Kirzner on the Law of Supply and Demand in Austrian Economics

Israel M. Kirzner’s Austrian analysis of the law of supply and demand and prices can be found in these short articles:

Kirzner, Israel M. 2000. “The Law of Supply and Demand,” The Freeman, January 1
http://www.fee.org/the_freeman/detail/the-law-of-supply-and-demand#axzz2rJCWXRKy

Kirzner, Israel M. 2000. “Entrepreneurial Discovery and the Law of Supply and Demand,” February 1, 2000
http://www.fee.org/the_freeman/detail/entrepreneurial-discovery-and-the-law-of-supply-and-demand#axzz2rJCWXRKy

Kirzner, Israel M. 2000. “The Irresistible Force of Market Competition,” March 1, 2000 http://www.fee.org/the_freeman/detail/the-irresistible-force-of-market-competition#axzz2rJCWXRKy

Kirzner, Israel M. 2000. “Toward an Austrian Critique of Governmental Economic Policy,” April 1
http://www.fee.org/the_freeman/detail/toward-an-austrian-critique-of-governmental-economic-policy#axzz2rJCWXRKy

First Kirzner notes,

“The basic insight underlying the law of supply and demand is that at any given moment a price that is ‘too high’ will leave disappointed would-be sellers with unsold goods, while a price that is ‘too low’ will leave disappointed would-be buyers without the goods they wish to buy. There exists a ‘right’ price, at which all those who wish to buy can find sellers willing to sell and all those who wish to sell can find buyers willing to buy. This ‘right’ price is therefore often called the ‘market-clearing price.’

Supply-and-demand theory revolves around the proposition that a free, competitive market does in fact successfully generate a powerful tendency toward the market-clearing price. This proposition is often seen as the most important implication of (and premise for) Adam Smith’s famed invisible hand. Without any conscious managing control, a market spontaneously generates a tendency toward the dovetailing of independently made decisions of buyers and sellers to ensure that each of their decisions fits with the decisions made by the other market participants. Were this tendency to be carried to the limit, no buyer (seller) would be misled so as to waste time attempting to buy (sell) at a price below (above) the market-clearing price. No buyer (seller) would in fact pay (receive) a price higher (lower) than necessary to elicit the agreement of his trading partner. To the extent that this proposition is valid, free competitive markets achieve what F. A. Hayek has justifiably called a ‘marvel.’ But it is in regard to the validity of this proposition (and in particular to our reasons for being convinced that this proposition is both valid and relevant) that Austrians differ sharply with mainstream textbook economics.”

Kirzner, Israel M. 2000. “The Law of Supply and Demand,” The Freeman, January 1
http://www.fee.org/the_freeman/detail/the-law-of-supply-and-demand#axzz2rJCWXRKy

So how does Austrian economics differ from mainstream neoclassical economics on this point?

As Kirzner points out, it differs in the following ways:

(1) Kirzner contends that neoclassical economics holds that market agents have “perfect knowledge,” while Austrians reject this and accept that agents have “imperfections in knowledge”:

“This conclusion is that in any free market, the market-clearing price is instantaneously (or, at least, very rapidly) established. If every market participant knows what every other market participant is prepared to do (including, especially, the quantity he is prepared to buy or sell at any given price), it follows that any price higher than the market-clearing price cannot emerge (since prospective sellers would realize that they would be left with unsold goods). It follows, similarly, that any price lower than the market-clearing price cannot emerge (since prospective buyers would realize that they will be left without the goods they wish to buy and for which they are in fact prepared to pay a higher price if necessary). The proposition that free-market prices are thus inevitably market-clearing prices proceeds inexorably from the belief that market prices are, in effect, instantaneously known to all potential market participants.

The assumption that all market participants are always fully aware of market opportunities in which they might be interested is often presented, in mainstream textbook expositions, as part of the assumption of so-called ‘perfect competition.’ Perfect competition explicitly presumes universal market omniscience. One way of expressing the Austrian unhappiness with the mainstream textbook treatment is to point out that to start supply-and-demand analysis by assuming that competition is ‘perfect’ (in the textbook sense) is not only to be wildly (and therefore unhelpfully) unrealistic.”

Kirzner, Israel M. 2000. “The Law of Supply and Demand,” The Freeman, January 1
http://www.fee.org/the_freeman/detail/the-law-of-supply-and-demand#axzz2rJCWXRKy

So Austrians reject the neoclassical unrealistic vision of “perfect knowledge” and “perfect competition.”

(2) But, for Austrians, while most prices are not market-clearing prices nor equilibrium prices (in the sense of being equal to marginal cost), nevertheless there exists a tendency for prices to move towards market clearing values (as also argued in Kirzner 1985: 205), and these movements towards the market clearing point are what supply and demand curves show:

“The core of the classroom analysis generally consists of discussion showing, first, that any market price higher than that indicated by the intersection of the two curves (that is, a price higher than the market-clearing price) must tend to produce competitive pressure toward a decrease in price (since the high price will generate a surplus of unsold merchandise); and second, that any market price lower than that indicated by the point of intersection must produce competitive pressure toward an increase in price (since the low price will generate a shortage of goods offered for sale, as compared with the quantities prospective buyers wish to buy).

