builder realizes his mistake—
in other words, the sooner he realizes that his blueprints are
based on an inflated brick count—the better off he is.
Once the builder realizes his mistake, he will immedi-

ately stop construction of the house. He will then come up with
a revised set of blueprints, which reflect the true number of
remaining bricks and other resources. The builder will con-
sider the possibility of “undoing” some of his earlier decisions,
but much of the work will be irrevocable. For example, if his
workers had cut some boards intending to make a dog house,
but now those boards need to be used on the main building
itself—to compensate for the fewer number of bricks—this
might be an acceptable substitution. But if the workers had
already constructed half of the dog house by nailing the boards
together and weather treating them, the builder might just
have to throw them away. He can’t salvage those particular
boards anymore, and in light of the brick shortage, the remain-
ing boards are too valuable to use in finishing the dog house.
The analogy with the actual economy should be clear. Dur-
ing the bust period, some firms shut down completely, releas-
ing their workers and other resources to other projects. Other
firms continue, but after substituting some of their materials
and making other cost-saving adjustments. But from the per-
spective of the economy as a whole, the various projects are
less ambitious than during the boom period, and moreover the
post-bust economy is in worse shape than if the boom had never
occurred. (This is analogous to the fact that the master builder
will end up with an inferior house compared to the one he
would have designed, had he known the true brick count from
the beginning. This is due to the waste of resources during the
period when he instructed his workers relying on the faulty
blueprints.)
The Causes of Mass Unemployment

Once the student understands the nature of the bust period,
the phenomenon of mass unemployment should make intui-
tive sense. However, you should be aware of two distinct
interventions that contribute to widespread unemployment:

First, the government/central bank fosters the artificial boom
through low interest rates, which inevitably ends up in a bust.
So the government/central bank set up a situation in which all
of a sudden, perhaps millions of people will be thrown out of
work.
However, if that were the end of the story, there wouldn’t
be a problem of prolonged mass unemployment. Wage rates
would start falling and would not stop until the displaced
workers had found new jobs.
The reason economies can suffer from very high unemploy-
ment rates, for years at a time, is that wage rates (for various
reasons) do not drop fast enough in order for the labor mar-
ket to “clear.” In terms of a supply and demand framework,
the demand for labor has shifted left (due to the change in
employers’ circumstances and expectations), meaning that the
new equilibrium wage is lower. If the actual market wage rate
moves downward very sluggishly, then there will be a surplus
of labor—also known as “unemployment”—until the actual
wage has fallen to the lower equilibrium wage.
There are various government interventions that can slow
the restoration of equilibrium in the labor market. One of the
most obvious is direct relief payments to unemployed work-
ers, but during the Great Depression (for example) President
Herbert Hoover explicitly urged big businesses not to lower
their wage rates after the stock market crash of 1929.
For the very advanced student, you might explain that
technically, what happens is that there are supply and demand
curves for multiple labor markets for different types of jobs.
The laid-off construction worker, for example, might be used
to making $60,000 per year and so he initially refuses to take a
job flipping burgers for $20,000 per year. Instead he continues
to check the newspaper and place his resume at various web-
sites, hoping for a job that pays at least $40,000. He can afford
to do this for months, even though he may have no personal
savings, because the government sends him unemployment

checks. Strictly speaking, the man is not a “surplus worker” in
the fast-food labor market, because (while receiving the gov-
ernment checks) he wants to supply 0 hours of labor flipping
burgers, at the market wage rate of $20,000 per year.
Now if the government were to suddenly cut off all unem-
ployment checks, our unemployed worker (and many like
him) would become much less picky. Several of them might
desire a job flipping burgers, which would increase the supply
curve of labor in the fast-food industry. This would lower the
equilibrium salary, say, to $19,000 per year, making it worth-
while for the employers in the industry to hire the new work-
ers. (In other words the wage rate would need to fall, in order
to move outward along the employers’ original demand curve
for fast-food labor.)
As you can see, the actual mechanics are much more com-
plicated than the simple summary of, “Government unem-
ployment benefits prop up wage demands and therefore slow
down the adjustment of the labor market.” But if we are going
to use just a single supply and demand graph to explain the
labor market, then the explanation is good enough for the
basic intuition.
Study Questions
1. Why is the business cycle sometimes called

the boom-bust cycle?
The business “cycle” consists of an upswing period (the
boom) and a downswing period (the bust). A chart of GDP
or employment might resemble a sine wave, where the peaks
corresponded to the height of the boom and the troughs cor-
responded to the depth of the bust.
2. Explain: “[I]n a sustainable, market-driven

