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The nature and existence of economic law, and its manifestation in
the interplay of market forces, must now be briefly traced back to the actions
of the individual human being.

THE INDIVIDUAL AND ECONOMIC BEHAVIOR
The possibility of perceiving chains of cause and effect uniquely eco-
nomic is due to the presence in human action of categories that have no
parallel in the realm of physical laws. And because the mind of the indi-
vidual investigating causation in economic affairs is capable of directly
understanding these categories (since, as we shall see, they are self-evident
to the human mind), he is capable of directly grasping the existence of
economic laws. The human mind is immediately conscious of the funda-
mental and all-pervasive category embedded in the web of all conscious
human action. This category is purpose. Actions are undertaken for
specific purposes. We are aware of the purposive character of our own
actions, and we understand that the conscious actions of other human be-
ings also are purposive. However much we may either despise or fail to
understand the particular purposes behind the actions of our fellows, we
do not doubt that their actions aim at securing for themselves some situa-
tion that they prefer over what they expect to prevail in the absence of
their actions.
Moreover, because we assume all action to be purposive, and because
we live in a world which offers at each instant the possibility of many
different kinds of action, we are immediately aware, too, that every human
action must be the embodiment of a choice among alternatives. At each
instant man must choose between the courses of action (including inaction)
that are open to him. Any such adopted course, we understand, has been
adopted as preferable to the rejected courses of action.
Thus, human action involves the categories of purpose, of alternatives,
of choice among these alternatives, of the preferred (that is, the adopted)
alternative, and of the rejected alternatives. These categories suffuse all
transactions of men, both in isolation and in the market. They are the
categories upon which economic theory depends for its very existence.
Economic theory approaches complex social and market phenomena by
searching for the individual actions from which these phenomena arise.
6 MARKET THEORY AND THE PRICE SYSTEM

Any such individual action is understood as having involved the adoption
of one alternative and the rejection of others. The adopted alternative is
understood as having been compared with, and preferred over, the other
alternatives; that is, it was considered as being either the means to the
attainment of the most cherished possible purpose or the most efficient of
the available means to the attainment of a specific purpose. Economic
theory understands that each action inevitably involved a cost. The
adopted alternative has been adopted at the expense of the rejected alterna-
tives. The rejected alternatives, which in themselves may have been highly
desirable, have been renounced for the sake of the adopted alternative.
Economic theory "explains" individual actions, therefore, by tracing them
to the circumstances that made them "profitable"; that is, to the circum-
stances that made the "costs" worthwhile. Changes in the patterns of
human action are traced in this way either to changes in the terms on
which alternatives are available relative to each other, or to changes in
the framework of purposes within which the worthwhileness of the relevant
costs are valued.
Market phenomena lend themselves readily to analysis in this way as
soon as it is realized that the terms on which alternatives are offered to an
individual are, in a market economy, determined in large part by the
actions of other individuals rather than merely by natural events. It be-
comes illuminatingly possible to view every transaction in the market as,
on the one hand, a consequence of the particular complex of alternatives
presented to the individual by the market before the action was undertaken,
and, on the other hand, as in some way affecting the complex of alterna-
tives that will be subsequently faced by the individual market participants.
Even the most intricately entangled web of market phenomena can be re-
duced to the elementary actions that they consist of. Systematic analysis
of market phenomena in this way is able to yield propositions linking chang-
ing patterns in prices, qualities and quantities of output, of consumption,
and the like, to logically prior changes in the "data." These logically prior
changes may be either in the circumstances (arising both inside and outside
the market) affecting the alternative opportunities open to individuals pur-
suing their purposes, or in the structure of purposes with reference to which
individuals appraise the relative usefulness of opportunities open to them.
To revert to an example mentioned several pages previously, a sharp
decrease in the quantity of ice supplied to the market can easily be linked,
by this kind of reasoning, to a subsequent price rise. As ice purchasers
find the availability of ice sharply reduced (other things being unchanged),
they find it necessary to restrict the obtainable limited quantities of ice to
only the most important of the uses to which the previously larger quantity
of ice had been put. Thus, any additional ice block that they contemplate
to purchase after the decrease in supply involves the potential fulfillment of
THE NATURE AND TASKS OF MARKET THEORY 7