Austrians do not have serious disagreement with such discussions in themselves; they simply point out that those discussions are utterly inconsistent with the assumption of perfect competition (which textbook analysis takes as its operative assumption). A little careful analysis of the perfect-competition assumption (which analysis can, however, unfortunately not be fitted into this space) suffices to show that under perfect competition there cannot in fact exist two curves (the demand curve intersecting with the supply curve). Under perfect competition the supply-and-demand diagram shrivels instantly to a single point—the point where the two curves would have intersected (had the curves themselves existed!). This is so because any point on a market supply curve or on a market demand curve that is not that intersection point can have analytical existence only by suspending some or all of the conditions that define the state of perfect competition. The diagram (valuable though it certainly is!) is simply not consistent with the assumed conditions under which it is supposed to be operating.”
Kirzner, Israel M. 2000. “The Law of Supply and Demand,” The Freeman, January 1
http://www.fee.org/the_freeman/detail/the-law-of-supply-and-demand#axzz2rJCWXRKy

So Austrians reject the Walrasian “perfect competition” model. This is confirmed by Kirzner in his other writings:

“the term ‘market-clearing price’ (a term not used by Mises) is used in standard economics to refer to the exhaustion of all mutually gainful exchange opportunities under the hypothetical conditions of (relevant) omniscience. Standard economics indeed notoriously proceeds, in applying supply and demand theory to the real world, to operate as if conditions of relevant omniscience can be taken as given. Mises is certainly not making any such assumption of omniscience. His market prices are certainly not ‘market clearing prices’ (in the usual sense of that term). There is, one is able to reassure the puzzled reader, therefore no contradiction in his exposition. Real world market prices are not the equilibrium prices of standard economic theory. (Real world prices relate to equilibrium only in a very narrow sense, a sense to which no attention at all is given in standard theory.) Real world prices are indeed likely to be ‘false’ prices, setting off entrepreneurial-competitive activity modifying the pattern of resource allocation. The real world pattern of resource allocation at any given moment can be described as optimal only relative to existing information in fact possessed by entrepreneurial market participants. The tension in Mises is quite imaginary; it is perceived—quite understandably and reasonably perceived—only as a result of reading Mises through the spectacles acquired in studying mainstream economics.” (Kirzner 2000: 168).

(3) Human beings as economic agents have imperfect knowledge and are imperfect themselves, given that they face uncertainty:

“For Mises, each human being is, in a very important sense, an entrepreneur. … And it is the entrepreneurial element in those decisions that is responsible, in the Austrian view, for that crucially important tendency toward market-clearing that (for Austrians as well as for non-Austrians) constitutes the heart of the law of supply and demand.

The Misesian notion of human action is significantly richer than the mainstream-economics notion of the economizing decision. An economizing decision is seen as the selection of the most desirable option out of an array of given alternatives with a given ranking of what is more desirable and less desirable. Since both the alternatives available and the ranking are already identified prior to the act of decision, such decision-making consists essentially of the solution to a mathematical maximization exercise; the outcome is predetermined: it is implicit in the given context within which the decision is to be made.

For Misesian human action, on the other hand, the action is, most importantly, seen as including the determination of both what the available alternatives are and what ranking of relative desirability is to be adopted. Determining these elements inevitably exposes the agent to the uncertainties of an open-ended future (in a sense absent in the context of the standard ‘economizing decision’): action is the present choice between future alternatives that must, in the face of the foggy uncertainty of the future, now be identified in the very act of choice. It is this aspect of human action that renders it, for Mises, essentially entrepreneurial. Mathematical expertise in solving maximization problems is of very limited help in choosing among courses of action when the very alternatives must be ‘created,’ as it were, by the agent’s entrepreneurial imagination and creativity, by his daring and boldness.”
Kirzner, Israel M. 2000. “Entrepreneurial Discovery and the Law of Supply and Demand,” February 1, 2000
http://www.fee.org/the_freeman/detail/entrepreneurial-discovery-and-the-law-of-supply-and-demand#axzz2rJCWXRKy

(4) For Austrians, arbitrage and alert entrepreneurs and their desire for profit create a tendency towards market clearing prices, even though real world prices will mostly be non-market clearing prices:

“For Austrians, the law of supply and demand is simply an insight into one particular (but central) element in this more comprehensive, dynamic, entrepreneur-driven market process. For any particular commodity, the market forces acting on the prices at which it will be bought and sold (and thus the market forces acting on the decisions made to produce and to buy it) tend to identify and exploit the opportunities (structured by the technology and the economics of its production on the one hand, and by the urgency with which potential consumers wish to consume it, on the other hand) and thus to ensure that the quantities which are simultaneously worthwhile for producers to produce and for consumers to buy will in fact tend to be produced, offered for sale, and purchased.

