Advanced Introduction to the Austrian School of Economics [1 ed.] 1781955743, 9781781955741

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Elgar Advanced Introductions are stimulating and thoughtful introductions to major fields in the social sciences and law, expertly written by some of the world's leading scholars. Designed to be accessible yet rigorous, they offer concise and lucid surveys of the substantive and policy issues associated with discrete subject areas.

The aims of the series are two-fold: to pinpoint essential principles of a particular field, and to offer insights that stimulate critical thinking. By distilling the vast and often technical corpus of information on the subject into a concise and meaningful form, the books serve as accessible introductions for undergraduate and graduate students coming to the subject for the first time. Importantly, they also develop well-informed, nuanced critiques of the field that will challenge and extend the understanding of advanced students, scholars and policy-makers. Titles in the series include: International Political Economy Benjamin f. Cohen

International Conflict and Security Law Nigel D. White

The Austrian School of Economics Randall G. Holcombe

Comparative Constitutional Law Mark Tushnet

Advanced Introduction to

The Austrian School of Economics RANDALL G. HOLCOMBE DeVoe Moore Professor of Economics, Florida State University, USA

Elgar Advanced Introductions

Edward Elgar Cheltenham, UK • Northampton, MA, USA

© Randall G. Holcombe 2014

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL5o 2JA

UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts o1o6o USA A catalogue record for this book is available from the British Library Library of Congress Control Number: 2013958020

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ISBN 978 1 78195 573 4 (cased) ISBN 978 1 78195 574 1 (paperback) ISBN 978 1 78195 575 8 (eBook) Typeset by Servis Filmsetting Ltd, Stockport, Cheshire Printed and bound in Great Britain by T.J. International Ltd, Padstow

For Ross, Mark and Connor: my children, and students ofAustrian economics.

Contents

ix

Preface The market process

21

Decentralized knowledge: the role of firms and markets

22

1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11

2

1

Spontaneous order Knowledge and economic coordination Equilibrium: the coordination of individual plans Equilibrium: the absence of unexploited profit opportunities The market as a discovery process The element of time The subjective nature of value The subjective nature of cost Utility and individual action Competition Conclusion

1.1

2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12 2.13 2.14

The entrepreneurial nature of firms Entrepreneurship as arbitrage Profit and loss Profits are not certain Profit and progress: a caveat Opportunity cost and profit-seeking Cost and price Information, knowledge and wisdom Research and development The division of knowledge and the supply chain Tacit knowledge and agglomeration economies Firms as repositories of knowledge Searching for prices: disequilibrium exchanges Conclusion

2 6 9 11 12 14 16 17 18 19

24 26 27 29 29 30 31 32 35 37 39 40 42 44

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ADVANCED INTRODUCTION TO THE AUSTRIAN SCHOOL OF ECONOMICS

3

Economic calculation

3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11 3.12 4

Money, banking and business cycles

4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10 4.11 4.12 5

Ludwig von Mises on economic calculation The socialists answer Mises The Austrian school's answer Decentralized knowledge Complex systems The mixed economy Economic progress The evolution of economic activity Product differentiation and progress Profit: indicator of progress Welfare: process versus outcome Conclusion

The money supply and fractional reserve banking The basic business cycle theory The causes of the business cycle Why do borrowers and lenders make these errors? The structure of capital The structure of production and business cycles The capital stock The coordination of economic activity Schumpeterian and Kirznerian entrepreneurship Inflation Free banking Conclusion

The resurgence of the Austrian school

5.1 5.2 5.3 5.4 s.s s.6 5.7 s.8

Rtferences Index

The rise of the Austrian school The dormant Austrian school in the mid-twentieth century The resurgence of the Austrian school Austrian economics and capitalism The role of government in the economy The ideology of the Austrian school The methodology of the Austrian school Conclusion

46

46 48 so 52 52 54 55 58 6o 62 64 66 69

70 71 73 74 77 79 82 85 87 89 90 91 95

95 97 99 102 105 107 109 112 117 121

Preface

The Austrian school of economics, nearly extinct in the middle of the twentieth century, has seen a remarkable resurgence toward the end of the twentieth century and into the twenty-first. In addition to an active academic research program, the financial press often refers to the ideas of the Austrian school. College students also have an interest in the Austrian school, I know from talking with my own students, even those who may not intend to go on to graduate study in economics, or look for work in financial institutions. This interest suggests the value of an advanced introduction to the ideas of the Austrian school, in-depth enough that reading it can provide a good understanding of Austrian economics, but accessible enough that someone with a basic knowledge of economics can read it and understand what differentiates the ideas of the Austrian school, and makes those ideas "Austrian" beyond just being economics. A school of thought is defined by the ideas of its members, and there is not a clear line that identifies its borders. First, there is the question of who belongs to a school of thought, and even if that is clear (which it is not), often members of a school of thought disagree with each other on some issues, even if they find broad agreement on most. Presumably, those areas that have broad agreement would constitute the ideas of the school - but members of a school might even disagree on identifying areas where there is broad agreement. For example, the role of entrepreneurship in an economy is an indispensable component of Austrian economics, but Israel Kirzner and Murray Rothbard, two of the more important members of the school, have some disagreements about what constitutes entrepreneurship. This volume deliberately glosses over any disagreements and controversies in an attempt to present a straightforward explanation of the school's major ideas. One might even call into question the value of describing a school of thought. In a 1974 conference in South Royalton, Vermont that played an instrumental role in the Austrian school's resurgence in the second

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half of the twentieth century, Milton Friedman gave an after-dinner talk in which he questioned the value of delineating economic ideas by schools of thought. He said, "There is good economics and there is bad economics," and said it was more productive to partition economics that way - and do good economics - than to partition it by schools of thought. Why should it matter whether an idea is more closely associated with the Austrian school, or the Chicago school, or the postKeynesian school, for example? Friedman offered good advice to those in attendance who wanted to engage in economic research, but these schools of thought do have distinguishable ideas associated with them, so despite Friedman's good advice to the practitioner of economics, there still is value in laying out the ideas of a school for those interested in understanding what gives that school a distinct identity. In keeping with Friedman's advice, all of the ideas I have included in this volume are good economics, in my view. An introductory volume like this is not the place to concentrate on controversies within the school, or to explain the problems with ideas I think are flawed. But, while the volume is my vision of the most important and distinguishing ideas of the Austrian school, I did attempt to write it in such a way that those who consider themselves knowledgeable about the ideas of the Austrian school would agree that this volume does, in fact, give a good introduction to the school's ideas. My own introduction to the Austrian school came when I was a graduate student, and then because of the interests of several classmates rather than from classroom material or discussion. Even though I was an economics major, I was unaware that there was an Austrian school of economics when I was an undergraduate. The ideas of the Austrian school appealed to me, and I attended a number of conferences devoted to the school's ideas, as a graduate student and then as a faculty member, including the 1974 South Royalton conference I mentioned earlier. I was a faculty member at Auburn University when the Ludwig von Mises Institute was established there in 1982. I am an Associated Scholar with the Institute, a member of the Society for the Development of Austrian Economics since its founding in 1996 and served as its president in 2007. I have had a long-standing interest in the Austrian school. As an introduction to the Austrian school, this book is aimed at those who do not have a deep knowledge of the school, and who want to understand what is distinctive about the Austrian school's methods

PREFACE

xi

and ideas. The volume is "advanced" because it assumes that readers have some background in economics, but it is an "introduction" because it does not assume any knowledge about the Austrian school. Because of its orientation as an introduction to the Austrian school, the references throughout the text and listed at the end of the book are to the more significant works by Austrian school authors, or by others whose ideas are related to the Austrian school. The book omits references to ideas that do not have a specific Austrian connection, so the references listed at the end of the book all have some relevance to the Austrian school rather than to economics more generally. I gratefully acknowledge the comments of those who have read all or part of the manuscript as it was in progress, including Peter Boettke, Samuel Bostaph, William Butos, Rob Bradley, Peter Klein, Peter Lewin, Dave Garthoff, Sanford Ikeda, Steve Kates, Jonathan Mariano and George Reisman. In trying to present an overview of the ideas of the Austrian school, I recognize that everyone may have a different vision, though I hope there are only slight differences in the details rather than differences related to the broad vision of the school. With that in mind, despite some excellent comments I have received on the project, responsibility for any shortcomings in the way I have presented the Austrian school's ideas must remain solely with me.

1

The market process

Economic analysis, as it has developed through the twentieth century and into the twenty-first, is built on the foundation of equilibrium analysis. The supply and demand framework within which economists explain the operation of markets is familiar to all students of economics. Prices adjust in markets so that the forces of supply and demand balance each other, and the quantity supplied equals the quantity demanded. The equilibrium framework implies that when an economy is not in equilibrium, market forces pull it toward equilibrium, but the supply and demand model itself depicts the equilibrium outcome, not the market forces that produce it. One of the distinguishing features of the Austrian school is that it focuses on the ongoing market process that tends to lead an economy toward equilibrium more than on the equilibrium outcome itself. The Austrian approach to economic analysis recognizes that there are market forces in an economy that create a tendency for it to move toward an equilibrium, but also that an economy will never actually arrive at an equilibrium. Partly this is because the market environment is always changing. People's preferences may change, and as knowledge advances, bringing with it new insights and technologies, new products and production processes are always being developed. Another reason an economy will never reach equilibrium is because the information necessary to arrive at an equilibrium is disbursed among all of the participants in an economy, and the nature of this decentralized information means that it can never be aggregated in such a way as to produce an equilibrium. The information available to market participants is constantly changing, so individuals are constantly updating their knowledge base with information that may be incomplete, uncertain and even contradictory. A market economy is organized to coordinate the plans of everyone in an economy, but the information required to do so is such that this coordination problem can never be completely and finally solved.

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Conceivably, if the knowledge base of all market participants remained unchanged, the economy could eventually approach an equilibrium, but as an economy moves toward equilibrium, the underlying market conditions are continually changing, and individuals are continually updating their information and expectations to adjust to those changes. Some factors that disrupt the coordination of economic activity may be temporary, but many introduce permanent changes in the economy, and economic adjustment leads to a structure of economic activity different from what has existed in the past. Within the framework of equilibrium economics one might say that the underlying equilibrium has changed, but in fact it is always changing, and equilibrium may not be the most appropriate description of the outcome toward which an economy is tending at any point in time. Equilibrium suggests that if an economy is disturbed from its equilibrium state, forces will pull it back to that state, but when the existing state is disrupted by the introduction of new products and new production methods, the economy will never return to where it was previously. Austrian school economists do refer to equilibrium concepts, but in the context of a continually evolving economy, equilibrium is a continually moving target. The market economy is a coordination mechanism that enables individuals to make use of the information they possess to plan their economic activities in such a way that they are consistent with everyone else's plans. This coordination does not always work perfectly, and one goal of economic analysis is to understand why it can sometimes break down. Despite some problems, however, the market mechanism works amazingly well to coordinate everyone's plans and to make effective use of all of the decentralized knowledge that is possessed by everyone in the economy. The economic forces that lead markets to clear, so that the quantity supplied equals the quantity demanded in all markets, are so strong that people typically take for granted that they can readily acquire any good or service by paying the market price. The Austrian school focuses on the process by which economic coordination takes place, leaving the outcome toward which it is tending as a matter of secondary importance.

1.1

Spontaneous order

Perhaps the most important lesson economics has to teach is that the activities of individuals can be effectively coordinated into an orderly

THE MARKET PROCESS

3

and efficient outcome without anyone planning it out, or even being able to foresee the outcome. The market economy is a spontaneous order. It is a result of human action, but not of human design. 1 Richard Wagner (2007) uses an analogy of people marching in a parade versus people moving from store to store in a shopping mall. In both cases there is an orderly flow of people, but in the first case each individual's movements are planned out and coordinated by a centralized topdown plan, whereas in the second case all individuals make their own plans and the overall outcome is orderly and efficient, even though the outcome cannot be forecast ahead of time. No central authority could predict who would be in which store at any particular time, yet each individual's decentralized planning leads to a spontaneous order that allows everyone's individual plans to be coordinated. Spontaneous order emerges in many social activities, both within and outside of economic phenomena. To see how spontaneous order can emerge through social interaction, consider an example outside economics: the development of language. Who invented language? Nobody. Language is the result of human action but not of human design. Language began with primitive people making sounds that came to be understood by others as having meanings. Some sounds referred to people, places, things or ideas: nouns. Other sounds denoted activities, which we now call verbs. Sometimes additional nuances might convey valuable meaning, so nouns and verbs can be modified by adjectives and adverbs. What a great idea! Who invented adverbs? Nobody. They are the result of human action but not of human design. Money is another result of human action but not of human design. In primitive times as people were recognizing the benefits of specialization in their economic activities, people found that rather than producing everything for themselves, they could specialize in activities in which they were more productive and trade their output to get more than if they produced everything they consumed themselves. For example, a person might see that he could produce farm tools and trade them to farmers, and end up with more food to consume than if he farmed himself. In such a system some goods would be better to accept in exchange than others. If people were offering a seller goods that seller did not want to consume, it would be better to accept brooms in exchange than milk, for example. If the individual did not consume the milk, it would spoil, whereas the brooms, being more durable, could be kept and traded to someone else later.

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ADVANCED INTRODUCTION TO THE AUSTRIAN SCHOOL OF ECONOMICS

Some goods are naturally more acceptable in exchange than others because those goods can be more easily traded away at a later date. Therefore, people are more willing to accept those goods in exchange even when they have no desire to consume them. Carl Menger (1871 [1976]), founder of the Austrian school, called money the most tradable of commodities. Over time people come to understand which goods are readily tradable and which are more difficult to trade away, and one or a small set of goods becomes accepted as a medium of exchange. Nobody invented money. It evolved as the result of human action but not of human design. The market economy is itself a spontaneous order: the result of human action but not of human design. Nobody invented or designed the market economy. Rather, individuals saw the advantages of specialization and gains from trade, and began trading with each other. As they did, market institutions, such as money, emerged without anyone planning them out. Individuals saw economic problems and challenges, but each problem also presents an opportunity to overcome it, and market institutions developed from the bottom up, with no central planner and no central plan. One example is the development of stock markets to facilitate financing economic activity. In the 15oos Europeans began undertaking commercial activities all over the world. Individuals with sufficient wealth could purchase and outfit a ship to engage in trade, with the hope that it would come back with goods from far-away lands that could profitably be sold at home. Most of the time these voyages were successful, but not always, and when the ship an investor had financed failed to return, that investor suffered heavy losses. Thus, the origin of the common phrase "when my ship comes in" to signify a fortunate event. This financing of trading ships was profitable, but risky. To deal with the risk, a group of individuals in Amsterdam got together and agreed to pool their resources to finance several ships. All would share in the profits when the ships returned. Some would likely not return, but by pooling their risks this way they could reduce their individual risk and maintain the same expected return on their investments. This enterprise was the Dutch East India Company, which was established in 1602. The enterprise proved profitable, and when the ships started coming in the owners decided to reinvest the proceeds to send out more ships, rather than just take the profits. But some owners wanted to get their money out, so they sold their shares to others

THE MARKET PROCESS

5

who wanted to participate. Soon the shares of the Dutch East India Company were regularly traded, to the extent that some individuals undertook the specialized activity of helping to match buyers and sellers for a fee. The successful marketing of shares of the Dutch East India Company encouraged other businesses to market shares in their companies, and so starting from a few individuals who saw a profit opportunity in helping to match buyers and sellers of shares, stock markets emerged as an institution that undertook this activity. Stock markets emerged as a result of human action but not of human design. Innovations that facilitate market exchange continually happen that way. Some stores were willing to allow trusted customers to buy on credit when they were short on money, and be paid back later. This was institutionalized as the stores offered credit cards to buyers. In the 1950s almost all credit cards were specific to one retailer. Department stores had their own credit cards and gas stations had theirs. People who wanted to buy something using a credit card had to have a card issued by that particular seller. Once credit cards were established, entrepreneurs recognized the value of having one card that was widely accepted, so that by the twenty-first century store-specific credit cards have nearly gone extinct and given way to cards like Visa and MasterCard that are nearly as widely accepted as cash. The credit cards people take for granted today are the result of human action but not of human design. They evolved into their current form as entrepreneurs found continually better ways of managing transactions. The market economy that has produced such a profound increase in people's material wellbeing since the beginning of the Industrial Revolution is a spontaneous order that has evolved as a result of human action but not of human design. Perhaps the most important lesson economics has to teach is that an orderly and efficient outcome can emerge without anyone planning it out. Looking back to the 1950s, 196os, 1970s and even the 198os, many reputable economists believed that central planning was a more efficient way to organize an economy than to leave things to the uncertainties of the market. After the collapse of the Berlin Wall in 1989, followed by the break-up of the Soviet Union in 1991, that view fell from favor and capitalism was viewed as a more effective economic system than socialism. To understand why capitalism works so well, one must understand the process by which markets allocate resources. The Austrian school's emphasis on the spontaneous order generated by the market process has led scholars in the school to look favorably on the market allocation of resources, and

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to be more critical of resource allocation through government planning than the economics profession in general. The most significant lesson economics has to offer is that people's activities can be coordinated through the market mechanism to produce a spontaneous order, without anybody planning or designing the outcome. Everybody makes their own individual plans, and the institutions of the market coordinate these individual plans so that, in general, people's plans can be realized, and people can make the best use of the information they possess to produce an outcome that works best for the prosperity of everyone. This insight goes back at least to Adam Smith (1776 [1937]), who noted that individuals pursuing their own interests are led by an invisible hand to do what provides the greatest benefit for everyone. A comparison of the outcomes of the centrally planned socialist economies of the twentieth century with capitalist economies shows that no central plan is necessary for a desirable outcome, and that, more typically, the outcome of a spontaneous order is more desirable than the outcome of a top-down plan. Individuals make their own plans, based on their own individual knowledge, and these decentralized plans are coordinated through the market mechanism to produce an orderly outcome that is the result of human action but not of human design.