a purpose held more important than the purpose whose fulfillment, be-
fore the decrease in supply, depended on the purchase of an additional ice
block. It follows that some of the alternatives that, before the decrease in
supply, were more important than an additional ice block may now be less
important than an additional ice block. An alternative whose sacrifice
for the sake of an additional ice block had hitherto been considered as not
worthwhile will now be considered, perhaps, as highly "profitable." In
other words, the cost that individuals will be prepared to incur (that is, the
price that they will be willing to offer) for an additional block of ice, has
risen. Further examination of the machinery of a competitive market
would then readily explain the subsequent higher market prices for ice.
The simple causal chain shown thus to link a decrease in supply with
a subsequent price rise has been adduced merely as an illustration of the
concatenation of decisions that make up any period of market history, and
of the kind of reasoning that can reveal the operation of economic law in
this way. The theory of the market that we study in this book applies
this kind of reasoning to the isolation of the principal types of causal chains
that express themselves through market forces and that make up the skele-
ton of the market system of economic organization.

ECONOMIC THEORY AND ECONOMIC REALITY
Our ice block illustration, at the same time, is able to clarify the rela-
tionship between the world of economic theory and the world of economic
reality. This relationship must be kept firmly in mind throughout what
might otherwise appear as the unrealistic or abstract chapters that make
up the bulk of this book.
Our theory of ice prices, it will be observed, did not depend upon the
particular physical properties of ice. Although we may know what physical
properties of ice make it an economic good, all that is required for our "ice
price" theory is simply the fact that ice is an economic good”simply, that
more of it is preferred to less of it. In fact, everything which we were able
to conclude concerning the price of ice can be asserted with equal validity
concerning economic goods in general.
Thus, abstractness and generality are the twin aspects of economic
theory that emerge from our illustration. Economic theory is abstract, in
the sense that the reasoning does not depend on the numerous particular
properties of the data we are theorizing about. Economic reasoning throws
light, for example, on situations that human beings associate with specific
sensations. The demand for food has to do with feelings of hunger or of
satiety; the demand for reading material has to do with the thrills of explora-
tion, suspense, or learning; the supply of labor has to do with feelings of
weariness and fatigue. It is emphasized that economic theory does not
8 MARKET THEORY AND THE PRICE SYSTEM


refer to these specific sensations. Economic theory abstracts the element
of preference”bare and colorless”that emerges in each of these situations.
In geometry a proposition may throw light on properties of rectangular
objects, including restaurant tables, milk cartons, and billboards. Geome-
try, however, has nothing essentially to do with eating in restaurants, drink-
ing milk, or advertising. Economic theory is in similar case: it abstracts
from actual situations those elements to which it is relevant.
Economic theory is, as a consequence, general, in that its conclusions
have validity for sets of data that may be widely different from each other
in every particular aspect other than the economic. (To relieve the abstract-
ness of the reasoning, numerous concrete examples are given of situations
that may be quite general; these examples will serve only as illustrations of
general propositions.) In the theory of the market economy, our proposi-
tions will relate to such entities as "goods that consumers desire more
urgently," or "resources that are in relatively short supply," or "production
processes that are relatively more efficient." Any such proposition may
apply to many different situations.
Our "ice block" illustration demonstrates, in addition, the possibility
of deducing economic propositions whose validity does not depend upon
the accuracy or completeness of any empirical observations. Since our
theory of ice prices did not depend on any particular physical properties of
ice, nor upon any particular psychological attitudes towards ice (except
that it be considered an economic good), our theory required no laboratory
experiments upon ice nor any psychological observations of behavior.
Our theory depended only on the logic of choice; that is, it required only
that we understand what human beings will do when they find that the
use that can be made today of a block of ice is more important than the use
that could have been made of it yesterday. We are able to develop proposi-
tions of this kind because we are acting human beings. We know, without
empirical observations, how a change in the attractiveness of the terms on
which a human being is free to choose will tend to affect the choice of any
being whose behavior is guided by reason similar to our own. Economic
theory is founded on this kind of knowledge that we possess. We can
analyze the effects of changes upon human action, in the abstract, because
we are immediately aware of the logic that governs all human action. The
logic that governs human action is the same logic that the economic theo-
rist applies in analyzing this action. If molecules had preferences and acted
purposefully to achieve them, then the physicist would have a source of
knowledge concerning the behavior of physical matter quite independent of
any empirical findings that he might make. This source would be his
own immediate understanding of how purposeful beings tend to behave
under changing patterns of alternatives. The economic theorist finds him-
self in precisely such a favored position.
THE NATURE AND TASKS OF MARKET THEORY 9

