12.1 The foundations of Austrian economics
4 min read•august 9, 2024
The , founded by in the late 19th century, revolutionized economic thought. It introduced the and emphasized individual in economic analysis, challenging classical economics' labor theory of value.
Key figures like expanded Austrian theory, developing as a unique methodological approach. This school's focus on and subjective value theory laid the groundwork for understanding , , and in economics.
Key Figures and Concepts
Founders and Core Principles of Austrian Economics
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- Carl Menger established Austrian School of Economics in late 19th century
- Published "" in 1871
- Introduced subjective theory of value
- Emphasized importance of individual human action in economic analysis
- Ludwig von Mises expanded Austrian economic theory in 20th century
- Wrote influential works like "Human Action" and ""
- Developed praxeology as a methodological approach to economics
- Methodological individualism forms foundation of Austrian economic analysis
- Focuses on individual human actions as basis for understanding economic phenomena
- Rejects aggregate or collective decision-making models
- Emphasizes importance of individual preferences and choices in shaping economic outcomes
- Praxeology serves as the distinctive methodology of Austrian economics
- Studies human action and decision-making
- Based on the axiom that individuals act purposefully to achieve their goals
- Employs logical deduction rather than empirical observation to derive economic principles
- Contrasts with mainstream economics' reliance on mathematical models and statistical analysis
Contributions to Economic Thought
- Carl Menger's work challenged classical economics' labor theory of value
- Introduced concept of
- Explained how individuals subjectively value goods based on their needs and preferences
- Ludwig von Mises developed monetary theory and
- Argued against socialist economic calculation
- Emphasized role of in market processes
- Methodological individualism influenced other schools of economic thought
- Impacted development of public choice theory (James Buchanan)
- Influenced new institutional economics (Ronald Coase)
- Praxeology provided framework for analyzing economic phenomena
- Applied to areas such as monetary theory, capital theory, and entrepreneurship
- Emphasized importance of time and uncertainty in economic decision-making
Value and Utility Theory
Subjective Theory of Value
- Subjective theory of value posits that value derives from individual preferences
- Rejects objective or intrinsic value theories (labor theory of value)
- Explains why same good can have different values for different individuals
- Value determined by marginal utility an individual derives from a good
- Depends on personal circumstances, needs, and desires
- Accounts for changing valuations over time as circumstances change
- Subjective value theory explains market prices and exchange ratios
- Prices emerge from interactions of subjective valuations of buyers and sellers
- Facilitates voluntary exchanges that benefit both parties
- Theory applies to both consumer goods and factors of production
- Explains why land, labor, and capital have value in production processes
- Accounts for differences in factor prices across industries and regions
Marginal Utility and Time Preference
- Marginal utility refers to additional satisfaction from consuming one more unit of a good
- Diminishes with increased consumption (law of diminishing marginal utility)
- Explains why water is cheap despite being essential, while diamonds are expensive
- Marginal utility determines consumer choices and market demand
- Consumers allocate resources to maximize overall utility
- Leads to equimarginal principle: equal marginal utility per dollar spent across goods
- reflects individuals' valuation of present vs. future consumption
- People generally prefer present goods to future goods of equal quality
- Explains existence of interest rates and intertemporal decision-making
- Time preference influences savings, investment, and capital formation
- Lower time preference leads to more saving and investment
- Higher time preference results in greater present consumption and less capital accumulation
Capital and Spontaneous Order
Capital Theory and Structure of Production
- Capital theory in Austrian economics emphasizes heterogeneity of capital goods
- Rejects notion of homogeneous "K" in production functions
- Recognizes specific purposes and complementarities of capital goods
- Capital structure consists of multiple stages of production
- Earlier stages (mining, refining) further from final consumer goods
- Later stages (retail, distribution) closer to final consumer goods
- Time plays crucial role in capital theory
- Production processes take time, involving opportunity costs
- Interest rates coordinate intertemporal production plans
- Capital theory explains business cycles and malinvestment
- Artificial credit expansion leads to unsustainable lengthening of production structure
- Results in boom-bust cycles as malinvestments are liquidated
Spontaneous Order and Market Processes
- Spontaneous order describes complex social patterns arising from individual actions
- Not result of central planning or design
- Emerges from decentralized decision-making of countless individuals
- Market prices serve as key mechanism for coordinating spontaneous order
- Convey information about relative scarcities and consumer preferences
- Guide resource allocation without need for central planning
- Entrepreneurship plays vital role in discovering and exploiting market opportunities
- Entrepreneurs act on price discrepancies and anticipated future conditions
- Drives innovation and economic progress through creative destruction
- Spontaneous order extends beyond economic realm
- Applies to language evolution, common law development, and social norms
- Highlights limitations of top-down social engineering and central planning
Key Terms to Review (19)
Austrian School of Economics: The Austrian School of Economics is a school of thought that emphasizes the importance of individual action, subjectivism, and the role of entrepreneurship in economic theory. It originated in the late 19th century and is known for its critique of mainstream economic theories, particularly regarding market dynamics and the effects of government intervention.
Business cycle theory: Business cycle theory examines the fluctuations in economic activity that an economy experiences over time, typically characterized by periods of expansion and contraction. This theory seeks to understand the causes and effects of these cycles, particularly how various economic factors interact to influence overall economic performance, and it plays a critical role in explaining the dynamics of markets and economies.
Capital structure: Capital structure refers to the way a company finances its overall operations and growth by using different sources of funds, including debt, equity, and hybrid instruments. The balance between these sources is crucial as it impacts the company's risk profile, cost of capital, and overall financial health. A well-defined capital structure aligns with the principles of Austrian economics, emphasizing individual choice and market processes in determining how resources are allocated and utilized within the economy.
