Friday, February 11, 2011

Bob Murphy on Subjective Value

Robert P. Murphy is easily one of my top favorite currently working economists. He's witty, wry, and on a personal note, every time I've talked to him he's been unfailingly helpful and is in my experience a really top-notch kind of a guy.

He's also brilliant at distilling economic concepts and explaining them simply, clearly, and with a bit of humor.

His most recent article at Mises Daily is on the theory of Subjective Value and is quite simply superb. He covers a lot of ground, but I'd like to excerpt a few of my favorite points and keep them here for posterity's sake. I would encourage you to read the full article no matter what.

First, Dr. Murphy notes that when people use the word "value", we use it in two different ways. In one sense, value means the subjective ranking we place on goods & services (and even ideas), and in another, we're using the word to refer to prices and more-or-less "objective" standards defined by the market.

So, speaking on subjective value rankings, Murphy writes:
"If we are referring to subjective value, then there is no "unit" of measurement at all. Suppose we take an old photograph of Jill's grandmother, and ask Jill, "Do you value this object?" Jill might say, "Yes, very much so." Then we hold up her calculator, and ask if Jill values it as well. Jill might say, "Yes, but not as much."

Finally, we ask Jill, "By what percentage does your valuation of the photograph exceed your valuation of the calculator?" Jill would be unable to answer such a nonsensical question. She can rank the two objects according to her subjective tastes; she can report that she values the photograph more than the calculator. But this doesn't imply that there are cardinal units of psychic satisfaction, with the photograph bestowing more units than the calculator."
Unfortunately, far too many economists and a ton of civilians don't actually understand the implications of this point. But contrast it with the alternative usage:
"On the other hand, suppose Jill is really strapped for cash, and so she is auctioning off her possessions on eBay. We might ask, "What do you think the photograph and calculator are worth? What's their value?" Jill might answer, "Well, the photograph comes from the Great Depression, so some history buff might give me $15 for it. And this HP scientific calculator sells new for $50, so I'm hoping I can get $30 for it used." If we then asked, "How much more valuable is the calculator than the photograph?" Jill could answer, "Well I'm just guessing, but probably about twice as much."
And then... The money quote is here:
With subjective preferences, there is no "measurement" going on. Modern economics can explain consumer behavior without assuming any underlying units of "utility." We only need to assume that people know how to rank units of goods in order from most to least preferred."
This is the jumping off point we should all start with in terms of making assumptions about human behavior within the economy.

Different values are awesome.
You should take a second here and note that this kind of renders much of "Behavioral Economics" a little useless to some degree, and it also dispells the notion of "Homo economicus", which is the idea that humans are all perfect "rational" economic calculators.

One of the principle flaws of the Chicago School monetarists, Keynesians, and especially the various schools of Behavioral Economics is that they all assume that there is an objectified standard of value that is consistent for every person. The Chicago School guys tend to ignore deviations from this standard, and work in hypothetical models off of the "Homo economicus" idea instead, as do Keynesians. Obviously, we know this isn't true and as Bob Murphy's points have shown above, it's not even possible to define what consists of "perfect" economic decision making.

But the Behavioral Economists, on the other hand, devote a significant amount of time trying to explain via sociological experiments why people are not only not perfectly rational calculators, but are in fact, "irrational".

As tempting as it is to see people as "irrational" in the realm of economic decision making, especially when you see someone blowing his money on lottery tickets, this is just as false a conclusion as the idea that people are perfect calculators. Thus, most of those experiments are ridiculous, purely because they rely on the value assumptions of the author of the experiment to determine which are rational choices and which aren't.

A lot of individualized, often extremely personal, information goes into people's choices - so much so that it's incredibly rare that we even fully understand why we're doing the things we're doing or why we like the things we like.

But that doesn't make our choices wrong.

Behavioral Economists (and sociologists/psychologists of all stripes, by the way) frequently want to ascribe their own values to their subjects, and this is a giant mistake. It may seem irrational to me for someone to buy a lottery ticket, because I know that the odds against winning are so great as to be virtually impossible, and thus it will - for most people - simply be a waste of money. However, if we're only talking about "money" then we've forgotten dozens of other contributing factors into people's economic choices.

In the case of lottery tickets; there are the issues of hope (false or otherwise), routine & ritual, personal amusement, and even social interaction (many offices, for instance, have a lottery pool which can be a fun way to enhance morale). For all of these reasons, and hundreds more (perhaps playing lotto reminds you of your mother or father, or your grandmother... perhaps it's the only time each week you get to talk to the cute convenience store clerk you have a crush on... etc.), it may seem irrational to the casual observer to engage in such an activity, but in reality it really isn't. Just because the values in play are unknown to the researcher doesn't mean that they don't exist.

Unfortunately, Behavioral Economists tend to assume that there's one measurable standard by which we can assess value, and like good utilitarians, they try to apply that standard to everyone's behavior. But value is subjective. And of course, since these economists start with a bad premise, they come to bad conclusions.