Now, the logical validity of a proposition of economic theory does not
mean that the real world presents any instances of the truth of the proposi-
tion. In mathematics, for example, it does not follow from the geometrical
proposition that states that the base angles of an isosceles triangle are equal,
that we will ever be able to find such a triangle. Similarly a proposition
linking a restriction in the supply of ice or of any economic good (other
things being unchanged) to a subsequent rise in its price does not, in itself,
mean that in the real world there has been or will ever be such a restriction
in supply (and it certainly does not mean that with any such a restriction
in supply, the "other things" will remain unchanged). All that a proposi-
tion can assert is that, if given changes occurred under given conditions,
then certain consequences would follow.
It is clear, then, that if the economic theorist is to be of any assistance
in understanding the real world, he must develop theorems concerning
situations that do occur. The economist who analyzes concrete economic
problems applies propositions of far-reaching generality to particular situa-
tions in which he recognizes the dominance of conditions similar to those
governing the relevant propositions. The application of economic theory
in this way certainly cannot be done without careful, accurate, and complete
factual and statistical descriptions of the real world situations in which it
is proposed to detect the operation of the economic laws that are expounded
by theory.
Therefore, the work of the "practical" economist, who aims at explain-
ing what has happened in the real world or at predicting the likely conse-
quences in the future of some proposed or adopted policy, must of necessity
include close attention to "facts." Important and indeed indispensable as
the examination of the "facts" of economic history”remote or current”may
be for these purposes, this task is clearly distinguished from that of con-
structing theories. The theorist makes assumptions and uses his reasoning
to develop the consequences implied in his assumptions. He may take his
assumptions from wherever he pleases, including the real world. Economic
theory refers to the reasoning out of consequences from assumptions, not
to the task of selecting assumptions.
Economic theory emerges then as a tool that can be used in understand-
ing the external world. The tool itself is "abstract," to be judged for its
truth not for its realism. A proposition of economic theory is, to repeat,
very much like a theorem in geometry: we prove its truth, and then we may
be able to discover in the real world a situation that illustrates its truth.
The economist applying theory to real world situations will clothe the
abstract propositions of theory with "actual" data. His final pronounce-
ments will "explain" one set of historical events by relating them to other
historical events. These pronouncements on the chains of causation, which
he claims to have detected in the real market, may certainly be properly
10 MARKET THEORY AND THE PRICE SYSTEM