If, for example, current production of this commodity is ‘too low,’ this means that opportunities exist for additional units to be produced at an outlay below the highest price potential consumers would be prepared to pay; it is ‘worthwhile’ to produce these additional units. Entrepreneurial producers will tend to discover and act on such opportunities. If, on the other hand, current production is ‘too high,’ this means that the production outlay for at least some units exceeds the highest price potential consumers are prepared to pay for them; these units were produced as a result of entrepreneurial error. Entrepreneurial producers will tend to discover these (marginal) losses and cut back on production.

The entrepreneurial forces acting on the market for any one commodity are thus continually pushing that market toward the market-clearing point—that is, to where (a) the quantity produced is such that (only) all units ‘worth producing’ are indeed produced, and (b) the market price for this commodity is just high enough to make it, as a practical matter, worthwhile for producers to produce this quantity, and is just low enough to make it worthwhile for consumers to buy it.

Clearly, these forces would, were all other dynamic changes in market conditions to be suspended, tend to achieve exactly those outcomes identified, in more conventional mainstream formulations of the law of supply and demand, by the intersection of the supply curve and the demand curve. It is for this reason that we have described Austrian economics as basically in agreement with mainstream economics in its emphasis on the centrality of the law of supply and demand. It is worthwhile, however, briefly to ponder the sense in which the Austrian version of the ‘law’ avoids reliance on any presumption of universal perfect market knowledge (a presumption that, as seen in the preceding article, pervades much standard economics).”
Kirzner, Israel M. 2000. “Entrepreneurial Discovery and the Law of Supply and Demand,” February 1, 2000
http://www.fee.org/the_freeman/detail/entrepreneurial-discovery-and-the-law-of-supply-and-demand#axzz2rJCWXRKy

(5) Kirzner takes up Hayek’s theories and sees the movement towards supply and demand equilibrium via flexible prices as a “learning” process:

“As Austrian economist F. A. Hayek emphasized, the market process we have been describing in entrepreneurial terms can also usefully be understood in terms of learning. The process through which the market tends to generate the ‘right’ quantity of a commodity, and the ‘right’ price for it, can be seen as a series of steps during which market participants gradually tend to discover the gaps or errors in the information on which they had previously been basing their erroneous production and/or buying decisions. Buyers who had overestimated the willingness of producers to produce and sell the commodity had been ‘incorrectly’ refusing to offer higher prices (that they would indeed have been prepared to pay); those who had underestimated that willingness were ‘incorrectly’ offering higher prices than were in fact needed to inspire sellers to produce. Sellers who had overestimated the willingness of buyers to buy were ‘incorrectly’ asking higher prices (and were producing more units of the commodity than it was ‘really worthwhile’ to produce), and so on. The market process is one in which, driven by the entrepreneurial sense for grasping at pure profit opportunities (and for avoiding entrepreneurial losses), market participants, learning more accurate assessments of the attitudes of other market participants, tend toward the market-clearing price-quantity combination.”
Kirzner, Israel M. 2000. “Entrepreneurial Discovery and the Law of Supply and Demand,” February 1, 2000
http://www.fee.org/the_freeman/detail/entrepreneurial-discovery-and-the-law-of-supply-and-demand#axzz2rJCWXRKy

(6) And Austrians also have a different understanding of “competition”:

“Following a long tradition in economics going back at least to Adam Smith, Austrians define a competitive market not as a situation where no participant or potential participant has the power to make any difference, but as a market where no potential participant faces nonmarket obstacles to entry. (The adjective ‘nonmarket’ refers, primarily, to government obstacles to entry; it is used to differentiate such obstacles from, for example, high production costs that might discourage entry. These latter do not constitute noncompetitive elements in a market; to be able to enter means to be able to enter a market if one judges such entry to be economically promising-it does not mean to be able to enter without having to bear the relevant costs of production.) That is, a situation is competitive if no incumbent participant possesses privileges that protect him against the possible entry of new competitors.

The achievements that free markets are able to attain depend, in the Austrian view, on freedom of entry, that is, on the absence of privilege. It is because the law of supply and demand (as understood by Austrians) depends crucially on freedom of entry that this meaning of the term ‘competition’ is so important.”
Kirzner, Israel M. 2000. “The Irresistible Force of Market Competition,” March 1, 2000 http://www.fee.org/the_freeman/detail/the-irresistible-force-of-market-competition#axzz2rJCWXRKy

So what is the problem with this Austrian theory?

First, the simple and plain fact – despite the claims of Austrians that their price theory and view of supply and demand is more realistic than neoclassical economics – is that the Austrian vision is still grossly unrealistic. It assumes most firms are price takers and really do adjust prices in response to demand and supply dynamics.

The Austrian theory is utterly refuted by the widespread existence of administered prices/mark-up prices in most capitalist economies: prices that are set on total average cost of production plus a profit mark-up, and that are generally and normally left unchanged when demand changes. The empirical evidence suggests that such mark-up prices account for somewhere between 54% to 70% of prices in modern market economies (see Appendix 1 below). That is the majority of prices and the percentages found in many surveys are so high that the Austrian story about prices can be taken seriously.

