The History of Austrian Economics & The Major Schools of Economics

To: Dr. Palano

From: John Roberts III

Date: March 18, 2011

Subject: Austrian Economics Course Comprehensive Essay

Introduction

This paper will address the history of economics and will explain how Austrian

economics contributed to the development of economic intellectualization. The essay will also

explain the most popular and important schools of economics, like Keynesian, Heterodox,

Mainstream, Classical, Neoclassical, and Austrian economics. This paper will elucidate the

major economic theories and concepts associated with these six different economic schools.

Finally, the essay will address the market niche concepts and theories of Austrian economics

and will examine the defining characteristics of Austrian economics such as subjectivism and

marginalism.

The Historical Setting of Economics and How Austrian Economics Contributed to the Development of Economic Intellectualization

Aristotle’s Influence

The word economics is derived from the Latin word Oeconomica, which is a concept

attributed to Aristotle. He wrote three short books involving economics that strongly parallel

Austrian economic concepts. In his first book Aristotle discusses ethics, which relates to the

condition of trust for spontaneous order to prevail in reference to Jane Jacob’s city theory in

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the academic journal, Urban Intervention and Local Knowledge. His second book addresses

methods of generating revenue, which relates to the Austrian concept of trust for spontaneous

order (profit opportunities will emerge spontaneously) and entrepreneurship, as also explained

in the Urban Intervention and Local Knowledge. Aristotle’s third book on economics deals with

the relationship between husbands and wives, which involves economics; however, because of

the complex dynamics associated with this subject, for the sake of page length and time, no

further description will be given.1 Indeed, looking at the key economic contributions of

Aristotle, the emanation of economics began around 300 B.C.

Cato’s & Brutus’s Influence 90 B.C

Porcius Cato and Marcus Junius Brutus, two of the most prominent and historical

Roman senators during the time of Caser Augustus, were regarded as the forefathers of the

Republic. The concept of a Republic was rooted in the idea of liberalism, which in the context

of economics gave people more economic freedom, such as exploitation of opportunities (e.g.

entrepreneurship), and a voice in the Senate to address their economic needs.2 The political

system of a Republic brought safety and security to cities under Roman rule, which allowed

them to conduct business and trade more freely.

1700 to 1800

Adam Smith's book, The Wealth of Nations written in 1776, is generally considered to

mark the beginning of Classical economics. Classical economics has been regarded as the first

modern school of economic thought. Its major inventors include Adam Smith, Jean-Baptiste

Say, David Ricardo, Thomas Malthus and John Stuart Mills. Classical economics originated in 1 Oeconomicus: A Social and Historical Commentary2 Rome Series

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Britain, eventually becoming the economic theory upon which the British government modeled

itself. Capitalists can thank Adam Smith and Classical economics for influencing the idea of a

free market without government intervention, which Austrian economics unequivocally agree

with.3

1800 to 1900

From the early to the mid-1800s economics was not permitted to be taught and sadly

disappeared entirely from the universities of the German Empire. Even more morose was that

most university professors readily enjoyed ridiculing economics and economists. The problem

during this time period was that universities, under the control of the German Empire, were

owned and operated by various kingdoms and grand duchies that formed the Reich. Professors

were civil servants expected to strictly obey the dictums issued by their aristocratic superiors,

the bureaucrats of the ministries of public institutions, which disapproved the inculcation or

lecturing of students about economics. In 1837, professors began to secretly disregard these

imposed restrictions on teaching economics, so the government resorted to more subtle and

efficacious methods to make the professors loyal supporters of the official policy. They

scrupulously sifted through the candidates before appointing them, ensuring only reliable men,

those who opposed studying and inculcating students about economics, obtained the university

chairs. Ergo academic freedom and economics receded into the background during most of the

19th century.4

3 Does the invisible hand hold or lead? Market adjustment in an entrepreneurial economy

4 The Historical Setting of the Austrian School of Economics

3

Due to the prejudicial restrictions and academic limitations placed on economic analysis

in the German Empire, many economists moved to Austria in the mid-1800s. Inciting their

move to Austria was liberalism (an economic philosophy that supports and promotes laissez-

faire economics and private property in the means of production), which removed the chains

that previously prevented any intellectual effort to teach economics in Austria. This could be

the inherent reason why Austrian economics agrees with liberalism.5 Additionally, this

explicates why many of the founding fathers of Austrian economics were actually German –

Ludwig von Mises, Carl Menger, Eurgen von Böhm-Bawerk, and the Nobel laureate Friedrich

Hayek. This German economists’ migration to Austria has become the commonly accepted

explanation as to how Austrian economics acquired its name. Austrian economics derives from

the German identity of these four founders and early supporters, who fled the old

Habsburg/German Empire for the economic freedom to teach and lecture in Austria.6

In the 3rd and 4th quarters of the 19th century, Austrian economists began to study the

works of British Classical economics, because they accepted the assumption that economic

theory is derived from experience. This intrigue with British Classical economics led to the

Austrian school of economics supporting Utilitarianism, which was procured from British

economists like Jeremy Bentham and John Stuart Mills.7 Utilitarianism is the ethical theory

holding that the proper course of action is one that maximizes the overall happiness, by

whatever means necessary. It holds that the morality of an action is determined only by its

resulting outcomes. Austrian economists agreed with Utilitarianism, because of its emphasis on

5 The Historical Setting of the Austrian School of Economics6 Austrian School of Economics7 The Historical Setting of the Austrian School of Economics

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maximizing utility and minimizing negative utility, in which British economics base utility on

preference satisfaction (Austrian core belief of subjectivism) and knowledge (Austrian core

belief of imperfect and specialized knowledge).8

The inauguration of the Austrian school of economics occurred in 1871 with the help of

Carl Menger, who is often thought of as the original and most prominent founding father of

