Austrian Economics, by Deborah L. Walker: The Concise Encyclopedia of Economics

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.

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.

Austrian Economics

History

The Cornerstones

Policy Implications

Conclusion