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The Core Points of Austrian Economics

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SkepticalMetal posted on Thu, Nov 1 2012 9:14 PM

I'm hoping some of you Austrian School experts can address these key values of Austrian economics, issue by issue, i.e. explain the reasoning behind the theory and how it works. (if this thread is successful, people looking to debate abroad can go on here and view the straightforward machinery of Austrian economics so it is possible to state the position clearly)

  • The theory that economic events are best explained by a deductive study of human action.
  • The theory that the use of economic models and statistical methods to model economic behavior are a flawed, unreliable, and insufficient means of analyzing economic behavior and evaluating economic theories.
  • The theory that testability in economics and consistently accurate mathematical modeling of an economic market are impossible because mathematical modeling of any real market affects the decision-makers in that market and "testing" relies on real human actors who cannot be placed in a lab setting without altering their would-be actions.
  • The theory that the way in which money is produced has real and not only nominal economic effects.
  • The theory that the cost of any activity should be measured by reference to the next best alternative.
  • The theory that, in a free market, interest rates and profits are determined by three factors: monetary gains or losses from a change in the consumption of a good or service, additional output that can be produced by additional inputs, and the time preference of the associated individual agents.
  • The theory that markets clear if prices are allowed to adjust freely.
  • The theory that inflation properly defined relates to an increase in the supply of money (including credit) which causes prices to rise.
  • The theory that capital goods and labor are highly heterogeneous (diverse), that money allows different goods to be analyzed in terms of their cost effectively, that economic calculation requires a common basis for comparison for all forms of capital and labor, that this process is the signaling function of prices, and that it is also a rationing function which prevents over-use of inherently limited resources.
  • The theory that the capital structure of economies consists of heterogeneous goods that have multi-specific uses which must be aligned to be effectively allocated, that the economic "boom-bust cycle" is caused by an artificial and unsustainable expansion of credit by the banks, and that this expansion causes businesses to make bad investment decisions which, in turn, necessarily cause major economic dislocation.

 

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"The theory that economic events are best explained by a deductive study of human action."

"The theory that the use of economic models and statistical methods to model economic behavior are a flawed, unreliable, and insufficient means of analyzing economic behavior and evaluating economic theories."

Necessarily true because of the praxeological axiom. Because in any period of induction people are persuing different ends do to people being exposed to different stimuli, we are incapable of understanding why people act in such a way without understanding certain facts about human action. Statistics showed how people acted in a certain period, but without a preset economic theory you cannot understand why they did what they did. Was there inflation because there was a full moon? Data is extremely valuable, but the intepretation can only be performed through some sort of economic theory and it can only tell us what things were at work in that specific instance, it cannot add to our knowledge of economic theory unless it allows us to see something which is a priori true which we overlooked before.

"The theory that testability in economics and consistently accurate mathematical modeling of an economic market are impossible because mathematical modeling of any real market affects the decision-makers in that market and "testing" relies on real human actors who cannot be placed in a lab setting without altering their would-be actions."

The first part is true because people act in dynamic and changing ways, not in terms of mathematical constants. As for testing, this just reveals the values and decisions of certain people under certain situations

"The theory that the way in which money is produced has real and not only nominal economic effects."

This is true because money income and prices affect how real goods and services are allocated, as revealed to us through market theory.

"The theory that the cost of any activity should be measured by reference to the next best alternative."

This is true because if someone has no choice, then there can be nothing lost when the action is performed, it is only through alternatives which we can have something which can be surrendered in order to bring something about, a cost.

"The theory that, in a free market, interest rates and profits are determined by three factors: monetary gains or losses from a change in the consumption of a good or service, additional output that can be produced by additional inputs, and the time preference of the associated individual agents."

You need to clarify this point.

"The theory that inflation properly defined relates to an increase in the supply of money (including credit) which causes prices to rise."

This is true because any other changes in the value of money are caused by real market desires, it is not a separate phenomena.

"The theory that capital goods and labor are highly heterogeneous (diverse), that money allows different goods to be analyzed in terms of their cost effectively, that economic calculation requires a common basis for comparison for all forms of capital and labor, that this process is the signaling function of prices, and that it is also a rationing function which prevents over-use of inherently limited resources."

Different capital goods and labor produce different things at different quantities. This is an empirical fact. Because entrepreneurs can receive a profit through utilizing goods which are of a lower price which produces a more value product, all capital and labor will be bid up to the level of their marginal value in bringing about the product. This requires a common base because in the absence of a numerical base it is impossible, except through arbitrary whim, to determine what is the most valuable way that goods can be utilized and where inputs are to be most effectively utilized. This system allows for calculation which bring all goods to where they are most desired by consumers. Any discrepancies will result in either profit or loss which will slowly be eradicated so long as no changes in the data of the market occur.

