12.1 The foundations of Austrian economics

The Austrian School of Economics, founded by Carl Menger in the late 19th century, revolutionized economic thought. It introduced the subjective theory of value and emphasized individual human action in economic analysis, challenging classical economics' labor theory of value.

Key figures like Ludwig von Mises expanded Austrian theory, developing praxeology as a unique methodological approach. This school's focus on methodological individualism and subjective value theory laid the groundwork for understanding market processes, capital structure, and spontaneous order in economics.

Key Figures and Concepts

Founders and Core Principles of Austrian Economics

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• Carl Menger established Austrian School of Economics in late 19th century
  • Published "Principles of Economics" in 1871
  • Introduced subjective theory of value
  • Emphasized importance of individual human action in economic analysis
• Ludwig von Mises expanded Austrian economic theory in 20th century
  • Wrote influential works like "Human Action" and "Theory of Money and Credit"
  • Developed praxeology as a methodological approach to economics
• Methodological individualism forms foundation of Austrian economic analysis
  • Focuses on individual human actions as basis for understanding economic phenomena
  • Rejects aggregate or collective decision-making models
  • Emphasizes importance of individual preferences and choices in shaping economic outcomes
• Praxeology serves as the distinctive methodology of Austrian economics
  • Studies human action and decision-making
  • Based on the axiom that individuals act purposefully to achieve their goals
  • Employs logical deduction rather than empirical observation to derive economic principles
  • Contrasts with mainstream economics' reliance on mathematical models and statistical analysis

Contributions to Economic Thought

• Carl Menger's work challenged classical economics' labor theory of value
  • Introduced concept of marginal utility
  • Explained how individuals subjectively value goods based on their needs and preferences
• Ludwig von Mises developed monetary theory and business cycle theory
  • Argued against socialist economic calculation
  • Emphasized role of entrepreneurship in market processes
• Methodological individualism influenced other schools of economic thought
  • Impacted development of public choice theory (James Buchanan)
  • Influenced new institutional economics (Ronald Coase)
• Praxeology provided framework for analyzing economic phenomena
  • Applied to areas such as monetary theory, capital theory, and entrepreneurship
  • Emphasized importance of time and uncertainty in economic decision-making

Value and Utility Theory

Subjective Theory of Value

• Subjective theory of value posits that value derives from individual preferences
  • Rejects objective or intrinsic value theories (labor theory of value)
  • Explains why same good can have different values for different individuals
• Value determined by marginal utility an individual derives from a good
  • Depends on personal circumstances, needs, and desires
  • Accounts for changing valuations over time as circumstances change
• Subjective value theory explains market prices and exchange ratios
  • Prices emerge from interactions of subjective valuations of buyers and sellers
  • Facilitates voluntary exchanges that benefit both parties
• Theory applies to both consumer goods and factors of production
  • Explains why land, labor, and capital have value in production processes
  • Accounts for differences in factor prices across industries and regions

Marginal Utility and Time Preference

• Marginal utility refers to additional satisfaction from consuming one more unit of a good
  • Diminishes with increased consumption (law of diminishing marginal utility)
  • Explains why water is cheap despite being essential, while diamonds are expensive
• Marginal utility determines consumer choices and market demand
  • Consumers allocate resources to maximize overall utility
  • Leads to equimarginal principle: equal marginal utility per dollar spent across goods
• Time preference reflects individuals' valuation of present vs. future consumption
  • People generally prefer present goods to future goods of equal quality
  • Explains existence of interest rates and intertemporal decision-making
• Time preference influences savings, investment, and capital formation
  • Lower time preference leads to more saving and investment
  • Higher time preference results in greater present consumption and less capital accumulation

Capital and Spontaneous Order

Capital Theory and Structure of Production

• Capital theory in Austrian economics emphasizes heterogeneity of capital goods
  • Rejects notion of homogeneous "K" in production functions
  • Recognizes specific purposes and complementarities of capital goods
• Capital structure consists of multiple stages of production
  • Earlier stages (mining, refining) further from final consumer goods
  • Later stages (retail, distribution) closer to final consumer goods
• Time plays crucial role in capital theory
  • Production processes take time, involving opportunity costs
  • Interest rates coordinate intertemporal production plans
• Capital theory explains business cycles and malinvestment
  • Artificial credit expansion leads to unsustainable lengthening of production structure
  • Results in boom-bust cycles as malinvestments are liquidated

Spontaneous Order and Market Processes

• Spontaneous order describes complex social patterns arising from individual actions
  • Not result of central planning or design
  • Emerges from decentralized decision-making of countless individuals
• Market prices serve as key mechanism for coordinating spontaneous order
  • Convey information about relative scarcities and consumer preferences
  • Guide resource allocation without need for central planning
• Entrepreneurship plays vital role in discovering and exploiting market opportunities
  • Entrepreneurs act on price discrepancies and anticipated future conditions
  • Drives innovation and economic progress through creative destruction
• Spontaneous order extends beyond economic realm
  • Applies to language evolution, common law development, and social norms
  • Highlights limitations of top-down social engineering and central planning