Austrian economics. Menger additionally developed the two most influential and fundamental

concepts of Austrian economics, marginalism and subjectivism. Marginalism’s central concept

concedes that the marginal utility of a good or service is the utility gained or lost from an

increase or decrease in the consumption of that good or service.9 Subjectivism identifies worth

as being based on the wants and needs of the members of a society, as opposed to value being

inherent to an object. To put it simply, subjectivism implies that individuals place different

monetary values on goods and services, so goods and services are in fact subjective not

objective. 10

1900s to Present Day

Economics significantly influenced historical events during the early 1900s until the end

of the Nazi regime in 1945. The aggressive imperialism, that twice ended in war and defeat,

and the limitless and escalating inflation of the 1920s were both horrors of the Nazi regime

caused by politicians who economically acted as they had been taught. These politicians were

educated by the champions of the Historical school of economics. When I say champions, I

mean pushovers or pseudo intellectuals who derived their economic ideas from anti-liberal and

8 Classical Utilitarianism from Hume to Mill9 Austrian School of Economics10 Why Subjectivism?

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anti-Austrian economics. Earlier I discussed how in the mid-1800s German universities did not

permit the teaching of economics and how economics disappeared entirely from the

universities of the German Empire. The Historical school of economics dominated German

university economic departments during the early to the mid-1800s. The government advisors

and officials who were the students of the Historical school were never taught the economic

theorems and logical concepts of the time proven Austrian school. Consequently, their

historical approach supplied faulty judgment or lack of economical discernment and knowledge

needed during the Great Depression of the 1920s, WWI, and WWII, because these German

political leaders lacked the economic analysis skills to solve these important events. The

Historical school of economics was to blame for these failures because in rejecting the

deductive approach they likewise dismissed the great economic insight from Austrian

economists such as Ludwig von Mises, Carl Menger, Eurgen von Böhm-Bawerk, and the Nobel

laureate Friedrich Hayek, who taught in Austria. Instead, German political leaders and other

advisors looked to the wrong economists, if you would even call them that; they look to

Schmoller who eventually conceded to Karl Marx’s socialism. If Germany had instead relied

upon a priori reasoning and adopted the Austrian school of economics that emphasized the

impracticability of socialism and the success of liberalism, they presumably could have been

able to make a quicker recovery from the Great Depression and quite possibly avoided WWI

and WWII. Because the German people trusted individuals like Marx, Schmoller, and Hitler to

make their country economically efficient through the use of socialism it is evident why they

were destined to fail.11

11 The Historical Setting of the Austrian School of Economics

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These persuasive statements and factual evidence illustrates why the German Empire

should have listened to Austrian economists. Mises considered socialism was impractical.

Austrians knew that socialism would fail due to four emphatically lucid and logical obstacles

impeding socialism. The first obstacle was private property and incentive, second, monetary

prices and the economizing role they play, third, profit and loss accounting, and fourth, the

political environment. By looking at these four empirical problems amalgamated with socialism

one can synthesize that without a political environment that protects and encourages private

property people’s incentive/motivation to work wanes, thus, monetary prices become obsolete,

which subsequently eliminates profit and induces loss accounting. When analyzing these

destructive socialist effects, one can deduce that advanced economic process is unobtainable

when a country adopts socialism. A socialism institutional regime attempts to abolish private

ownership in the means of production, which causes advanced industrial production to be

reduced to the point that decision makers are left in the dark when denied the necessary

compass to resolve a problem. Mises warns that the abolishment of private property leads to

political control over individual decisions and thus the eventual suppression of political liberties

to the concerns for the collective.12

According to Hayek, who was Menger’s mentee, he believed that socialism is a problem

of ethics and psychology because of socialism’s issue with human motivation. Under the

socialist system the decision of alternatives cannot be rationally made due to the lack of human

motivation. Hayek also believed that socialism was impossible because the institution

configuration of socialism precludes economic calculation by eliminating the emergence of the

12 Economic Calculation: The Austrian Contribution to Political Economy

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specific knowledge that is necessary for calculations to be made by economic actors. Hayek

states that the aims and programs of socialism are factually impossible to achieve and execute.

Overall, the collapse of socialist states in countries of the East, Central Europe (Germany), Cuba,

and the Soviet Union has hurt the longevity of socialist economics. Over the past century these

country collapses have turned many once inspired socialist supporters to abandon this

economic theory and move towards liberalism, which hails and helps to galvanize the Austrian

Economic School.13

To reaffirm the point I expressed above, considering how Schmoller contributed to the

anti-liberal realization. I would like to add that it was Schmoller’s debate with Menger over

Methodenstreit (1880-1890s) that compellingly induced German’s animosity towards liberalism

by the end of 19th century. Methodenstreit is a German term referring to an intellectual

controversy or debate over epistemology, which is a branch of philosophy concerned with the

nature and scope/limitations of knowledge. This controversy was between the supporters of

the Austrian School of economics, led by Carl Menger and the proponents of the German

Historical School, led by Gustav Schmoller. It was Schmoller’s fault that the German Historical

School felt animosity towards liberalism because he defended an untenable position and did

not realize what the Methodenstreit controversy was about. The matter in dispute was

whether there could be such a thing as a science, other than history, that could deal with the

aspects of human action. At this time radical materialist determinism was a philosophy

universally accepted in Germany. Radical material determinist thought that human ideas,

volitions, and actions were produced by physical and chemical events. They also believed that

13 Economic Calculation: The Austrian Contribution to Political Economy

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the natural sciences will one day describe in the same way in which today they describe the

emergence of a chemical compound out of the combination of several ingredients.14

Schmoller and his disciples rejected this philosophy because it was incompatible with

the religious tenets of the Prussian Government. He repeatedly blamed the economists for

prematurely making inferences from quantitatively insufficient material. In his opinion, more

statistics, history, and the collection of more “material” was needed to substitute a realistic

science of economics for the hasty generalizations of the British “armchair” economists. He did

not realize the gulf that separated his view from those of the German philosophers who

demolished positivism’s ideas about the use and treatment of history. Positivism asserts that

only authentic knowledge is that which is based on sense, experience, and positive verification.