Secondly, the glaring problem with the Austrian view of competition – with its emphasis on opposing alleged government obstacles to competition – is that mark-up pricing industries themselves, not only through the mark-up price but also through effective use of excess capacity and inventories, create severe market barriers to entry, a state of affairs which destroys the Austrian view of market “freedom of entry” in most product markets. For, if a mark-up price remains generally fixed in relation to demand changes, and does not even rise when demand rises, how can there even exist any effective market signals to businesses to enter a new market with high prices when those high prices do not even appear in the first place?

The answer is obviously that these “market signals” do not appear, and that the Austrian theory has already collapsed because most markets (which are mark-up/administered pricing markets) do not set prices in the way required by the theory.

Furthermore, even though the Austrians want to argue that “non-market” barriers to entry refer mostly or wholly to government intervention and that “market” barriers present no problem, they have failed to consider very serious real world “market” barriers that originate from the private sector itself.

Many modern markets are dominated by corporate enterprises, which have long been concerned with creating barriers to entry and which are not motivated by the idea of long-period maximisation of profits (in the neoclassical or Austrian sense). Instead, many corporations are more concerned with not inducing new entries into their markets (Lee 1998: 54–55).

As noted above, many modern firms have excess capacity available to deal with unexpected increases in demand, along with inventories (Lavoie 1992: 124). The effective use of excess capacity is a powerful method by which modern firms deter other firms from entering a market, and such a practice functions as a strong barrier to entry (Lavoie 1992: 124, citing Sylos Labini 1971: 247).

But Austrians like Kirzner remain mired in an economic theory divorced from reality, and are blissfully unaware of the empirical evidence that refutes their theories.

Appendix 1: Empirical Evidence on Administered Prices
“Downward’s Pricing Theory in Post-Keynesian Economics: Chapter 8,” January 23, 2014.

“Mark-up Pricing in South Africa,” January 20, 2014.

“Mark-up Pricing in Sweden,” January 9, 2014.

“Mark-up Pricing in Canada,” January 7, 2014.

“Some More Empirical Evidence on Full Cost Pricing,” December 10, 2013.

“Mark-up Pricing in New Zealand,” November 30, 2013.

“Mark-up Pricing in Australia,” November 30, 2013.

“Mark-up Pricing in Japan,” November 29, 2013.

“Mark-up Prices in Iceland,” November 25, 2013.

“Mark-up Pricing in Norway,” November 23, 2013.

“Mark-up Pricing in Ireland,” November 22, 2013.

“Two Marketing Studies on US Administered Prices,” November 16, 2013.

“Hall and Hitch on Marginal Cost and Price,” November 4, 2013.

“Administered Pricing in the United Kingdom,” October 19, 2013.

“Administered Prices in the Eurozone: Some Empirical Data,” October 16, 2013.

“Gardiner Means on Administered Prices,” June 20, 2013.

“Early Literature on Administered Pricing,” May 8, 2013.

BIBLIOGRAPHY
Kirzner, Israel M. 1985. “Prices, the Communication of Knowledge, and the Discovery Process,” in Kurt R. Leube and Albert H. Zlabinger (eds.), The Political Economy of Freedom: Essays in Honor of F. A. Hayek. Philosophia Verlag, Munich. 193–206.

Kirzner, Israel M. 2000. The Driving Force of the Market: Essays in Austrian Economics. Routledge, London and New York.

Kirzner, Israel M. 2000a. “The Law of Supply and Demand,” The Freeman, January 1
http://www.fee.org/the_freeman/detail/the-law-of-supply-and-demand#axzz2rJCWXRKy

Kirzner, Israel M. 2000b. “Entrepreneurial Discovery and the Law of Supply and Demand,” February 1, 2000
http://www.fee.org/the_freeman/detail/entrepreneurial-discovery-and-the-law-of-supply-and-demand#axzz2rJCWXRKy

Kirzner, Israel M. 2000c. “The Irresistible Force of Market Competition,” March 1, 2000 http://www.fee.org/the_freeman/detail/the-irresistible-force-of-market-competition#axzz2rJCWXRKy

Kirzner, Israel M. 2000d. “Toward an Austrian Critique of Governmental Economic Policy,” April 1
http://www.fee.org/the_freeman/detail/toward-an-austrian-critique-of-governmental-economic-policy#axzz2rJCWXRKy

Lavoie, Marc. 1992. Foundations of Post-Keynesian Economic Analysis. Edward Elgar Publishing, Aldershot, UK.

Lee, Frederic S. 1998. Post Keynesian Price Theory. Cambridge University Press, Cambridge and New York.

Sylos Labini, P. 1971. “La théorie des prix en régime d’oligopole et la théorie du développement,” Revue d’Economie Politique 81.2: 244–272.

Kirzner on Austrian Business Cycle Theory

In “An Interview with Israel M. Kirzner,” Austrian Economics Newsletter (vol. 17.1, 1997), Kirzner makes some very fascinating remarks on Austrian business cycle theory (ABCT). In the extract below, AEN (Austrian Economics Newsletter) stands for the interviewer:

AEN: You’ve never thought of providing a systematic critique of the Austrian business cycle theory, for instance?

