Austrian Economics

Here are two excellent articles from Econlib that explain Austrian Economics.



The Austrian School of Economics


by Peter J. Boettke
(Excerpted from EconLib)

The Science of Economics

Proposition 1: Only individuals choose.

Man, with his purposes and plans, is the beginning of all economic analysis. Only individuals make choices; collective entities do not choose. The primary task of economic analysis is to make economic phenomena intelligible by basing it on individual purposes and plans; the secondary task of economic analysis is to trace out the unintended consequences of individual choices.

Proposition 2: The study of the market order is fundamentally about exchange behavior and the institutions within which exchanges take place.

The price system and the market economy are best understood as a “catallaxy,” and thus the science that studies the market order falls under the domain of “catallactics.” These terms derive from the original Greek meanings of the word “katallaxy”—exchange and bringing a stranger into friendship through exchange. Catallactics focuses analytical attention on the exchange relationships that emerge in the market, the bargaining that characterizes the exchange process, and the institutions within which exchange takes place.

(Note: Hayek defined catallaxy as “The order brought about by the mutual adjustment of many individual economies in a market.” – Law, Legislation, and Liberty, Vol. 2, pp. 108–9)

Proposition 3: The “facts” of the social sciences are what people believe and think.

Unlike the physical sciences, the human sciences begin with the purposes and plans of individuals. Where the purging of purposes and plans in the physical sciences led to advances by overcoming the problem of anthropomorphism, in the human sciences, the elimination of purposes and plans results in purging the science of human action of its subject matter. In the human sciences, the “facts” of the world are what the actors think and believe.

The meaning that individuals place on things, practices, places, and people determines how they will orient themselves in making decisions. The goal of the sciences of human action is intelligibility, not prediction. The human sciences can achieve this goal because we are what we study, or because we possess knowledge from within, whereas the natural sciences cannot pursue a goal of intelligibility because they rely on knowledge from without. We can understand purposes and plans of other human actors because we ourselves are human actors.

The classic thought experiment invoked to convey this essential difference between the sciences of human action and the physical sciences is a Martian observing the “data” at Grand Central Station in New York. Our Martian could observe that when the little hand on the clock points to eight, there is a bustle of movement as bodies leave these boxes, and that when the little hand hits five, there is a bustle of movement as bodies reenter the boxes and leave. The Martian may even develop a prediction about the little hand and the movement of bodies and boxes. But unless the Martian comes to understand the purposes and plans (the commuting to and from work), his “scientific” understanding of the data from Grand Central Station would be limited. The sciences of human action are different from the natural sciences, and we impoverish the human sciences when we try to force them into the philosophical/scientific mold of the natural sciences.

Microeconomics

Proposition 4: Utility and costs are subjective.

All economic phenomena are filtered through the human mind. Since the 1870s, economists have agreed that value is subjective, but, following alfred marshall, many argued that the cost side of the equation is determined by objective conditions. Marshall insisted that just as both blades of a scissors cut a piece of paper, so subjective value and objective costs determine price (see microeconomics). But Marshall failed to appreciate that costs are also subjective because they are themselves determined by the value of alternative uses of scarce resources. Both blades of the scissors do indeed cut the paper, but the blade of supply is determined by individuals’ subjective valuations.

In deciding courses of action, one must choose; that is, one must pursue one path and not others. The focus on alternatives in choices leads to one of the defining concepts of the economic way of thinking: opportunity costs. The cost of any action is the value of the highest-valued alternative forgone in taking that action. Since the forgone action is, by definition, never taken, when one decides, one weighs the expected benefits of an activity against the expected benefits of alternative activities.

Proposition 5: The price system economizes on the information that people need to process in making their decisions.

Prices summarize the terms of exchange on the market. The price system signals to market participants the relevant information, helping them realize mutual gains from exchange. In Hayek’s famous example, when people notice that the price of tin has risen, they do not need to know whether the cause was an increase in demand for tin or a decrease in supply. Either way, the increase in the price of tin leads them to economize on its use. Market prices change quickly when underlying conditions change, which leads people to adjust quickly.

