An Introduction to Austrian Economics

The history of economic thought, like that of other disciplines, reveals a mixture of systems of thought that have been separated into particular schools of ideas. This method of categorizing the ideas of different thinkers concentrates on the likenesses of certain groups while overshadowing their differences. The French Physiocrats who rose to prominence during the second half of the eighteenth century represent the first modern school of economic thought. Classical economic thought, Marxism, and socialism subsequently followed. During the latter part of the nineteenth century there emerged in western Europe two clashing schools of economic thought: the German Historical school and the Austrian school. The German Historical school sought to discover economic truth through the study of economic history. In 1883 their empirical methodology became the target of the early Austrians, who maintained that economic knowledge arises from theoretical analysis and not from the study of history. For more than two decades, the Methodenstreit, or controversy over methods, persisted.

This monograph is an attempt to explain the essential ideas of the Austrian school, which began with Carl Menger, professor of political economy at the University of Vienna from 1873 to 1903. In 1871 in his Grundsatze der Volkswirtschaftslehre (Principles of Economics), Menger produced a theory of value that was to resolve the question that had so long perplexed the great classical economists. This theory was the subjective theory of value based on the principle of marginal utility.1 It dispelled the classical notion that the value of a thing is an objective measure intrinsic in the good itself. Economic goods were now seen to be valued subjectively in terms of the satisfaction that the user expects to derive from their incremental use. A more thorough treatment of the subjective theory of value, which was to become the foundation of the whole Austrian system, is presented in later sections. It remained for Menger’s two great disciples, Friedrich von Wieser and Eugen von Böhm-Bawerk, to refine the subjective theory and to clarify its full ramifications in the areas of cost and capital and interest theory.

Wieser expanded on Menger’s problem of imputation, which explained resource prices or costs as being derived from the expected prices of the consumer goods that the resources were used to produce. The formation of value was thus shown to be a circular process, and the concept of costs, a gap in Menger’s theory, was tied into the subjective theory of value. Wieser’s “law of cost” or doctrine of alternative costs held that the costs of producing a product reflect the competing offers of other producers for the resources used in production; costs are merely payments made necessary in order to attract resources away from their next most remunerative utilization.

Böhm-Bawerk’s great contribution was his theory of capital and interest. He emphasized the significance of time in the economic process and defined capital as the produced factors of production. The crucial idea in his analysis was that “roundabout” means of production enable humans to increase their productivity, both in terms of increased quantities of goods producible without equipment and tools and in terms of goods producible only through capital goods. The period of waiting resulting from the use of indirect processes provided the basis for his explanation of the phenomenon of interest. He argued that people value present goods more highly than future goods with similar characteristics, other things being equal. This assumption contained the basis for justifying the margin between selling price and costs, the margin that went to the capitalists who supplied the funds for intermediate products or capital goods. Their return was an interest payment for the period of time during which their investments had been used and was not an exploitation of the workers, as Marx had contended. Thus the subjective theory of value was expanded to include the time-preference principle. Although the Austrian theory of capital was somewhat revised, Böhm-Bawerk’s essential explanation of interest and the process of roundabout or indirect production has retained a dominant position in present-day Austrian theory.

Two important modern theorists in the Austrian school are Ludwig von Mises and Friedrich von Hayek. Mises received widespread attention from other economists in the 1920s with his challenge that socialism was totally impossible in a modern economy because of its lack of market prices, for him the indispensable means of rational resource allocation. Both Mises and Hayek have contributed significantly in molding the Austrian theory into an integrated whole. Their explanation of cyclical swings in business as resulting from uncontrolled credit expansion at the hands of government added another significant block to the Austrian structure. Hayek’s focus on the problem of “knowledge in society” and the vital need for coordinating the actions of interacting market participants has provided insights of crucial importance to the study of economics. This book will draw substantially from the ideas of Hayek and Mises, along with those of two students of Mises, Israel Kirzner and Murray Rothbard, both of whom have made significant contributions to the elucidation and elaboration of the Austrian analysis.

Although the Austrian school is no longer distinguished from other schools in its acceptance of the subjective theory of value, marked characteristics remain inherent in the Austrian approach to economic analysis that set it apart from others. One such characteristic is its rigid methodological position. Reference has been made already to the Methodenstreit that Menger initiated in a book published in 1883.2 Austrian economic analysis is carried out largely on the basis of theoretical, deductive reasoning; empiricism has little place in Austrian economic theory--thus their battle with the German Historical school. Economic phenomena, originating from a social environment, are deemed by the Austrians too complex and variable to permit the kind of experimental analysis that the physical scientists use. Accordingly, Austrian theory is opposed on methodological grounds to mathematics as a tool of economic analysis. Conceptual understanding, not quantitative relations, is seen as the only meaningful basis of economic science. Menger, the father of the Austrian school, insisted on and followed this qualitative orientation throughout his works, as did his successors.

The second important characteristic of Austrian theory is its methodological individualism. Austrians believe that economic phenomena are not the expression of some social force or hypostatized entity like “society.” Rather, they are the result of the conduct of individuals engaged in economic activity. The total economic process cannot be understood, therefore, except by analyzing its basic elements, the actions of individuals.

The Austrian analysis uses as its data human nature and the realities of the human predicament. Individual human values and human actions, amidst limited means including perceived knowledge, are placed at the center of economic science. The factors of human error, the uncertainty of the future, and the inescapable passage of time must receive their due attention. This analytical approach cuts through the seeming complexities of an advanced market economy and provides a basic understanding of the economic process by examining essential market elements. Dispelled is any mystique surrounding the economy, market prices, business profits and losses, interest rates, inflation, and economic recessions and depressions. These phenomena are not inexplicable nor without cause, as will be shown in subsequent sections.

This book, as its title indicates, presents an overview of basic Austrian theory. Its focus is on the free market or capitalist economy. The seminal works of the Austrian economists surely cannot be neglected for a deeper understanding of the topics herein discussed. These original works must be consulted, especially in order to obtain a thorough appreciation of the serious implications of governmental intervention into the market process, which is now rampant. Suggested readings for expanded understanding are provided at the end of each major section.

It is hoped that this book can serve as an effective introduction to the Austrian theory. (One can hardly avoid feeling some reluctance in using the term “Austrian economics” for fear of suggesting that it is perhaps something different from straightforward, sound economics.) The disarray of Keynesian economics, the bewildering artificiality of econometrics, the sad record of predictions by “professional” economists, unrealistic textbook models such as perfect competition and pure monopoly, persistent inflation and unemployment, and widespread politizations of economic interests have created a warranted distrust of all economic theory. Yet the Austrian analysis cannot be overlooked if a greater understanding of the market process and the effects of interferences with its operation is to be achieved. The book should prove useful as a supplement in a course in economic theory or a course in the history of economic thought at either the undergraduate or graduate level.

• 1The history of economic thought now credits Menger, William Stanley Jevons, an English economist, and Leon Walras, a French economist, with having established independently the subjective theory of value at roughly the same time. See Mark Blaug, Economic Theory in Retrospect (Homewood: Richard D. Irwin, Inc., 1962), pp. 272-73.
• 2Now translated into English as Problems of Economics and Sociology (Urbana: University of Illinois Press, 1963).