KIRZNER: No, I’ve never had too much interest in the Austrian business cycle theory. I’ve never felt that the Hayekian business cycle theory was essentially Austrian. In fact, Mises, who was the originator of this whole idea in 1912, didn’t see it as particularly Austrian either. There are passages where he notes that people call it the Austrian theory, but he says it’s not really Austrian. It goes back to the Currency School and Knut Wicksell. It’s certainly not historically Austrian. Further, I would claim that, as developed by Hayek, there are many aspects of it that are non-Austrian. I don’t believe that to be an Austrian you have to buy into the Hayekian view of business cycles.

AEN: Are there any aspects of Hayek’s business cycle theory that you regard as Austrian?

KIRZNER: I recently wrote a paper to accompany the facsimile German edition of Prices and Production. I identified what seemed to me to be elements of Hayek’s later work on coordination, miscoordination, and knowledge. I argued that the germs of his later ideas can be traced to this volume, especially his description of the upswing stage of the cycle. This is a phase during which some decisions are out of sync with other decisions. Current investors are making decisions which anticipate the decisions of others down the road, which are in fact not there. Leaving the exact mechanism aside, that is the kind of thing Hayek taught us to look for in analyzing the market process. In that respect, it's Austrian.

AEN: And the rest of the theory?

KIRZNER: Otherwise, the Austrian theory of the business cycle is a macro theory. It’s an equilibrium theory. And it treats capital in an objective sense rather than a subjective sense. It treats time as somehow embedded in the capital goods themselves. So I’ve always had a certain reserve about that particular theory, however brilliant it may be. I think the way Hayek developed it was not quite consistent with the way Mises laid it out in 1912.

AEN: Do you accept the idea that interest-rate manipulation by the central bank can cause distortions in the structure of production?

KIRZNER: Certainly the Austrian cycle theory showed brilliantly how this can happen. But it’s one thing to develop a theory which could explain a downturn. It’s quite another to claim that historically every downturn is to be attributed to that particular theory. That does not necessarily follow. If one were asked, does this theory necessarily explain each and every cycle, I would say no.

Mises used to poke fun at those who criticize the Austrian theory of the business cycle as being too simple. He said that still doesn’t tell what’s wrong with it. That’s correct, as far as it goes. Perhaps many market aberrations are of this kind. But that can only be a question of historical understanding. We must be able to look at every case to see just what is happening.

A number of points emerge from this:

(1) Kirzner never felt “that the Hayekian business cycle theory was essentially Austrian.”

(2) Hayek’s version of ABCT contains “aspects” that are “non-Austrian.”

(3) Austrians do not even need to adhere to ABCT, as it is not some fundamental idea of Austrian economics.

(4) Hayek’s development of ABCT was not “quite consistent with the way Mises laid it out in 1912.”

(5) Kirzner did not even think that all recessions could be explained by ABCT.

You have to wonder, then, what Kirzner would think of modern Austrians desperately trying to use ABCT to explain every recession that has ever happened. And, moreover, for the moderate subjectivist Austrians who agree with Kirzner, a question occurs: what recessions in their mind aren’t explained by ABCT?

FURTHER POINT

The commentator Iain below alerts me to another issue. Kirzner argues that “the Austrian theory of the business cycle is a macro theory. It’s an equilibrium theory.”

How strange it is, then, to see Austrians denying the validity of macroeconomics or macro concepts, particularly when Roger Garrison, one of the leading neo-Austrian moderate subjectivists in the tradition of Hayek, has devoted himself to creating an Austrian macroeconomics (Garrison 1984 and 2002). Furthermore, Steve Horwitz notes how Hayek’s work in the 1930s was essentially in macroeconomic theory and what its legacy was:

“Hayek’s ‘pre-Keynesian’ macroeconomics was not left to die on the vine. Although not much discussed in self-consciously Austrian books, there is an Austrian macroeconomics that is alive and well. There are three distinct issues that Austrian macroeconomists have been pursuing in the post-revival years. First are the extensions of the Mises–Hayek theory of the trade cycle ... . Second is the recent interest in the idea of ‘free banking’ .... Third, and arguably even less explicitly Austrian, is the work of Leland Yeager, Axel Leijonhufvud, and Robert Greenfield that has tried to revive interest in the pre-Keynesian monetary disequilibrium theorists...” (Horwitz 2000: 2).

J. E. King gives a further explanation of ABCT and macroeconomic and equilibrium theory:

“In the 1930s, however, Hayek had formulated an influential theory of the trade cycle, which he explained as the result of mistaken government policy. Excessive monetary expansion in the upswing pushed the rate of interest below its ‘natural’ value, encouraging a short-lived boom in investment that extended the average degree of ‘roundaboutness’ of production beyond its sustainable level. In the ensuing depression the appropriate capital structure was restored by means of a decline in the level of investment expenditure. Hayek interpreted the reduction in output and employment in the downswing as the unavoidable consequence of the initial policy error (Hayek 1931). His analysis of money and capital was heavily criticized at the time [Sraffa, 1932; Kaldor 1937]. It not only proved to be vulnerable to the Cambridge capital critique ..., but also appeared to rely upon concepts of equilibrium (the ‘natural rate of interest’, for example) that were inconsistent with the broader principles of Austrian economic theory” (King 2002: 229–230).