1.2

Knowledge and economic coordination

The main function of a market economy is to coordinate the economic activities of all of its participants. Partly, this means that market forces work to equate the quantity supplied to the quantity demanded in all markets. This is what economists often mean when they refer to market equilibrium, but in light of the critical analysis of the concept of equilibrium given earlier, it is probably more descriptive to refer to the equating of the quantity supplied with the quantity demanded as "market-clearing" rather than "equilibrium." As already noted, it is often the case that events that disturb the current state of affairs are permanent changes that have a permanent effect on the allocation of economic resources. Regardless of the terminology, all economists have a good understanding of the market-clearing forces in an economy and the way they coordinate people's activities by bringing the quantity supplied to equal the quantity demanded.

THE MARKET PROCESS

7

Taking a longer view of the economic process, economic conditions are always changing, and information about those changes is widely disbursed and often subject to interpretation. People have incomplete information. Nobody knows everything everyone else knows, so the knowledge one person has will be different from, and perhaps contradictory to, the knowledge of other people. Even more, individuals themselves may have information from different sources that is conflicting and contradictory. In what is surely the single most influential academic article written by an Austrian school economist, Hayek (1945) notes that every individual has some specific knowledge of time and place. Individuals possess knowledge that not only does nobody else have but nobody else could have. A market economy coordinates all of the decentralized knowledge held by individuals throughout the economy. Much of the knowledge people have is tacit knowledge, which means knowledge that they are able to use but which they are not able to effectively communicate to others. Tacit knowledge can be used only by the people who have it. Hayek notes that while people often think of knowledge in the sense of scientific knowledge, a great deal of knowledge consists of past experiences and observations that provide a basis for action and decision-making, but that the holder of the knowledge would be unable to summarize by writing it down or explaining it to someone else. Much as one cannot learn how to ride a bicycle or hit a baseball only by listening to someone else explain how to do it, or watching someone else do it - those activities must be learned through experience - many economic activities are also undertaken with tacit knowledge. Corporate chief executive officers (CEOs) and others in management positions get paid high salaries because they have acquired tacit knowledge that is not easily communicated to others. If this were not the case, corporations would hire people with new Masters of Business Administration (MBA) degrees to run their companies - who do have the latest scientific knowledge about business management - rather than the more experienced people they actually hire. If this were not the case, the mentoring that employers deliberately provide to their junior employees would be unnecessary. Tacit knowledge is possessed by everyone in the economy, not just those at the top of the corporate hierarchy. Hayek (1937 [1949]) emphasizes that as people gain experience in a job they learn to do it better and more productively, and as people gain experience in a particular line of business they are better able to judge what would be

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successful in that line of business. Often, what would make a desirable business location, what would be a desirable change in a product design or what could improve the efficiency of a production process is something people are better able to determine with experience. While these examples are from the top of the business hierarchy, even those who have entry level jobs pick up tacit knowledge through experience and become more productive as a result. Not only is knowledge often decentralized and tacit, people with incomplete knowledge and with different knowledge bases frequently will arrive at conflicting conclusions. Some people perceive that action A will be a profitable course of action while others believe that in the same situation action B will be profitable. Both may be right, both may be wrong or one course of action may be better than the other. To offer but one example, when Apple introduced its iPhone in 2007 many observers believed it would meet with limited success because the phones prior to the iPhone had mechanical keys that observers thought users would prefer to the touch screen interface on the iPhone. Within a few years of the iPhone's introduction, however, the touch screen interfaces were the clear market favorite. In the face of this type of uncertainty, and with decentralized and tacit knowledge, the market is a discovery process. One cannot know whether A or B will be more profitable, because the answer depends on people's subjective preferences, and those preferences will only be revealed through market transactions. The information does not exist in the absence of the market. People can make use of their knowledge to direct economic resources in ways that they believe will be profitable. The market rewards the effective use of knowledge with profits and penalizes the ineffective use of knowledge with losses, so the market provides a mechanism for directing resources toward those goods and services consumers value most. In many cases profitable decisions will be the result of superior knowledge, but other times they may be the result of luck. Regardless, the information is a product of the market and does not exist in the absence of the market. Once the market reveals the profitable course of action, that information has been revealed to all market participants, and market forces lead toward the production of goods and services that provide additional value to the economy. In an economy where underlying conditions are unchanging obviously, a hypothetical economy- solving the problem of effectively

THE MARKET PROCESS

9

allocating resources would be almost trivial. Prices of goods for which the quantity supplied exceeded the quantity demanded would fall, and prices of goods for which the quantity demanded exceeded the quantity supplied would rise, until the economy came to rest with an equilibrium configuration of prices. The real economic problem is that underlying conditions are always changing, and in ways that are difficult to foresee and potentially difficult to understand even when they are seen. When knowledge is decentralized and tacit, there is no way even in theory that a central planner could gather up all the relevant information and allocate resources efficiently. The market is a mechanism for coordinating the knowledge possessed by all individuals in an economy so that it can be used most effectively.

1.3

Equilibrium: the coordination of individual plans

Hayek (1937 [1949]) depicts economic equilibrium as the coordination of individual plans. In the short run this means that markets clear, so that the quantity supplied equals the quantity demanded in all markets. Everyone who wants to buy at the market price can, and everyone who wants to sell at the market price can, so everyone's plans are coordinated. Over the longer run additional complications come into play. An entrepreneur who begins building a factory or an apartment building now can only estimate the demand for the factory's output, or for rental apartments, when their projects are completed. If their estimates were overly optimistic, their plans will not be able to be realized. Some factories may lay idle, and some apartments will remain unrented. If their estimates were overly pessimistic, consumers may not be able to realize their plans. Consumers might set aside money to buy a house, or to take a family vacation, in a year or two, only to find that when the time comes prices have risen such that their plans cannot be realized. For an economy to be in equilibrium, the plans everyone makes today must be able to be realized in the future. O'Driscoll and Rizzo (1985) use this notion of equilibrium as the coordination of individual plans, and Lewin (1997) offers a good explanation of Hayek's ideas on equilibrium. Everyone recognizes that the future is uncertain, so they make plans with contingencies as much as they are able. The family in Atlanta plans their Hawaiian vacation two years hence, with the proviso that if they have insufficient funds they will go to Orlando instead. O'Driscoll and Rizzo (1985), recognizing that people may have to adjust their plans to

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unforeseen changes in circumstances, prefer to call the coordination produced by the market pattern coordination. People make plans that are flexible enough that they can adjust them to meet various contingencies. Sometimes contingency plans are not sufficient, and people's plans cannot be realized. The economy falls out of equilibrium. Factors that can cause people's plans to fail to be coordinated will be discussed later; at this point note that one way to view equilibrium, following Hayek, is that people's plans are coordinated so that people are able to realize their plans. When the passage of time is considered in this way, equilibrium becomes a slippery concept. People are always updating their plans in light of new information they acquire, so in that sense nobody's plans they have today are going to be completely realized into the indefinite future. O'Driscoll and Rizzo (1985, pp. 8o-81) discuss this under the heading of exact coordination. The economy will never be in equilibrium in the sense that all the plans everyone has made will all be realized. However, that coordination of plans is closer to reality when one realizes that people are able to incorporate contingencies into their plans. People make plans for tomorrow, but they update those plans as new information presents itself so that when tomorrow arrives, they are able to realize their updated plans. Equilibrium seems to imply a determinate outcome toward which the economy tends, but changing conditions would also seem to imply that the equilibrium toward which the economy tends is itself always changing. A market process approach suggests that the economy is continually evolving, and people's plans are continually adapting to new conditions. The market generates information that allows individuals to adapt, so that as the future unfolds, people are able to realize their updated plans. Considering the fact that people make plans well into the future - it may take years from the initial planning and design of a product for the product to come to market - the fact that in most markets the quantity supplied equals the quantity demanded most of the time is a remarkable achievement of the market mechanism. It works so well that people typically take it for granted. Not only do consumers often take for granted that they can go to the store and buy any one of a multitude of products at a moment's notice, economic models often take it for granted as well. Models often assume markets are in equilibrium without analysing the forces that get them there.

THE MARKET PROCESS

1.4

11

Equilibrium: the absence of unexploited profit opportunities

Kirzner (1973) depicts equilibrium as the absence of unexploited profit opportunities. It is difficult to envision a real-world economy where there are no unexploited profit opportunities, so an economy would never arrive at equilibrium. Entrepreneurs notice and act on these profit opportunities, pulling an economy closer to equilibrium, and Kirzner emphasizes the equilibrating role of entrepreneurship. Meanwhile, new profit opportunities constantly arise, keeping the economy from ever arriving at equilibrium. Hayek and Kirzner are both prominent Austrian school economists, so it is interesting to see the differences in the way they define equilibrium. An economy could be in equilibrium as Hayek defines it, with everyone's plans coordinated, while an unnoticed profit opportunity continues to lie unnoticed, so the economy would not be in equilibrium as Kirzner defines it. An economy can be in equilibrium following Hayek's definition, but not according to Kirzner's. However, if an economy is in equilibrium according to Kirzner's definition, it must also be in equilibrium according to Hayek's. If there are no unexploited profit opportunities (Kirzner), everyone's plans must be coordinated (Hayek), for if they were not, an entrepreneur could profit from facilitating the coordination of people's plans. In a neoclassical competitive equilibrium, with perfect information and where all markets clear, both Hayek's and Kirzner's definitions of equilibrium are satisfied, so there is no way to differentiate these two views of equilibrium in that framework. Hayek's idea of equilibrium as the coordination of individual plans is generally accepted and will be the equilibrium concept most used here, but with the caveat that the Austrian school's process-oriented approach to economic analysis emphasizes the ongoing evolution of economic activity, making equilibrium a hypothetical concept rather than a description of the real-world economy. Markets tend to clear, so the Austrian school accepts the concept of equilibrium in that sense, but when an existing configuration of prices and quantities is disturbed, the disturbance often changes the underlying economic conditions so that the economy will not return to its previous state.

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ADVANCED INTRODUCTION TO THE AUSTRIAN SCHOOL OF ECONOMICS

The market as a discovery process

People interact with each other in markets by exchanging goods and services under terms that are mutually beneficial. People agree to exchanges only if all parties to those exchanges believe they will benefit. While economists often talk about equilibrium prices, and many models are built around the notion that market forces produce equilibrium prices, the notion of an equilibrium price is an abstraction. Buyers can see (some of) the prices at which some sellers are willing to sell, and sellers can see (some of) the prices at which buyers are willing to buy, but there is no information available to anyone about an equilibrium price. In many cases, before making a purchase, buyers will look at offers from many sellers, both to find a favorable price and to consider quality differences that might come with different prices. If some sellers' prices are higher than others, information will spread and the seller will lose customers, which puts a check on how much a seller can charge. If sellers find that they consistently are unable to produce enough to meet demand at their current prices, they will raise them. These are all individual adjustments that buyers and sellers make when they look for the most favorable transactions they can find. Nobody tells buyers and sellers what equilibrium prices are; prices tend toward market-clearing prices as the result of the interaction of buyers and sellers in markets. The market value of any good or service is completely determined by the interaction of suppliers and demanders in that market. The market process reveals the value of goods and services in an economy. The market price of each individual transaction provides information that aids buyers and sellers in determining what prices they would be willing to accept in the future. Prices may rise and fall over the course of a day or week, but one would be hard-pressed to say that one price is an equilibrium price and another is a disequilbrium price. Prices change depending on economic conditions, which may be very local conditions at times. Conversely, prices may remain the same as economic conditions change. Often, suppliers are reluctant to raise or lower prices based on changes in daily or weekly conditions, so will absorb changes in underlying conditions by adjusting their inventories. Sellers of umbrellas may find it to be better business practice to maintain constant prices, which provide information to their customers, rather than raise umbrella prices on rainy days, for example. Could we then say that the

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heavier sales of umbrellas made on rainy days were made at disequilibrium prices? Prices represent terms that are mutually agreeable to buyers and sellers, and price changes are an ongoing part of the market process. The idea of disequilibrium prices has limited usefulness to the Austrian school's view of the market process. This process by which the market reveals the value of goods and services is essential to the coordinating function the market plays. Because knowledge is decentralized, and because much knowledge is tacit, people would have a very limited ability to coordinate their economic activities without market prices. In his famous essay, "I, pencil," Leonard Read (1958) noted that nobody knows how to make a pencil. Read notes that the graphite "lead" is mined in Ceylon (now Sri Lanka) and mixed with clay from Mississippi and several other products - he mentions candelila wax from Mexico as one- in a complex production process. The cedar wood for the pencil undergoes a separate complex process before being mated with the graphite. The brass ferrule that holds the eraser has to be mined and refined, and the eraser is made from rape-seed oil that originated in the Dutch East Indies (now Indonesia) and pumice from Italy, combined with other ingredients. Read's story is powerful because he shows how something as simple as a pencil requires the coordination of the economic activities of people from all over the world. These people cooperate even though they will never meet, and speak different languages so they would have trouble communicating with each other if they did meet; yet their economic activities are coordinated so that they all cooperate to produce a pencil that is inexpensively available to consumers throughout the world. Nobody in the world has sufficient knowledge to build a pencil, yet markets coordinate the economic activities of individuals throughout the world to manufacture them. Much of the information people need to know about the economic activities of others is summarized in market prices. Through the process of market exchange, markets discover the prices of graphite, cedar, brass and the other ingredients that go into making a pencil, so firms that produce them can decide on how much of what combination of materials to use in the manufacturing process. Perhaps different types of wood or different types of metal could be substituted. If materials become too expensive, people may substitute mechanical pencils, or pens, for wood pencils. The market discovers the value of goods and services as people engage in exchange, and those market prices convey a substantial amount of information about the knowledge others in the economy have. The manufacturer

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of a pencil does not have to know how to mine graphite to make use of the knowledge of people who do. The knowledge remains decentralized even as people's economic activities are coordinated. The information about the value of the various components that go into making a pencil, and the value of the pencil itself, is generated by the market process. The information would not exist if the market process did not produce it. The market is a discovery process that reveals these values, but information about the values of these goods would not exist if the market process did not produce it. The market process both produces the information and makes it available to market participants. Without the market, there would be no information to be discovered about the value of these goods.

