ECON 307 - Outline Eighteen

Carl Menger and His Followers - The Major Contributions of the Austrian School

What are the major cornerstones of the Austrian School?

    Subjectivism, Individualism, Uncertainty (emphasis on knowledge), Processes vs. End States (change)

Because of the emphasis on these cornerstones:  METHODOLOGY:  Why are they "radical" - not in the mainstream?

1.  Methodological individualism:

            Only individuals act -- and we study human action as economists.  Only individuals have purposes.

Purposeful human action -- individuals act purposefully.  They act to remove a "felt uneasiness" (von Mises).

2.  Methodological subjectivism:

            Individual's values, knowledge and understanding of history, of the physical world and the way it works, expectations, plans of action, etc. are the individual's own and may be and often are different from those of others.

Individuals respond to incentives based upon their own subjective values, tastes, knowledge, etc.

Individual value, therefore, cannot be measured!  Not only is value subjective to the individual, what an individual values today, he or she might not value tomorrow.

So people basically value something because it can meet an end for that individual.  One does not value a piece of bread for its own sake, a person values it because the bread can fulfill an end (such as "remove hunger" ).

So market prices reflect the values that people have relative to the scarcity (or availability) of a good.  As we have seen, this is what Carl Menger added in the 1870s -- market prices were finally understood.

3.  Emphasis on Uncertainty (as the world really is):

            And individuals act in the world of uncertainty.  That is why institutions that decrease uncertainty are so important.

    So what is relevant to an individual's action and to another individual's understanding of that action is not the physical reality surrounding the actor and the action, but the subjective perceptions of that reality.

So human beings act purposefully - they wish to attain ends or goals.  Since they wish to attain these goals, they must be valuable to them; accordingly they must have values that govern choices.  And again, these values are subjective to the individual.

Therefore, Austrian economists do not "assume away" uncertainty and instead assume perfect knowledge (as many mainstream models do).

4.  Processes vs. End States

All action in the real world, furthermore, must take place through time; all action takes place in some present and is directed toward the future (immediate or remote) attainment of an end. If all of a person's desires could be instantaneously realized, there would be no reason for him to act at all - and all action would stop. 

But this is not the case -- action continues - change takes place.

The emphasis on these cornerstones is why Austrian economist not limit themselves to mathematics in trying to understand social phenomena.

Math cannot capture a) subjectivism, b) change, c) uncertainty as it is demonstrated through purposeful human action of individuals.

It is hard to pull out just a few of the major contributions (commentary) - but let's start with capital theory.

1.  Austrian Capital Theory:

Here we have to start with Eugen von Boehm-Bawerk (1851-1914):

Boehm-Bawerk read Menger's Principles as a student, and though he never studied under Menger, he quickly became an adherent of his theories.

His main contributions:

1.      Time Preferences:  In this work, Natural Value, Boehm-Bawerk built upon the time-preference ideas of Carl Menger, insisting that there is always a difference in value between present goods and future goods of equal quality, quantity, and form. Furthermore, the value of future goods diminishes as the length of time necessary for their completion increases. So people prefer something today vs. tomorrow generally speaking.

Boehm-Bawerk cited three reasons for this difference in value.

a.       First of all, in a growing economy, the supply of goods will always be larger in the future than it is in the present.

b.      Secondly, people have a tendency to underestimate their future needs due to carelessness and shortsightedness.

c.       Finally, entrepreneurs would rather initiate production with goods presently available, instead of waiting for future goods and delaying production.

2.    Diminishing Marginal Utility and Time Preferences:  related to the time preferences issue, in Capital and Interest Bohm-Bawerk discusses the famous example of the pioneer farmer faced with decisions about the allocation of his sacks of grain among the various uses-as basic feed for himself, his chickens and his parrots, and as an ingredient for making brandy. The essence of Austrian (Menger’s) marginalism is conveyed with his telling the story of what would happen if the farmer were to suffer the loss of one sack of grain (poor parrots). Time preferences will also play a role in forming the marginal utility (what people will choose to do without as something becomes more scarce).  This story and many variations on it, told many times by textbook writers over the decades since, stand in contrast to the twice-differentiable total-utility functions that evolved from William Stanley Jevons' marginalism and the general-equilibrium equations that dominate in Leon Walras'. 

3.    Exploitation Theory Critiqued: Most significant in this early work, and also related to his emphasis on time, is his devastating critique of the exploitation theory, as espoused by Karl Marx and the Socialists we talked about earlier.  According to Bohm-Bawerk, capitalists do not exploit workers; they accommodate workers-by providing them with income well in advance of the revenue from the output they helped to produce. He asked:  "Is there any justification for the payment of interest to the owners of capital?" The justification, in his view, rests on his time preference theory – a simple fact of reality to him: people value present goods more highly than future goods of the same quantity and quality. Future goods trade at a discount, or alternatively, present goods trade at a premium. The payment of interest is a direct reflection of this intertemporal (through time) value differential.  This interest, paid to capitalists, allows workers to receive income on a more timely basis than would otherwise be possible.  In other words, workers get paid a defined wage today, whereas the capitalist must wait until the product is sold, and also must bear the uncertainty of what it sells for in order to earn anything.

4.    The Time Structure of Production:  Also related to 1-3, Böhm-Bawerk introduced his bull's-eye figure-a pattern of concentric rings intended to depict the time-structure of production. Production begins in the center with the use of the original means (land and labor); the process emanates outward over time; and the final product emerges at the outermost ring to satisfy the consumers' ultimate ends. Two bull's eye figures appearing on consecutive pages are used to contrast a well-developed economy with a less-well-developed one. This depiction can be seen as a forerunner of the more straightforward representation of the means-ends framework introduced by F. A. Hayek.  The Hayekian triangle, which is divided along the time axis into "stages of production," corresponds closely with the bull's eye figure, which is divided along the radius into "maturity classes."  Maturity reflecting different stages in the production process – each entering the picture at different times.  The question is: how do we coordinate these stages through time?