It appears that Kirzner in the comments above is pointing to precisely this issue.

BIBLIOGRAPHY

Garrison, R. W. 1984. “Time and Money: The Universals of Macroeconomic Theorizing,” Journal of Macroeconomics 6: 197-213.

Garrison, R. W. 2002. Time and Money: The Macroeconomics of Capital Structure, Routledge, London.

Hayek, F. A. von, 1931. Prices and Production, G. Routledge & Sons, Ltd, London.

Horwitz, S. 2000. Microfoundations and Macroeconomics: An Austrian Perspective, Routledge, London and New York.

Kaldor, N. 1939. “Capital Intensity and the Trade Cycle,” Economica n.s. 6.21: 40–66.

King, J. E. 2002. A History of Post Keynesian Economics since 1936, Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.

Sraffa, P. 1932. “Dr. Hayek on Money and Capital,” Economic Journal 42: 42–53.

The Different Types of Austrian Economics

Although I advocate Post Keynesian economics, I have always been rather intrigued by Austrian economics. In the 1930s, when John Maynard Keynes was establishing the beginnings of the Keynesian revolution, his great intellectual opponent was the Austrian economist Friedrich August von Hayek.

The Austrian school arise in the 1870s as part of the marginalist revolution in economic thought. The founder was Carl Menger, who wrote an influential book called the Principles of Economics in 1871.

In a previous post (see “Friedrich von Wieser and Eugen von Philippovich von Philippsberg: Austrian Economists and Fabian Socialists”), I noted that the early Austrian school was in fact split into two factions: (1) a Classical liberal wing and (2) a wing that was not opposed to government intervention per se, and that even included members sympathetic to Fabian socialism. Hayek explains the history of the Austrian school in this interview:

LEIJONHUFVUD: In economics, let me come back to a question we have touched upon before. In the twenties in Vienna, was there such a thing as an Austrian school in economics? Did you and your contemporaries perceive an identification with a school?

HAYEK: Yes, yes. Although at the same time [we were] very much aware of the division between not only Meyer and Mises but already [Friedrich von] Wieser and Mises. You see, we were very much aware that there were two traditions—the [Eugen von] Böhm-Bawerk tradition and the Wieser tradition—and Mises was representing the Böhm-Bawerk tradition, and Meyer was representing the Wieser tradition.

LEIJONHUFVUD: And where did the line between the two go? Was there a political or politically ideological line involved?

HAYEK: Very little. Böhm-Bawerk had already been an outright liberal, and Mises even more, while Wieser was slightly tainted with Fabian socialist sympathies. In fact, it was his great pride to have given the scientific foundation for progressive taxation. But otherwise there wasn’t really—I mean, Wieser, of course, would have claimed to be liberal, but he was using it much more in a later sense, not a classical liberal (Nobel Prize-Winning Economist: Friedrich A. von Hayek, pp. 49–50).

The split in the Austrian school in the 1920s was between (1) the classical liberal wing of Eugen von Böhm-Bawerk/Mises (which evolved into modern American libertarianism), and (2) the wing of von Wieser, some of whom were leaning towards Fabian socialism.

However, with the migration of Austrian economics to America and the emergence of Mises as a leading figure, the Classical liberal wing won out, and modern Austrian economics developed from the Classical liberal wing under Mises’ influence.

For much of the 1940s, 1950s and 1960s, Mises, Hayek and Rothbard were the major Austrian thinkers. However, there were a number of other less well known third-generation Austrian economists in this era, including Oskar Morgenstern (1902–1976), Gottfried von Haberler (1900–1995), Fritz Machlup (1902–1983), Paul N. Rosenstein-Rodan (1902–1985), and Friedrich A. Lutz (1901–1975). Not all of them were reflexively hostile to government. Paul N. Rosenstein-Rodan, for instance, was famous for his work on how the state can initiate industrialization in poor nations through planned investment (Rosenstein-Rodan 1943).

In the US, the Austrian tradition was strongly influenced by Mises and Rothbard. Then Austrian economics experienced a resurgence in America from the 1970s onwards:

“American Austrianism revolves around an axis that passes through Auburn University, George Mason University, and New York University. It gets its spin from a 1974 conference held at South Royalton, Vermont, a week-long affair that featured lectures by Murray Rothbard, Israel Kirzner, and Ludwig Lachmann” (Garrison 2001: 259).

A proceedings of that conference was later published as The Foundations of Modern Austrian Economics (ed. E. G. Dolan; Mission, Kansas, 1976). For a fascinating discussion of the history of this Austrian resurgence, see Mario Rizzo’s post “What Is Austrian Economics?” (November 23, 2009) at the ThinkMarkets blog and the comments on it.