1.6

The element of time

Economic processes occur over time. An equilibrium framework for analysing economic phenomena tends to obscure the significance of time, because in that framework it appears that the conditions that define an equilibrium remain given and unchanging, and the role of the market process is to pull the economy toward that equilibrium. In fact, economic conditions are constantly changing, partly as a result of the decisions continually being made by other economic actors who are deciding their courses of action based on necessarily imperfect information. Future conditions depend on decisions people are in the process of making in the present. Their choices determine the future trajectory of the economy. Thus, people do incorporate various contingencies into their plans, and the discovery process is only partly discovering facts about the physical world, and is largely discovering how others are reacting to both the physical world and to the anticipated plans of others in the economy. In the first category, people will be alert to how the weather might affect their plans -for example, how it will affect a farmer's crops, or a tourist's vacation plans- or how the discovery of a new manufacturing process or a new type of product might affect the market for an existing product. In the second category, producers must be alert to changes in people's consumption preferences, and consumers must be alert to changes in the types of goods and services, and their prices. Because people base their current decisions on information that is necessarily incomplete and sometimes contradictory, their judgments

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do not produce a determinate outcome, and the future trajectory of the economy depends on the choices people make in the present. The economic notion of an economy being pulled toward an equilibrium suggests that the equilibrium outcome is implied in the initial conditions. Even in equilibrium models that build in time, the equilibrium trajectory of the economy is implied in the initial conditions. Time is important in economics because the future is uncertain. Individuals gather information to help them make judgments about future events, but even that information is continually evolving. The information available tomorrow will be different from the information available today, and may even contradict the information available today. Within the market process, people are continually obtaining and updating information about future conditions that are always uncertain, and their decisions under uncertainty are factors that affect those future conditions. Incorporating time into economic analysis is more than just having a model that depicts economic processes that occur over time. It is incorporating the uncertainty that always comes with economic decisions, and incorporating the way that people acquire knowledge about the choices and economic opportunities they will have in the future. The open-ended nature of the future precludes planning for it by, for example, considering all the possible states of the future world, assigning probabilities to them and then taking the best course of action given those expected states of the world. One reason is that in the real world some possible outcomes cannot be foreseen because of the limits of people's knowledge. Similarly, even if one could know every possible future state of the world, it would not be possible to assign probabilities to them. The real world is characterized by uncertainty, which makes the future indeterminate and unpredictable. Economic analysis helps people to make judgments about the future, so people can have some expectations about future income (both theirs and aggregate income), prices and availability of goods. The future is not completely unknowable. Because of their accumulated knowledge, people's expectations about the future tend to be roughly correct most of the time. An important part of understanding how the economy works is understanding how people obtain that knowledge, and how the knowledge of everyone in the economy is coordinated to produce an orderly outcome that is the result of human action but not of human design. But the element of time in economic analysis means

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more than just recognizing that time passes. It means understanding how individuals can make plans today that they hope to fulfill in the future, and how the economic system coordinates those plans.

1.7

The subjective nature of value

The value of goods and services is determined by the subjective evaluation of people who purchase them. That subjective value may vary from person to person, and may vary for the same person at different points in time. A person who lives in a dry climate may place little value on umbrellas, and may not even own one. A person who lives in a rainy climate may own several (I do, and always keep one in my car and one in my office because unexpected showers can pop up where I live). Someone caught in the rain while traveling may be willing to pay substantially more for an umbrella than if the person was shopping around for a new one in good weather. Similarly, the value people place on goods and services can vary due to fads, fashions and information that becomes available. Music, clothing, reading material and even foods are valued differently by people, and in the aggregate as indicated by market prices, over time. For example, eggs were once viewed as an ideal food for their nutritional value, until people became more concerned with their cholesterol content. The subjective value people placed on eggs fell, reducing the demand for them. Value is not an objective quality attached to goods and services; it is determined by the subjective evaluation that consumers place on the utility they get from consuming them. One of the observations that Carl Menger (1871 [1976]) made in his Principles of Economics is that if people increase the quantity they consume of a good or service, the additional units they consume will be used to satisfy less urgent desires, and those less urgent uses will have a lower subjective value to the consumer. Water provides a good example. The first few cups of water an individual consumes every day are very valuable, and indeed, life-sustaining. People who live in places where water is costly to obtain, such as in the desert, or astronauts in space, pay a lot to get it and have an incentive to conserve it. If water is scarce, people might take sponge baths to conserve it; where it is more plentiful, they might take leisurely showers. If water is very inexpensive, they might use it to water houseplants, or to wash their dog or their car. These uses that have a lower subjective value do not reduce the value of the water they drink to sustain their lives, however. The

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first few units of water consumed will have a high subjective value, and if more is available, consumers will use them for uses that have increasingly less subjective value. If the price of water goes up, people will reduce their consumption by reducing the water used for activities that have less value; perhaps such as washing their cars. But this is a conjecture and may vary from person to person. We cannot know the subjective values other people place on goods and services except by observing their behavior in the marketplace. Some people who are very fond of their cars might take fewer showers so they can continue to keep their cars spotless. Because value is subjective, the value of goods is only revealed when people engage in market transactions. The transactions indicate that all parties to them believe they are gaining value, and the market price is the value of the utility gained from the marginal unit.

The value individuals place on goods and services varies from person to person, and over time. By revealing how much individuals are willing to pay for goods and services, the market reveals this information about the value of goods and services. Information on value does not exist in the abstract, waiting to be discovered. That information is generated through the market process.

1.8

The subjective nature of cost

The demand side of the subjective nature of value is not an idea that is unique to the Austrian school but on the supply side, economists often present costs as objective facts, not explicitly, but implicitly and without any analysis. Economic costs are market values just as are the prices of final goods, and they are determined the same way, subjectively. The value of inputs into the production process is determined by the value of the output those inputs produce, so the subjective value people place on final goods and services is what determines the value of the inputs that produce those goods and services. Menger (1871 [1976]) called consumer goods "goods of the first order," and the intermediate goods that are inputs into the production process "higher-order goods." The price of higher-order goods is determined by the value consumers place on goods of the first order. If the value of a final good or service rises, that will make the inputs that produce the good or service more valuable.

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Two centuries ago if a piece of land had oil on it, the value of the land was reduced because seepage of the gooey stuff interfered with the ability to farm the land. The use of oil products for fuel, lubricants and other purposes now makes land with oil on it more valuable. The value of the input is determined by the value of the final goods it can produce. Similarly, professional basketball players get paid more than the top track and field athletes not because it takes more skill to play basketball but because people are willing to pay more - they subjectively value watching basketball more - than they are willing to pay to watch track meets. The value of inputs into the production process is determined by the subjective value people place on the value of the output they produce. Professional basketball players were paid much more in the 2ooos than in the 1950s, both absolutely and relative to other professions. Why? Because in the 1950s it was rare for games to be televised and audiences were mostly limited to those who paid for a ticket to watch games in person. Half a century later, people could watch televised games and advertisers placed a high value on being able to reach those audiences, so the subjective value of the output increased, in this case because of advances in technology. The higher subjective value of the output meant that the subjective value of the inputs - the labor services of the basketball players - increased. Value is subjective, and because the value of inputs is determined by the value of the output they produce, cost is subjective. The subjective nature of cost is a straightforward implication of the subjective nature of value.

1.9

Utility and individual action

People act because they expect to be better off taking those actions than if they did not act. They expect to receive utility from the results of their actions. Taking a market process approach to the analysis of individual action, people engage in economic activity because they believe they will be better off because of their actions. The essential relationship between utility and individual action is that people act because they think it will increase their wellbeing, or utility. To develop complex models of general economic equilibrium, mainstream economics ascribes utility functions to individuals that require

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some assumptions about their individual preferences. Economists often assume that preferences are transitive, which means that if A is preferred to B and B is preferred to C, then A is preferred to C. Goods are assumed to have diminishing marginal rates of substitution. For models to hold up, utility functions are assumed to be continuous and differentiable. Without these restrictive assumptions, there is no guarantee that the model will have a unique stable solution. The market process perspective focuses on the ongoing exchanges that take place and the continually evolving types of output that an economy produces. By focusing on the economic process rather than an equilibrium outcome, most of the assumptions about utility that the equilibrium approach demands are not necessary. As long as individuals engage in economic activity because they believe the result of their action will be an increase in utility, that is a sufficient description of the individual preferences. There is no reason to specify equilibrium conditions because people are always acting, or planning to act in the future. Conditions are always changing, so Austrian school economists do not place the same importance on the idea of a unique stable equilibrium as other economists do. The assumptions economists must make about individual behavior are much less restrictive when taking a market process approach to economic analysis than when taking an equilibrium approach. The market process approach to human behavior does not describe people as maximizing utility but rather as engaged in mutually beneficial exchange. 2

1.10

Competition

Economic models often view competitive markets from an equilibrium perspective. In this perspective, the market mechanism generates competitive prices, and both buyers and sellers in competitive markets are "price takers," which means they accept the market price as given and adjust their behavior to it, deciding how much to buy or sell at the market price. In a similar manner, the model of competitive markets makes the assumptions that output in the market is homogeneous, and that buyers and sellers in the market have complete information. Taking a market process view of competition, "markets" do not set prices, buyers and sellers set prices, even in very competitive markets. Sellers decide what they will charge for their products, and even though they must take prices others charge into account, they do not take those prices as given. For prices to change in markets, which they

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often do, some sellers have to decide to change what they charge for their products. This is true even in very competitive markets, like stock markets. While traders can enter a market order to buy at the "market" price, that price is the lowest price at which someone has entered an offer to sell; similarly, putting in a market order to sell means the price is set by the person who has entered the lowest offer to buy. Prices are set by buyers' and sellers' offers to buy and sell at a particular price, not by "the market." Buyers and sellers either set their own prices or agree to buy or sell at a price that has been set by someone on the other side of the market. The same is true with product characteristics. Despite the frequent assumption of homogeneous products, this is a simplifying assumption economists often make so their models are more tractable, not a conclusion derived from the competitive model, or an actual characteristic of competitive markets. In fact, differentiating products to make them more attractive to purchasers is a competitive strategy. 3 Similarly, "production functions" are not given to producers. Individual producers decide what production technologies to use, and what characteristics the products they sell will have, even in markets that are very competitive. Information is not perfect, and is costly to obtain. Different people have different sets of information, and some of it will be, in hindsight, incorrect. Some sellers may sense that they could charge more for their products, and raise their prices. If they are correct, others will follow and the "market" price will adjust upward. In this case, other sellers who have not adjusted their prices are selling at "disequilibrium" prices, below the level that would clear the market. If they are incorrect, the sellers who raised their prices are selling at "disequilibrium" prices. Either way, some exchanges are occurring at "disequilibrium" prices. Prices are always changing, but "the market" never sets or changes prices. Individual buyers and sellers do that, and when they do, prices will vary from seller to seller. Similarly, buyers often shop around for the best combination of price and quality, which will vary from seller to seller. The process by which markets tend to equilibrate is ongoing, and generates information that helps to guide buyers and sellers to utilize resources at their disposal to increase value.

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Competition is an ongoing process that brings with it continual changes in prices, production processes and product characteristics. These continual changes, which Joseph Schumpeter (1934, 1947) referred to as creative destruction, replace old products and production processes with new ones and generate economic progress. The concept of competitive equilibrium, often used in economic analysis, is not descriptive of the way an actual economy functions. It ignores many of the choices that continually face market participants, and assumes away much of the economic activity that people continually engage in as they adjust their economic activity to changing economic conditions and newly revealed information.

1.11

Conclusion

The market process approach to economic analysis depicts an economy that is continually evolving as people design new products and production processes, and gain information about their economic activities and the activities of others. Producers not only discover better production methods, they learn about consumer preferences, and about developments by their competitors and suppliers. Knowledge in a market economy is decentralized, always changing, and information can sometimes be contradictory. Each individual faces the challenge of making best use of available knowledge, and the role of the market economy is to coordinate all of this decentralized knowledge so that people's activities are mutually consistent and their economic plans can be realized. Without this coordination, people would be unable to rely on the economic activity of others, so the division of labor would break down. Economic conditions are continually changing, and the market mechanism provides the means by which people can adjust their own activities to the continually changing plans and circumstances of others. This market process approach to economic analysis provides the foundation for the ideas of the Austrian school. NOTES 1 This is one of the key ideas Hayek (1949) emphasizes. The very descriptive phrase "the result of human action but not of human design" was coined by eighteenth-century Scottish philosopher Adam Ferguson, and was popularized by Hayek in the twentieth century. 2 Buchanan (1964) emphasizes economics as the study of exchange rather than the study of individual choice and utility maximization. 3 Kohn (2004) makes this point Also see Holcombe (2013, chapters) on this point.

2

Decentralized knowledge: the role of firms and markets

Taking a very static - or equilibrium - view of the economic role of a firm, the firm purchases inputs that fall into the broad categories of land, labor and capital, and combines them into outputs. The way that firms transform inputs into outputs is given in the firm's production function. The firm's production function gives the combinations of various inputs that are used to produce outputs, much like a baker has a recipe for combining ingredients to bake an apple pie. Typically, economists assume that the formula - the production function - is given to the firm, so the firm must use this formula to transform inputs into outputs. Typically, the inputs and outputs are also assumed as given. Extending the baking analogy, the baker can use flour, apples, sugar and other specified ingredients as inputs to follow the recipe to produce the output of an apple pie. In this framework, the baker's sole task is to choose the appropriate combination of inputs and use the recipe given in the production function to produce apple pies as profitably as possible. For the analogy to hold, there will be some flexibility in the recipe. The mix of inputs can vary, and can be chosen so that the amount of sugar relative to apples varies to make the pies sweeter or more tart. The mix of flour to apples can be chosen so that the pie crust is thicker or thinner. The baker also must choose the appropriate number of pies to produce to maximize profit. And the baker must be careful to use inputs efficiently; for example, to not waste apples or other ingredients so that the pies use the minimum amount of inputs for the output that is produced. Economists often present this production function depiction of the firm in mathematical terms, saying Q = fi.K, L), where Q is the output produced, f is the production function, or recipe used to produce the output, and K and L are the inputs of capital and labor. This formulation leaves out the land that was mentioned above, and depicts capital and labor as homogeneous. Combine certain amounts of capital and

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labor, and the result is output. In this production function approach the firm is assumed to have no alternative to the production function f, can only use those given inputs K and L and must produce output Q. The standard theory of competitive markets often assumes that all firms in an industry produce a homogeneous output, so the type of Q produced is the same for all of them. In this formulation, the only things the people who manage a firm can choose are the quantities of K and L, which are then transformed by the production function they are given into a certain amount of Q. Now consider the baker, who surely does have a recipe for apple pie. But the baker does not have to stick to that recipe. How about adding raisins to the pie? Substituting brown sugar for refined white sugar? Perhaps corn sweetener would be less expensive, but just as acceptable to those who buy the pies. The baker might even change the type of output and produce cherry pies instead of, or in addition to, apple. When one looks at the baker's production function, so often assumed given to the producer, all of its components are subject to change by the producer. The producer can use different types of inputs, combine them in different ways and can vary the characteristics of the output. In the real world of competitive markets, characterized by continual economic progress, firms have to continually modify everything that they do so that they can keep up with their competitors. Bakeries, like other retailers, are continually changing their product mixes to adjust to customer demands, coming up with new offerings and looking for ways to cut the cost of producing their current offerings. Economic progress in some areas of the economy, like electronics, is visible enough that it is barely worth mentioning, but this same economic progress is present throughout the economy, even though it is often not so visible. New farming methods and new strains of seeds increase crop yields and make crops more resistant to disease and drought. Farm machinery is continually improving. Methods in manufacturing and even retailing continue to lower costs, even though those advances may barely be visible to people outside those businesses. The improved products and production methods that lower costs and raise people's material wellbeing present a continual challenge to the people who run firms. Because their competitors are continually improving what they do, each firm must also improve, or fall further behind others in the market. The most important challenge that those

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who run firms face is to look for better production methods and better product characteristics so that they can keep up with the continual economic progress in the market.