Carl Menger: Carl Menger was an Austrian economist and the founder of the Austrian School of Economics, known for developing the theory of marginal utility which revolutionized economic thought. His work laid the groundwork for the Marginal Revolution alongside contemporaries like Jevons and Walras, emphasizing the importance of individual choice and subjective value in understanding economic phenomena.
Dispersed knowledge: Dispersed knowledge refers to the concept that knowledge is not centralized or owned by any single individual or organization but is instead spread across various people and locations. This idea emphasizes that individuals possess unique information based on their experiences and local conditions, making it difficult for any one entity to fully grasp all the relevant information necessary for effective decision-making in complex economic systems.
Entrepreneurship: Entrepreneurship is the process of designing, launching, and running a new business, typically with an innovative idea or product. It involves taking risks to create value and drive economic growth, often leading to the development of new markets and job creation. Entrepreneurs are essential for fostering competition and efficiency in the economy, making them pivotal during the rise of capitalism and market economies, as well as in the theoretical framework of Austrian economics.
Human action: Human action refers to the purposeful behavior of individuals that reflects their choices and decisions in the pursuit of goals. This concept is foundational to understanding economic behavior as it highlights the role of individual agency in shaping economic outcomes and market dynamics. By emphasizing human action, it underscores the importance of subjective values, preferences, and the decision-making process in economic theory.
Knowledge problem: The knowledge problem refers to the difficulty in acquiring, processing, and utilizing information necessary for effective economic decision-making. It emphasizes that centralized planning cannot replicate the decentralized knowledge dispersed among individuals in an economy, which is crucial for efficiently allocating resources and responding to changing conditions.
Ludwig von Mises: Ludwig von Mises was an influential Austrian economist and philosopher known for his work in the development of the Austrian School of economics, particularly his contributions to praxeology and the critique of socialism. He laid the groundwork for understanding economic behavior through individual action, emphasizing the role of subjective value and the limitations of government intervention in the economy. His ideas on the business cycle further established a framework for understanding economic fluctuations, especially in the context of monetary policy.
Marginal utility: Marginal utility refers to the additional satisfaction or benefit that a consumer derives from consuming one more unit of a good or service. This concept is central to understanding consumer behavior, as it illustrates how individuals make decisions based on the incremental benefits gained from each additional unit consumed. It helps explain the law of diminishing returns, where the satisfaction gained from each additional unit tends to decrease as consumption increases.
Market processes: Market processes refer to the dynamic interactions between buyers and sellers in a marketplace, leading to the formation of prices and allocation of resources based on supply and demand. These processes are essential for understanding how economic activity is coordinated in decentralized economies and highlight the importance of individual choices and preferences in shaping market outcomes. Through competition and voluntary exchange, market processes facilitate the efficient distribution of goods and services.
Methodological individualism: Methodological individualism is the principle that social phenomena can be explained by analyzing the actions and decisions of individual agents. This concept emphasizes that collective behaviors and outcomes are ultimately grounded in the choices made by individuals, which serves as a fundamental approach in economic and social sciences. It supports the idea that understanding individuals' motivations and preferences is crucial for studying broader social dynamics, including economic theories and historical contexts.
Praxeology: Praxeology is the study of human action and decision-making, focusing on the logical implications of choices made by individuals. It emphasizes that all economic phenomena arise from purposeful actions, which are driven by individual preferences and goals. This concept forms a foundational element of Austrian economics, as it shifts the focus from mathematical models to understanding human behavior in economic contexts.
Principles of economics: Principles of economics refer to the fundamental concepts and theories that explain how economies function, including how resources are allocated, goods and services are produced, and markets operate. These principles help to understand the decision-making processes of individuals, businesses, and governments. Key elements include supply and demand, opportunity cost, and market equilibrium, which are crucial for analyzing economic behavior and policy implications.
Socialism as a calculation problem: Socialism as a calculation problem refers to the critique that centrally planned economies struggle to allocate resources efficiently due to the absence of price signals generated by free markets. This concept argues that without the price mechanism, planners lack the necessary information to make informed economic decisions, leading to misallocation of resources and inefficiencies. It emphasizes the importance of individual preferences and decentralized decision-making in achieving economic coordination.
Spontaneous order: Spontaneous order refers to the natural emergence of order in a society or economy through the voluntary actions of individuals rather than through central planning or coercion. This concept emphasizes how individual decisions, based on personal knowledge and circumstances, can lead to organized patterns and systems that are more efficient and adaptable than those created by top-down interventions. The idea highlights the importance of decentralized processes in economic activity and social interactions.
Subjective theory of value: The subjective theory of value posits that the worth of a good or service is determined by the preferences and individual valuations of consumers rather than any intrinsic properties or labor inputs. This perspective emphasizes that value is not inherent but rather shaped by personal perceptions, scarcity, and the context in which goods are evaluated, making it a cornerstone of Austrian economics.
Theory of money and credit: The theory of money and credit is an economic framework that examines the role of money in facilitating trade and the function of credit in the economy. It emphasizes how the supply of money and the availability of credit influence economic activity, including production, consumption, and investment decisions. This theory is essential in understanding monetary dynamics, including inflation, interest rates, and the overall functioning of markets within the Austrian economic perspective.
Time preference: Time preference is the concept that reflects an individual's or society's valuation of present goods over future goods, indicating how much people prefer to consume or enjoy something now rather than later. This idea highlights the inherent trade-offs between immediate satisfaction and delayed gratification, influencing decision-making, savings behavior, and investment choices in an economic context.