Proposition 6: Private property in the means of production is a necessary condition for rational economic calculation.

Economists and social thinkers had long recognized that private ownership provides powerful incentives for the efficient allocation of scarce resources. But those sympathetic to socialism believed that socialism could transcend these incentive problems by changing human nature. Ludwig von Mises demonstrated that even if the assumed change in human nature took place, socialism would fail because of economic planners’ inability to rationally calculate the alternative use of resources. Without private ownership in the means of production, Mises reasoned, there would be no market for the means of production, and therefore no money prices for the means of production. And without money prices reflecting the relative scarcities of the means of production, economic planners would be unable to rationally calculate the alternative use of the means of production.

Proposition 7: The competitive market is a process of entrepreneurial discovery.

Many economists see competition as a state of affairs. But the term “competition” invokes an activity. If competition were a state of affairs, the entrepreneur would have no role. But because competition is an activity, the entrepreneur has a huge role as the agent of change who prods and pulls markets in new directions.

The entrepreneur is alert to unrecognized opportunities for mutual gain. By recognizing opportunities, the entrepreneur earns a profit. The mutual learning from the discovery of gains from exchange moves the market system to a more efficient allocation of resources. Entrepreneurial discovery ensures that a free market moves toward the most efficient use of resources. In addition, the lure of profit continually prods entrepreneurs to seek innovations that increase productive capacity. For the entrepreneur who recognizes the opportunity, today’s imperfections represent tomorrow’s profit.1 The price system and the market economy are learning devices that guide individuals to discover mutual gains and use scarce resources efficiently.

Macroeconomics

Proposition 8: Money is nonneutral.

Money is defined as the commonly accepted medium of exchange. If government policy distorts the monetary unit, exchange is distorted as well. The goal of monetary policy should be to minimize these distortions. Any increase in the money supply not offset by an increase in money demand will lead to an increase in prices. But prices do not adjust instantaneously throughout the economy. Some price adjustments occur faster than others, which means that relative prices change. Each of these changes exerts its influence on the pattern of exchange and production. Money, by its nature, thus cannot be neutral.

This proposition’s importance becomes evident in discussing the costs of inflation. The quantity theory of money stated, correctly, that printing money does not increase wealth. Thus, if the government doubles the money supply, money holders’ apparent gain in ability to buy goods is prevented by the doubling of prices. But while the quantity theory of money represented an important advance in economic thinking, a mechanical interpretation of the quantity theory underestimated the costs of inflationary policy. If prices simply doubled when the government doubled the money supply, then economic actors would anticipate this price adjustment by closely following money supply figures and would adjust their behavior accordingly. The cost of inflation would thus be minimal.

But inflation is socially destructive on several levels. First, even anticipated inflation breaches a basic trust between the government and its citizens because government is using inflation to confiscate people’s wealth. Second, unanticipated inflation is redistributive as debtors gain at the expense of creditors. Third, because people cannot perfectly anticipate inflation and because the money is added somewhere in the system—say, through government purchase of bonds—some prices (the price of bonds, for example) adjust before other prices, which means that inflation distorts the pattern of exchange and production.

Since money is the link for almost all transactions in a modern economy, monetary distortions affect those transactions. The goal of monetary policy, therefore, should be to minimize these monetary distortions, precisely because money is nonneutral.2

Proposition 9: The capital structure consists of heterogeneous goods that have multispecific uses that must be aligned.

Right now, people in Detroit, Stuttgart, and Tokyo City are designing cars that will not be purchased for a decade. How do they know how to allocate resources to meet that goal? Production is always for an uncertain future demand, and the production process requires different stages of investment ranging from the most remote (mining iron ore) to the most immediate (the car dealership). The values of all producer goods at every stage of production derive from the value consumers place on the product being produced. The production plan aligns various goods into a capital structure that produces the final goods in, ideally, the most efficient manner. If capital goods were homogeneous, they could be used in producing all the final products consumers desired. If mistakes were made, the resources would be reallocated quickly, and with minimal cost, toward producing the more desired final product. But capital goods are heterogeneous and multispecific; an auto plant can make cars, but not computer chips. The intricate alignment of capital to produce various consumer goods is governed by price signals and the careful economic calculations of investors. If the price system is distorted, investors will make mistakes in aligning their capital goods. Once the error is revealed, economic actors will reshuffle their investments, but in the meantime resources will be lost.3

Proposition 10: Social institutions often are the result of human action, but not of human design.