2.1

The entrepreneurial nature of firms

The role of people who run firms can be broken down into two components: management and entrepreneurship, as Boudreaux and Holcombe (1989) describe. In the discussion of the previous section, finding the optimal mix of inputs to combine using the production function to produce output is the management function of the firm. Good management means operating the firm's processes as efficiently as possible. The role of the firm's management is to select the right combination of inputs to produce the output at lowest cost, which is determined by the production function, and to try to minimize any waste in the production process. If labor shirks, then management will have to spend more on wages than the cost-minimizing amount. Similarly, any waste of other inputs raises the firm's cost. Managers maximize profit by minimizing the cost of their inputs, and producing at the optimal scale using the optimal mix of inputs. Entrepreneurship is the spotting and acting on a profit opportunity that has previously gone unnoticed. This could mean looking for a different production function, or recipe for production, using different inputs, producing a different output or selling to a different market. The management function of the firm takes the parameters of the production function as given. The firm produces a given Q using inputs K and Land combining them according to production functionf The entrepreneurial firm recognizes that all of those parameters can be changed. The firm may be able to profit from changing the type of output it is producing, the inputs it is using or the production process itself. Henry Ford's adoption of the assembly line to produce automobiles is the prototypical example of a change in the production process. Assembly lines had been used before Ford used them, but not for producing automobiles. Ford spotted the profit opportunity in using this new production method to produce automobiles. Apple Computer offers an obvious example of an entrepreneurial firm changing the type of output it produces as they have introduced the iPod, iPhone, iPad and other innovative products.

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Kirzner (1973) emphasizes the pure observation of the profit opportunity as the entrepreneurial act, and notes that it takes no resources to notice a profit opportunity; just alertness. The alert entrepreneur sees that there is a previously untapped market, an improved method of production, some innovation in the characteristics of an existing product that will improve its profitability or even a whole new product that has not been marketed. While it takes no resources to be alert to profit opportunities, an entrepreneurial firm must act on the observation of the profit opportunity for entrepreneurship to take place. While much can be made of the entrepreneur's observing and acting on a profit opportunity, there is always some uncertainty about whether what appears to be a profit opportunity will actually turn out to be profitable. As Foss and Klein (2012) emphasize, there is always a substantial amount of judgment that goes into determining whether any given entrepreneurial action will in fact be profitable. Any discussion of entrepreneurship tends to focus more on the entrepreneurial successes than the entrepreneurial attempts that failed, so it is important to recognize the uncertainty inherent in entrepreneurship, and the judgment that is required to successfully transform what appears to be a profit opportunity into an actual profit. Because some firms are entrepreneurial, all firms must be. A firm could not simply find a profit-maximizing formula using its production function and survive by continuing to follow that formula for any length of time. Other firms will be innovating by finding less costly methods of production, and more desirable product characteristics, so the firm that just follows the same formula year after year will fall continually behind others in the market. Profits will dwindle and turn into losses. Because of the nature of economic progress, all firms must be entrepreneurial to remain viable. All firms must always be looking for previously unnoticed profit opportunities. Schumpeter (1947, p. 82) notes, "The essential point to grasp is that in dealing with capitalism we are dealing with an evolutionary process. . . . Capitalism, then, is by nature a form or method of economic change and not only never is but never actually can be stationary." Schum peter's statement supports undertaking economic analysis using a market process approach rather than an equilibrium approach, and also indicates the challenge that entrepreneurs are up against. They cannot discover a successful formula and stick with it because conditions are always changing, so firms must change in response, or find

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themselves left behind by changing market conditions. Foss and Klein (2012) emphasize that entrepreneurship is not simply being observant enough to notice profit opportunities; it relies heavily on the judgment of the entrepreneur. Nobody can foresee the future, so entrepreneurs must use their best judgment to determine how they should adapt today to the future conditions of the market that can only be imperfectly anticipated. Good management is important to the firm, but entrepreneurship is absolutely essential. Firms may be able to get by and even prosper over the long run despite some inefficiencies, but without entrepreneurship the firm with a successful formula today will fall increasingly behind others in the market as economic progress occurs. Firms must be entrepreneurial to keep up with their rivals. A major distinguishing feature of the Austrian school of economics is its emphasis on the entrepreneurial aspects of the firm rather than the management aspects.

2.2

Entrepreneurship as arbitrage

Following Kirzner's idea of entrepreneurship as the observation of an unexploited profit opportunity, entrepreneurship can be thought of as arbitrage: buying at one price and selling at a higher one. For example, someone might notice that apples sell for $0.75 in one city and $1 in a nearby one. A profit opportunity exists because apples can be purchased for $0.75 and sold for $1. To actually engage in the entrepreneurial act, however, will take production and time. The entrepreneur will have to buy or rent a truck to transport the apples, which will result in some expense, and there may be spoilage as the apples are shipped, further reducing the entrepreneur's profit. Taking production into account, there is no profit opportunity if it costs $0.25 or more to ship the apples from one city to the other. Time is also a factor. By the time the entrepreneur actually gets the apples to the second city, it may be that the price of apples has fallen there, so the apples can only be sold for $0.85. If the shipping cost is $o.1o or more per apple, what at first appeared to be a profit opportunity will have turned out to result in a loss. Because an economy is always evolving, economic conditions will necessarily be different by the time the innovation is acted upon.

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Consider a more complicated case of manufacturing a new automobile. In principle, this example is little different from the example of shipping apples. The entrepreneur envisions that the firm can hire labor, buy steel and glass and other auto parts, and sell the automobile for more than the cost of the inputs. As with the example of the apples, all that stands in the way of earning the profit is production and time. One can see that in the years between conception and the production of the finished automobile, conditions may have changed, so a new automobile that appeared to be a profit opportunity at one point in time may result in losses. Delorian and Fisker provide two examples of automobile companies that started up with innovative ideas that ultimately proved unprofitable. Even in an arbitrage activity with a very short time horizon, such as arbitrage trading on international exchange markets, in which the time between spotting a profit opportunity and acting on it by trading takes only milliseconds, production and time still stand in the way of actually receiving a profit. Traders require fast computers and good algorithms for spotting profit opportunities. Computers and the wages of programmers and traders are a cost of engaging in such arbitrage, and conditions still change fast enough that profit opportunities often only last for milliseconds before they are competed away. Traders are always looking for faster computers and faster algorithms to make their trades. Entrepreneurship can be thought of as arbitrage because profit opportunities involve buying inputs and selling the resulting output for more than the cost of the inputs. Production and time stand between the entrepreneurial insight and the realization of profit. This is true whether one is selling apples, building automobiles or engaging in arbitrage trading in international exchange markets. 1

2.3

Profit and loss

Firms purchase and combine inputs to produce and sell output. If the value of the output the firm produces is greater than the cost of purchasing the inputs, then the firm adds value to the economy by taking less valuable inputs and combining them into more valuable output. The difference between the cost of the inputs and the revenue from selling the output is profit, so firms receive profit when they add value to the economy. Conversely, if a firm sells its output for less than the cost of the inputs it uses to produce that output, the firm destroys some

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value in the economy, and the firm suffers losses. Value is destroyed when more valuable inputs are transformed into less valuable output. Profitable firms add value to the economy; unprofitable firms subtract value from the economy. Profit and loss serve the important role of providing an incentive for firms to add value to the economy. Firms that successfully add value to the economy are able to grow and increase their economic activity. Firms that subtract value from the economy eventually shrink until they disappear. Entrepreneurs try to discover and act on profit opportunities, as Harper (1996) notes, by developing conjectures on what would be profitable innovations, and testing them out in the market. When entrepreneurs are successful they add value to the economy. The motives of entrepreneurs are nearly irrelevant to their actions that add value to the economy. Whether they are looking out for the good of the economy as a whole, or selfishly seeking profit for their own benefit, their entrepreneurial actions benefit everyone. As Adam Smith (1776 [1937]) noted, in a market economy individuals pursuing their own interests are led by an invisible hand to promote the general welfare. Successful entrepreneurship means making profits because profitable firms survive and grow while unprofitable firms eventually run out of assets and go out of business. Profits and losses are indicators of whether entrepreneurs are successful at creating value. Entrepreneurs use their judgment to determine whether certain actions - new product characteristics, new production methods - will be profitable. They can never be sure that an innovation will be profitable because that innovation will be something new. A new method of production, even if it has been tried by other industries or other firms in the same industry, may run into unforeseen problems. Nobody can know for sure whether a new product, or an innovation in the characteristics of an existing product, will sell enough at a high enough price to be profitable because it is new and has never before been tried. Entrepreneurs use their best judgment, and profit when they are correct, but lose when they are incorrect. Thus, profit is an indicator of successful entrepreneurship and loss is an indicator of unsuccessful entrepreneurship. Because the survival of a firm is dependent on its ability to remain profitable, there is a selection process that eliminates unprofitable firms

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and allows profitable firms to grow. It is not much of a leap to conclude that the entrepreneurs who oversee firms want them to be as profitable as possible, but regardless of their motivation, the selection process reinforces profitable activity.

2.4

Profits are not certain

The heading of this section almost goes without saying. Profits are never a sure thing for a firm. When entrepreneurs act on a profit opportunity, the profit they anticipate is the result of actions they take at one point in time that will lead to a profit later. The entrepreneur may underestimate the difficulty and expense of acting on that profit opportunity, the entrepreneur may be overly optimistic about the value consumers place on the innovation and there is always the risk that other entrepreneurs may introduce innovations that crowd out the entrepreneur's innovation. Because profits are never certain, entrepreneurs will engage in innovative activity only if they anticipate that the reward in terms of anticipated profit outweighs the potential for loss. For this reason, profits are necessary for economic progress. If profits were immediately competed away, there would be no reward for entrepreneurial innovation. Any innovation would run the risk of incurring a loss, so innovation and progress only occur because the innovator anticipates profiting from the innovation. Profits are necessary for economic progress.

2.5

Profit and progress: a caveat

The link between profit and economic progress applies when the activity of the firm is undertaken through voluntary exchange. It applies when firms buy their inputs and sell their outputs in markets where all transactions are the result of mutual agreement among the participants. Sometimes, government interference with markets results in transfers of resources that are not wholly voluntary. For example, firms that receive government subsidies may produce output that costs more to produce than its value to consumers. The subsidy, which is a forced transfer from taxpayers to the firm, and ultimately to the consumers of the firm's products, breaks the link between profit and progress. Similarly, if government is the purchaser, there is no assurance that output purchased with tax dollars is worth more than it

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costs because taxpayers are forced to pay the cost regardless of their preferences. Government mandates have a similar effect. For example, many governments mandate that ethanol be added to motor fuels. The purchase of the fuel by consumers adds value to the economy because they can be observed to voluntarily purchase it, but the requirement that the fuel contain ethanol may reduce value if the cost of producing the ethanol in the fuel is greater than the value consumers perceive it adds to the fuel. When resources are allocated outside the market - outside the system in which transactions are voluntary - firms can profit from coerced transfers that do not add value to the economy. The role of government in the economy will be discussed further in Chapter 3.

2.6

Opportunity cost and profit-seeking

Equilibrium models often depict firms as profit max1m1zers, but regardless of whether firms try to maximize profit, there is no way to tell whether they actually are. When a firm chooses one course of action, it does so in lieu of making a different choice, and there is no way to know what would have happened had the firm made the different choice. Firms can tell whether their current activities are profitable, but they cannot tell whether some alternative would have been more profitable, so they cannot know whether they are, in fact, maximizing their profits. Someone opening a bakery would have to decide whether to rent what appears to be a more desirable location on Oak Street, and pay more rent, or take what appears to be a less desirable location on Elm Street for a lower rent. Should the bakery choose the Oak Street location and make a profit, that decision would turn out to be profitable, but because the bakery did not open on Elm Street, there is no way for the firm to know whether the Elm Street location would have been more profitable. Similarly, the bakery chooses a price for its pies. If it turns out to be profitable, there is still no evidence that it has chosen the profit-maximizing price. Perhaps a lower price would sell enough pies to more than make up the difference and a lower price would increase profits. Perhaps most people would be willing to pay a higher price, so a higher price would be more profitable. The firm could experiment by trying different prices, but that could cost it some business if customers found the bakery's pricing to be unpredictable and started shop-

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ping elsewhere. And perhaps a lower price for pies at the Elm Street location would be more profitable than a higher price on Oak Street. By choosing one option, the firm foregoes other options, so the firm can never know whether the option it has chosen is the profit-maximizing one. Buchanan (1969) emphasizes this as an implication of the subjective nature of cost. Firms can tell if they are profitable, but they have no way to tell whether they are maximizing profits. Firms can gather information by doing market research, perhaps as simply as offering customers alternatives. Would it be more profitable to sell apple pies or cherry pies? The firm can offer both and adjust its output to the demand it perceives. Entrepreneurs are always looking for profit opportunities, and profit and loss gives them the guidelines to indicate whether their innovations add value to the economy. Whether they are maximizing profit can never be known, and in an economy characterized by economic progress is of peripheral relevance anyway. Firms must always be adjusting their activities and looking for new profit opportunities to keep up with the innovations made by others in the market.

2.7

Cost and price

Economists since Adam Smith have concluded that in competitive markets the price of a good tends to be just sufficient to cover the cost of production, with the implication that the cost of inputs is given, and the price of the good gravitates toward the cost of production. Smith (1776 [1937], p. ss) says, "When the price of any commodity is neither more nor less than what is sufficient to pay the rent of land, the wages of labour, and the profits of stock employed in raising, preparing, and bringing it to market, according to their natural rates, the commodity is then sold for what may be called its natural price." Alfred Marshall (1920, p. 367) discusses the factors that may influence price changes over time and concludes, "In a stationary state then the plain rule would be that cost of production determines value." The value Marshall refers to is the market price, and the conclusion Marshall draws has the direction of causality backwards. In the long run the price of a good determines its cost of production. Carl Menger (1871 [1976]) refers to final goods or consumption goods as goods of the first order, and goods that are inputs into the production

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process of other goods as higher-order goods. Menger emphasized the subjective nature of value. How much a first-order good will sell for depends on the utility a consumer anticipates it will generate after its purchase. This is not an objective characteristic of a good but rather depends on the valuations of consumers at a particular point in time. The previous chapter noted that professional basketball players get paid more than professional top track and field athletes not because it takes more talent or ability to play basketball, but because consumers prefer to watch basketball more than track meets. The incomes of players in those two sports would be reversed if there was a greater demand to watch track meets than basketball. As the previous chapter noted, basketball players were paid much more at the beginning of the twenty-first century than in the 1950s because in the 1950s televised games were rare, so the value of the final product - the basketball game - was almost entirely in the sale of courtside tickets. The value of the product is greater in the twenty-first century because of the television audience, and because the value of the output is greater, the value of the inputs that produce that output is greater. The value of the inputs is determined by the value of the output those inputs produce. The same is true of capital goods and raw materials. Those inputs are more valuable if consumers place more value on the goods produced by them. The value of a factory is determined by the value consumers place on the goods that factory produces, not how much money was spent to build the factory. The value of inputs into the production process is determined by the value consumers place on what those inputs produce. So, the cost of production is ultimately determined by the value of what is being produced.