These bad conclusions also lead many mediocre economists to believe that a large amount of trades people engage in are irrationally bad deals for one party to the benefit of another - and of course, this usually means "there oughta be a law!"

But returning to Robert Murphy's points, the truth is - because value is subjective, it means that when the vast majority of trades happen, both parties benefit:
"When two people engage in a voluntary trade, they both benefit. In other words, they both walk away with the "more valuable" object. As Updegrove realizes, this would be impossible with an objective property, such as weight; it's impossible for both parties to walk away from a trade with the heavier object.

But once we realize that value is in the eye of the beholder, then we can understand that people value objects differently and hence can each swap a less-preferred item for a more-preferred one.

What's really interesting is that this holds not only in barter — where Johnny trades his bologna sandwich for Sally's peanut-butter sandwich, and both kids think they got the better end of the bargain — but also in monetary exchanges.

For example, if I give a butcher $30 for a ham, it is because I value the ham more than the $30 in cash that I hand over. But, on his end, the butcher values my $30 more than that particular ham.

In this trade, it's not the case that I thought, "This ham is worth $30." No, I thought the ham was worth more than $30, if "worth" refers to the subjective value I place on it. If I thought the ham were worth $30, then why would I bother swapping my $30 for it."
The beauty of all of this is that within each transaction, the wealth - by which I mean, goods valued by the individual - of each party has increased. In his example, Bob's wealth increased by 1 ham, and the butcher's wealth increased by $30.

Both walk away happy, and this gives rise to my absolute favorite thing about free people trading in the market: The double thank you.

Because both parties benefit from trade (or else, why would they do it?), both legitimately got more from the outcome - in their own judgment - than they gave up. So both people thank each other for it - and they usually mean it. Naturally people can make mistakes, and they can be tricked (for example, by fraudulent claims about the deal they are making), but in the overwhelming majority, people get what they want.

It works best, of course, when it's a direct trade, but it's the same regardless if I'm trading with my neighbor or with the owner of a national chain of grocery stores. I hand over my money and the clerk thanks me in part because its their job, but ultimately because my money will eventually contribute to her salary. And as my groceries are bagged and ready to go out to the car, I thank the clerk - because without her, and more importantly without the store and all of its distributors, I wouldn't be able to eat.

Buyer says thank you, seller says thank you... and the pie has grown a little bit.

Contrast that with non-market transactions. Take paying taxes, for instance. Does anyone with half a brain thank the government for demanding that they give up a portion of their income at every turn in life? Did I thank the government for adding around $2,000 to the price of my car at the point of purchase? No... Of course not.

And why not? Because the transaction is involuntary, and I do not believe that I've walked away with more from the exchange than I have given up.

If I don't pay taxes consistently, the government will find me. They will send men with guns to my house, they will put chains on me, and they will toss me in jail (or shoot me if I try to escape). It will not matter to them that I do not wish to fund endless wars - in Iraq & Afghanistan, on terrorism worldwide, on drugs, on poverty, or on any other idea. It will not matter to them that I do not wish to contribute to unsustainable, and counter-productive social programs. It will not matter to them that I believe the purview of government should be a fraction of what it is today. It won't even matter to them that I feel like I'm getting ripped off when I give up (as I did in Los Angeles) over $200 each year to the state only to get two little stickers and a piece of paper confirming that the state acknowledges that I own and will be driving my car.

There is no double thank you necessary for that.

Now... Dr. Murphy's ultimate discussion is about the Gold Standard and currency valuation in response to another writer who is confused by it. For me, that's the least interesting part of the essay... So instead, let's just skip to the end. Murphy concludes:
"The actual process through which subjective valuations lead to objective market prices is complicated. The average person doesn't need to understand it. However, everyone should be aware of the basic principles of modern value theory, as sketched in this article. Precisely because value is subjective, voluntary trades are win-win situations. At the same time, market prices are objective measures of wealth, and they allow firms to calculate whether they are using resources efficiently or not."
Prices and value are related, but not identical - in the same way that money and wealth are related, but not identical.

Value is subjective, and varies wildly from person to person. This is why aggregating economic statistics, and using them to create mathematical models of the economy, is usually a path doomed to fail. This is also why talking about economic behavior as "rational" or "irrational" is usually pretty silly.

People act in economics because they are self-interested and they want to exchange their present conditions with some more preferable condition through trade. It's really that simple.

People do it from an early age, too... Naturally everyone swapped peanut butter sandwiches for turkey & cheese, or for a rice crispie bar or cookies when they were little, and kids trade toys & baseball cards just the same. As you get older, the rules don't really change. If you have something I want then I can make you an offer for it. If you think my offer is of higher value than what you stand to lose, then you'll take it.

Simple stuff. Powerful implications about the world we live in.

Think about it.

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