Many of the most important institutions and practices are not the result of direct design but are the by-product of actions taken to achieve other goals. A student in the Midwest in January trying to get to class quickly while avoiding the cold may cut across the quad rather than walk the long way around. Cutting across the quad in the snow leaves footprints; as other students follow these, they make the path bigger. Although their goal is merely to get to class quickly and avoid the cold weather, in the process they create a path in the snow that actually helps students who come later to achieve this goal more easily. The “path in the snow” story is a simple example of a “product of human action, but not of human design” (Hayek 1948, p. 7).

The market economy and its price system are examples of a similar process. People do not intend to create the complex array of exchanges and price signals that constitute a market economy. Their intention is simply to improve their own lot in life, but their behavior results in the market system. Money, law, language, science, and so on are all social phenomena that can trace their origins not to human design, but rather to people striving to achieve their own betterment, and in the process producing an outcome that benefits the public.4

The implications of these ten propositions are rather radical. If they hold true, economic theory would be grounded in verbal logic and empirical work focused on historical narratives. With regard to public policy, severe doubt would be raised about the ability of government officials to intervene optimally within the economic system, let alone to rationally manage the economy.

Perhaps economists should adopt the doctors’ creed: “First do no harm.” The market economy develops out of people’s natural inclination to better their situation and, in so doing, to discover the mutually beneficial exchanges that will accomplish that goal. Adam Smith first systematized this message in The Wealth of Nations. In the twentieth century, economists of the Austrian school of economics were the most uncompromising proponents of this message, not because of a prior ideological commitment, but because of the logic of their arguments.

About the Author

Peter J. Boettke is a professor of economics at George Mason University, where he is also the deputy director of the James M. Buchanan Center for Political Economy and a senior fellow at the Mercatus Center. He is the editor of the Review of Austrian Economics.

Further Reading

General Reading

Boettke, P., ed. The Elgar Companion to Austrian Economics. Brookfield, Vt.: Edward Elgar, 1994.
Dolan, E., ed. The Foundations of Modern Austrian Economics. Mission, Kans.: Sheed and Ward, 1976. Available online at: http://www.econlib.org/library/NPDBooks/Dolan/dlnFMA.html
Classic Readings

Böhm-Bawerk, E. Capital and Interest. 3 vols. 1883. South Holland, Ill.: Libertarian Press, 1956. Available online at: http://www.econlib.org/library/BohmBawerk/bbCI.html
Hayek, F. A. Individualism and Economic Order. Chicago: University of Chicago Press, 1948.
Kirzner, I. Competition and Entrepreneurship. Chicago: University of Chicago Press, 1973.
Menger, C. Principles of Economics. 1871. New York: New York University Press, 1976.
Mises, L. von. Human Action: A Treatise on Economics. New Haven: Yale University Press, 1949. Available online at: http://www.econlib.org/library/Mises/HmA/msHmA.html
O’ Driscoll, G., and M. Rizzo. The Economics of Time and Ignorance. Oxford: Basil Blackwell, 1985.
Rothbard, M. Man, Economy and State. 2 vols. New York: Van Nostrand Press, 1962.
Vaughn, K. Austrian Economics in America. Cambridge: Cambridge University Press, 1994.
History of the Austrian School of Economics

Boettke, P., and Peter Leeson. “The Austrian School of Economics: 1950–2000.” In Jeff Biddle and Warren Samuels, eds., The Blackwell Companion to the History of Economic Thought. London: Blackwell, 2003.
Hayek, F. A. “Economic Thought VI: The Austrian School.” In International Encyclopedia of the Social Sciences. New York: Macmillan, 1968.
Machlup, F. “Austrian Economics.” In Encyclopedia of Economics. New York: McGraw-Hill, 1982.
Footnotes

1.
Entrepreneurship can be characterized by three distinct moments: serendipity (discovery), search (conscious deliberation), and seizing the opportunity for profit.