2.8

Information, knowledge and wisdom

Because firms do not have their production functions given to them but must figure out for themselves profitable methods of production, profitable characteristics of output and profitable markets in which that output can be sold, entrepreneurs are always looking for information about undiscovered profit opportunities. A substantial amount of information is contained in market prices. For example, gold is an excellent conductor of electricity, so perhaps a manufacturer producing radios should use gold wire rather than copper. But the price of

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gold relative to copper indicates that copper wire would be more profitable to use. If there is a disruption of copper supplies the price of copper will rise, indicating to the firm that it might be wise to draw down their copper inventories rather than purchase now; a dip in the price of copper might indicate a good time to build up inventories. Firms might want to substitute one input for another if relative prices change. Those running the firm do not have to know whether copper prices increased because of striking copper miners, or bad weather at sea that has delayed copper shipments. All the decision-makers need to know is that copper is now more scarce, so there is a reason to economize on its use. Prices convey that information. Those running the firm can look at prices of inputs and prices they command for their output and get a substantial amount of information. But information by itself is often not useful. It needs to be combined with other information to provide knowledge upon which decisions can be made, as Holcombe (2007) notes. Just knowing the price of copper conveys some information, but someone familiar with the market will have a better idea of how much prices typically fluctuate, which will help make the decision as to whether the firm should draw down its copper stocks or whether it will need to buy at the higher price, and when the price falls, how much (if any) additional copper should be bought and stockpiled to hedge against future upward fluctuations. While prices convey much information, someone who knows the copper market well and understands why the price has recently risen will be in a better position to judge how quickly (if ever) it is likely to fall. Entrepreneurs gather information, and the collection of information they have provides them with knowledge about the markets in which they trade. People who have more information, and who have a better idea of how the various pieces of information relate to each other, have a better knowledge base upon which to make decisions. As Klein (1999) notes, an essential role entrepreneurs play is dealing with uncertainty: making the best use of the necessarily incomplete knowledge they have on-hand. Langlois (2007, 2013) concludes that because the economy is continually changing, firms provide an institutional structure that creates a knowledge base within which entrepreneurs can respond to change and uncertainty to deal with the problem of adjusting to people's continually evolving economic plans. Knowledge does not by itself point a decision-maker toward the best decision. It takes wisdom to understand the implications of that

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knowledge and to make successful decisions based on it. This is the role of entrepreneurial judgment. Nobody knows, and nobody can know, what the future will hold, so the entrepreneur must act within an economy that is not determinate but that depends on decisions other entrepreneurs are making in the present. An entrepreneur might have an idea for an innovative product, which after design time, time to build a manufacturing facility and time to get the product to market would take two years. Whether that product will be profitable in two years in part depends on what competing products will appear on the market during that time, on the cost of inputs into the production process two years hence and on the willingness of consumers to purchase the product at a price that would earn a profit for the entrepreneur. These things cannot be known in the present, so it depends on the wisdom of the decision-maker, who must make a judgment in the face of uncertainty. The knowledge the entrepreneur has will make the decision better than just a random guess, but cannot eliminate all uncertainty. As a simple example, someone designing a computer program today must anticipate the power of computers in the future when the program will be sold. If the program is designed to run on today's computers, there is a good chance that when the program is released, more powerful computers will be able to run competitors' programs that are more full-featured. The entrepreneur must anticipate not only the hardware design of future computers but the likelihood of competing products that will lessen the market for that entrepreneur's entry. To do so, the entrepreneur must collect information, combine it into a base of knowledge and have the wisdom to make best use of that knowledge. From this discussion, it should be apparent that not everybody has the same knowledge. Economists often make the assumption that an economy is characterized by "perfect information," which means that everyone is able to costlessly obtain complete information, but not only is this assumption clearly not true in the real world, the actions of entrepreneurs depend upon it not being true, as Richardson and Teece (1997) note. An entrepreneur acts on a profit opportunity with the idea that by acting now, the entrepreneur will be able to profit before other entrepreneurs notice the opportunity and act themselves, which would compete away the entrepreneur's profit. With perfect information, a profit opportunity noticed by one entrepreneur would be noticed by everyone, and the resulting entry would rapidly compete away any profit, eroding the profitability of the opportunity. A profit opportu-

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nity yields profit only because the economy is not characterized by perfect information, so an entrepreneur can act to take advantage of it, and reap the resulting profit, before others recognize the opportunity. Witt (1999) notes that not only does everyone have a different knowledge base, some people are naturally more willing to act on their entrepreneurial insights than others. This gives rise to one reason entrepreneurs work within firms. Entrepreneurial individuals take the risks of acting on their insights, and hire individuals who are less inclined to do so. Working for a wage cuts the individual's risk, while at the same time limiting the individual's return. The entrepreneur can assemble a group of employees to employ not only their physical labor but also their unique knowledge. Not only does each individual have his or her own base of knowledge - that knowledge of specific time and place that Hayek (1945) emphasized - an entrepreneurial economy depends on individual knowledge being unique because entrepreneurs profit only when they are able to introduce innovations before other competitors see them. In a well-known book, Edith Penrose (1959) argues that the collection of individuals with the knowledge base to engage in productive activity takes time, and this naturally limits the ability of a firm to grow. As firms expand, they hire new individuals who cannot be fully integrated into the firm's structure - its knowledge base - right away. The time it takes to integrate new employees into the firm's knowledge structure limits any firm's ability to grow. Economics as a discipline has focused increasingly on the importance of information since the last half of the twentieth century, but information by itself has no value and may even be misleading. Information must be incorporated into a knowledge base, and information has value within the context of the broader knowledge of individuals who have that information. Even then, because of uncertainty, and because different sources of information are often contradictory, it takes wisdom to effectively use knowledge. Entrepreneurial judgment in the face of uncertainty is an important determinant of profitability.

2.9

Research and development

Schumpeter (1934) makes the distinction between invention and innovation. Invention is the technical advance; the science and

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engineering that adds to knowledge and enables new products to be made. Innovation is the employing of these inventions into marketable products. Much credit is appropriately given to the scientific advances over the past several centuries that have enabled economic progress to occur, but scientific advances alone do not improve the standard of living until they are incorporated into products that people can buy and consume. The ancient Chinese had scientific and technical knowledge 1 soo years ago that was not surpassed until the Industrial Revolution came to Europe, but the Industrial Revolution took place in Europe rather than in China because the Chinese did not incorporate their inventions into innovations; they did not use their scientific and technical knowledge to produce products that increased the standard of living of their population. Invention is not sufficient for economic progress. Innovation is also necessary. The innovators are the people who increase the standard of living. As an example, the graphical user interface that operates on twentyfirst century computers was invented at Xerox, so the people at that company were the inventors. However, Xerox never made a profitable product using their invention. Rather, Steve Jobs at Apple Computer, and Bill Gates at Microsoft, saw the potential of the invention and brought the graphical user interface to market. They used different strategies. Jobs bundled the operating system with the computer, so people who wanted the Macintosh operating system had to buy an Apple computer. Gates sold his operating system to many computer vendors, offering people who wanted his operating system a wider choice of hardware, and also at lower cost. Both models ultimately proved profitable. Xerox was the inventor. Apple and Microsoft were the innovators. Many similar examples exist. Henry Ford did not invent the assembly line, but used someone else's invention in his innovation. Andrew Carnegie did not invent the Bessemer process for making steel, but used someone else's invention in his innovation. Inventions do not produce economic progress until innovators find profitable ways to use them. While it is true that the innovations cannot be made until the inventions they use are invented, often the inventions are the result of an economic system in which inventions can be used in innovations. Firms engage in research and development to look for inventions that might be useful and profitable. They would have no incentive to spend

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the money to engage in this research and development if they did not foresee the possibility of a profit opportunity as a result. Kirzner (1973) defines entrepreneurship as spotting that profit opportunity, but in almost all cases profit opportunities are not spotted at random; they are spotted because someone was looking for them. People build a knowledge base that makes it more likely that they will be able to spot profit opportunities, and one way to add to that knowledge base is by undertaking research and development. The people doing the research can spot the profit opportunity that will not be visible to others. Research and development creates an environment within which people are more likely to be able to see profit opportunities. The research and development, however, produces the invention. The role of the entrepreneur is to turn inventions into innovations - to bring profitable products to market using those profit opportunities they spot first. The innovation could not occur without the invention, but often the invention would not have been made without the potential for using it in an innovation. Research and development is one step that can lead toward economic progress, and it is often financed by an entrepreneur who sees it as a way to produce profit opportunities that those underwriting the research can act on before others. While scientific and technological advances are important, they must be recognized as different from the innovation that generates economic progress. Entrepreneurship turns inventions into innovations, which generate economic progress.

2.10

The division of knowledge and the supply chain

One way to think about the role of firms in an economy is that they are organizations that combine inputs to produce output. The activities of a firm are described by its production function. This paints a very incomplete picture of the firm: a picture that focuses on the management aspects of the firm rather than its entrepreneurial activities. The survival of the firm depends on its being able to keep up with developments in the market by finding more effective production methods and by improving the characteristics of its output, or developing altogether new products. The entrepreneurial nature of firms means that firms must continually be developing their knowledge bases to be able to make those improvements.

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Adam Smith (1776 [1937]) wrote about the division oflabor, and firms fit within this system by creating a division of knowledge, as Richardson (1972) describes it. In the computer industry, for example, the firms that make the microprocessors are different from the firms that make the hard disks and other storage devices, which are different from the firms that make the computer displays, which are different from the firms that design the computers and assemble all these parts into the final product. Each firm specializes in developing a particular type of knowledge that other firms do not have, and do not need to have. This division of knowledge makes firms more productive because they can specialize and focus their attention on a more narrow set of activities. Firms rely on their suppliers to produce better inputs at lower prices than they could do themselves, and in turn are able to sell better outputs at lower prices than if they tried to do everything themselves. Even if a firm can make the component parts of its products as efficiently as another, there are still advantages to buying inputs from other firms. One is that they can shop around to find the best suppliers, but a greater advantage in an entrepreneurial economy is that the best supplier may change from time to time as firms innovate. The ability to shop around means that suppliers must continually innovate to offer more value to their customers, or risk losing them. The firm that could produce its own inputs just as well today may not be equally effective in the future, so by supplying one's own inputs, the firm is not only doing so on the basis that it is the best producer of those inputs at present, but will also continue to be able to stay ahead of rival suppliers in the future. Firms take advantage of the division of knowledge when they specialize, and purchase inputs from other firms with different concentrations of knowledge. One reason that production in an economy is divided among many firms, and one reason why a single firm does not grow so large that it dominates the entire economy, is that firms are more productive when they specialize in a certain type of knowledge. Firms build a concentration of specialized knowledge they can sell to other firms, and to final consumers. One might view firms as specializing in producing particular types of goods and services, but that specialization requires that the firm's employees have the specialized knowledge to produce them. The division of production into firms creates this specialization and division of knowledge. A firm's output is the product of the knowledge of the people who work there, and what firms really have to sell is that knowledge, embodied in what they produce.

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Tacit knowledge and agglomeration economies

Hayek (1945) emphasizes the difference between what he calls scientific knowledge and a more general knowledge about how to undertake economic activities. Scientific knowledge can be recorded and passed along through study, or explanation, but much knowledge comes from experience and cannot be clearly articulated. This type of knowledge is tacit knowledge. Some evidence that tacit knowledge is economically significant is that businesses are willing to spend large sums of money to hire CEOs and other top management to run those businesses. As the previous chapter noted, if that knowledge was of the "scientific" type that could be passed along through books, or personal explanation, businesses would do just as well to hire people with new MBAs to run their firms - who have the advantage of a recent education with all the latest management ideas. Firms do not do this because people gain tacit knowledge through experience, and that knowledge is not easily communicated to others. Firms will mentor their employees by matching up an experienced employee with newer hires, so that by first-hand observation the newer hire can pick up some of the tacit knowledge the more senior employee has acquired. These examples focus on management activities, but the same is true in almost any line of work. Learning by doing occurs in all lines of work, and some of this knowledge that is accumulated comes from experience and cannot be transferred to others through explanation alone. People can pick up some tacit knowledge from others who are in close proximity through observation and experience. Desrochers (2001) explains how this gives rise to agglomeration economies. Thus, places like Silicon Valley are productive places to undertake work in computers and electronics because people in the area can observe what other individuals and firms in close proximity are doing, and learn from their experience. Similarly, Detroit saw the growth of the automobile industry, and New York is a center of the financial industry, because of the agglomeration economies that allow people in close proximity to each other to observe and pick up ideas from those nearby. Sometimes "close proximity" can mean being in the same city or the same region, but sometimes this tacit knowledge exists within the boundaries of firms. Those within the firm can see and learn from what others in the firm are doing, but those outside the firm do not have the same opportunity for first-hand observation. So, agglomeration

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economies exist not only within the boundaries of a geographic area, like Silicon Valley, but also within the boundaries of firms. This points toward another vital role that firms play in an economy.

2.12

Firms as repositories of knowledge

Entrepreneurs identify and act on profit opportunities, and firms are the institutional structure within which they work to realize the profit that is their return to entrepreneurship. Sautet (2ooo) notes that firms serve many functions. They lower transaction costs. For example, it may be more cost-effective for an entrepreneur to maintain a labor pool in salaried positions than to go into the market and contract to hire labor for each specific task the entrepreneur wants done. The firm may be viewed as a nexus of contracts in that it contractually specifies the tasks individuals undertake and the compensation they receive for their participation in the firm's activities. The Austrian school emphasizes the role that knowledge plays in economic activity so, as Foss (1997, 1999) notes, not surprisingly, knowledge plays a key role in the way the Austrian school views the function of the firm in the economy. The idea that there is a division of knowledge in an economy and that firms specialize in concentrating certain types of knowledge has already been noted. Firms play another vital role in the economy as repositories of knowledge. Entrepreneurship, as the engine of economic progress, is the identification and acting on a profit opportunity. However, what might appear as a likely profit opportunity could turn into a loss for many reasons. When entrepreneurs try out new ideas there is no way to be certain that they will be profitable because they have not been tried before. So, entrepreneurs need the expectation that they can capture profit if their plans are realized. However, in a competitive economy, profit is competed away over time. If the entrepreneur is successful, other entrepreneurs will see the innovation and imitate it, and entry into the innovator's market will reduce those profits until all firms earn only a normal rate of return. Entrepreneurs must have the expectation that the profit they make from their innovations is sufficient to compensate them for the risks of introducing them before that profit is competed away by entrants into their markets. An important role of the firm is to contain the knowledge underlying the innovation, so that the profits from the innovation stay within

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the firm. If all knowledge were easily observed, recognized and acted upon, profits from innovation would be rapidly competed away, but much knowledge is tacit knowledge that is not easily observed by others. The firm's boundary serves the twin goals of containing tacit knowledge within the firm, which benefits the firm's owners and employees, and preventing that tacit knowledge from spreading to competitors. Those within the boundaries of the firm benefit from sharing tacit knowledge among themselves. Employees are more productive if they can absorb tacit knowledge from their colleagues, which makes the firm more profitable. Those profits are ultimately the source of employee income. Managers and owners of firms obviously benefit from the increased profitability that results from the sharing of tacit knowledge within firms. Meanwhile, by containing tacit knowledge within the firm's boundaries, competitors will find it more difficult to replicate the firm's profitable innovations, enabling the innovating firm to maintain profit from the innovation longer. One reason entrepreneurs utilize firms is to create this boundary that keeps the profits from an entrepreneurial innovation within the firm. People inside the firm's boundary benefit from sharing tacit knowledge among themselves, making the firm more profitable, and benefit from containing that knowledge within the firm's boundaries so that competing firms are unable to appropriate it. Economic analysis typically depicts firms as combining inputs of land, labor and capital to produce output, but one important function of the firm is to combine the specialized knowledge of the firm's workers to produce profitable output. Land, labor and capital can be obtained through market transactions, and what differentiates one firm from another is the knowledge of its entrepreneurs, managers and employees. This provides one explanation for why firms purchase inputs from a supply chain rather than producing their own inputs. Suppliers can demonstrate that they have the tacit knowledge to produce a superior input without revealing the knowledge necessary to produce it. And, recognizing that innovations can occur in the production of inputs, firms may wish to buy their inputs rather than produce them because another supplier might produce a better input in the future. 2 By producing inputs in-house, a firm may be committing to inputs that over time are less valuable than those of another supplier who has developed a comparative advantage.