judged for their realism. If a decrease in the supply of one good was
found to have been followed by a rise in the price of a second good, the
economist, applying theory, may perhaps explain the chain of events by say-
ing that the second good is a close substitute of the first. The theory on
which he bases his explanation is unquestionably true: the restriction of
the supply of one good, other things being unchanged, leads to a rise in
the price of substitutes. But whether the economist's explanation is real-
istic and relevant depends on whether the second good is or is not a substi-
tute for the first; whether other things were unchanged; and so on.
In carrying out his task of explaining what has happened in the real
world, or in predicting the likely consequences in the real world of a par-
ticular event, the economist thus combines theory with empirical fact.
For these purposes it is frequently quite unnecessary to analyze his final
report into its theoretical component on the one hand, and its factual
component on the other hand. The skillful economic commentator will
combine keen observation of events with statements revealing the theo-
retical interdependency of these events. A particular case of local unem-
ployment may be linked to a shift in consumer tastes or to the emergence of
new, cheaper resource markets elsewhere; an outflow of gold may be linked
to particular governmental monetary policies; a particular pattern of in-
dustrial organization may be traced back to the tax structure, and so on.
It would not be necessary, nor even helpful, in these cases, to separate
economic theory from economic fact.
In studying a book such as this one, however, it is imperative that the
distinction between theory and fact be kept clear. This book deals essen-
tially with theory. It presents the kinds of logical procedures that must
be used to understand the operation of a market economy. It presents
the basic tools that the trained economist will use repeatedly in interpret-
ing events in the real world. If these tools are to be used with success, they
must first of all be forged as ends in their own right. Economic theory
must first be recognized for what it is in and of itself: a body of abstract
propositions deduced from hypothetical assumptions.

MARKET THEORY, ECONOMIC THEORY, AND ECONOMICS
We are now in a position to state how the subject matter of this book
relates to economic theory as a whole and, even more generally, to the entire
discipline of economics.
The theory that we study in this book makes up the core of economic
theory, but by no means exhausts it. We investigate here the structure and
operation of a market economy in its broadest theoretical outline; and it
is within this general body of theory that most other branches of economic
theory find their place. We are provisionally able to refrain from paying
THE NATURE AND TASKS OF MARKET THEORY 11

attention to these other branches of theory only by drastically simplifying
the hypothetical market economy we deal with. Once the theory of the
simplified market process has been mastered, then more complex and
particular market situations can be dealt with by logical extensions of the
theory.
In our study, for example, we ignore the possibility of trade between
two separate market economies; we therefore do not study the theory of
international trade with its impact on the market process within each
country. Again, in our study, we almost completely ignore the special role
played by the government as an economic agent; we therefore do not study
the theory of public finance and the modifications brought about in the
market process by governmental taxation, expenditures, or debt. We do
not consider, in our study, the numerous complexities that are introduced
into the market process by the various possible institutions connected with
money; we therefore do not study monetary theory. In the same way (and
partly as a result of these simplifications) we do not consider the possibility
that market forces might arise that can disrupt periodically the smooth
operation of the market process; in other words we ignore the necessity to
construct a theory of the trade cycle; and so on.
In our study, therefore, we construct the theoretical framework within
which all aspects of the economic theory of a market economy must be set.
We follow through the fundamental market forces upon which and through
which the impact of any special, additional economic forces will be felt.
The theoretical attack upon any particular economic problem in the
market must then be carried out against the background of this general
and widely accepted theory of the market.
Economic theory thus embraces a range of theorems covering many
more problems than are treated in this book. Moreover, as we have seen,
the subject economics, in turn customarily involves much besides economic
theory. The study of an economic problem will typically involve much
more than theory, and even for the purely theoretical aspect of such
a study, the propositions of general market theory will be only partially
satisfactory. The skilled economist must scan the data, using his theo-
retical competence to suggest or to detect matters requiring further explana-
tion. In seeking such explanation he must apply his theoretical tools to
the masses of data he believes to be relevant. It is not the task of market
theory to set forth the methods by which the economist can most success-
fully use the empirical data at his disposal or the methods by which he can
most skillfully apply theoretical tools to such data.
Market theory provides the basic tools required for even the most pre-
liminary approach to economic problems. More specialized tools, in the
form of the propositions of particular branches of economic theory, may be
required to analyze specific problems. These tools, too, depend on the
12 MARKET THEORY AND THE PRICE SYSTEM


availability and quality of the basic tools we are about to assemble. The
scope of market theory, within economic theory generally and within
economics as a whole, is indeed narrow. Despite its narrowness, however,
it is market theory that nourishes these wider fields. And in this lies its
paramount importance.