Modern Austrians come in a number of forms, and there are clear differences between them. In my view, a useful division of modern Austrians would be as follows:

(1) The Anarcho-capitalists
E.g., Murray Rothbard, Hans-Hermann Hoppe and Jörg Guido Hülsmann;

(2) The minimal state/classical liberal Austrians in the tradition of Mises
This variety supports praxeology and utilitarianism;

(3) Hayek’s economics, with a minimal state;

(4) Moderate subjectivist Austrians
E.g., Israel Kirzner and Roger Garrison;

(5) Radical subjectivists like Ludwig M. Lachmann (1906-1990), and Austrians influenced by him.

(see Böhm 1989: 60–61; Hutchison 1994: 222).

One should note that the differences between these types of Austrians are not trivial.

From the 1970s, a new generation of Austrians challenged the older, pure aprioristic methodology of Mises, and advocated a greater role for empirical testing, and Hayek had already moved away from Mises’ methodology with his paper “Economics and Knowledge” (1937).

Personally, I have little time for Austrians of types (1) and (2). The anarcho-capitalists (1) have a radical view that the state must be completely abolished and all of its functions privatized. In the form developed by Rothbard, the case for anarcho-capitalism is based on an untenable and deeply flawed moral argument using natural rights and Aristotelian, neo-Thomist natural law theory (Rothbard 1998). Though my purpose here is not to offer a detailed critique of anarcho-capitalism, one of the most convincing arguments against it is that private protection firms would in fact have an incentive to victimise potential customers to increase market share. Violence of the type that already happens between private mafia groups might occur. A natural monopoly would probably develop as the most powerful firm drove its competitors out of business (or a cartel might become dominant), and one would be left with a de facto state, the very thing anarcho-capitalism sought to abolish! (see Holcombe 2004: 330–331). Moreover, the power relations in an anarcho-capitalist society would appear to be rather like feudalism, with no sense of the common good (Freeman 2001: 147–149). If history is any guide, a movement towards anarcho-capitalism might well result in the kind of incessant violence and warfare between private warlords/protection agencies, as in medieval feudalism. Above all, do we really want to privatise the ownership, use and production of nuclear weapons or biological and chemical weapons? Quite frankly, an anarcho-capitalism system would be one of utter insanity.

The classical liberal Austrians (2) in the tradition of Mises support a minimal state with limited functions, like justice and defence. But Mises’ praxeology is heavily aprioristic, involves an absurd and radical rejection of empirical evidence, and falls apart once one sees the vast number of unsupported subsidiary hypotheses, both present and assumed, that underlie his deductive arguments. Moreover, by admitting the possibility of rational government intervention on utilitarian grounds, Mises’ ideology has a severe logical contradiction (see “Was Mises a Socialist?: Why Mises Refutes Himself on Government Intervention”).

Austrians of type (5) are more interesting. The Austrian radical subjectivists have a “kaleidic” view of economics influenced by the views of the peculiar Austrian–Keynesian hybrid George L. S. Shackle (Lachmann 1976) and stress the subjectivist nature of value, expectations, and knowledge. Lachmann, for example, even denied that free market systems tend to equilibrium or have coordinating processes (Kirzner 2000: 46–47). Lachmann’s radical subjectivism is rejected by Austrians of type (4), who condemned his position as “nihilism” (Kirzner 2000: 47). This rejection is not unreasonable from the perspective of those who support extreme laissez faire economics, because, if there is no neoclassical tendency to full employment equilibrium or Hayek’s plan coordination in a free market system, the alleged economic or moral superiority of such a system collapses. It is thus not surprising that the Lachmann-inspired wing of Austrians aroused some hostility from the moderates who defended the free market as an equilibrating or coordinating mechanism (Dunn 2008: 136).

I am not certain whether Gerald P. O’Driscoll and Mario J. Rizzo are moderate subjectivist Austrians of type (4). Their interesting book The Economics of Time and Ignorance (Oxford, UK, 1985) appears to use Lachmann’s views on the role of time and fundamental uncertainty, but also tries to overcome the charge of “nihilism” by postulating the idea of pattern coordination in place of equilibrium (Gloria-Palermo 1999: 138).

O’Driscoll and Rizzo have made some favourable comments about Post Keynesian economics:

“[i]t is evident that there is much more common ground between post-Keynesian subjectivism and Austrian subjectivism …. the possibilities for mutually advantageous interchange seem significant” (O’Driscoll and Rizzo 1985: 9).

There are indeed some limited similarities in economic analysis between Austrians of type (4) and (5) and the Post Keynesian economists (Böhm 1989: 61).

Paul Davidson, one of leading American Post Keynesians, criticised The Economics of Time and Ignorance in his classic articles “The Economics of Ignorance or Ignorance of Economics?,” Critical Review (1989) 3.3/4: 467–487, and “Austrians and Post Keynesians on Economic Reality: Rejoinder to Critics,” Critical Review 7.2/3 (1993): 423–444. Clearly, there are also very significant differences between Austrians and Post Keynesians.