Schmoller did not see that the tenor of Dilthey’s doctrine (which is a theory of knowledge that

asserts that knowledge comes primarily via sensory and historical experience) was the

annihilation of the fundamental thesis of his own epistemology - that some laws of social

development could be distilled from historical experience. In the end, Schmoller embarrassed

himself and drove Germans further away from him and closer towards the socialism that

inevitably lead to Germany’s demise in WWI and WWII.15

It was not until the 20th century, pending the postwar period, that economists began to

realize the importance of the entrepreneur as the driver of economic progress. Several

decades later, from the 1960’s through the 1970’s, economists began to focus on institutions in

their analysis of economic growth (Kasper & Streit, 1998). Once this occurred, Neoclassical

14 The Historical Setting of the Austrian School of Economics

15 The Historical Setting of the Austrian School of Economics

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economics began to fade away. As Stiglits writes, “the neoclassical view prevailed until 30–40

years ago, when people became convinced that the laws of supply and demand did not explain

everything about economic equilibria. The breakthrough came when people began to

recognize that economic theory ought to be able to explain the reason for institutions in a

society”.16

Institutions are one of the fundamental concepts of the Austrian school of economics

and without institutions entrepreneurship could not exist. Hayek also mentions institutions and

went so far as to develop a theory of the evolution of democratic political and legal institutions

responding to historical influences without the intelligent design of an authoritative legislator,

which he promulgated in his copious articles published in 1960, 1973, 1976, and 1979. The

final Austrian economic contribution to the 20th century was economic calculation to the

discipline of the political economy, which is something I think is so significant I will address the

subject later in this paper.17

The Different Economic Schools

In this section I will briefly describe the six different economic schools of thought that

are the most globally prominent and frequently discussed. These include Austrian economics,

Classical economics, Neoclassical economics, Keynesian economics, Heterodox economics, and

16 Entrepreneurship and Development: Cause or Consequences17 Entrepreneurship and Development: Cause or Consequences

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Mainstream economics. Classical economics and Keynesian economics are two of the most

commonly compared economic schools of thought in the topography of economics. All other

economics base their theories in correlation to either the Classical or Keynesian approach to

economics. The two major conceptual differences between the two schools involve equilibrium

and price flexibility. Price flexibility proposes that prices adjust in the long run in response to

market shortages or surpluses. Also, it states that changes in the price level are met by equal

change in resource prices, especially wages. Keynesian economics believes in market

disequilibrium (the amount of goods or services sought by buyers/demand is not equal to the

amount of goods or services produced by sellers/supply) and that prices are imperfectly

flexible. The Classical school concludes that the market is at equilibrium and prices are

perfectly flexible as long as supply and demand are unequal. To put this into the context of

Austrian economics, the Austrian school shares more similarities and agrees with Classical

economics more than the Keynesian school. The one theory that the Austrian School does not

agree with the Classical School on is the concept of the market being at equilibrium - Austrians

believe that the market is at disequilibrium. The concept of market disequilibrium is, however,

one of the few theories upon which the Austrians and the Keynesians agree. Overall, Austrian

economics agrees more with the theories of Classical economics than the theories associated

with the other economic schools.

Mainstream Economics

Mainstream economics is a loose term referring to the non-heterodox economics taught

in most prominent universities. They agree with the relatively new concept of applying

mathematic modeling to solve and make predictions about economic situations and human

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actions. This especially aggravates Austrians because one of their fundamental concepts is that

models, particularly in the case of human actions, are not accurate extrapolations that apply to

the real world. Mainstream economics is largely dominated by the resulting synthesis, being

largely Keynesian in macroeconomics and Neoclassical in microeconomics. The

microeconomics of Mainstream economics can be defined in terms of optimization and

equilibrium. There are four assumptions to which Mainstream economics are committed. The

first assumption is maximizing behavior satisfies models and behavioral theories. The second

assumes stable preferences, which suggests there exists models of endogenous preferences.

The third assumes equilibrium, which Mainstream economics suggests that game theory has

transformed concepts of market equilibrium to the extent that it is not clear what it means to

say that economists are, in general, committed to assuming equilibrium. The fourth, and last,

assumption is perfect knowledge and they argue that countless economists have explored ways

of modeling imperfect knowledge, even where probabilities cannot be attached to outcomes.

What holds Mainstream economics together is positive methodology, which explains why

Mainstream economists believe the assumptions that everyone in the market has perfect

knowledge and that the economy is always in long-run equilibrium. One of the major

differences between Mainstream economics and Austrian economics is that explanatory axioms

underlie Austrian economics and a set of empirical laws underlie Mainstream economics.

Austrian economics and Mainstream economics do have many theory differences; however,

Austrian economics has contributed to Mainstream economics adoption of marginalism and the

subjective theory, the two bedrock concepts of Austrian economics developed by Carl

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Menger.18 Thanks to the Austrian school, marginalism has now become an integral part of

Mainstream economic theory.19

Problems with Mainstream Economics According to Austrian Economics

The most interesting controversy between the two economic schools involves empirical

laws. According to Rothbard, the set of empirical laws that underlies Mainstream economics is

flawed for at least three reasons. First, no one has discovered any empirically robust law.

Secondly, theories can never be tested because it is impossible to undertake controlled

experiments where all relevant variables are held constant and hence ceteris paribus clauses

will never be satisfied. Finally, and thirdly, is the act of making a prediction may change the

forces at work. Mainstream economics most distinctive distinguishing feature is model-building

and Austrian economics suggest models are not a real world representation and only cause

further confusion. Austrian economists believe in universal economic theorems like market

disequilibrium and perfectly flexible prices, however, Mainstream economists deny there are

economic theorems of universal validity that can apply to any city or person.20

Classical Economics

Classical economics is widely regarded as the first modern school of economic thought,

which originated in Britain. Its major developers were Adam Smith, Jean-Baptiste Say, David

Ricardo, Thomas Malthus and John Stuart Mills. One can infer by their last names that most of

the Classical economic founders were British. According to most economic historians, Adam

Smith's The Wealth of Nations published in 1776 “marked the beginning of classical

18 The Austrian Theory of the Marginal Use and of Ordinal Marginal Utility19 Austrian Economics and the Mainstream: View from the Boundary20 Austrian Economics and the Mainstream: View from the Boundary

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economics”.21 Adam Smith identified the wealth of a nation with the yearly national income,

instead of the king's treasury. Smith saw this income as produced by labor, land, and capital.