expansion—where the interest rate falls
because people are consuming less and
saving more—the extra resources flowing
into the new investment projects are
coming from the sectors which are seeing a
drop in sales.”
A market-driven expansion is sustainable because the increased
output of capital goods (which are necessary to allow a higher
standard of living in the future) come at the short-term expense
of a decreased output of consumer goods. During a market-
driven expansion, “total output” doesn’t actually go up right
away, but only the composition of output changes.
3. *Do central banks typically lower interest

rates by imposing a price ceiling (analogous
to rent control)?
No, central banks do not use penalties and fines to set an artifi-
cial price ceiling, as governments do with rent control. On the
contrary, central banks lower the actual market rate of interest
below its free-market rate, by injecting newly created fiat money
into the credit market. This moves the supply curve of loanable
funds to the right, lowering the “equilibrium” interest rate.
4. *How does capital consumption give the

illusion that an economy can have its cake
and eat it too?
During a sustainable, market-driven expansion, the capital
goods sectors expand while the consumption goods sectors
shrink. During an artificial, government-driven expansion, all
sectors apparently grow. This is the economy “having its cake
and eating it too.” This apparent paradox is made possible by
capital consumption, in which resources devoted to the main-
tenance of the structure of production get diverted to boost the
output of particular capital good and consumption good lines.
5. How does an unsustainable boom lead to

mass unemployment?
The boom causes workers to become employed in unsustain-
able projects. Once the realization sets in, these workers need
to be reallocated to other firms or even industries. It takes time
for the displaced workers to be reintegrated into the market.
(Other government policies can hinder this process.)
• “Fear the Boom and Bust,” a Hayek-Keynes Rap Anthem, at
http://www.youtube.com/watch?v=d0nERTFo-Sk.
A very popular music video that features a debate of
sorts between John Maynard Keynes and Friedrich
Hayek.

Callahan lays out the Austrian business cycle theory in
very understandable prose. Some students may find his
analogy of a bus easier than Mises’s example of a house
builder.
• Mario Rizzo, “The Misdirection of Resources and the Current

Recession,” at http://mises.org/daily/3348.
This is a talk that New York University economics
professor Mario Rizzo gave to the Club for Growth /
Heritage Foundation in 2009. Rizzo does a good job
illustrating that the typical commentary on the “Great
Recession” ignored the underlying microeconomics of
resource allocation. His discussion is very compatible
with our treatment of the business cycle.
• Robert Murphy, “The Mystery of Central Banking,” at http://

This essay provides yet another analogy or thought
experiment to get the student to recognize the
superficiality of the common media coverage of the
business cycle.
• Robert Murphy, “The Importance of Capital Theory,” at http://

This essay focuses on the issues of capital consumption
and unemployment, using a fanciful story of (Keynesian
economist) Paul Krugman being shipwrecked on an
island populated by primitive villagers.

In this selection, Rothbard develops the idea that in a
free market, unemployment is “voluntary” in a certain
sense. If you have the student read this selection, be
careful to stress that Rothbard is not arguing that,
say, a large fraction of the U.S. workforce decided to
take an extended vacation during the 1930s. Rather,
what Rothbard is showing is that the social problem
of unemployment is a creation of the government/
central bank. On a truly free market, there wouldn’t
be widespread “involuntary” unemployment.
• Roger Garrison, “Sustainable and Unsustainable Growth,”

PowerPoint show at http://www.auburn.edu/~garriro/ppsus.
htm.
Garrison’s slideshow offers a wonderful illustration
of the various interlocking features of a sustainable,
market-driven expansion versus an unsustainable,
government-driven one. However, Garrison wants
mainstream economists to understand the analysis, and
so he uses diagrams such as the “Production Possibilities
Frontier” that are standard fare in a mainstream
textbook. You will have to decide whether it is worth
learning the new terminology in order to appreciate the
slideshow.
suggested
Discuss the master
activities builder analogy with the
student in more depth.
Hone in on the point that
the longer the builder sticks to the original blueprints, the
worse the final house will be. To get this point across, you
can work through several examples during the chronology.
If the builder realizes the mistake in the very beginning,
before the workers even begin digging, then he can revise
the blueprints in light of the true brick supply, and the
only “waste” will be his own time in drawing up the original
blueprints. If the builder realizes the mistake after the
first floor is already built, then things are far more serious,
because the builder has already gone down a particular
path and “locked in” much of the available resources. And
if the builder waits until he literally runs out of bricks, then
at that point he may have difficulty even sealing off the roof
to keep out rain, depending on how erroneous the original
brick estimate was.
The important insight is that the builder has more options,