2.
The search for solutions to this elusive goal generated some of the most innovative work of the Austrian economists and led to the development in the 1970s and 1980s of the literature on free banking by F. A. Hayek, Lawrence White, George Selgin, Kevin Dowd, Kurt Schuler, and Steven Horwitz.

3.
Propositions 8 and 9 form the core of the Austrian theory of the business cycle, which explains how credit expansion by the government generates a malinvestment in the capital structure during the boom period that must be corrected in the bust phase. In contemporary economics, Roger Garrison is the leading expositor of this theory.

4.
Not all spontaneous orders are beneficial and, thus, this proposition should not be read as an example of a Panglossian fallacy. Whether individuals pursuing their own self-interest generate public benefits depends on the institutional conditions within which they pursue their interests. Both the invisible hand of market efficiency and the tragedy of the commons are results of individuals striving to pursue their individual interests; but in one social setting this generates social benefits, whereas in the other it generates losses. New institutional economics has refocused professional attention on how sensitive social outcomes are to the institutional setting within which individuals interact. It is important, however, to realize that classical political economists and the early neoclassical economists all recognized the basic point of new institutional economists, and that it was only the mid-twentieth-century fascination with formal proofs of general competitive equilibrium, on the one hand, and the Keynesian preoccupation with aggregate variables, on the other, that tended to cloud the institutional preconditions required for social cooperation.



What Is Austrian Economics


by Deborah L. Walker
(From EconLib)

History

The Austrian school of economics dates from the 1871 publication of Carl Menger’s Principles of Economics (Grundsätze der Vokswirtschaftslehre). Two of Menger’s students, Eugen von Böhm-Bawerk and Freidrich von Wieser, carried his work forward and made considerable contributions of their own. Especially notable is Böhm-Bawerk’s analysis of capital and interest. In the 1920s, 1930s, and 1940s, Ludwig von Mises and Friedrich A. Hayek continued the Austrian tradition with their works on the business cycle and on the impossibility of economic calculation under socialism.

Austrian analysis fell out of favor with the economics profession during the fifties and sixties, but the awarding of the Nobel Prize in economics to Hayek in 1974, coupled with the spread of Mises’s ideas by his students and followers, led to a revival of the Austrian school.

The Cornerstones
The major cornerstones of Austrian economics are methodological individualism, methodological subjectivism, and an emphasis on processes rather than on end states.

Methodological individualism.
Economics, to an Austrian economist, is the study of purposeful human action in its broadest sense. Since only individuals act, the focus of study for the Austrian economist is always on the individual. Although Austrian economists are not alone in their methodological individualism, they do not stress the maximizing behavior of individuals in the same way as mainstream neoclassical economists. Austrian economists believe that one can never know if humans have maximized benefits or minimized costs. Austrian economists emphasize instead the process by which market participants gain information and form their expectations in order to lead them to their own idea of a best solution.

The most important economic problem that people face, according to Austrian economists, is how to coordinate their plans with those of other people. Why, for example, when a person goes to a store to buy an apple, is the apple there to be bought? This meshing of individual plans in a world of uncertainty is, to Austrians, the basic economic problem.

Austrian economists do not use mathematics in their analyses or theories because they do not think mathematics can capture the complex reality of human action. They believe that as people act, change occurs, and that quantifiable relationships are applicable only when there is no change. Mathematics can capture what has taken place, but can never capture what will take place.

Methodological subjectivism.
An individual’s actions and choices are based upon a unique value scale known only to that individual. It is this subjective valuation of goods that creates economic value. Like other economists, the Austrian does not judge or criticize these subjective values but instead takes them as given data. But unlike other economists, the Austrian never attempts to measure or put these values in mathematical form. The idea that an individual’s values, plans, expectations, and understanding of reality are all subjective permeates the Austrian tradition and, along with an emphasis on change or processes, is the basis for their notion of economic efficiency.