With property rights to land and capital held by individuals, the national income is divided up

between laborers, landlords, and capitalists in the form of wages, rent, and interest or profits.

The Classical political economy is popularly associated with the idea that free markets can

regulate themselves. “The classical school was followed by Neoclassical economics in Britain

beginning around 1870”.22 Classical economics is similar to Austrian economics because they

both emphasize the essential elements of economics such as private property,

entrepreneurship, division of labor and institutions.23

Neoclassical Economics

The Neoclassical school of economics believes in stable preference like Mainstream

economics and market equilibrium like Keynesian and Austrian economics. Additionally,

Neoclassical economists are avid supporters of the price mechanism (refers to a wide variety of

ways to match up buyers and sellers through price rationing), which is one of the major

concepts emphasized by Austrian economics. A core concept of neoclassical economics

involves model building, for they have a hankering to create models for every conceivable

economic situation just like Mainstream economics.24 Because of this compulsive dedication to

model building Neoclassical economics dominates microeconomics. One of the assumptions

underlying the Neoclassical model of perfect competition is that everyone in the economy has

perfect knowledge about every economic opportunity. This assumption rules out the possibility

21 Does the Invisible Hand Hold or Lead? Market Adjustment in an Entrepreneurial Economy 22 Does the Invisible Hand Hold or Lead? Market Adjustment in an Entrepreneurial Economy23 Does the Invisible Hand Hold or Lead? Market Adjustment in an Entrepreneurial Economy24 Austrian Economics and the Mainstream: View from the Boundary

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that any unrecognized profit opportunities could exist in the economy, which means with

perfect knowledge there are no entrepreneurial opportunities.25 The rational choice theory is

another important staple concept of Neoclassical economics that uses a narrower definition of

rationality than the Austrians. Neoclassical economists perceive rationality to simply mean that

an individual acts in a way that balances costs against benefits to arrive at an action that

maximizes personal advantage (Milton Friedman 1953).26

Problems with Neoclassical Economics According to Austrian Economics

The fundamental problem Austrian economists have with Neoclassical economics is they

heavily rely on and endorse mathematical modeling. The root of this problem is that Austrian

economists comprehend that the complexity of human behavior makes mathematical modeling

of an evolving market extremely difficult and inconclusive to indubitably affirm it portrays a

valid reality. Instead, Austrians advocate explanatory axioms and a laissez faire approach to the

economy.27 Laissez faire describes an environment in which transactions between private

parties are free from state intervention, including restrictive regulations, taxes, tariffs, and

enforced monopolies. Austrians strongly believe the Neoclassical growth theory is ill-equipped

to deal with the time and institutional aspects that are critical for a firm understanding of

economic development. The Neoclassical formalized model overlooks the deeper issues that

irrefutably influence entrepreneurship, such as institutional evolution, politics, legislation, and

sociology. To put it simply, in the view of the Austrian school of economics, Neoclassical

economic theory is an inappropriate and unrealistic tool to analyze and prescribe policies that

25 The Origins of Entrepreneurial Opportunities26 On Rationality, Ideal Types and Economics: Alfred Schutz and the Austrian School27Austrian Economics and the Mainstream: View from the Boundary

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will induce economic development. Neoclassical economics concerns itself with the operation

of markets, not with how markets develop. When applying Neoclassical theory to economic

history and development, it ignores the incentive structure that is embodied in institutions and

entrepreneurship. The Neoclassical analysis of economic performance through time contains

two erroneous assumptions, that institutions do not matter and that time does not matter,

both of which are extremely important to Austrian economic theory.28

Keynesian Economics

The two basic concepts that Keynesian economics supports includes price is imperfectly

flexible and the market will be at disequilibrium. John Keynes, the founder of Keynesian

economics believed that if price is imperfectly flexible this would ultimately lead to full

employment of labor; however, other economic schools denied this. Keynesian economics

advocates a mixed economy chiefly the private sector, but with a large role of government and

the public sector.29 They put a major emphasis on macroeconomics and informally have the

reputation as the school of economics that dominates the macro-level of economics.30 During

the later part of the Great Depression, World War II, and the post-war economic expansion

between 1945 and 1973, Keynesian economics served as the economic model for several

countries. Its popularity could not last forever, for it began to lose favor and influence

following the stagflation of the 1970s and the recent stagflation in 2007 and 2008.31 The one

major problem Austrian economics associate with Keynesian economics is their concept of price

28 Entrepreneurship and Development: Cause or Consequence?29 The Collected Works of F.A. Hayek30 Spotlight on Keynesian Economics31 Economics: Principles in action

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being imperfectly flexible, because according to Austrians the price mechanism of supply and

demand causes price to be perfectly flexible, thus pulling the market back towards equilibrium.

Heterodox Economics

Heterodox economics generally refers to theories or to schools of economic

thought that are considered outside of Mainstream economics. This form of economics is

viewed as an umbrella term that covers multifarious economic approaches, schools, and

traditions. These include institutional, post-Keynesian, socialist, Marxian, feminist, ecological,

social, and the most significant Austrian economics.32

The Affinity between Heterodox and Austrian Economics

Austrian economics is thought of as a Heterodox school of economics because they both

emphatically accentuate the spontaneous organizing power of the price mechanism. The five

leading characteristics of the emerging new orthodoxy of Heterodox economics are bounded

rationality, rule following, institutions, cognition, and evolution. When listed in order these

characteristics of Heterodox economics create the acronym BRICE. The interesting fact about

BRICE is that the Austrian school of economics believes in and emphasizes all the characteristics

within the acronym BRICE.33

BRICE - Bounded Rationality

Austrian economists, Mises and Hayek, assumed bounded rationality; even Adam Smith

presumed this as well. People are expected to have only bounded rationality, meaning people

are rational but not perfect. In Hayek’s theory of bounded rationality, the bounds to human

32 The Nature of Heterodox Economics33 Austrian Economics at the Cutting Edge

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rationality have a logical and meta-mathematical dimension, and are not merely a contingent

empirical fact about limited power of cognition.34

BRICE - Rule Following

In the emerging new orthodoxy of Heterodox, people are modeled as rule followers.