the earlier he discovers the mistake; it never hurts to
discover the mistake sooner, rather than later. In other
words, if the builder realizes his mistake T days into the
project, and then revises the blueprints accordingly, the
final house can’t possibly be better than the one the
builder would design if he caught his mistake T-1 days into
the project. This is because the builder on day T-1 is always
allowed to mimic his behavior as if the original blueprints
were still active. So he can always put himself in the same
position as he would have found himself, if he discovered
the mistake on day T. That’s why the final house will either
be the same, and probably much better, if he discovers his
mistake sooner rather than later.
Once the student really sees this point, you can ask him
or her to evaluate the response of world governments and
central banks to the Great Recession following the housing

bubble. By engaging in massive stimulus programs, and
cutting short-term interest rates to virtually zero, these
institutions have done their best to prolong the boom
period. They are analogous to outsiders trying to hide
the dwindling brick supply from the master builder, who
encouraged him not to revise his blueprints, but instead to
keep chugging along and keep his workers busy.
test — Lesson 23
The Business Cycle
Short Answer:
1. Briefly describe the pattern of a typical boom-bust cycle. (Hint: DON’T

explain the causes of the cycle, just explain what the cycle is.)
2. What are countercyclical policies? Describe two examples.
407
3. Why is market-driven economic growth sustainable?
4. Why does the text say that government-driven economic growth can
be unsustainable?
5. What is capital consumption? How is it relevant for the theory of

boom-bust in the textbook?
6. According to the text, what is the “actual function that a prolonged

spell of large-scale unemployment serves,” in the wake of a collapsing
boom?
411


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What is the book about?

What is the book about?

What topics does it cover?

What topics does it cover?

L

Jeremy and Helen Davis

Permission to reprint in whole or in part is gladly granted, provided full

For information write the Ludwig von Mises Institute

2. How We Develop Economic Principles . . . . . . . . . . . . . . . . . . 21

3. Economic Concepts Implied By Action . . . . . . . . . . . . . . . . . . 39

4. “Robinson Crusoe” Economics . . . . . . . . . . . . . . . . . . . . . . . . . 51

PART II: CAPITALISM: THE MARKET ECONOMY

6. Direct Exchange and Barter Prices . . . . . . . . . . . . . . . . . . . . . 89

7. Indirect Exchange and the Appearance of Money . . . . . . . 107

Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

8. The Division of Labor and Specialization . . . . . . . . . . . . . . 129

9. Entrepreneurship and Competition . . . . . . . . . . . . . . . . . . . 145

10. Income, Saving, and Investment . . . . . . . . . . . . . . . . . . . . . . 161

11. Supply and Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177

12. Interest, Credit, and Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197

13. Profit and Loss Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . 217

14. The Stock Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235

PART III: SOCIALISM: THE COMMAND ECONOMY

16. The Failures of Socialism—History . . . . . . . . . . . . . . . . . . . . 271

Socialism’s Body Count . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273

PART IV: INTERVENTIONISM:

18. Sales and Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305

19. Tariffs and Quotas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323

20. The Economics of Drug Prohibition . . . . . . . . . . . . . . . . . . . 341

Test Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351

21. Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359

22. Government Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379

23. The Business Cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395

After walking through the main body of the student text in

completely miss what the question is trying to elicit, showing

Thinking Like an Economist

should be warned that Mises’s writing style can be difficult

Thinking Like an Economist

In the same light, in this course we focus on traditional top-

not possible, then (according to Popperians and those econo-

The Scope and Boundaries of

complications such as the gravitational pull of a nearby but-

Why Study Economics?

1. Can economics make you rich?

2. Is economics a science? Why or why not?

3. Does scarcity affect everyone?

4. Do the laws of economics still work inside a

5. *Isn’t it just as important for the average

*An asterisk indicates a more challenging question.

because government funding for particle physics would never

• Robert Murphy, “The Core of What Economics Teaches,”

• Lew Rockwell, “Why Austrian Economics Matters,”

• Nassau Senior, “An Introductory Lecture on Political Economy,”

True or False on Basic Ideas:

1. The economic perspective is the most important one

2. Economics is important only if you’re going to become

3. At its core, economic theory cannot be tested.

4. Economic “laws” aren’t objective, but instead depend

Matching Essential Terminology: