Austrian Economics: Measurement-Free Theories And Principles

The Austrian School of Economics, founded by Carl Menger in 1871, is a heterodox school of economic thought that emphasizes methodological individualism – the concept that social phenomena are primarily driven by the motivations, actions, and self-interest of individuals. This school of thought, also known as Austrian Economics, stands out for its unique approach to understanding human action, the role of entrepreneurs, the market, capital, and the importance of individual freedom.

One distinctive aspect of Austrian Economics is its focus on capital and entrepreneurship, recognizing their central role in economic systems. It also starts with the individual as the explanatory model, deviating from the statistically constructed aggregates often used in mainstream economics. This approach, known as methodological individualism, asserts that social phenomena must be explained by individual actions and decisions rather than abstract collective categories.

Austrian Economics is characterized by its rejection of complex formulas and data-driven approaches commonly associated with economists. Instead, it favors thought experiments and a priori thinking to discover economic laws of universal application. This school of thought holds that economic values are subjective and determined by individual preferences, needs, and circumstances.

While Austrian Economics has evolved over time, its core principles remain unchanged. The insights it offers provide a deeper understanding of economic relations and their social and political implications. By focusing on realistic assumptions about human behavior and economically relevant aspects of the real world, Austrian Economics offers a more accessible and accurate perspective on economic theories.

Utility measurement

Austrian economics 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.

The Austrian school originated in 1871 in Vienna with the work of Carl Menger, Eugen von Böhm-Bawerk, Friedrich von Wieser, and others. It was methodologically opposed to the Historical school, in a dispute known as the Methodology Struggle.

The Austrian school owes its name to members of the German Historical School of Economics, who argued against the Austrians during the late 19th-century Methodology Struggle, in which the Austrians defended the role of theory in economics as distinct from the study or compilation of historical circumstance.

The Austrian school is one of three founding currents of the marginalist revolution of the 1870s, with its major contribution being the introduction of the subjectivist approach in economics.

The Austrian school shares the marginal utility principle with neoclassical economics. According to this, the subjective value an individual attaches to a good or service decreases when more of this good is immediately available. The law of diminishing marginal utility states that the additional (marginal) satisfaction a person gains from consuming each additional unit of a good or service decreases as more units of this good or service within a definite time frame are used for consumption. Marginal utility refers to the additional benefit a consumer receives from consuming another unit of a good or service. In other words, the principle of diminishing marginal utility states that—all other things being equal—the additional satisfaction obtained from each unit consumed decreases as the amount consumed increases.

In economics, utility is a term used to determine the worth or value of a good or service. More specifically, utility is the total satisfaction or benefit derived from consuming a good or service. Economic theories based on rational choice usually assume that consumers will strive to maximize their utility.

The economic utility of a good or service is important to understand because it directly influences the demand, and therefore price, of that good or service. In practice, a consumer's utility is usually impossible to measure or quantify. However, some economists believe that they can indirectly estimate the utility of an economic good or service by employing various models.

"Ordinal" utility refers to the concept of one good being more useful or desirable than another. "Cardinal" utility is the idea of measuring economic value through imaginary units, known as "utils." Marginal utility is the utility gained by consuming an additional unit of a service or good.

Austrian economist Carl Menger, in a discovery known as the marginal revolution, used this type of framework to help him resolve the diamond-water paradox that had vexed many previous economists. Because the first available units of any economic good will be put to the most highly valued uses, and subsequent units go to lower-valued uses, this ordinal theory of utility is useful for explaining the law of diminishing marginal utility and fundamental economic laws of supply and demand.

To Bernoulli and other economists, utility is modelled as a quantifiable or cardinal property of the economic goods that a person consumes. To help with this quantitative measurement of satisfaction, economists assume a unit known as a "util" to represent the amount of psychological satisfaction a specific good or service generates for a subset of people in various situations. The concept of a measurable util makes it possible to treat economic theory and relationships using mathematical symbols and calculations.

However, it separates the theory of economic utility from actual observation and experience, since "utils" cannot actually be observed, measured, or compared between different economic goods or between individuals.