Though static by its very construction, the bull's-eye figure, as well as the better known Hayekian triangle, is intended to facilitate the analysis of change.

Hayek used this to form the Hayekian triangle:

Lengthening of the Capital Structure or "Roundaboutness": (Higher and Lower order goods):

The message is clear: An expansion of the capital structure is not to be viewed as a simultaneous and equiproportional increase in capital in each of the maturity classes; it is to be viewed as a reallocation of capital among the maturity classes. Overlooked by his predecessors and largely ignored by the modern mainstream, this is the market mechanism that keeps the economy's intertemporal production plans in line with the intertemporal preferences of consumers. The significance of this market mechanism was at issue in his debate with John B. Clark, who held that once capital is in place, the maintenance of capital is automatic and that production and consumption are, in effect, simultaneous.

So for Austrian economists:

Capital is a structure (capital must "fit" together -- through time and with the representation of consumer preferences).  This all relates to interest rates and time preferences.

Hayek, of course also added the element how the rules of the game change or create the capital structure.  These rules include laws - but also culture.  Therefore, capital from one economy is not necessarily going to work in another country.  And in fact, can do more harm than good.

2.  Economic Calculation:  Most especially Mises -- then followed up by Hayek.

Is Socialism Possible?

Remember first the definition of socialism (which is why this term is used quite frequently in this discussion):

Prior to Mises raising the calculation problem in 1920, the critics of socialism concentrated on the incentive problem:

According to many socialists – the problem was due to the fact that man’s nature had been formed and could be changed:

Although Mises talked about the incentive issue – that was not his main point.

What Mises did was to say, OK, assume there is no incentive problem (we have all become the “socialism man”) – if that is the case, then will socialism be a successful economic system.  His answer was “no.”

Let’s look at his famous writing, “Economic Calculation in the Socialist Commonwealth” (1920):

Mises first talked about:

People usually talk about the distribution of consumption goods in the Socialist Commonwealth.

Who is to do the consuming and what is to be consumed by each?  Socialists emphasize equality in terms of consumer goods – we all have the same “equal” distribution.

But, Mises said, this is of secondary importance.  Can have exchange among consumption goods under socialism within the narrow limits permitted. 

But the major problem is that no production goods will ever be exchanged and therefore it will be impossible to determine their monetary value.

If we can’t determine that – then the consumer goods to be distributed will be few (there is no way of “economizing” on the use of resources and determined haphazardly by planners – have nothing to do with the wants of the people.)

Money could never fill in a socialist state the role it fills in a competitive society in determining the value of production goods.  Calculation in terms of money will be impossible.

Hence—it then becomes “impossible in any socialist state to posit a connection between the significance to the community of any type of labor and the apportionment of the yield of the communal process of production.”

So remember – labor is included here!  What should people do?  What should they train to become? There are no answers in socialism.

The Limits of Monetary Calculations

1.       Money is no yard-stick of value!  Value is not measured in money, nor is price.  They merely consist in money.

Money as an economic good is not a stable value – its value is determined by S & D like any other commodity and subject to diminishing marginal utility.

 But these fluctuations are comparatively trivial in regard to its exchange –relations.

(with “good” money)

2.       Monetary value does not include value outside of exchange relations.

Money is the common denominator that makes valuation comparisons possible –

For example:  A resource is “worth” this much (say $100,000) in market A and this much (say $200,000) in market B – it is comparable.  But these prices only arise out of exchange.

The human mind cannot orientate itself properly among the bewildering mass of intermediate products and potentialities of production.  We must have some “aid to the human mind” for deciding where resources should go. 

And in order to gain this “aid” – we need exchange – which means we need private property rights in the means of production!

With private property everybody is a consumer and everybody a producer … and thereby resources flow in economically “correct” directions.  Correct meaning – towards more highly valued uses, not wasted.

A socialist economy will have to be a static economy.

There is only groping in the dark!  There is no trial and error.  There is no entrepreneurial discovery!

Conclusion

So Mises concludes that in order to have a successful economy (where the basic necessities of life are met), we must have:

Economic Calculation:  “the decision-making ability to allocate scarce capital resources among competing uses.”

My friend Pete Boettke sums in up this way (quote):

1.       Without private property rights in the means of production, there will be no market for the means of production.

2.       Without a market for a means of production, there will be no monetary prices established for the means of production.

3.       Without monetary prices, reflecting the relative scarcity of capital goods, economic decision makers will be unable to rationally calculate the alternative uses of capital goods.

Mises (from Human Action):  “Every single step of entrepreneurial activities is subject to scrutiny by monetary calculation.  The premeditation of planned action becomes commercial precalculation of expected costs and expected proceeds.  The retrospective establishment of the outcome of past action becomes accounting profits and losses.”

So market prices in capital goods (which we have already learned reflect the subjective value of individual consumers) – determine the potential costs of production – which then determine if a profit will be made or not.

Example:  Under socialism – imagine this scenario:  the government owns all means of production.  So it owns a plant that makes hamburger patties.  It also owns the ranches that produce the cows, the truck company that transports the meat, etc.

The “planners” are trying to decide if this is the best use of this plant - the best use of the trucks, of the land that houses the cow ranch.  All they can do is guess.  So therefore, they make hamburgers that nobody wants, and they don’t make hot dogs that a lot of people want.  They use these capital goods in unproductive ways – ways that waste resources.  Even to the point of not being able to meet the basic necessities of life.

So this argument by Mises lead to The Economic Calculation Debate

F. A. Hayek (1899-1992) vs. J. M. Keynes (1883-1946)