Rule following can be defined objectively with the aid of information theory, in particular the

concept of mutual information. Economists have discovered that generally individuals and

institutions work best when they are governed by relatively simple rules rather than complex

rules in which they must use discretion. The conclusion is that in order for people and

institutions to prevail in a harmonious and prolific environment there needs to be a set of

simple and lucid rules they will follow.35

BRICE - Institutions

From the beginning, Austrian economists recognized that institutions matter and

included close institutional analysis in their work. Carl Menger’s theory of the evolution of

money is the standard example of the Austrian theory of institutions. The importance of

institutional analysis in the Austrian theory led Mises and Hayek to a definitive position in the

socialist calculation debate. This position concluded that socialism could not work because of

its many conflicting issues with the core concepts of Austrian economics, such as private

property and incentives.36

BRICE - Cognition

34 Austrian Economics at the Cutting Edge35 Austrian Economics at the Cutting Edge36 Austrian Economics at the Cutting Edge

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When it comes to cognition, Austrian economics has been devoted to cognition since

Hayek became infatuated with the economical influences of cognition. The activity of the mind

is typically defined as cognition and Hayek believed that a person’s cognition was particularly

important for an individual’s ability to adapt to any environment. Hayek, as well as many other

Austrian economists like Mises, believed cognition allowed people to make piecemeal

adjustments to their environment, especially in the case of exploitation, because exploitation is

the driving force behind the idea of entrepreneurship. As for subjectivism, one of the core

concepts of Austrian economics, Austrian’s view subjectivism of expectations as a species/type

of cognitive economics.37

BRICE - Evolution

In the case of evolution, it was one of the standard defenses of rational maximizing; and

Milton Friedan’s essay on positive economics relies on evolution. Austrian economics is notable

for its evolutionary theory of institutions, which explicates the negative ramifications that result

from socialism. Recent Austrian economists like Ulrich Witt have worked on theories that

emphasize social evolution. Michael Wohlgemuth in 2002 made an innovative application of

Austrian evolutionary reasoning regarding politics. Evolution is thought to sometimes

approximate an optimal solution and thus should be utilized by not just Austrian and Heterodox

economists, but by all economists who seek economic improvement.38

Concluding the Similarities that Austrian and Heterodox Economic Share with BRICE

Looking at all the examples and illustrations presented in the previous paragraphs about

BRICE, one realizes the influential implications of each characteristic. By the Austrians agreeing 37 Austrian Economics at the Cutting Edge38 Austrian Economics at the Cutting Edge

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with and emphasizing the five Heterodox characteristics of bounded rationality, rule following,

institutions, cognition, and evolution, they have enhanced the economic significance of the new

orthodoxy, Heterodox economics. Seeing that these two economic schools believe in many of

the same theories and concepts, one becomes optimistic about the possibility of new economic

developments emerging in the near future. A world in which two economic schools work on a

problem or solution together is far better and more efficient than one school pitted against the

other, which has usually been the case throughout the history of economics.

Austrian Economics

The name, Austrian economics, derives from the identity of its founders and early

supporters, who were citizens of the old Austrian Habsburg Empire, including Carl Menger,

Eugen von Böhm-Bawerk, Ludwig von Mises, and Nobel laureate Friedrich Hayek. These

economists left Germany to teach economics in Austrian universities, because during the early

to mid-1800s economics were not allowed to be taught in German universities. This is another

theory how Austrian economics acquired its name. The Austrian school believes that price is

perfectly flexible because people value choices. They also believe that all markets are at

disequilibrium. The Classical school believes in perfectly flexible prices just like the Austrians,

however, unlike the Classical school, Austrian economics do not agree with the Classical theory

that the market is at equilibrium. According to Peter Boettke, there are three defining

characteristics of Austrian economics which consists of: first, methodological individualism and

subjectivism, the second, analytical focus on the agent of change (e.g. the entrepreneur) and

market processes of adjustment to change, and third, an examination of the institutional

conditions required for spontaneous order. The market niche concepts and theories associated

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with Austrian Economics include the price mechanism, subjectivism, marginalism,

entrepreneurship, institutions, and economic calculation.39

Market Niche Concepts and Theories Associated with Austrian Economic

Price Mechanism

The price mechanism, one of the core concepts of Austrian economics, is based on

supply and demand. The price mechanism or market-based mechanism refers to a wide

variety of ways to match up buyers and sellers through price rationing. It also describes the

price of goods and services based on demand and supply. An example of the price mechanism

is through the use of announcing bids and asking prices. Generally speaking, when two parties

wish to engage in a trade, the purchaser will announce a price they are willing to pay, the bid

price, and the seller will announce a price they are willing to accept, the asking price.40

Subjectivism

Subjectivism is one of the fundamental concepts of Austrian economics that Carl Menger

developed. The subjective theory of value is an economic theory of value that identifies worth

as being based on the wants and needs of the members of a society, as opposed to value being

inherent to an object. It holds that to possess value an object must be both useful and scarce,

with the extent of that value dependent upon the ability of an object to satisfy the wants of any

given individual, thus products and services are subjective not objective. The economic theory

39 Austrian School of Economics40 Austrian School of Economics

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of subjectivism points out what is lost when legislators make simplistic distinctions between

necessities and luxuries or when, unlike voluntary transactions, legislative policy fails to take

account of subtle differences between the circumstances and tastes of different people. It is

impossible to make and implement a clear distinction between luxuries and essentials. The

government cannot make this distinction as well as a consumer can. It is dubious for the

government or policymakers to try and distinguish between essential and frivolous imports

according to whether they serve production or economic growth or mere consumption.