If, for example, an individual judges that a piece of pizza will yield 10 utils and that a bowl of pasta will yield 12 utils, that individual will know that eating the pasta will be more satisfying. For the producers of pizza and pasta, knowing that the average bowl of pasta will yield two additional utils will help them price pasta slightly higher than pizza.

Additionally, utils can decrease as the number of products or services consumed increases. The first slice of pizza may yield 10 utils, but as more pizza is consumed, the utils may decrease as people become full. This process will help consumers understand how to maximize their utility by allocating their money between multiple types of goods and services as well as help companies understand how to structure tiered pricing.

Economic utility can be estimated by observing a consumer's choice between similar products. However, measuring utility becomes challenging as more variables or differences are present between the choices.

If utility in economics is cardinal and measurable, the total utility (TU) is defined as the sum of the satisfaction that a person can receive from the consumption of all units of a specific product or service. Using the example above, if a person can only consume three slices of pizza and the first slice of pizza consumed yields ten utils, the second slice of pizza consumed yields eight utils, and the third slice yields two utils, the total utility of pizza would be twenty utils.

Marginal utility (MU) is defined as the additional (cardinal) utility gained from the consumption of one additional unit of a good or service or the additional (ordinal) use that a person has for an additional unit.

Using the same example, if the economic utility of the first slice of pizza is ten utils and the utility of the second slice is eight utils, the MU of eating the second slice is eight utils. If the utility of a third slice is two utils, the MU of eating that third slice is two utils.

In ordinal utility terms, a person might eat the first slice of pizza, share the second slice with their roommate, save the third slice for breakfast, and use the fourth slice as a doorstop.

While there is no direct way to measure the utility of a certain good for an individual consumer, it is possible to estimate utility through indirect observation. For example, if a consumer is willing to spend $1 for a bottle of water but not $1.50, economists can safely state that a bottle of water has economic utility somewhere between $1 and $1.50. However, this becomes difficult in practice because of the number of variables that are present in a typical consumer's choices.

In the Austrian school, utility is simply the concept economists use to explain choice. That is to say

Marginalism

The marginal revolutionists argued that the value of a commodity is not based on the amount of labour expended but rather reflects how useful people perceive the commodity to be in satisfying their ends. This had radical implications for the way economists understood the world: consumer valuations, not the amount of effort, determine prices.

Menger introduced the concept of marginal utility to resolve the paradox of why consumers value diamonds more than water. Marginal utility refers to the importance attached to a thing based on the belief that it can remove uneasiness. The marginal utility of a good decreases as the number of units in its supply increases, and vice versa.

Menger's marginal utility theory was a key contribution to the Austrian School's early theoretical development. Other contributions include the subjective theory of value, the formulation of the economic calculation problem, and the subjective approach to price theory.

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. It is one of several theories that emerged from the marginal revolution, which was a departure from classical economics. The modern version of the theory was developed independently and almost simultaneously by William Stanley Jevons, Léon Walras, and Carl Menger in the late 19th century.

The subjective theory of value 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. A good's value 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.

According to the subjective theory of value, by assuming that all trades between individuals are voluntary, it can be concluded that both parties to the trade subjectively perceive the goods, labour, or money they receive as being of higher value than the goods, labour, or money they give away. Wealth is understood as referring to individuals' subjective valuation of their possessions, and voluntary trades may increase total wealth in society. This is because each participant in a voluntary transaction gains more value than they originally had.

The subjective theory of value was a dramatic departure from the assumption of earlier economists, including Karl Marx, that an object's value was the sum of the costs of the labour and resources it took to produce it. It also suggests that an object's value is not intrinsic but changes according to its context. A product's scarcity is among the factors that can alter its value in the marketplace. Situational circumstances, cultural significance, sentimentality, nostalgia, and scarcity all influence the value of objects.

The subjective theory of value helped to better understand human action and decision-making in economics. It has provided valuable insights into some of the most important and complex economic issues of our time.

The role of the entrepreneur

The Austrian School of Economics places great emphasis on the role of the entrepreneur in a capitalist economic system. Entrepreneurs are seen as central to this system, as they recognise profit opportunities, anticipate market changes, identify unmet needs, and direct resources towards producing goods and services that meet those needs. This process is based on dealing with uncertainty about the future, and the specific entrepreneurial profit comes from the successful management of this uncertainty.