Processes versus end states.
An individual’s action takes place through time. A person decides on a desired end, chooses a means to attain that end, and then acts to attain it. But because all individuals act under the condition of uncertainty?especially uncertainty regarding the plans and actions of other individuals?people sometimes do not achieve their desired ends. The actions of one person may interfere with the actions of another. The actual consequences of any action can be known only after the action has taken place. This does not mean that people do not include in their plans expectations regarding the plans of others. But the exact outcome of a vast number of plans being executed at the same time can never be predicted. When offering a product on the market, for example, a producer can only guess as to what price will produce the greatest demand for his product or how many, if any, new competitors will enter his market. Offering a product on the market is always a trial-and-error, never-ending process of changing one’s plans to reflect new knowledge one gains from day to day.

Since the Austrian economist holds all costs and benefits to be subjective and, therefore, not measurable, only the individual can decide what actions are efficient or inefficient. Often the individual may decide, after the fact, that a decision was not efficient. In the actual process of acting to achieve an end, an individual will discover what works best. And even then, what worked best this time may not work best next time. But a person cannot know this without the process of acting.

The notion of an equilibrium state is sometimes seen as the epitome of economic efficiency: supply would equal demand, and therefore, no surplus or shortage of goods would exist. This assumes, however, that market participants know where the equilibrium price is and that moving toward it will not change it. But if the price is already known, why isn’t the market already in equilibrium? Furthermore, the movement to equilibrium is a process of learning and of changing expectations, which will change the equilibrium itself. To the Austrian economist efficiency is defined within the process of acting, not as a given or known end state of affairs. Efficiency means the fulfillment of the purposes deemed most important to an individual, rather than the fulfillment of less important purposes. The Austrian economist never speaks of efficiency outside of the individual.

Policy Implications

So what do Austrian economists do? They try to understand the process by which knowledge is generated, spread, and used within the economy. They focus on the institutions that emerge because people lack perfect knowledge and try to cope with this uncertainty. Money is just one example of such institutions.

So what do Austrian economists do? They try to understand the process by which knowledge is generated, spread, and used within the economy. They focus on the institutions that emerge because people lack perfect knowledge and try to cope with this uncertainty. Money is just one example of such institutions.A medium of exchange, or money, spontaneously emerges because individuals engaging in trade want to decrease the uncertainty that they will be able to obtain goods that they themselves are not producing. When a commodity is generally accepted in all exchanges, people can specialize (in producing corn, for example) and can be certain that they will be able to exchange the corn for the medium of exchange. They can then use the medium to obtain other goods that they want. The existence of money enhances the benefits of specialization and division of labor. Austrian economists explain how and why money and other institutions emerge; they do not take them as given, as do many neoclassical economists.

The basic question for the Austrian economist is, Which institutions enable individuals to reach their own goals, and which do not? Therefore, their policy recommendations run to changes in the institutional framework within which a society operates. Two key public policy issues that provide good illustrations of Austrian analysis are antitrust and central planning.

Antitrust. The neoclassical economic theory of perfect competition defines a competitive market as one in which there are a large number of small firms, all selling a homogeneous good and possessing perfect knowledge. The structure of the market, according to this analysis, determines the competitiveness of a market. But Austrian economists Friedrich A. Hayek and Israel M. Kirzner have rejected this theory of competition. According to Hayek there is no competition in the neoclassical theory of perfect competition. Competition to an Austrian economist is defined simply as rivalrous behavior, and to compete is to attempt to offer a better deal than one’s competitors. Competition in the market arises out of one firm distinguishing its products in some way from those of other firms. And because firms in the real world do not have perfect knowledge, they do not know what a successful competitive strategy is until they try it. Competition is, therefore, as Hayek explains, a “discovery procedure.” As each firm attempts to do better than all other firms, the knowledge of what consumers actually want in the market is discovered.

If the neoclassical definition of competition is accepted, many people may want antitrust laws to eliminate excessive divergences from an industry structure characterized by a large number of small firms. If the Austrian definition of rivalrous behavior is accepted, then antitrust laws are seen to be beneficial only if market structure affects rivalrous behavior. But the evidence indicates that market structure does not affect the competitiveness of a market. What matters to Austrian economists is whether governments interfere with rivalrous behavior. For example, when government imposes import quotas, domestic firms in an industry are shielded from the rivalrous competitive behavior of potential and actual foreign competitors. Or when the government prohibits entry into an industry, such as in the delivery of first-class mail, the competitive process of discovering new and more efficient ways of offering the service to the consumer is stifled.