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Recognizing that firms are knowledge repositories also suggests one reason for limits on a firm's size. People within a firm have an incentive to share tacit knowledge among themselves to make the firm more profitable, which can lead to higher incomes for all employees. However, when firms get large, employees might view their fellow workers as competitors, and in trying to get ahead of the fellow employees they view as rivals, hide tacit knowledge that could make fellow employees more productive. Because firms profit from the sharing of tacit knowledge within a firm's boundaries, firms that become large enough that co-workers view each other as competitors will find themselves at a disadvantage. 3 Also, because tacit knowledge is not easily communicated from one person to another, co-workers in larger firms will not be in as close proximity, so will not be in as good a position to absorb tacit knowledge. The reason entrepreneurs work within firms is easier to understand when firms are viewed as knowledge repositories. Specialization of knowledge differentiates firms, and helps to contain tacit knowledge within the firm's borders. This increases the profits from entrepreneurial innovation, which is why entrepreneurs benefit from organizing production within firms. Firms serve many economic functions, as Sautet (2ooo) notes. The firm's role in containing the knowledge of its workforce to preserve the profits from innovation has been insufficiently recognized.

2.13

Searching for prices: disequilibrium exchanges

In the neoclassical framework of competitive equilibrium, firms and purchasers in competitive markets are depicted as price-takers. The assumption is that all market participants are such a small part of the total market that they all take the market price as given to them. One can see a logical problem with this assumption. If everyone takes the market price as given, prices would never change. If prices change, somebody has to change them. It is not difficult to understand that if sellers are having trouble main-

taining a supply of their products at the existing price, they have an incentive to raise them; conversely, if they are having trouble selling their products at the existing price, they have an incentive to lower their price to attract customers. And it is not difficult to understand that sellers may be reluctant to change their prices based on what

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appears to be temporary fluctuations in demand because customers return based on expectations of the prices they will pay. For example, if a restaurant had more customers than expected on Monday, it would probably not be a good business strategy to raise prices on Tuesday. Customers showing up on Tuesday might find the higher prices sufficient disincentive to look for another restaurant, and regular customers might be difficult to keep if the restaurant's prices were difficult to predict. Similarly, it probably would not be good business strategy to lower prices on Tuesday as a result of a slow business day on Monday. Despite the neoclassical economic advice to price where marginal revenue equals marginal cost, with fluctuations in demand and input prices that could be permanent or temporary, a firm's pricing policy will rely heavily on the tacit knowledge of the firm's management. Firms sometimes price some products attractively, as loss leaders, to bring in customers who will buy other products, again basing a firm's pricing policy on the knowledge of those within the firm rather than just taking the market price as given. 4 One issue with this whole line of thinking is that it accepts the idea of a single market price. In fact, prices will vary from seller to seller, and over time, partly because the market-clearing forces in an economy are pulling prices of different sellers toward different equilibrium prices, and partly because some exchanges will take place at non-equilibrium prices as buyers and sellers are searching for the most favorable transactions they can make. Some sellers may charge more for a given physical product because they offer a better service or a more convenient location. Is that differential a part of an equilibrium price? One can only tell by seeing if, over time, the seller is unable to supply as much as demanders want to buy (the price is below its market-clearing level) or if the seller cannot sell enough to maintain profitability (the price is above its market-clearing level). Individual buyers and sellers cannot observe the entire configuration of prices along with other advantages or disadvantages that go with each seller, so individuals can never know whether they are buying or selling at the "equilibrium" price. Before prices can change, some buyers and sellers must observe that existing prices cannot continue to clear the market, so some exchanges must occur at disequilibrium prices to reveal the information that prices should change. There is not a single price that exists in the market, and an equilibrium price does not exist except to the extent that it is revealed through the market transactions of individuals and firms. As noted earlier, a more

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accurate term would be market-clearing price because underlying conditions are always changing, often because of factors that create permanent changes in the marketplace. So prices follow a path that tends to clear the market, and that price is revealed as a result of all of the transactions that are made in the market. The market produces information about prices and costs; information that does not exist in the abstract without the market activity that generates it. Exchanges will be made at various prices, and over time those prices reveal to market participants whether price movements would be warranted: whether for sellers they could likely command a higher price, and whether for demanders they could likely purchase at a lower price. As Horwitz (2ooo, p. 36) notes, if prices were to reach "equilibrium," the problem of economic calculation would have already been solved. Because prices are always changing, because market conditions are always evolving and because prices do not exist except to the extent that they are generated by the market, the concept of equilibrium prices - and therefore disequilibrium prices -is a slippery one. Any price at which a voluntary exchange takes place indicates that both the buyer and seller viewed the exchange as advantageous.

2.14

Conclusion

The challenge of economic organization is to make the best use of the decentralized knowledge that exists throughout the economy. Every individual possesses what Hayek (1945) called the specific knowledge of time and place, information that at best can only be imperfectly shared with other individuals. A market economy coordinates all this knowledge so that, even though it remains decentralized, it is effectively used by everyone. The market is a mechanism that coordinates the economic activity of its participants. Market prices provide information to market participants, but the market mechanism also generates information about the value of goods and services - information that would not exist if the market did not create it. Firms play a crucial role in the organization of a market economy. The Austrian school emphasizes the entrepreneurial nature of firms. Firms do have an important management function, which is to allocate resources efficiently. But taking a longer view, the entrepreneurial function of the firm, which generates economic progress, is a more important contributor to economic wellbeing. Looking at the remarkable array of goods and services that people can consume today com-

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pared to a century ago, or even 20 years ago, illustrates the benefit in terms of economic wellbeing that entrepreneurship has produced. Entrepreneurship is driven by profit. Entrepreneurs are always looking for ways to improve their products, to lower their production costs or to introduce new products into the market. But innovation is risky. Ideas that appeared to be profitable at the design stage might turn out not to be, so entrepreneurs will not take the risk of incurring losses unless the profit potential of the innovation appears sufficiently attractive to offset the risk of a loss. Profit is necessary for entrepreneurship and economic progress. One role that firms play is that they contain the tacit knowledge that produces a firm's profit within the boundaries of the firm. Those within the firm have an incentive to share their knowledge with their colleagues because this will make the firm more profitable. They have an incentive to keep that knowledge from people in competing firms so that their profit is not competed away by imitators. Thus, entrepreneurs work within firms as a way of containing and appropriating the profit that comes from their innovations. One motivation for developing an economic theory of the firm is to understand the way that firms work. A greater motivation from the standpoint of economic analysis is to understand the role that firms play in markets, and in the overall economy. In this context, the firm is an institutional structure that allows entrepreneurs to assemble a knowledge base, and to appropriate the productivity of that knowledge in the form of the firm's profit. NOTES 1 Kirzner (1985, pp. 84-5) divides entrepreneurship into arbitrage, speculation and innovation. As discussed here, speculation and innovation both collapse into arbitrage in the sense that they amount to making purchases at one point in time to sell those purchases at a profit later, where the purchases and sales are always separated by production and time. 2 Langlois and Robertson (1995, chapter 7) discuss vertical integration of firms, and note that there are good reasons for firms to vertically integrate. 3 Pongracic (2009) discusses the importance of intra-firm institutional structures to align the incentives of workers with the interests of the firm's owners. 4 Marginal revenue would not equal marginal cost for the loss leader, but should when the revenue and cost of all of the firm's sales are included.

3

Economic calculation

Perhaps the most significant idea that defines the Austrian school of economics is that market prices are necessary for rational economic calculation. The relationship between economic calculation and market prices is an important fundamental idea that underlies the school's economic framework, but also is significant to the Austrian school because of its role in the socialist calculation debate in the first half of the twentieth century. The arguments developed by the Austrian school during that debate helped to solidify the Austrian school's ideas about the role of market prices in economic calculation, but also provided a very visible identity to the Austrian school, and helped to refine the concepts that set the Austrian school apart from other schools of economic thought. In the view of many economists during the twentieth century, the Austrian school was most closely identified with the claim that central economic planning cannot work. That claim, in turn, was based on the argument that market prices are necessary for rational economic calculation. Perhaps the best way to introduce the Austrian school's views on economic calculation, then, is to describe them within the context of the socialist calculation debate.

3.1

Ludwig von Mises on economic calculation

The socialist calculation debate began in 1919 when Ludwig von Mises, who was then an economist at the Vienna Chamber of Commerce, presented a paper before the Vienna Economic Society in which he claimed that market prices are necessary for rational economic calculation, so rational economic calculation was not possible under a system of central economic planning. 1 Mises's paper, eventually expanded into his book, Socialism, in 1922, attacked the very foundations of central economic planning. Earlier critics of socialism had pointed out other potential problems of collective ownership and centralized planning; most notably, the problem that in the absence of markets the incentive to engage in productive activity would be eroded. Marx's socialist

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slogan, "from each according to his ability; to each according to his needs," removed any incentive to appear able, and replaced it with an incentive to appear needy. 2 Mises's criticism was more fundamental. He was not saying that there were some problems that needed to be addressed before socialism could work but rather that because socialism would do away with market prices, it could not rationally allocate economic resources. On this point, it is worth contrasting the ideas of Mises and the Austrian school with "public choice" ideas on government planning. The subdiscipline of public choice uses economic methods to analyse political decision-making, and has identified a wide range of problems that lead to inefficiencies in government allocation of resources. Public choice analysis has pointed out that democratic voting does not always aggregate individual preferences to identify what is in the public interest, that the political process is often manipulated by special interests to provide them with benefits at the expense of the general public and that incentives in government bureaucracies often do not give socalled public servants an incentive to live up to that name and further the public interest. So, there are many reasons why government allocation of resources may be inefficient. The Austrian school tends to ignore all these inefficiencies. It does not ignore them because they think they are unimportant, but rather because even if one assumes that everyone in government is public spirited and tries to do the best they can to further the public interest, they still cannot do it, because without market prices rational economic planning is not possible. While it is true that all these "public choice" problems may make central economic planning less efficient, even if those problems are assumed away, the most public spirited of central planners will be unable to allocate resources efficiently without market prices. Thus, the public choice problems are irrelevant because even the most public-spirited civil servants, politicians and citizens would not be able to effectively allocate resources through central economic planning. Mises (1998, p. 2) discusses this in the opening pages of his most comprehensive treatise on economics, Human Action, first published in 1949. He talks about people who "drew ambitious plans for a thorough reform and reconstruction of society." He goes on to say, "They did not search for the laws of social cooperation because they thought man could organize society as he pleased. If social conditions did not fulfill

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the wishes of the reformers, if their utopias proved unrealizable, the fault was seen as the moral failure of man. Social problems were considered ethical problems. What was needed in order to construct the ideal society, they thought, was good princes and virtuous citizens. With righteous men any utopia might be realized." Then, referring to the development of economic analysis, Mises says, "The discovery of the inescapable interdependence of market phenomena overthrew this opinion.... In the course of social events there prevails a regularity of phenomena to which man must adjust his action if he wishes to succeed." In this discussion, Mises is talking about more than just central economic planning, but the argument applies to the central planning that was the ideal in the Soviet Union and other Eastern bloc countries, with their five-year plans and Central Planning Boards that were designed to direct economic activity. People cannot organize society any way they please and expect that the results will work out as they hope. Economic organization must be designed to be consistent with the laws of economics - the inescapable interdependence of market phenomena. That means private ownership of property and market prices in capital markets as well as in markets for final goods and services. The logic behind Mises's reasoning has been developed in the preceding chapters. Value is subjective, and goods and services do not have an intrinsic value that somehow can be discovered independent of the transactions that determine and reveal that value. The market generates that information about the value of goods and services, so the information does not exist without a market to create it. This is especially significant with regard to capital goods, because they are durable goods whose value depends upon the value of the final goods they will produce. Expectations about future market conditions, clouded by the uncertainty of the future, determine the value of capital goods, and capital markets are required to coordinate these expectations of investors.

3.2

The socialists answer Mises

To better understand the Austrian school's ideas on economic calculation, it is useful to see how the defenders of central economic planning responded to Mises, and why the Austrian school thought that those defenses did not answer, or even fully comprehend, the nature of Mises's argument. The definitive answer to Mises was deliv-

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ered by Lange and Taylor (1938, pp. 57-8), who claim "to be grateful to Professor Mises ... " for his "powerful challenge that forced the socialists to recognize the importance of an adequate system of economic accounting to guide the allocation of resources in a socialist economy." With some sarcasm, they say "a statue of Professor Mises ought to occupy an honorable place in the great hall of the Ministry of Socialization or of the Central Planning Board of the socialist state." They then proceed to explain how the problem raised by Mises had already been solved by economists (they credit Pareto and Barone) decades before. The solution they cite is a method for calculating a general equilibrium set of prices, in the same way a capitalist economy does so, by trial and error. In a socialist economy, money would not need to change hands; prices would be used for accounting purposes only. The central planning board can start by announcing a set of prices and asking suppliers and demanders how much they would want to buy or sell at those prices. As explained later, this process would apply to the production process, and rarely if ever to final consumers. For example, the central planning board would ask the managers of steel mills how much steel they would supply at a specific administered price, and ask the managers of auto factories, refrigerator factories and so forth how much steel they would demand at that price. These managers would choose their quantities to maximize the accounting profit they would earn from their production. If the quantity demanded was greater than the quantity supplied, this would signal the central planning board to raise the administered price, and if the quantity demanded was less than the quantity supplied, this would signal the central planning board to lower its price. Prices could continually be adjusted in this way for all markets until the quantity supplied equaled the quantity demanded for all goods and the central planning board could engineer a general economic equilibrium, with an equilibrium set of prices, in the same way that the market does. Central planning in a socialist economy can exactly mimic the operation of a market economy, following the Lange and Taylor logic. Abba Lerner (1946) published a more substantial exposition of the ideas put forward by Lange and Taylor, but the essence of the socialist answer to Mises is that a central planning board would be able to use the same method of trial and error the market uses to find equilibrium prices in all markets, so the central planning board could, if they wanted to, exactly duplicate in a socialist economy the resource

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allocation that would be produced by a capitalist economy. This framework is often referred to as market socialism because central planning duplicates the operation of the market. The consensus among academic economists by the mid-twentieth century was that the framework offered by Lange, Taylor and Lerner demonstrated that Mises's claim that rational economic calculation is not possible in a socialist economy was incorrect, so the socialists "won" the debate. There would be little point in establishing a socialist economy if all it did was duplicate the operation of a capitalist economy, and Lange and Taylor note that while their system answers Mises's challenge by demonstrating that a socialist economy can produce results at least as good as a capitalist one, a centrally planned economy can actually do better because it can engineer results that are more socially desirable. The distribution of income could be designed to improve social welfare, and the allocation of resources could be controlled by the central planning board to make the socialist economy more productive than a capitalist one. For one thing, more resources could be devoted to investment relative to consumption, to allow a higher rate of economic growth, and of course, planners could design the output of consumer goods toward those that would enhance people's standards of living. Fad and fashion could be replaced by goods that actually improved people's quality of life. Rather than leave the allocation of resources to the uncertainties of the market, the central planning board can allocate resources to maximize social welfare.

