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04/17/2021

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Did Rothbard “Borrow” the Income and Substitution Effects?

4 min read

Did Rothbard “Borrow” the Income and Substitution Effects?

From the introductory undergraduate to the advanced PhD courses in microeconomics, most students are taught that the concept of an indifference curve is very useful in analyzing individual choice. I emphasize the term “useful” for a reason. No professor I have asked about the concept ever said it was literally true. I don’t think anyone who understands the concept would ever try to claim that this is how humans actually make choices. Rather, we have been instructed to treat the microeconomic models only as tools for prediction of phenomena.

Murray Rothbard and other economists of the Austrian School have rejected the concept of indifference and have developed an approach based on Menger’s law of diminishing marginal utility and Mises’s axiom of action. This approach, built upon ordinal rankings of human ends, is formulated in Rothbard’s treatise Man, Economy, and State as the value-scale concept. Professor Rothbard used this concept to derive the laws of diminishing marginal utility and of demand and supply, and he used it to explain price formation and other economic phenomena.

However, Bryan Caplan, a George Mason University professor, claims that this value-scale approach is inadequate for explaining the so-called income and substitution effects of a price change. Caplan claims that, while Rothbard’s consumer theory is not capable of explaining the distinction between the income and the substitution effects of a price change, Rothbard still uses these terms in his work. Professor Caplan goes on to argue that Professor Rothbard has “borrowed” these terms from mainstream neoclassical theory.

This claim is based on the observation that the mainstream neoclassical derivations of the income and substitution effects are based on the use of indifference curves and the constrained-optimization framework. The implicit assumption here is that that the derivation of the income and substitution effects in general is somehow dependent on the concept of indifference, and thus not possible within Rothbard’s theoretical framework.

The thesis of the following article is that Caplan is wrong. It can be shown that a price change does indeed have its income and substitution effects within Rothbard’s theoretical framework. A clear indication that Professor Rothbard was aware of this, although he did not go through the steps of explicitly demonstrating the two effects, is the following paragraph of his Man, Economy, and State:

All consumers’ goods are, on the other hand, partial substitutes for one another. When a man ranks in his value scale the myriad of goods available and balances the diminishing utilities of each, he is treating them all as partial substitutes for one another. A change in ranking for one good by necessity changes the rankings of all the other goods, since all the rankings are ordinal and relative. A higher price for one good (owing, say, to a decrease in stock produced) will tend to shift the demand of consumers from that to other consumers’ goods, and therefore their demand schedules will tend to increase.[1]

Thus, Rothbard notes that individual value scales are formed using one’s knowledge of the relevant money prices and that a change in prices will change the ordering of different items on one’s value scale. Consequently, a price change will have its substitution effect. Moreover, the idea that money prices are the key element of individual value scales is also at the root of Mises’s regression theorem, which Rothbard elaborated at some length.

It also may be obvious that, given a fixed stock of money, an increase (or decrease) in the money price of an item reduces (or increases) the purchasing power of that stock, and thus reduces (or increases) the quantities of different items that can be purchased. Essentially, this is the economic meaning of the income effect of a price change.

However, given the claims that the value-scale approach is somehow inadequate for defining the income and substitution effects, it seems that there are still some benefits to going through the steps of the value-scale approach. I will demonstrate how and why a price change affects the purchasing power of a stock of money, and how and why substitution between different items takes place.

In the following sections, I will first present the mainstream neoclassical framework for deriving the income and substitution effects of a price change, and then develop an example of how Rothbard’s value-scale approach could be applied to the problem.

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