What’s it: the Austrian school of economics emphasizes individualism, subjectivism, opportunity costs, and time preference in consumption and investment.
Austrian economists used logical and deductive reasoning. They view the subjective value of economic agents as the ultimate cause of all economic outcomes. They share views with neoclassical schools but focus more on money and government.
Also called the Austrian School.
Austrian economists believe economics is an apriori discipline. Economic phenomena can be explained through reasoning or knowledge resulting from theoretical deduction rather than observation or experience.
Knowledge and beliefs determine individual judgment and choices. The consequences of each choice affect various economic phenomena. Therefore, to explain this phenomenon, economists should dig deeper into such judgments and choices rather than observations, hypotheses, and models.
Thoughts of the Austrian School of Economics
In this article, I will write some of the critical contributions of the Austrian school of economics, such as:
- Price and utility
- Opportunity cost
- Interest rates and prices for capital goods
Price and marginal utility
Austrian economists view the economic value of goods and services as subjective. It is not only for the goods and services you consume but also for production inputs, such as capital goods and raw materials.
A valuable item for you, but not for your colleagues. Such subjective judgments determine the demand for and prices for goods and services. When consumers perceive an item to be of low value, they buy less, and therefore, the price should be low.
This view contrasts with classical economists who view prices as a function of the cost of production.
Likewise, neoclassical economists view prices as dependent on the forces of supply and demand in the market. The two forces interact and determine the equilibrium price.
Then, the Austrian School views that as the quantity of goods increases, each additional goods’ subjective value decreases. This concept is the basis for the diminishing marginal utility.
Ludwig von Mises later used it to explain monetary phenomena. As the amount of money increases, its value decreases further.
Opportunity cost represents the next alternative you sacrifice when making choices and decisions. Individuals use an assessment of each economic activity choice’s subjectivity, both in consumption, investment, and production. When choosing one, these subjective judgments lead them to make the best choice, measured in terms of the next best alternative’s value.
Interest rates and capital prices
Eugen Böhm von Bawerk developed the Austrian economic idea of interest rates. According to him, time preference is a determining factor for interest rates. Subjective decisions guide individuals when they should spend money, whether now or in the future.
If individuals prefer to spend money in the future, they will save it. That leads to an increase in the saving rate and a decrease in interest rates in the economy. As a result, the economy provides more wealth for new business projects.
Furthermore, Böhm-Bawerk stated, the value of the future productivity of capital goods determines their price. Therefore, to calculate their current price, we discount them at the interest rate. The future productive value follows a subjective consideration of time preference, determining the supply and demand for capital goods.
Austrian economists explain the inflation phenomenon through the concept of diminishing marginal utility. As the money supply increases, its value decreases further.
Initially, the additional supply can fulfill several essential purposes. However, the next extra supply serves only less essential purposes. The situation lasts for each additional supply of money. Thus, if the money supply continues to grow, the value of money will decrease even further.
Austrian School beliefs about business cycles
Austrian economists believe that misguided government intervention leads to a business cycle. To encourage economic growth, the government cut interest rates to an artificially lower level. Too-low interest rates cause the company to accumulate too much equipment. It shifts aggregate demand to the right and creates an inflation gap in the economy.
Once companies realize they have spent too much money, they will suddenly stop investing. A sudden drop in investment spending suppresses aggregate demand. It dramatically shifts the aggregate demand curve to the left. This situation then caused a contraction throughout the economy.
In conclusion, government intervention causes booms and busts in the economy. To return the economy to a new equilibrium, Austrian economists argue that all prices, including wages, must fall. To avoid the boom-and-bust cycle, Austrian economists, therefore, saw no need for government intervention.
Different views of the Austrian School of Economics and the Neoclassical School
The Austrian and the Chicago or neoclassical school of economics share in common regarding government intervention. Both emphasized the free market and saw government intervention would only lead to nothing better. However, in several other aspects, the two schools of thought are entirely different.
In the view of Neoclassical thought, money was unnecessary. Because, to reach general equilibrium, the exchange of goods and services can take place through bartering. Also, the government’s role does not exist because the economy can go to a new equilibrium on its own.
Neoclassical economists do not have a theory related to the business cycle. They only cite Schumpeter’s creative destruction theory as the source of the cycle.
In contrast, Austrian economists viewed misguided government intervention as defining the business cycle. During an economic downturn, the government can influence the economy by adopting an expansionary monetary policy.
Interventions can lead to unbalanced savings and investment, which results in investment projects being misdirected and ultimately proving unsustainable. Thus, Austrian economists viewed government intervention as unnecessary.
Criticisms of the Austrian school’s business cycle beliefs
First, the business cycle occurs due to shocks from the demand side and supply-side shocks. Short-run aggregate supply shocks can cause the economy to fluctuate around its potential output.
The stagflation during the 1970s is an example of aggregate supply-side shocks. The increase in oil prices increases the production costs of various industries. Because most industries use oil – from transportation to plastics – the price increases have triggered economic stagnation and soaring inflation in the United States.
Second, the Great Depression during the 1930s also refuted Austrian economic thoughts. Keynes’s views proved more effective in getting out of the situation. Keynes viewed the Depression as requiring government intervention because the economy would not return to equilibrium by itself.
In these situations, households and businesses are unwilling to increase consumption and investment. Their spending decisions depend on profit, income, and employment conditions, all of which correlate with economic conditions. Therefore, a possible alternative is through government spending.
Keynes views some government spending as discretionary policies. It does not depend on economic conditions but on government policy.
Famous economist of the Austrian school of economics
Austrian economics school began to develop in 1871 with the book Principles of Economics by Carl Menger. Eugen Böhm von Bawerk and Friedrich von Wieser then followed Menger’s contribution. These three are known as the first wave of the Austrian school of thought.
Eugen Böhm von Bawerk developed a capital theory using land and labor as the original production factors. His colleague, Friedrich von Wieser, later developed the imputation theory and the opportunity cost theory.
The following famous generations are Ludwig von Mises and Friedrich von Hayek. They share views on neoclassical school but focus on two main topics, namely money and government.
Ludwig von Mises then applied the marginal utility concept to money through his book Theory of Money and Credit (1912). He believed that the additional money supply would only decrease its value because money’s marginal utility decreased. Every extra money we can use for additional purposes, although less urgent than the previous goal.
Here are 10 essential books from Austrian economists, according to Econlib.org:
- Carl Menger, Principles of Economics, 1871.
- F. A. Hayek, Individualism and Economic Order, 1948 and Ludwig von Mises, Human Action, 1949.
- Israel Kirzner, Competition and Entrepreneurship, 1973.
- Lawrence H. White, Free Banking in Britain, 1984. Published with Cambridge
- Gerald P. O’Driscoll and Mario Rizzo, The Economics of Time and Ignorance, 1985.
- Don Lavoie, Rivalry and Central Planning, 1985.
- Peter Lewin, Capital in Disequilibrium, 1999.
- Roger Garrison, Time and Money, 2001.
- Steven Horwitz, Microfoundations, and Macroeconomics: An Austrian Perspective, 2000.
Apart from these books, you can also find a wide variety of literature on the Austrian economist’s views at the Mises Institute. And one of the places to study Austrian Economics is George Mason University.