3.3

The Austrian school's answer

The discussion of the ideas of the Austrian school given in the first two chapters indicates why the Austrian school has been highly critical of the market socialism framework that Lange, Taylor and Lerner offered as an answer to Mises. That market socialism framework explains how a central planner could, through trial and error, find an equilibrium set of prices for an existing set of goods, but the Austrian school recognizes that the calculation of market-clearing prices as only a subset of what markets accomplish and the market socialism framework does nothing to address the entrepreneurial actions that result in economic progress. That model of market socialism would result in economic stagnation because it offers no mechanism for an economy to make use of newly developed knowledge, nor to incorporate entrepreneurial innovations into an economy.

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One criticism of socialism is that it blunts the incentive to be productive. But this idea is, at best, secondary to the Austrian school's critique of socialism. The essence of the Austrian school's answer to market socialism is that it only addresses the market-clearing function of a capitalist economy, and leaves out the entrepreneurial and innovative functions that are responsible for the economic progress and high standards of living that characterize market economies. The most prominent single statement on this subject is Hayek's (1945) article, "The use of knowledge in society," in which Hayek emphasizes the role of the market in coordinating the decentralized knowledge that is held by all market participants. Hayek notes that the problem market socialism purports to solve is the finding of an equilibrium set of prices when the demand and supply of all goods is unchanging. Hayek admits that a central planning board could solve this problem as Mises's critics have alleged, but says that this "is emphatically not the economic problem which society faces." The real problem is coordinating all of the decentralized knowledge in a society, when that knowledge is constantly changing, and is often contradictory. Chapter 1 emphasized the difference between the equilibrium approach to economics and the Austrian market process approach, and Mises's critics in the socialist calculation debate were taking an equilibrium view of the economy, arguing that central planners could find an equilibrium set of prices the same way the market does. The market process approach recognizes that the discovery of market-clearing prices is only a part of the market process, and answers Mises's critics by saying not only do they not address the other important aspects of the economy that generate economic progress but that Mises's argument that these other aspects that determine the rational allocation of resources cannot be accomplished without markets is correct. These ideas about rational economic calculation developed by the Austrian school in the socialist calculation debate helped develop the unique identity of the Austrian school. Many of the more recent contributions of Austrian school economists, like Ikeda (1997) and Reisman (1998), develop the implications of the information problems involved in attempting to plan out the economic order. The remainder of this chapter examines the role of markets in economic calculation in more detail.

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Decentralized knowledge

Perhaps the most fundamental feature of an economy that leads to understanding the coordinating role of markets is that knowledge is decentralized, and often tacit. The concepts of tacit and decentralized knowledge were introduced in Chapter 1, and they are at the foundation of understanding why the Austrian school rejects the idea that central planning can duplicate the actions of the market. The market coordinates all this decentralized knowledge without it having to be aggregated or centralized, so everyone in the economy can take advantage of the knowledge held by everyone else, without actually having to obtain that knowledge. But it is not simply that the market does a better job of using that decentralized knowledge; because the knowledge is often tacit, and because different people will have contradictory knowledge, it would not even be possible to aggregate that knowledge so that a central economic planner could use it. Individuals engage in economic calculation, based on the best information that they have about the economic activities of others, and based on their own knowledge. They get feedback on the value of their economic activity through market compensation. Individuals profit if they add value to the economy, and suffer losses if their economic activity subtracts value. Individuals make their own judgments, and the market provides feedback about the value of their economic activities. Central planners can never obtain the decentralized and tacit knowledge to make the same kind of judgments that are made by market participants. Economic knowledge is not just a collection of objective and quantifiable facts. It is subjective, always incomplete and necessarily speculative because future economic conditions depend upon the decisions people make in the present, based on their incomplete knowledge. Government enterprises often are unable to make a profit, even when the government grants itself a monopoly. Central planners are unable to make use of decentralized and tacit knowledge, whereas the market mechanism coordinates this knowledge so that it can be channeled to its highest valued use, without having to be aggregated or centralized.

3.5

Complex systems

A complex system is one in which the components interact in such a way that the result of their interaction cannot be predicted. A market

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economy is a complex system, and a self-organizing system. The market system coordinates the economic activities of all of its participants to produce an orderly outcome, the details of which cannot be known in advance. Economic progress occurs as entrepreneurs introduce innovations into an economy, some of which will prove profitable and some of which will not. Every entrepreneur anticipates a profit, even while recognizing the risk of a loss. Without the anticipation of profit, the entrepreneur would not have taken the risk. The profit and loss in the market reinforces value-enhancing innovations and limits valuereducing innovations, but whether an innovation adds or subtracts value from the economy cannot be known until it is introduced and market participants have revealed their preferences. People's demands for goods and services are revealed as a result of market activity, and do not exist except as they are revealed by the market. There is no way for an economic planner to obtain that information outside the market mechanism that generates it. Whether an innovation adds value to the economy can only be known after it is introduced, and that information guides the trajectory of the economy in a way that cannot be anticipated in advance. O'Driscoll and Rizzo (1985) emphasize the significance of the fact that the future state of the economy is necessarily uncertain because it depends on decisions that entrepreneurs make in the present. Those entrepreneurial decisions are based not only on facts that could, in principle, be known in the present but also on the decisions that people are making today and will make in the future based on information that cannot be known with certainty. While all this may sound obvious, note that general equilibrium growth models that are often employed by economists are deterministic, so that initial conditions in the present determine the future trajectory of the economy. Using such a framework to explain economic growth and progress naturally leads economists toward thinking that if they change some policy parameters today, they can alter the trajectory of economic growth in a predictable way. The model works this way, so if the model represents the real world, the real world should work this way too. The market process approach, where individuals today necessarily make decisions based on incomplete and possibly contradictory information, depicts a trajectory of the economy that is not deterministic because it depends on the subjective judgments of individuals in the face of inevitable uncertainty. While economic analysis can help make general predictions about the future direction of the economy, one cannot, even in principle, predict the details.

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Wagner's (2007) example of comparing the orderly procession of a parade with the orderly movement of people in a shopping mall is again illustrative. While one can predict the general pattern of movement of people in the shopping mall, it would not be possible, even in principle, to predict where each individual will be at any particular time. One person's movements depend on the movements of others. If one store appears too crowded now, the person may come back later. If someone meets a friend, they may stop to talk. The process is not deterministic, and the specific actions of individuals are not predictable. The idea that central economic planners could allocate resources more effectively than the decentralized market system is what Hayek (1988) called the fatal conceit. A complex system cannot be comprehended in its entirety, so changes in one part of the system will have unanticipated consequences in other parts. Rational economic calculation must be decentralized, and undertaken by the individuals who hold that decentralized knowledge. The complex nature of the economy offers another argument that supports Mises's claim that rational economic calculation is not possible in a socialist economy.

3.6

The mixed economy

The alternatives to economic organization are not only capitalism or socialism but intermediate types of organization that rely on a combination of market production for some goods and services and government production for others: a mixed economy. The mixed economy is often supported because people identify problems with the way the market is allocating resources, and push for government intervention to solve those problems. The market is good for producing goods and services, the argument goes, but needs to be regulated to create fair outcomes, and to correct for the failures that markets sometimes exhibit in their production of goods and services. Because the economy is a complex system, government interventions into the economy are likely to create additional unanticipated problems, and these new problems will then result in a demand for additional interventions to solve the new problems. Often, the problems are apparent, but either people do not recognize that they are created by government intervention or they believe that additional interventions will create an outcome better than with no interventions. Ikeda (1997) describes this as the dynamics of the mixed economy. One interven-

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tion leads to another, with the result that if a society chooses the mixed economy as its model of economic organization, the economy will move further and further away from a market economy over time, and more toward central economic planning. The dynamics of the mixed economy follow from the analysis of economic calculation that has been the focus of this chapter. When resource allocation is shifted from the market toward government, the information generated by market prices is lost, and the decentralized coordination mechanism of the market is replaced by the hierarchical decision-making process of government. Economic calculation becomes less rational, and the resulting problems lead to increasing government intervention. Economic institutions are important determinants of the ability to engage in rational economic calculation, as Harper (1998) emphasizes, and a movement away from market institutions and market prices stands in the way of the ability of individuals to make rational decisions about resource allocation. This argument is directed to the idea that government can improve on the market's allocation of resources. Many Austrian school economists argue that there is a role for limited government in the economy, but place limits on the scope of government. 3 The more open-ended argument in support of a mixed economy maintains that sometimes government intervention can improve on the market's allocation of resources and places no limits on government's scope. Use the market where it works best, and government production or control where it works best. The argument ignores the complex system nature of the economy, and falls into Hayek's fatal conceit. An attempt to design a mixed economy pushes the economy further toward central economic planning as increasing interventions are demanded to remedy the problems caused by earlier ones. 4

3.7

Economic progress

The market process approach to economics focuses on the economic calculation of individuals as they interact with each other to look for opportunities to increase their wellbeing. Individuals do not choose an equilibrium course of action. They do not "maximize" anything; they choose among alternatives as they look for ways that they can do things differently to make themselves better off, through both their production decisions and their consumption decisions. Everyone is looking for

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opportunities, and in this sense everyone is entrepreneurial. Because of this, the economy is continually evolving as people try out new ideas with the anticipation that they will find their wellbeing increased. This applies to everybody, including people who are looking for new jobs, or for ways to increase their productivity (and incomes) in their existing jobs, but a heavy emphasis is placed on the entrepreneurs who act within firms because the innovations they introduce into the economy have the highest aggregate impact. Entrepreneurs are always looking for ways to lower their cost of production, to improve the characteristics of the goods and services they sell and to introduce new products into the market. As the previous chapter noted, the people who run firms must be entrepreneurial because other firms in their industry are. Firms that do not find ways to improve their product offerings and lower their costs will find themselves falling increasingly behind those who do. In contrast with a depiction of markets in equilibrium, economic conditions are always changing, and the biggest long-run driver of change is the actions of entrepreneurs who are looking for profit opportunities. People who run firms want to make decisions that turn out to be profitable, but firms do not "maximize profit" because they can never know how profitable a course of action would have been that they did not take. A firm that chooses to produce product A instead of B will discover how profitable it is to produce A, but will not discover how profitable it would have been to produce B, because that course of action was not taken. Profit opportunities rarely present themselves in a form that presents no risk to the entrepreneur. For something as simple as a retailer deciding whether to carry more inventory, or whether to stock additional product lines, the cost of purchasing and financing the inventory must be weighed against the expectation that sales will increase as a result, and the decision becomes even more complicated if capital costs, such as expanded storage space for the inventory, must be factored in. Changes in product characteristics - perhaps as simple as modifying the packaging on a small item or as complex as introducing a new model of automobile - place the entrepreneur in a position of having to weigh costs that must be incurred before the innovation appears on the market against the expected benefits of potential future sales. This depends on customer demand, which will in part depend on innovations that might appear in the meantime from other producers in that

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market. This will never be a matter of simply adding up the costs and benefits of various options because the actual costs and benefits will always be uncertain. Lange and Taylor talked about the process of trial and error in the market, but they were only talking about finding market-clearing prices, and depending on the "error" (either a surplus or a shortage, in their framework), the direction of adjustment is obvious. But when there are essentially unlimited options in terms of product variety, inputs and production methods, the adjustment that would produce additional profit is not obvious. This is where entrepreneurial judgment becomes important, and as Chapter 2 noted, the wisdom to make the correct judgment is a matter of utilizing tacit knowledge that cannot be reduced to a simple calculation. Entrepreneurs gather information, which will be about current and expected future prices, inputs and customer demands, and that collection of pieces of information forms the knowledge base of the entrepreneur. Some information may be relevant to the decision at hand; other information may be misleading. The wisdom of the entrepreneur is what leads toward making the profitable decision and introducing a profitable innovation. This is the process of economic calculation, which relies on a knowledge base of current information and judgment about future economic conditions. In the real-world economy, economic calculation is based on knowledge that is always uncertain. The market process rewards with profit entrepreneurs whose judgments add value to the economy, and penalizes entrepreneurs whose judgments take value from the economy with losses. This allows those who have made profitable decisions in the past to gain more command over resources, and limits the resources available to those whose decisions resulted in losses. The result is that value is added to the economy, which produces economic progress. That progress occurs because of the new goods and services, and more efficient production methods, which are continually being introduced into the economy. When one considers how much better off people are today than they were a century ago, or so years ago, or even 20 years ago, a large part of that increase in wellbeing is the result of the new goods and services that come with economic progress. In the United States, per capita income increased by about seven times in the twentieth century, but people were not consuming seven times the amount of the same goods and services at the end of the century that they consumed at the

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beginning. Local travel evolved from horse-drawn carriages to automobiles, and cross-country and intercontinental travel evolved from trains and ships to jet aircraft. Long-distance communication evolved from paper letters to email, and by the end of the century cellular telephone and the internet allowed instantaneous communication with anyone throughout the world. Refrigerators replaced ice boxes, and microwave ovens replaced coal and wood-burning stoves. Economists often measure growth as income growth, but aggregating growth this way while leaving out economic progress leaves out the fundamental cause of growth. Were it not for these new goods and services economic progress made available, incomes could not have increased as much as they actually did. The amount of growth that has taken place since the beginning of the Industrial Revolution would not have been possible had it not been from the economic progress that brought with it new goods and services. That economic progress is the result of entrepreneurship, and that entrepreneurship can only take place within the economic calculation of a market economy.