"The theory that the capital structure of economies consists of heterogeneous goods that have multi-specific uses which must be aligned to be effectively allocated, that the economic "boom-bust cycle" is caused by an artificial and unsustainable expansion of credit by the banks, and that this expansion causes businesses to make bad investment decisions which, in turn, necessarily cause major economic dislocation."

The first part of this is answered above. Time preference is huge in determine the value of land and capital goods because the interest rate determines a huge amount about profit differentials. If interest rates are extremely high then something needs to be able to produce a great deal, and quickly, so as to be able to pay off the debts which he has incurred. However, if the interest rate is very low then entrepreneurs will be able to invest in longer term projects because he will not incur costs as great through through his borrowing and lending. This whole process means that when interest rates are high demand for longer term capital goods is not very high because what they can be used to produce is not profitable. However, if interest rates are low then the demand for capital goods which have projects which require a long time to come to fruition increases because they yield profitable results. This increases the demand for long term capital goods, which spawns their production and also spawns more investment in long term projects.

When interest rates are lowered through an expansion of credit an unsustainable process comes about because as the new money used to purchase things and demand for goods in general shifts to the right. This, in turn, causes a general rise in price because no new capacity to produce has been reached. Since the interest rate is a ratio between demand for present goods and future goods, determined by the expected return from investment vs. general time preference (it's not quite as neat as that but it'll do for a basic explanation). This means that eventually the consumption to investment ratios reestablish themselves at a point which is not equal to the new rate of interest, assuming that forced savings or a shift in time preference/production potential has not occurred. Since entrepreneurs invest in higher order goods and longer term projects it takes more time for their projects to come to fruition. Once the interest rates change, however, the prices and returns anticipated throughout the process change dramatically. This makes many entrepreneur's investments unprofitable, they have to stop mid-project and accept any corresponding losses. This is compounded by the fact that lower interest rates disinsentivizes savings and will exacerbate the problem from what it otherwise would have been. This results in mass business failure and a sudden fall in demand, which leads to further fall in business activity.

This is all the result of mass entrepreneurial error anyway, and it is only the tampering of this key pricing mechanism which is likely to cause such radical misallocation, the inevitable result of a lower time preference and greater demand for future goods, but which is only temporary. A sudden natural fall in interest rates would have a similar affect.

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Thanks. Could you explain how markets clear when the prices aren't planned out and set?

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I suggest you pick up any standard economics textbook for that.

Essentially, if there is a greater quantity demanded than the quantity supplied at the current price, the price is bid up. If there is a lower quantity demanded than the quantity supplied at the current price, the price is bid down.

Note: Perfect competition of standard micro doesn't exist, but the mechanism is more or less similar.

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Ya know... The thing is that, even though that's AE and just plain economics 101, I have the hardest time really saying that has to be the case just in terms of how much people hold. I don't know, I  feel the wording is awkward even if academically it's spot on.

The logic is simple, that if the only variables are price and quantity of a homogeneous good, then buyers will continue to exchange until they either don't have enough money to buy anymore, and sellers will continue to exchange until they either don't have any more goods to exchange or the utility of giving up another increment of the good will give them less than the money they would get from it. Any discrepancies in price of the same good will result in arbitrage movements for profit to those who desire the good most, and this process raises the price. If the price is too high then producers will cave and lower the price so that they will be able to sell off goods at a lower price which they still value more than the current price in relation to their good. If prices are set then both parties have to compare the utility of the set price to the utility of the good which will prevent people from trading at that point which they really want to trade.

Where it get's tricky is when you move past basic barter and into the world of imperfect competition, where although the price will allow the market to clear, the way the price is set is very different, as well as how markets may clear (surpluses by a monopoly may be destroyed, for instance)

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So if I had a flat video game company and I wanted to hire an economist to study in-game currency (sound familiar) do you recommend I hire an Austrian?

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I would definitely not hire an Austrian. Maybe a financial analyst.

There's almost no entrepreneurship in Valve's games.

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Why? (to both statements)

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Don't forget that Economics being a science is value free.

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Well, by "values," I simply meant the theories that make Austrian economics what it is.

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@Wheylous

I actually find that normal micro econ textbooks (the four I have been exposed to and my class) do an absolutely awful job of explaining why markets clear. The most eloquent explanation that I've ever read is Rothbard's work in MES, no doubt.

@Skeptical Metal

What exactly is the Austrian looking at in the video game example? He would probably be able to tell you why it is that certain events had happened in the value of currency within a video game, but he probably wouldn't be able to help you do much in making money in the industry, if that's what you're asking.

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