Policymakers do not understand how the price system brings into play the dispersed knowledge

that people have about their own tastes and circumstances. Some consumers choose to buy

extraordinary things and deliberately deprive themselves of the other things generally counted

as necessities. Subjectivist economists believe that consumers are the only ones able to

appraise essential and frivolous products and services, not the government.41

Marginalism

Marginalism is another key concept that Carl Merger developed for Austrian economics.

Marginalism’s central concept is the marginal utility of a good or service. Marginal utility is the

utility gained/lost from an increase/decrease in the consumption of that good or service.42 A

simple definition of marginalism is that the relationship between cost and quantity should be

taken at the margin. Austrian economists believes in the law of diminishing marginal utility,

meaning that the first unit of consumption of a good or service yields more utility than the

41 Why Subjectivism?42 “Austrian School of Economics” The Concise Encyclopedia of Economics

22

second and subsequent units. The Austrian school also talks about marginal cost which is the

change in total cost that arises when the quantity produced changes by one unit. This is the

cost of producing one more unit of a good. If the good being produced is infinitely divisible, so

the size of a "unit" is infinitesimal, then assuming the cost function is differentiable the

marginal cost function is the first derivative of the total cost function with respect to quantity.43

Entrepreneurship/Innovation

This fundamental concept is at the heart of the Austrian economic spirit.

Entrepreneurship occurs when an individual acts to take advantage of a profit opportunity that

presents itself in the economy. In its simplest form, the entrepreneur might notice that one

person is willing to sell something for less than someone else is willing to pay for it, so the

entrepreneur can act as a middle man, profiting from buying at the lower price and selling for

more. The profit, which is the return to the entrepreneur’s alertness to the opportunity, was

created entirely by the entrepreneur’s activity, because the sale would not have taken place

without someone having noticed the profit opportunity. The simplest definition of

entrepreneurship involves noticing previously unexploited profit opportunities.44

Economic Calculation

Economic calculation of the political economy is Austrian economics contribution to the

20th century. The simple definition of economic calculation refers to the decision-making ability

to allocate scarce capital resources among competing uses. Mises wrote economic calculation

is either an estimate of the expected outcome of future action or the establishment of the

43 The Austrian Theory of the Marginal Use and of Ordinal Marginal Utility

44 The Originals of Entrepreneurial Opportunities

23

outcome of past action. Its most practical meaning is to show how much one is free to

consume without impairing the future capacity to produce. Economic calculation provides the

foundation for the main contributions of the Austrian school in monetary theory, capital theory,

business cycle theory, the entrepreneurial theory of the market process, and the examination

of interventionism. This means that all the unique contributions of Austrian economics to

substantive economics can be traced back to the central importance of economic calculation

for human cooperation. Mises states that socialism is not a reliable system of society’s

economic organization because it lacks any method of economic calculation. Mises’s great

contribution to economic science was to establish that this (man must mentally process the

alternatives placed before him, and to do so he must have some “aid to the human mind” for

comparing inputs and outputs) decision-making ability is dependent on the institutional context

of private property. Mises argument for the need for economic calculation concluded that

without private property in the means of production, there will be no market for the means of

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

established for the means of production. And without monetary prices, reflecting the relative

scarcity of capital goods, economic decision makers will be unable to rationally calculate the

alternative use of capital goods. To sum up Mises argument, simply without private property in

the means of production, rational economic calculation is not possible.45

The Defining Characteristics of Austrian Economic

Methodological Individualism

45 Economic Calculation: The Austrian Contribution to Political Economy

24

Methodological individualism is a widely-used term in the social sciences. Its advocates

see it as a philosophical method aimed at explaining and understanding broad societies-wide

developments as the aggregation of decisions by individuals. The term was originally coined by

Joseph Schumpeter in 1908. Methodological individualism does not imply political

individualism, although methodological individualists like Friedrich Hayek and Karl Popper were

opponents of collectivism. Collectivism views the whole as being greater than the sum of its

individual parts, and gives priority to group rights over individual rights; this is the bases for

socialism and communism. Detaching methodological individualism from political

individualism, Max Weber's position, argued at the start of the twentieth century that if a

properly-functioning communist regime were to arise, it too would have to be sociologically

understood on methodological individualist principles.46

Entrepreneurship

Austrians stress that entrepreneurship does not describe a distinct group of individuals,

but rather, is an omnipresent aspect of human action. When the market is not in equilibrium,

profit opportunities exist, and entrepreneurs discover and act on these profit opportunities to

equilibrate the market. The taxonomy of the origins of entrepreneurial opportunities includes

factors that disequilibrate the market, factors that enhance production possibilities and most

notably, opportunities created from previous acts of entrepreneurship. Entrepreneurship

creates the opportunity for more entrepreneurs, which leads to economic progress.

46 Is There an Intellectual Market Niche for Austrian Economics?

25

Entrepreneurship activity benefits the buyer, the seller, and more generally, the entire

economy. In 1973, Kirzner emphasized the role of entrepreneurship in equilibrating an

economy, which would lead to a more efficient allocation of resources. He identifies three

major categories of factors that create profit opportunities: (1) Factors that disequilibrate the

market; (2) Factors that enhance production possibilities; and (3) Entrepreneurial activity that

creates additional entrepreneurial possibilities. When production possibilities increase,

entrepreneurial opportunities are created in several ways. More inputs, including increases in

the quality of physical and human capital, allow inputs to be combined in new ways. Income

growth opens the possibility of marketing new goods, or expanding the market for goods that

are income-elastic. Undertaking such activities requires the entrepreneurial insight to see that

there are profits to be made from changing the way one does business.47

The two most important core institutions for encouraging entrepreneurship are well-

defined property rights and the rule of law. Examples of institutions that stunt economic

growth include government, police and/or court corruption, excessive taxation and/or

regulation, unstable and/or inconsistent monetary and fiscal policy (Frye and Shleifer, 1997).