According to Austrian economists, antitrust legislation is neither necessary nor desirable. In recent years many mainstream economists working in the area of antitrust have begun to express this view (see Antitrust). This is especially true of economists in the so-called Chicago school of industrial organization, such as Harold Demsetz, Armen Alchian, and George Stigler. Stigler, in his book The Organization of Industry, wrote: “In economic life competition is not a goal: it is a means of organizing economic activity to achieve a goal.”

Central planning. The failure of centrally planned economies to allocate resources to meet the most basic human needs is something that Mises and Hayek predicted long ago (see Socialism). They pointed out that every individual in an economy possesses knowledge (about production techniques, availability of some sources of supply, etc.) only some of which is known by others. This knowledge is dispersed throughout the economy and is constantly changing. In a centrally planned economy the information available to the planners is a tiny fraction of the amount in various people’s heads. Therefore, much information in a centrally planned economy is never acted on. The socialist manager who knows of a cheap source of supply can’t necessarily use it because he must get permission to do so, and even if he gets permission, it is likely to be too late to use it.

But in a free market, explain Mises and Hayek, private ownership of the means of production allows people to use their information; they don’t need permission. Private ownership also allows people to bid for resources, which in turn generates market prices for these resources. People can then use these prices to decide, as producers or consumers, what goods to buy or sell, and how to use them. A market price summarizes the diverse knowledge of millions of individual human beings as they act in the market. The very act of buying a good at a particular price signals the producer to continue producing and selling this good. The producer does not have to know why consumers buy the goods they do, only that they do. And profits are also knowledge signals in the market that direct resources into one industry and out of another. This is why Austrian economists have always been highly critical of central planning and strong supporters of a free market.

Conclusion

Although the theory of competition and economic calculation are good examples of Austrian economic analysis, there are many others. The Austrian theory of the business cycle and of the inflationary process that takes place because of credit expansion through monetary policy, and the Austrian explanation of the emergence of money in a modern economy are also important contributions to economic analysis. Today, Austrian economists are also working in the areas of environmental economics, labor economics, and legal analysis. Many of the traditionally Austrian theories, and even methods, are being accepted into mainstream economic analysis.

This is especially true of the Austrian view of central economic planning. The Austrian analysis of central planning, although never stated explicitly as such, is found in the writing of many mainstream economists. Robert Heilbroner, for example, who himself advocated socialist policies in the past, attributes the collapse of the Soviet economy to a knowledge problem. He states:

Planning thus requires that the immense map of desired national output be carved up into millions of individual pieces, like a jigsaw puzzle – the pieces produced by hundreds of thousands of enterprises, and the whole thing finally reassembled in such a way as to fit. That would be an extraordinarily difficult task even if the map of desired output were unchanged from year to year, but, of course, it is not….

And Charles L. Schultze, formerly President Jimmy Carter’s chief economic adviser, writes: “The first problem for the government in carrying out an industrial policy is that we actually know precious little about identifying, before the fact, a ‘winning’ industrial structure.”

About the Author
Deborah L. Walker teaches economics at Metropolitan State College of Denver and was previously an economics professor at Loyola University in New Orleans.

Further Reading

Dolan, Edwin G., ed. The Foundations of Modern Austrian Economics. 1976.

Hayek, Friedrich A. Collectivist Economic Planning. 1975.

Hayek, Friedrich A. Individualism and Economic Order. 1948.

Kirzner, Israel M. Competition and Entrepreneurship. 1973.

Menger, Carl. Principles of Economics. 1871. Reprint. 1981.

Mises, Ludwig von. Human Action: A Treatise on Economics. 1949.

Human Action: A Treatise on Economics. Fourth revised ed., 1996.

Spadaro, Louis M., ed. New Directions in Austrian Economics. 1978.