Free-Market Schools: Austrian Methodology's Shared Legacy?

The Austrian School of Economics is a heterodox school of economic thought that emerged in the 1870s in Vienna, Austria, with the work of Carl Menger, Eugen von Böhm-Bawerk, Friedrich von Wieser, and others. It emphasizes methodological individualism, arguing that economic theory should be derived from the motivations and actions of individuals. This school of thought also introduced the concept of marginalism in price theory and the subjective theory of value. While the Austrian School has distinct characteristics, it shares some similarities with other free-market schools, such as the Chicago School and neoclassical economics. However, it is important to note that the Austrian School has been criticized by mainstream economists for its rejection of mathematical modeling and macroeconomic analysis.

Subjective theory of value

The subjective theory of value (STV) is an economic theory that explains how the value of goods and services is set and how it can fluctuate over time. The theory claims that the value of a good is not determined by any inherent property of the good, nor by the cumulative value of its components or the labour needed to produce it. Instead, it is determined by the individuals or entities who are buying and/or selling that good.

STV was developed in the late 19th century by economists including Carl Menger, Eugen von Böhm-Bawerk, William Stanley Jevons, and Léon Walras. It was a departure from classical economics and, in particular, the labour theory of value, which states that there is a direct correlation between the value of a good and the labour required to produce it.

According to STV, the value of a good is determined by its utility to the individual consumer, rather than its labour input or production costs. This means that the value of a good may increase substantially following its creation if it is perceived as being more important or desirable. There are many variables that can influence this process, including changes in the age of the good, personal affinity, cultural significance, scarcity, and situational circumstances.

For example, an individual will experience more radical improvements to their life and satisfaction from acquiring the first unit of a good compared to the marginal utility from acquiring additional units of the same good. They will initially prioritise obtaining the goods they most need, such as essential food, and once their need for it is satisfied, their desire for other luxury or surplus goods will begin to rise.

Proponents of STV also believe that in a free market, competition between individuals seeking to trade goods and services results in a market equilibrium set of prices emerging. This can be seen during auctions, where bidders express their belief in the value of an item through their bids, and the value of the item rises with each bid, even though the nature and function of the item remain unchanged.

The development of STV was partly motivated by the need to solve the diamond-water paradox, which had puzzled classical economists such as Adam Smith and John Law. This paradox states that although water is more essential to survival and provides far more utility value, diamonds are valued much higher in the market. STV presents a solution by arguing that value is not determined by the total usefulness of diamonds and water, but rather by the usefulness generated by consuming an extra unit of each. Water is more abundant than diamonds, so people feel less "urgency" when they consume more water, and the extra utility generated from consuming an extra unit of water decreases.

In summary, the subjective theory of value suggests that the value of any object is not intrinsic but variable, depending on its context and the perspective of its users. It is determined by the individual who buys or sells it and can be influenced by factors such as scarcity, cultural significance, and situational circumstances.

Marginalism in price theory

Marginalism was developed in the 19th century by three European economists: Carl Menger, William Stanley Jevons, and Leon Walras. It marked a significant shift from classical economics, which relied on the labour theory of value, to modern economics, emphasising the subjective nature of value. According to marginalism, the value of a good or service is determined by its marginal use, rather than its total use or the labour required to produce it. This insight was particularly useful in resolving the Diamond-Water Paradox, as described by Adam Smith.

The law of diminishing marginal utility is a key aspect of marginalism, stating that as consumption of a good or service increases, the marginal utility derived from each additional unit decreases. This law helps explain why individuals are willing to pay more for a good or service when they have less of it, and why prices tend to decrease as consumption increases. For example, an individual might be willing to pay a higher price for an additional diamond compared to an additional glass of water because diamonds are scarcer and hold greater marginal utility.

Marginalism has important implications for businesses when setting prices. By understanding marginal utility, businesses can price their products at a level that maximises profit while satisfying customer demand. This involves considering the marginal cost of producing one more unit and comparing it to the marginal revenue generated from its sale. As long as marginal revenue exceeds marginal cost, it is often economically viable to continue production.

Furthermore, marginalism provides insights into supply and demand curves. Demand curves, for instance, can be explained through marginal rates of substitution, which represent the rate at which a consumer is willing to exchange one good for another while maintaining the same level of satisfaction. As consumers acquire more of a particular good, their marginal utility decreases, leading to a decrease in their willingness to substitute other goods for it.

In conclusion, marginalism in price theory is a fundamental concept that underpins modern economic thinking. By focusing on marginal utility, it offers a powerful framework for understanding consumer behaviour, pricing strategies, and the dynamics of supply and demand. Its development in the 19th century revolutionised economics and continues to shape the field today.

Economic calculation problem

The Austrian School of Economics, founded by Carl Menger in 1871, is a heterodox school of economic thought that advocates strict adherence to methodological individualism, the concept that social phenomena result primarily from the motivations and actions of individuals along with their self-interest. Austrian-school theorists hold that economic theory should be exclusively derived from basic principles of human action.