Entrepreneurs make decisions based on imperfect knowledge, and their competition works as a discovery process. Markets are seen as a spontaneous order that arises naturally from the actions of individuals, without the need for central planning or direction. Prices serve as signals that help individuals coordinate their actions in a decentralised manner, and Austrian economists argue that central planners cannot have all the real-time, subjective knowledge required for an efficient distribution of resources.

Entrepreneurs are viewed as imaginative and bold individuals who are alert to opportunities. They are arbitrageurs or middlemen who buy or sell to make a profit and need not be producers, innovators, or capital owners. They are agents of change who profit by taking advantage of opportunities while acting in the interest of the consumer.

Austrian economics also recognises that entrepreneurship is based on the employee/employer relationship, viewing it as a strategic partnership. This perspective humanises economic relationships and helps to understand the motivations of all parties involved.

Overall, the Austrian School of Economics sees entrepreneurs as playing a crucial role in the functioning of a capitalist economic system, driving innovation, responding to market changes, and ensuring efficient allocation of resources.

The market as a spontaneous order

Austrian economics 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.

The Austrian school originated in 1871 in Vienna with the work of Carl Menger, Eugen von Böhm-Bawerk, Friedrich von Wieser, and others. It was methodologically opposed to the Historical School, in a dispute known as the Methodenstreit, or methodology quarrel.

The Austrian school owes its name to members of the German Historical School of economics, who argued against the Austrians during the late 19th-century Methodenstreit ("methodology struggle"), in which the Austrians defended the role of theory in economics as distinct from the study or compilation of historical circumstance.

The Austrian school, led by Carl Menger, Ludwig von Mises, and Friedrich Hayek, made spontaneous order a centerpiece in its social and economic thought. Hayek's theory of spontaneous order is the product of two related but distinct influences that do not always tend in the same direction. As an economic theorist, his explanations can be given a rational explanation. But as a legal and social theorist, he leans very heavily on a conservative and traditionalist approach, which instructs us to submit blindly to a flow of events over which we can have little control.

Many classical-liberal theorists, such as Hayek, have argued that market economies are a spontaneous order and that they represent "a more efficient allocation of societal resources than any design could achieve". They claim this spontaneous order (referred to as the extended order in Hayek's book, *The Fatal Conceit*) is superior to any order a human mind can design due to the specifics of the information required. Centralised statistical data, they suppose, cannot convey this information because the statistics are created by abstracting away from the particulars of the situation.

The market itself is to be understood as a spontaneous order, as a system in which order arises naturally from the actions of individuals, without the need for central planning or direction. In markets, individuals who pursue their interests inadvertently create an efficient allocation of resources. Prices serve as signals that help individuals to coordinate their actions in a decentralised manner. This concept is decisive for the criticism of central planning. The economists of the Austrian school argue that central planners cannot have all the real-time, often qualitative, and subjective knowledge required for an efficient distribution of resources in an economy. One needs market prices that are determined by supply and demand in the market and are the result of the spontaneous actions of individuals. One cannot maintain a complex economy by command and obedience. By focusing on human action, Austrian economics concludes that central economic planning must necessarily fail. Since planners lack the necessary information in the form of market prices, they cannot rationally allocate capital even if they have the best intentions. The complex web of economic relations can only be maintained by market processes driven by the voluntary actions of individuals.

From the point of view of the Austrian school, institutions such as markets, property rights, legal systems, and money arise organically from the actions and interactions of individuals and are not the product of state design. These systems evolve by trial and error, through which norms and conventions emerge naturally. For example, the development of property rights is seen as a spontaneous process that helps individuals resolve conflicts over scarce resources without the need for a central authority. This understanding of order in society stands in direct contrast to the top-down view of state intervention, which is central to many other schools of economic thought. While acknowledging the need for some basic legal frameworks, Austrian economists argue that additional kinds of state intervention distort the natural order and regularly lead to unintended negative consequences.

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