The lack of institutions in countries like post-communist Russia and the Ukraine with their

unofficial economic activities is the cause of their lack of economic growth. Historically,

countries that have well-defined property rights and a strong rule of law have a high growth

rate. When analyzing developing countries, those that have adopted these core institutions as

well as others that stem from them, such as freedom of choice, predictable government

activity, rules conducive to increase market and firm development, freedom of contract and

47 The Originals of Entrepreneurial Opportunities

26

exchange, have grown at a faster rate compared to their counterparts which have adopted

different institutions. Property rights and entrepreneurship are critical in encouraging capital

flow and economic development into a country. It is widely agreed that the entrepreneur is

the catalyst of economic progress.48

The Institutional Conditions Required for Spontaneous Order

The third defining characteristic at the heart of Austrian economics is an examination of

the institutional conditions required for spontaneous order. This question stimulates the

economic senses for the gravity of this inquiry is indubitably hard to swallow not due to the

nature of the answers complexity. We, however, can thank the author Peter Boettke, for his

ambiguous and reserved explanation of the institutional conditions required for spontaneous

order. Since the authors had the audacity to pose such an inquisition and offer no explanation

to elucidate his own challenging question, the reader is left to seek out an answer that is more

convoluted and multifarious than the explanation of the Holy trinity. The author goes a step

further to add abounded impendence of confusion upon an already flustered reader by pitting

the four most prominent patriarchs of the Austrian school of economics against each other.

When Peter Boettke states “The Philosophical justifications provided for this research program

differ among Austrian economists – such as Mises, Hayek, Rothbard, and Menger”, this allows

the author to divert the ominous perplexity of the question of institutional conditions back to

the original economists who constructed Austrian economics. In my opinion, the author is too

confounded about how to answer the question that he is surely intimidated that his

explanation would cause him to be unmitigatedly assailed by the entire economic community.

48 Entrepreneurship and Development: Cause or Consequence?

27

Due to the author’s inability of elucidating the necessary institutional conditions required for

spontaneous order to prevail, it seems that I must muster the fortitude to translucently

explicate the necessary conditions for spontaneous order to succeed.49

The only way to achieve an accurate definition that describes the institutional conditions

required for spontaneous order (self-ordering, self-sustaining, and self-regulation economics) to

prevail is to read another academic journal entitled Austrian Economics and Game Theory: A

Stocktaking and an Evaluation. The only conclusive definition I was able to derive from this

source about institutional conditions that related to spontaneous order was a vague but

insightful sentences that offered a more informational description involving institutions and

spontaneous order. The text stated “Game theory ideas have been used in a number of

attempts during the last 10-15 years to address Austrian and Classical liberal ideas on the

spontaneous emergence of beneficial institutions. The Game Theory is a mathematical method

for analyzing calculated circumstances, such as games, where a person’s success is based upon

choices of others. Indeed, game theory appears ideally suited to deal with issues that have

traditionally been a major concern to Hayekian Austrians, such as the formation of conventions

and other spontaneous orders. A number of non-Austrian but clearly sympathetic to Austrian

economics (Langlois 1986, Witt 1986, Buchanan 1997, Klein 1997) have utilized game theory to

analyze institutions, in some cases extensively.”50 Regarding the question involving the

institutional conditions required for spontaneous order, I can induce from reading these few

sentences that the conditions involved with the game theory may help address many Austrian

ideas about the many beneficial institutions that derive from spontaneous order. Later in the

49 Is There an Intellectual Market Niche for Austrian Economics>50 Austrian Economics and Game Theory: A Stocktaking and an Evaluation

28

article the reader is able to see how economists have begun to utilize the game theory to

analyze institutions. When one analyzes the game theory one realizes that this theory appears

ideally suited to deal with some of the fundamental issues, such as the formation of

conventions and other spontaneous orders, which have been the major concerns to Hayekian

Austrians. The game theory has also been able to address the significant Austrian explananda,

such as spontaneous emerged rules, which Neoclassical economists do not agree with. To

finally conclusively answer the 3rd defining characteristic of Austrian economics, an examination

of the institutional conditions required for spontaneous order, it seems like the main condition

that needs to be met is there must be institutions that promote the sustainability of

spontaneous order. From the past few sentences, it seems like the game theory is

progressively becoming a condition that will promote spontaneous order, with its influence of

Oskar Morgenstern who characterizes himself as an Austrian supporter and his utilization of the

game theory to analyze institutions, and its dedication to address Austrian explananda like

spontaneous emerged rules.51

The last academic journal that addressed the 3rd defining characteristic of Austrian

economics - examining the institutional conditions required for spontaneous order, was Urban

Interventionism and Local Knowledge. This article gives the most accurate and definitive

definition that describes the institutional conditions required for spontaneous order to prevail.

In this journal the author explained that trust and security in a city and local knowledge are

conditions for spontaneous order. According to Jane Jacobs, and Austrians economists, a city is

a spontaneous order because of its abilities of self-ordering, self-sustaining, and self-regulating.

51 Austrian Economics and Game Theory: A Stocktaking and an Evaluation

29

For a city to have this order trust must be apparent. Trust is the expectation that one’s physical

safety and security in public spaces will not be endangered. This expectation of safety and

security is a bedrock condition for spontaneous order. A degree of social cooperation can be

achieved, in the last resort, through government coercion. The challenge for social theory is to

explain whether and under what conditions such cooperation can emerge spontaneously. One

of Jacob’s principal contributions to our understanding of cities as spontaneous orders is her

insight that safety and ultimately trust depends on a surprisingly high degree of the structure

and location of public spaces, and that the relations that emerge spontaneously from a secure

foundation of trust essentially supports self-ordering processes of discovery and economic

growth.52

There are four conditions that help to generate the spontaneous formation of these

social phenomena. Frist, public spaces should have mixed primary uses that attract people to

particular districts so that people use them in large numbers at different times. Secondly, short

blocks with frequent opportunities for people to turn corners and vary their routes make

streets more interesting. They multiply the number of potential meeting points, increase one’s

exposure to more of the intricacies of the local environment, and increase the chances of

seeing the unexpected and making unexpected connections. Third, interspersed with newer

buildings should be old ones that have lower property values, so that new ideas have less costly

way to become established. Fourth and final, there needs to be a sufficiently dense

concentration of people, for whatever purpose they may be there, in order to promote both

safety and a high demand for an array of uses, including residential, recreational, and work