Austrians of type (4) include Israel Kirzner, who argues that plan/pattern coordination (the Austrian substitute for neoclassical equilibrium) in a free market economy can be achieved by entrepreneurial discovery and creation (Parsons 2003: 7). Type (4) Austrians also include Roger Garrison and others who even engage in “Austrian macroeconomics,” which seems peculiar, given that other Austrians reject the whole concept of macro-theory in economics.

From the perspective of Post Keynesianism, Austrians of type (4) and especially (5) are the most interesting. Ludwig Lachmann, like Keynes, stressed that expectations are subjective, and Lachmann even produced work that has a positive view of aspects of Keynes’ thought. Lachmann’s paper “John Maynard Keynes: A View from an Austrian Window” (South African Journal of Economics 51 (1983): 253–260) argues that

“In the field of methodology Keynes and the Austrians agree that economics is a social science to which methods that have proved successful in the natural sciences should not be applied without careful inspection, …. But Keynes’s mind also moves in another direction. ‘I also want to emphasize strongly the point about economics being a moral science. I mentioned before that it deals with introspection and with values. I might have added that it deals with motives, expectations, psychological uncertainties. One has to be constantly on guard against treating the material as constant and homogeneous. It is as though the fall of the apple to the ground depended on the apple’s motives, on whether it is worthwhile falling to the ground, and whether the ground wanted the apple to fall, and on mistaken calculations on the part of the apple as to how far it was from the centre of the earth’ … Keynes sees in social facts manifestations of the human mind. While to Hayek it is the complexity of these facts, their multitude and diversity, that defies the attribution of numerical values to social concepts, to Keynes it is their mental character … that does so. Rather to the surprise of some of us, Keynes emerges as being more deeply committed to subjectivism than is his Austrian opponent (Lachmann 1983: 256).

These similarities have been noted by other scholars too (Caldwell 1989; Parsons 2003: 6).

Though the practical policy recommendations and political outlook of Post Keynesians and Austrians will remain deeply in conflict, there might be something that Post Keynesians can learn from studying the theories of Austrians of type (4) and (5) above.

WALTER BLOCK’S CLASSIFICATION OF AUSTRIAN SUBJECTIVISM

In an article published in 1988, Walter Block proposes a useful division of different types of Austrian subjectivism:

1. The nonsubjectivists
2. The moderate subjectivists (i.e., Yeager)
3. The Austrian subjectivists (i.e., Rothbard, Kirzner, Buchanan)
4. The ultra- or extreme subjectivists (i.e., Jack Wiseman, G.L.S. Shackle, Ludwig Lachmann, and “hermeneuticians” associated with the market process group located at George Mason University) (Block 1988: 201).

Categories (2) and (3) here include my category of “Moderate subjectivist Austrians.”

BIBLIOGRAPHY

Böhm, S. 1989. “Subjectivism and Post-Keynesianism: Towards a Better Understanding,” in J. Pheby (ed.), New Directions in Post-Keynesian Economics, Edward Elgar, Aldershot, Hants, England. 59–93.

Block, W. 1988. “On Yeager’s ‘Why subjectivism?,’” Review of Austrian Economics 2: 199–208.

Caldwell, B. J. 1989. “Post-Keynesian Methodology: An Assessment,” Review of Political Economy 1465-3982, Volume 1, Issue 1, 1989, Pages 43 – 64

Dolan, E. G. (ed.). 1976. The Foundations of Modern Austrian Economics, Sheed & Ward, Mission, Kansas.

Dunn, S. P. 2008. The “Uncertain” Foundations of Post Keynesian Economics: Essays in Exploration, Routledge, London and New York.

Freeman, S. R. 2001. “Illiberal Libertarians: Why Libertarianism Is Not a Liberal View,” Philosophy & Public Affairs 30.2: 105–151.

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Gloria-Palermo, S. 1999. The Evolution of Austrian Economics: From Menger to Lachmann, Routledge, London and New York.

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Kirzner, I. M. 2000 The Driving Force of the Market: Essays in Austrian Economics, Routledge, New York.

Lachmann, L. M. 1976. “From Mises to Shackle: An Essay on Austrian Economics and the Kaleidic Society,” Journal of Economic Literature 14.1: 54-62.

Parsons, S. D. 2003. “Austrian School of Economics,” in J. E. King (ed.), The Elgar Companion to post Keynesian Economics, E. Elgar Pub., Cheltenham, UK and Northhampton, MA. 5–10.

Rosenstein-Rodan, P. N. 1943. “Problems of Industrialization of Eastern and South-Eastern Europe,” Economic Journal 53.210/211: 202–211.

Rothbard, M. N. 1998. The Ethics of Liberty, New York University Press, New York and London.

Vaughn, K. I. 1994. Austrian Economics in America: The Migration of a Tradition, Cambridge University Press, Cambridge and New York.

Yeager, L. B. 1987. “Why Subjectivism?,” Review of Austrian Economics 1: 5–31.