Econ 1b, Foldvary

The Austrian School of Economics

            The Austrian school originated in Austria, but is now world-wide.

            The dominant school of thought today is the neo-classical school, which developed in the late 1800s from the classical school.

            The Austrian school began in 1871 with the publication of Principles of Economics by Carl Menger, founder of that school of thought.

            Austrian-school economists introduced some concepts that became part of neoclassical theory, but some Austrian theory has not been assimilated, and that is the theory which we will study in this class.

            Austrian-school theory is also called market-process theory because Austrian economics emphasizes the dynamic movements of people changing in a market and changing the market rather than the neoclassical concept of an equilibrium where prices and quantities no longer change, and human beings have become abstracted away in supply and demand curves.

            The benefit of learning Market-Process theory is to have a more complete understanding of economics and the economy, which then helps you make better economic decisions.

            In the judgment of Austrian-school economists, we can’t really understand the market economy unless we include the dynamics explained by market-process theory.

            Another term for the market process is the spontaneous order,

in contrast with the designed order of an organization.

            What is “order”? What makes it different from chaos?

            Order is an environment in which a person can learn to form reliable expectations as to the elements of the system and their rates of change.

            An example of a spontaneous order is traffic in highways and streets.

            Another example is a skating rink.

            These exhibit an order that is not planned.

            “Spontaneous” means that each person acts on his own rather than taking orders.

            A symphony is a designed order; each musician follows the order of the score.

            But the music performances in some area during some time is spontaneous.


            The term “praxeology” was used by the Austrian economist Ludwig von Mises as a label for a general theory of human action.

            The methodology of praxeology is deductive logic, based on the concept of human action.

            The deductive method derives propositions from axioms, premises which themselves are not derived from other propositions.

            The derived propositions become pure theory which applies to all human action regardless of culture, time, and place.

            For example, the law of demand is pure theory, derived using deduction.

            Axiomatic-deductive propositions are the foundation of economic thought.

            Pure economic theory is derived from these axioms.

            Specific and applied theory is in turn derived using pure theory.

            Human action

            Ludwig von Mises regarded human action as the most important basis for praxeology.

            Human action consists of purposeful and willful activities performed by persons,

consisting of means to achieve ends.

            Action is the purposeful pursuit of ends.

            A person’s subjective values are and ends are the basis for all human action.

            The desire to achieve an end motivates action.

            Action involves gains and costs.

            The actor imagines options that remove uneasiness or improve his condition.

            Uneasiness is the feeling of having less utility than one would have if one’s goals were achieved.

            An economic actor chooses the option that in his judgment has the greatest expected net gain (benefit minus cost), based on the rankings of his subjective values and ends.

            People generally seek to first satisfy their highest ranked end, then the lower ones.

            For example, if you only had a little bit of water, you would use it for drinking rather than for bathing or watering your lawn.

            Human action economizes, seeking to maximize gains or minimize costs.

            The reason people economize is because of scarce resources and uncertainty.

            Most importantly, time is a scarce resource.

            The means used to satisfy ends involve goods, time, and people.

            Economics is basically the study of these means.

            What makes it possible to study economics is that human action can be meaningfully interpreted by other people, since we have many similar ends and wants.

            Praxeology “consists of the elaboration of the logical implications of the concept of action”.

            Pure economic theory is a subset of praxeology. Other intersecting sets include psychology, sociology, and political science.

            Praxeology begins by analyzing the action of an individual, and then analyzes the interaction of individuals, as with exchange.

            Examples of pure economic theory deduced from axioms include the law of demand, the law of comparative advantage, and the theorem in welfare economics that the unhampered competitive market maximizes social well being.

Methodological individualism

            The method of analysis of market-process theory is methodological individualism.

            With MI, the foundational unit of economic analysis is the individual human being.

            The alternative method is methodological holism, where the analysis is based on looking at an economy or society as a whole, with an independent status, or using concepts such as culture as prior to individuals.

            Some writers use expressions that are holistic, such as that “society prefers” something or that some country seeks to do something.

            Those who use methodological individualism should seek to avoid such confusions.

            The methodology of scholarly neoclassical economics is mathematics, with the view that if a set of propositions cannot be expressed in mathematics, they do not constitute theory.

            In neoclassical economics, “rigor” means mathematical.


            Methodological individualism places the individual person at the foundation of economic theory.

            The rationale is that all action is individual.

            All thinking and feeling are individual.

            We are economically and socially interdependent, but our minds are distinct and independent.


            Every exchange involves trading a good with less subjective value for one with greater subjective value.

            Equilibration is the exhaustion of grains from trade.

            Prices and quantities move towards an equilibrium as shortages and surpluses get eliminated, but in a changing world, markets are also constantly in disequilibrium.

            Having won the intellectual battle with historicism, Austrian economists next confronted the doctrines of Marxists and other socialists.

            This has been called the “calculation debate.”

            Statist socialists claimed that central planning was more effective than markets.

            Austrians, mainly Ludwig von Mises and Friedrich Hayek, argued that if the world were socialist, the economy would be hopelessly inefficient.

            Mises argued that efficient production requires economic calculation, with prices that reflect scarcity and values. Profit and loss lead entrepreneurs to produced goods most valued by consumers. With central planning, there is no way to measure scarcity and valuations.

            Hayek emphasized the decentralized nature of knowledge.

            Central planners lack the knowledge needed for effective central planning.

            Also, it makes no sense to measure social efficiency against the standard of complete information and an unrealistic absence of pricing power.

            Later, Austrian economists confronted the Keynesian school, with its doctrine of intervention and market failure.

            Austrian economics came to be regarded as a free-market school. Although there is no inherent ideology in Austrian economics, there is a strong connection between Austrian and freedom-oriented thought.

            Austrian economists regard gaps in coordination not as failures but either as inevitable costs or else opportunities for entrepreneurial profit, if government does not interfere.

Capital goods and the business cycle

In Austrian theory, capital goods have a time structure.
Lower-order goods circulate quickly, have a short time duration, like inventory.
Higher-order goods have a long duration or period of production.
Low interest rates increase investment in higher order capital goods, like real estate construction.
High interest rates flatten the structure, with less investment in long-lasting capital goods.
When interest rates get pushed down by monetary policy, the time structure flattens, and there is too much investment in real estate construction,
and too much speculation in rising land value.
That results in a recession and financial crash.
The Austrian remedy is "free banking," letting the market set the money supply and interest rates.