52 Urban Interventionism and Local Knowledge

30

related. There should be “the almost unconscious reassurance of general street support in

upholding civilization”.53 Any breakdown in these support structures ultimately reduces the

overall security of the street and beyond. Much of this knowledge is called “local knowledge,”

which consists of knowing how to get things done, but also of knowing whom to trust and

under what circumstances. In the end trust feeds back into and reinforces the expectation of

safety and security, for when people can expect strangers to help them uphold community

norms, norms are when there is trust, they also feel safe and more secure in public spaces.

Local knowledge of time and place for maintaining a healthy community of strangers in safety

and security takes time, but then communication between strangers and trust networks, will

thus support the more formal business practices in a successful district, indirectly but critically,

and in this way promote the more extensive use of markets and the price system.54

The trust that evolves in such a city that has been so elaborately described serves as a

foundation for dynamic economic processes. It encourages a mixture of primary and

supporting secondary uses of public spaces within a given district like industries, schools,

homes, government and business offices, grocery stores, gas stations, restaurants, bars, and

churches. All these forms of capital attract a growing number of people at different times of

the day and night. This type of environment attracts further diversity in the use of public

spaces and networks of what, Jacob, calls “codevelopment,” which is a type of interdependence

and complementarity among primary and supporting activities like the synergy among

investment banks, insurance firms, and law offices on Wall Street, that especially thrive in large

settlements. Like trust, “codevelopment”, is an outcome of a successful neighborhood district

53 Urban Interventionism and Local Knowledge54 Urban Interventionism and Local Knowledge

31

as well as a basis for future economic growth and adjustment. When the elements of

“codevelopment” are in place, cities can become “the natural generators of diversity and

prolific incubators of new enterprises and ideas”.55 The opportunities for chance meetings,

serendipitous connections, and accidental discoveries are tremendously multiplied in such an

affluent and economically growing environment. In this type of environment people and

business thrive because in great cities public and semi-public meeting and gathering places like

coffee houses, restaurants, bookstores, university seminars, specialty shops, unusual

neighborhoods, theaters, museums, and parks and plazas are so high in number and variety

compared to those found in smaller settlements that they really constitute a difference in

opportunities and exploitation. In this way, great cities serve as the primary incubators of new

ideas and entrepreneurship, and there is in them a strong tendency to be not only the financial

and political centers of the regions in which they reside but the creative centers as well. They

are thus the engines of economic and cultural change, and dominate the political landscape of

modern society.56

When you look at the simple fact that trust leads to local knowledge that leads to

business that leads to production that leads to new ideas that leads to entrepreneurship, one

realizes that if you can create a city or community that is based on trust were the citizens feel

safe and secure everything else will follow. So in the end, if everyone adopts Jane Jacob’s four

conditions that help to generate the spontaneous formation of these social phenomena, than

your communities, cities, countries, or the world will have spontaneous order – self-ordering,

self-sustaining, self-regulating, which ultimately leads to economic growth. With the

55 Jacobs 196156 Urban Interventionism and Local Knowledge

32

enlightenment of the propitious and opulent Austrian economics spontaneous order it is our

duty, no, our obligation as rational and perspicacious individuals to inspire and encourage the

utilization of spontaneous order. We should endorse this because we desire cities with great

grandeur and great cities are part of Hayekian spontaneous order and they stimulate copious

institutions and informal networks that characterize a mature market process.57

Out of all the three academic journals I referenced to explain and inform the reader

about institution conditions required for spontaneous order the best of the three academic

journals that analyzed, rationalized, and illustrated in perfect detail was, Urban Interventionism

and Local Knowledge. If this ideal economic theory could work world-wide than there would be

no longer any 2nd or 3rd world countries, with spontaneous order it sounds like a utopia.

Because Austrian economics’ spontaneous order stimulates efficiency and prolific

societies/cities, spontaneous order is the central concern to the theory of interventionism.

Conclusion

When considering all the different schools of economics, the Austrian school of

economics contains the best principles and concepts to stimulate economic growth. The

market niches for Austrian economics include the price mechanism, subjectivism, marginalism,

entrepreneurship, institutions and institutional conditions necessary for spontaneous order,

disequilibrium, perfectly flexible prices, and economic calculation. Austrian economics stress

the need for private property and how private property affects production, monetary prices,

57 Urban Interventionism and Local Knowledge

33

and economic calculation. Mises, one of the most prominent Austrian economists, explains the

need for private property by stating without private property in the means of production, there

will be no market for the means of production, and without a market for a means of

production, there will be no monetary prices established for the means of production, and

without monetary prices reflecting the relative scarcity of capital goods, economic decision

makers will be unable to rationally calculate the alternative use of capital goods. In conclusion,

without private property in the means of production, rational economic calculation and

economic growth is not possible. One of the most important core concepts of Austrian

economists is institutions. Austrian economics emphasize that the lack of institutions in

countries like post-communist Russia and the Ukraine with their unofficial economic activities is

the cause of their lack of economic growth. When considering developing countries, those that

have adopted core institutions like private property rights and rule of law as well as others that

stem from it - freedom of choice, predictable government activity, rules conducive to market

and firm development, freedom of contract and exchange - have also grown at a faster rate as

compared to their counterparts, which have adopted non-Austrian economic institutions. In

the end for a country to have the most effective and efficient economic growth they need to

follow and encourage the core economic theories of Austrian economics like entrepreneurship,

private property rights, rule of law, subjectivism, and marginalism. By adopting the concepts of

Austrian economics communities, cities, and countries will be able to achieve sustainable

economic growth.

34

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