One of the Austrian School's key contributions to economic thought is the economic calculation problem, which refers to a criticism of planned economies. The idea was first stated by Max Weber in 1920, and later discussed by Mises and Hayek. The calculation problem essentially states that without price signals, the factors of production cannot be allocated efficiently, rendering planned economies ineffective.

Mises argued in a 1920 essay that the pricing systems in socialist economies were necessarily deficient because if the government owned the means of production, no prices could be obtained for capital goods as they were merely internal transfers of goods. Therefore, they were unpriced and hence the system would be inefficient, since central planners would not know how to allocate resources efficiently. This led him to conclude that "rational economic activity is impossible in a socialist commonwealth".

Hayek further developed this idea, stating that market prices reflect information that determines the allocation of resources in an economy. He argued that socialist systems lack the individual incentives and price discovery processes by which individuals act on their personal information, and therefore socialist economic planners lack the knowledge required to make optimal decisions.

The debate over the economic calculation problem rose to prominence in the 1920s and 1930s and came to be known as the socialist calculation debate. This period saw a divergence between the Austrian School, which analysed markets as institutionally channelled entrepreneurial discovery processes, and the mainstream approach, which focused on models of market equilibria.

The economic calculation problem is a key criticism of socialism and is seen as showing that it is not a viable or sustainable form of economic organisation.

Austrian Business Cycle Theory

According to ABCT, the productive structure of the economy consists of multistep processes that occur over variable amounts of time and require the use of different complementary capital and labour inputs at different points in time. Thus, the success or failure of the economy depends on coordinating the availability of the right kinds of resources in the right amounts at the right time. A key tool in this coordinating process is the interest rate because, in Austrian theory, interest rates reflect the price of time.

A market interest rate coordinates among the many, varied preferences of consumers for consumption goods at various points in time with the multiplicity of plans of entrepreneurs to engage in production processes that yield consumption goods in the future. When a monetary authority like a central bank alters market interest rates (by artificially lowering them through expansionary monetary policy), it breaks this key link between the future plans of producers and consumers.

This sparks an initial boom in the economy as producers launch investment projects and consumers increase their current consumption based on false expectations of future demand and supply for various goods at various points in time. However, the new boom-time investments are doomed to failure because they are not in line with consumers' plans for future consumption, labour in various jobs, and savings, or with the productive plans of other entrepreneurs to produce the required complementary capital goods in the future. Because of this, the resources that the new investment plans will require at future dates will not be available.

As this comes to light over time through rising prices and shortages of productive inputs, the new investments are revealed to be unprofitable, a rash of business failures occurs, and a recession ensues. During the recession, the unproductive investments are liquidated as the economy readjusts to bring production and consumption plans back into balance.

For the Austrians, the recession is an admittedly painful healing process made necessary by the discoordination of the boom. The length, depth, and scope of the recession can depend on the size of the initial expansionary policy and on any (ultimately futile) attempts to ease the recession in ways that prop up unproductive investments or prevent labour, capital, and financial markets from adjusting.

Methodology

The Austrian School of Economics is a heterodox school of economic thought that emerged in the 1870s in Vienna, Austria, primarily through the work of Carl Menger. It is also referred to as the "Vienna School," "Psychological School," or "Causal Realist Economics." This school of thought emphasizes methodological individualism, the concept that social phenomena are primarily driven by the motivations, actions, and self-interest of individuals. Austrian theorists maintain that economic theory should be derived solely from fundamental principles of human behaviour.

The Austrian School's methodology stands in contrast to other economic schools, such as the German Historical School, neoclassical economics, and Keynesian economics. While these schools often rely on historical data, statistical aggregates, and mathematical models, the Austrian School favours a priori thinking, verbal logic, introspection, and deduction to understand economic phenomena. They believe that economic laws of universal application can be discovered through logical reasoning, independent of empirical observation.

A core principle of the Austrian School is the subjectivity of economic value. Carl Menger, in his book "Principles of Economics" (1871), argued that the value of goods and services is subjective and varies across individuals. This idea formed the basis for the theory of diminishing marginal utility, which suggests that as the quantity of goods increases, their subjective value to an individual decreases.

The Austrian School also emphasizes the role of time in economic activity. All economic actions occur over specific periods, and the element of time is ever-present in their economic models. They view interest rates as reflecting the price of time and consider the impact of time preferences on economic decisions.

Additionally, the Austrian School highlights the importance of cause-and-effect relationships in economic processes. They believe that economic phenomena are driven by purposeful human action and interaction in real-time, involving specific economic goods. They also recognize the role of entrepreneurs in coordinating economic activity and bearing the risks associated with uncertainty.

In terms of market dynamics, the Austrian School views markets as emergent orders that arise from individual actions rather than being consciously designed. They emphasize the role of prices as signals that encapsulate competing values, future expectations, and resource scarcity. Price signals, according to this school of thought, are essential for coordinating economic plans and allocating resources efficiently.

The Austrian School's methodology has led to insights in various economic areas, including supply and demand, inflation, money creation, foreign exchange rates, and business cycles. However, it has also faced criticism and is considered outside mainstream economic theory due to its rejection of mathematical modelling and macroeconomic analysis.

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