SUMMARY
Chapter 1 clarifies the relationship between the theory of the market
and other branches of economics.
Society consists of individuals seeking to act to improve their positions.
A market exists where the individuals are in close enough contact with one
another to be aware of mutually profitable opportunities for exchange.
A market system exists where the individuals in a society conduct their
economic activities predominantly through the market.
Economic analysis reveals chains of cause and effect linking together
and coordinating the mass of transactions taking place in the market.
Market theory investigates these chains of cause and effect. Market theory
is made possible by the unique properties of human actions. These prop-
erties are embodied in the act of choice among alternatives, an act that the
observing mind of the economist can "understand." Complex market
phenemona may then be "understood" by relating them to individual acts
of choice.
Economic theory is abstract, selecting only the key features of an
economic situation for use in subsequent reasoning. Economic theory is
general; its conclusions have validity for a wide range of possible real
situations. Market theory provides the general framework for the analysis
of a market system. Within this broad framework the various specialized
branches of economic theory deal with more complex special cases. The
theory in this book thus proceeds by drastic simplification.


Suggested Readings
Robbins, L, An Essay on the Nature and Significance of Economic Science, The
Macmillan Co., London, 1935.
Hayek, F. A., "The Facts o£ the Social Sciences," in Individualism and Economic
Order, Routledge and Kegan Paul Ltd., London, 1949.
Mises, L. v., Human Action, Yale University Press, New Haven, Connecticut, 1949,
pp. 1-71.
Stigler, G. J., The Theory of Competitive Price, The Macmillan Co., New York,
1942, Ch. 1.
The Market: Its Structure
ana Operation



chapter and in the next, we sur-
I N THIS
vey the market, its over-all operations and achievements. Later we will
analyze, separately, the different functional sectors that compose the market,
and how these various sectors interact within the market. Here, we will
contemplate the forest in its entirety, before scrutinizing the separate trees,
and then examine the consequences for the other trees of the existence and
growth of each separate tree.

THE CONDITIONS UNDER WHICH THE MARKET OPERATES
We are considering the theoretical operation of a market system.
The model of the market we will be working with can be characterized by
the set of ideal conditions governing the model, which we construct for
the purpose.
In a market system each member of the society is free to act, within
very wide limits, as he sees fit. Moreover, the system operates within a
framework of law which recognizes individual rights to private property.
This means that each individual is free at each moment to employ the means
available to him for the purpose of furthering his own ends, providing only
that this should not invade the property rights of others. At the same
time each individual can plan his activities with the assurance provided
by the law, first that the means available to him at any one time are secure
against appropriation by others, and, then, that he will not be prevented by
others from enjoying the fruits of his productive activities.
The system recognizes the rights of individuals to enter into arrange-
ments with one another which they believe will be of mutual benefit. Indi-
13
14 MARKET THEORY AND THE PRICE SYSTEM


viduals may act cooperatively either by pooling their resources to produce
jointly, or by each agreeing to specialize in one kind of production and
to exchange parts of their production, or by the one agreeing to furnish
productive services to the other in return for finished products or their
equivalent. Our ideal system may be thought of as, in one way or another,
ensuring the smooth fulfillment of such cooperative arrangements. Contracts
are made in good faith, and contractual obligations are fulfilled to the
letter.
Members of the system, being human beings, at any one time have
likes, dislikes, and preferences; each follows his own moral standards.
Each member acts to fulfill "his own" purposes: but these purposes are not
necessarily "selfish" ones and they may be directed toward alleviating the
pain of others; and so on. Each member has more or less imperfect knowl-
edge of the facts surrounding his field of action; each, in some degree,
possesses curiosity, intelligence, determination; each has potential or actual
talent for some or other activities, depending on his (natural or acquired)
physical and other qualities.
Members of the system need not be aware of the entire scope of the
market system or of the theory of its operation, but we may assume them
to be generally content to seek to achieve their purposes within the frame-
work of the system as they find it. In other words, while we make no other
assumptions concerning the nature of the actions of individual members,
we are assuming that no activity is expended with the sole purpose of re-
placing the market system by some system of societal organization governed
by conditions substantially different from those outlined here. The sys-
tem is thus consistent with the existence of the political and coercive ap-

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