3.8 The evolution of economic activity The market process, in which the economy is continually evolving in response to entrepreneurial innovation, presents a different picture of economic activity from an approach that views the economy as tending toward equilibrium. The parallel between economic progress and biological evolution was noted by Alfred Marshall, who despite having developed an equilibrium framework for his analysis, thought that as economics moved forward an evolutionary framework would be more appropriate. Marshall (1920, p. 322) says, "as we reach to the higher stages of our work, we shall need ever more and more to think of economic forces as resembling those which make a young man grow in strength, till he reaches his prime; after which he gradually becomes stiff and inactive, till at last he sinks to make room for other and more vigorous life." Taking up Marshall's challenge to take a more evolutionary approach, Lachmann (1986) sees little value in analysing equilibrium states of the economy because economies are never at rest - at equilibrium - and are always evolving. Thus, the state of the economy at any point in time is determined by the pull of forces trying to equilibrate the economy that is, the forces that pull toward market-clearing- and the forces that

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cause the economy to evolve - the entrepreneurial forces that produce economic progress. Taking an evolutionary approach to economic analysis, O'Driscoll and Rizzo (1985, p. 5) say "error and correction of error are important facets in the dynamic process. In counter-distinction to the neoclassical approach, however, these errors do not wind down to a determinate equilibrium state. Thus, we have process or evolution without traditional equilibria." As with biological evolution, economic progress occurs through differentiation, selection and replication. The key distinction between biological evolution and economic evolution is in differentiation. Biological mutations occur at random, but the conscious decisions of entrepreneurs create differentiation in markets. Biological evolution just happens, but economies will stagnate unless entrepreneurs make deliberate decisions to introduce innovations into the economy. One can see, for example, the notable lack of any economic progress from around 500 AD to about 1500 AD. The incentives for entrepreneurial innovation were not present, and the Industrial Revolution occurred with the emergence of capitalism, an economic system that allowed entrepreneurial individuals to profit from the innovations they introduced into the economy. By 500 AD civilization had advanced well beyond a primitive existence, but then stagnated. One explanation is that the level of progress that had been achieved by the Roman Empire, and in ancient China, and in Peru, had reached the limits of development for a hierarchical economic and social system, and that economic progress could only resume with the development of a decentralized market system. Rational economic calculation requires markets and market prices, and because knowledge is decentralized and often tacit, must be undertaken by the individuals who have that knowledge. It cannot be aggregated and used effectively in a centralized system. In contrast to biological evolution, the differentiation that drives economic progress is the result of the conscious decisions of entrepreneurs who use their knowledge to find profit opportunities. The parallel to the natural selection of biological evolution is the economic selection that results from profit and loss. Those innovations that prove profitable are selected, while those that generate losses wither and die. Thus, economic progress cannot occur without profit and loss to drive the selection process. If economic success comes from political favoritism, or physical dominance, the incentives for entrepreneurial innovation

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will be absent, and as happened in the Dark Ages between the fall of the Roman Empire and the beginning of the Industrial Revolution, the economy will stagnate. Replication occurs in the economy because those entrepreneurs who are successful will be able to use their profits to expand their economic activities, and others in the economy will be able to observe the successes of profitable firms and imitate them. Thus, entrepreneurial successes multiply while entrepreneurial failures fall by the wayside. This, again, shows the importance of profit and loss to economic progress. Economic evolution is the product of entrepreneurial judgment in the face of uncertainty. Entrepreneurs can make mistakes, and because of uncertainty, two individuals can see the same facts but interpret them differently and make different judgments. Because of this, the trajectory of the economy is not deterministic. The trajectory of the economy is path-dependent, Arthur (1989) notes, because decisions people make under uncertainty today alter its future course. One can never know what will happen in the future, even though economic analysis can help entrepreneurs, and everyone, make informed judgments about future economic activity. A market economy produces an orderly outcome as the result of human action but not of human design, but while the overall order can be anticipated, all of the details cannot.

3.9

Product differentiation and progress

One area where the Austrian school's views differ from the standard textbook analysis is product differentiation. Armentano (1972) notes that when entrepreneurs differentiate their products, they do not just do so to make their products different but to make them better than those offered by their competitors. As already emphasized, whether a new product or product characteristic is better is a matter of the subjective evaluations of the people who will purchase the products. Entrepreneurs cannot know for certain whether their innovations are really improvements until they are introduced into the marketplace, even though they introduce them anticipating that consumers will prefer them to what was available before. In a survey of top-selling intermediate microeconomics books, Holcombe (2009) finds this idea of continual improvements in prod-

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ucts being generated as a result of product differentiation absent from those textbooks. The "textbook" discussion of product differentiation describes firms with differentiated products as producing output at higher than minimum average total cost, whereas in a competitive industry with homogeneous products output will be produced at minimum average total cost. Thus, product differentiation results in highercost output. Those firms also produce less output than if they and their competitors produced homogeneous output. If there were fewer firms in the industry with the differentiated products, each producing more output, the industry's output would be produced at lower cost. However, consumers would then have no choice about the characteristics of the products they could buy. Imagine the soft drinks industry, for example, without differentiated products. There would only be one type of soft drink, rather than the choice of Coke, Pepsi, Sprite, 7-Up and so forth. So, the textbook conclusion is that there is a trade-off: product differentiation allows consumers more choices but at a higher cost. That "textbook" depiction of product differentiation is the result of the analysis being undertaken in a static equilibrium framework. If a market process framework is used instead, product differentiation occurs because entrepreneurs are trying to make their products more attractive to buyers, and increasing value to consumers. Product differentiation offers buyers more than just an increased number of options; it offers them better products that give them greater utility. One characteristic of the Austrian school's approach to economic analysis is that it treats time as an important component of economic analysis. The "textbook" analysis of product differentiation depicts markets with differentiated products in a static framework, devoid of the element of time. Thus, the framework ignores the dynamic effects of product differentiation that produce continually improved products that better satisfy consumers' desires. Seeing this connection between product differentiation and economic progress calls into question the "textbook" conclusion that product differentiation results in highercost output. For example, if a new variant of a product is introduced that gives purchasers higher utility than the products previously available, it adds utility and gives consumers better value for their money. One might conclude that if all firms produced this new variant, each firm would produce more and at a lower average total cost, but the new variant would not exist without product differentiation. The process of product differentiation adds value to the economy, in contrast to

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the static "textbook" conclusion that product differentiation increases costs and prices. Taking the market process approach, product differentiation is the engine of economic progress. Entrepreneurs differentiate their products not just to make them different but to make them better. The test of whether the differentiated products really add value to the economy is whether they are profitable. The continual innovation that occurs because of product differentiation is what causes economic progress.

3.10

Profit: indicator of progress

The analogy between biological evolution and economic evolution breaks down when one examines the normative implications of evolution. Evolution makes biological systems change over time, but while they are different there is no benchmark by which one could say that a new species, or a new ecosystem, is better than the ones that went before. 5 Economic evolution generates economic progress, and profit is an indicator that the new economic conditions are better than what they replaced. This is another area in which the Austrian school's ideas are different from the conclusions that result from an equilibrium view of the economy. Taking an equilibrium approach to economic analysis, profit is an indicator of an inefficient allocation of resources. Profit indicates that either the economy is not in equilibrium, which is inefficient, or that the profitable firms have some monopoly power, which is also inefficient. A market process approach views profit as an indicator of economic progress. To take a concrete example, consider the very profitable IBM during the late 1960s and 1970s, which was sued by the US Justice Department for monopolizing the computer industry. IBM had introduced their 360 computer in 1965 and it rapidly dominated the market. IBM's dominant market share and profit made it appear, in the equilibrium approach, to be an inefficient monopoly, a view widely enough shared to bring about the Justice Department's antitrust suit. Consider the source of IBM's profit from a market process approach. IBM introduced a new and innovative product into the market, and the profit the company made from it was the result of customers being

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willing to pay IBM so they could use that new product rather than the other computer options that were available to them. The profit that IBM earned represented the extra value customers placed on their computers over those offered by other computer manufacturers. That profit was an indicator of the economic progress the IBM 360 computer represented. Why did IBM decide to go through the expense of designing, manufacturing and bringing that computer to market? It was the lure of potential profit that the company anticipated the product would bring. So, the expectation of future profit was necessary for the product to be produced; in other words, that profit was necessary for that progress to occur. The profit that IBM earned represented the extra value that was produced for consumers as the result of its production. The evidence that customers valued that product more was that they were willing to voluntarily pay for it. Profit is an indicator of economic progress, and reveals that economic evolution makes the economy not just different from how it was in the past but better. People's actions reveal the improvement by their voluntary willingness to pay for it. Profit is an indicator of progress, but it is not a measure of progress because some of the benefits of economic progress go to consumers. When a profitable product is introduced, some of the benefits go to the entrepreneurial firm in the form of profit, but some go to consumers, who benefit from consuming that new product rather than what was available before. As time goes on, competing firms imitate features of the new product and the profits of the innovator are competed away. While the profits are competed away, the benefits from the innovation remain. Through economic competition, those profits shift toward consumers and become consumer surplus. The vast economic wellbeing that has been the result of centuries of economic progress is the result of profitable innovations that, over time, have seen those profits erode through competition and shift toward consumers, in the form of consumer surplus. The profits are necessary because they are the lure that entices entrepreneurs to introduce innovation into the economy. And they are an indicator of economic progress because they represent the purchasers' willingness to pay for those innovations. And over time as the profits are competed away, the benefit of the innovations increasingly shifts away from producers and toward consumers.

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One way to differentiate the market process approach from the equilibrium approach to economic analysis is to consider which of the following two statements is true: profit is an indicator of an inefficient allocation of economic resources; or profit is necessary for an efficient allocation of resources. The equilibrium approach concludes that profit results from disequilibrium, or monopoly power, so indicates an inefficient allocation of resources. The market process approach says that profit is necessary for economic progress, which results in an increasingly efficient allocation of resources. The way profit is viewed in an economy differentiates the Austrian school's approach to economic analysis from that of most other schools. The application of this distinction to antitrust law shows that the distinction is of more than just academic interest. The market process approach to economic analysis leads to different public policy conclusions than the commonly used equilibrium approach.

3.11

Welfare: process versus outcome

The equilibrium approach to economic welfare takes a static view of the efficiency of resource allocation. Welfare is maximized when resources are allocated in such a way that nobody can be made better off without making someone else worse off. This condition, called Pareto optimality after the same Pareto who, according to Lange and Taylor, developed the answer to Mises's challenge on socialist calculation, views welfare maximization as the outcome of economic processes. The goal of standard welfare economics is to arrive at an optimal allocation of resources, and should that optimal allocation be attained, welfare is maximized and the economy could not do any better than this Pareto optimal allocation. The market process approach depicts welfare maximization as an ongoing process. The economy never arrives at a position where welfare is maximized because a market economy always has the potential for economic progress that will make welfare higher in the future than it is in the present. Welfare is maximized by the continual entrepreneurial innovation that continues to add value to the economy, so welfare increases over time and never arrives at a welfare maximum. When one thinks about how much better off people are today than a century ago, or even 20 years ago, it is obvious that their increased wellbeing is due to the economic progress that has occurred over time,

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and little if any improvement is due to the economy moving closer to a Pareto optimal allocation of resources. This point is of more than just theoretical interest. A substantial amount of public policy is based on the static equilibrium approach to welfare maximization. Antitrust law takes a static view of profit, as noted earlier, and a substantial amount of regulation is justified because of the potential for externalities, because of informational asymmetries that may exist in the economy or because markets may fail to produce the optimal allocation of resources for other reasons. Cordata (1992) notes that the market process approach recognizes the importance of protecting property rights to facilitate exchange and prevent predation, but beyond this, any static inefficiencies in the market allocation of resources represent profit opportunities, and entrepreneurial innovation can turn these inefficiencies into profits for the innovators through mutually advantageous exchange. Value is subjective, and there is no standard to judge economic efficiency beyond the values the market places on goods and services. Public policy toward externalities is often presented within a framework where government policy corrects a market failure, but information about actual external costs is not available absent market data. If there actually is an inefficiency, market incentives exist to correct it. The Austrian school does not minimize the economic costs that can be generated by externalities, but at the same time questions the ability of government policies to mitigate those costs. As Ikeda (1997) notes, well-intentioned government interventions in the economy can generate unforeseen negative consequences, which lead to calls for more government interventions, which may generate even more problems. The more the government becomes involved in resource allocation, the more it erodes the market signals that are generated through voluntary exchange. The Austrian school recognizes that while externalities may have undesirable consequences, the government policies that are often designed to address externalities also can have undesirable unintended consequences. Herbener (1997), building on Rothbard (1956), notes that when voluntary exchanges occur, welfare is enhanced because all parties agree to the exchanges, signifying that they are better off. When government intervenes to try to correct inefficiencies that people may perceive, there is no guarantee that welfare is increased because people are being coerced through taxation, regulation or both. The fact that

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people must be forced indicates that they are worse off; otherwise they would voluntarily do what the government is forcing them to do. Because government intervention forces some people to act in ways they would not were it not for that coercion, it makes those people who are coerced worse off, and one can never be sure that such an intervention enhances welfare. Austrian school economists are not uniformly in agreement about the role of government in the economy, but one can see that taking a static equilibrium approach to economic welfare justifies substantially more government intervention into an economy than taking a market process approach. The reason is two-fold. First, the static view of welfare maximization overlooks the fact that inefficiencies in resource allocation present a profit opportunity for entrepreneurs. Over time, entrepreneurial innovation can overcome inefficiencies and generate economic progress. Second, the static equilibrium view of welfare maximization is overly optimistic about the prospect of government intervention producing an improvement in resource allocation. Government interventions will have unintended consequences, which can lead to calls for more government intervention, making resource allocation less efficient in the future. Both of these reasons lead Austrian school economists to be more apprehensive about government intervention, and more likely to favor market outcomes over government-directed resource allocation. The Austrian school is often viewed as more market-friendly than other schools of economic thought, and some reflection on the implications of the school's market process approach to understanding economic activity reveals why.

3.12

Conclusion

The Austrian school's framework for understanding economic calculation is one of the features that distinguishes Austrian economics from other schools of thought. The Austrian school's ideas on economic calculation were refined in the socialist calculation debate led by Ludwig von Mises, who argued that rational economic calculation would not be possible under central economic planning. Mises and his student Hayek made the clearest arguments that defined the Austrian school's views, and their arguments are perhaps best seen by contrasting them with the arguments of Mises's critics. The critics who argued that central planners could undertake rational economic calculation said that central planners could, through trial and error, calculate

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market-clearing prices for goods in an economy, but implied in their arguments was the assumption of fixed supply and demand functions, and a fixed set of goods for which prices would be calculated. Taking a market process approach to understanding economic calculation, the market mechanism coordinates knowledge that is often tacit, that is constantly changing and that different economic actors will interpret differently. The nature of the information that is necessary to rationally allocate resources means it can never be aggregated and known to a single entity. The economy is a complex system in which different individuals all make best use of their individual knowledge, and because it is a complex system, the economy can never be completely comprehended in its entirety. During his lifetime, the economics profession generally believed that Mises, who passed away in 1973, had lost the socialist calculation debate. The profession's conclusion rested on two legs. First, the arguments of Lange, Taylor, Lerner and others were seen as winning the theoretical argument. Second, in the post-World War II era when the Soviet Union was viewed as a superpower, one response to Mises's claim that central planning cannot work is that the Soviet Union provided evidence that it is working. The conventional wisdom was that even though per capita income in the Soviet Union was well below that in the United States and Western Europe, the Soviet Union and other Eastern bloc centrally planned economies were growing faster, and would catch up. The trade-off, as many prominent Western economists saw it, was between the faster economic growth and a more robust economy that came with central planning, and the greater amount of personal and economic freedom that came with capitalism. After the collapse of the Berlin Wall in 1989, followed by the breakup of the Soviet Union in 1992, the conventional wisdom on Mises and the socialist calculation debate shifted. It was apparent that what ended the Cold War was not the military might of one side over the other but rather the economic strength of the market economies in the West over the centrally planned economies in the East. In hindsight, the strength of those centrally planned economies was overestimated, and their collapse led even Mises's critics to re-evaluate his arguments and accept the possibility that he might have been right. This, in turn, boosted the reputation of the Austrian school more generally. Whereas at one time the general feeling was that Mises and the Austrians were obviously wrong, after the breakdown of the centrally planned economies it appeared to many that the Austrian school had more insight

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into the problems of central economic planning than did the former conventional wisdom. The Austrian school of economics is often associated with the support of laissez-faire economic policies, and an analysis of the Austrian approach to economic calculation lends some insight as to why. The knowledge that allows economic calculation to take place is decentralized, and is in a form that prevents it from being aggregated. The market mechanism coordinates all this decentralized knowledge without it having to be aggregated, but more than that, the knowledge could not be aggregated anyway. The economy is a complex system that cannot be comprehended in totality. But through decentralized decision-making coordinated through the market mechanism, it produces an orderly outcome that is the result of human action but not of human design. The Austrian school's support for the market allocation of resources follows from the way the school understands the market process. NOTES 1 See Rothbard (1999) for a good discussion of Mises's life and ideas. 2 This slogan appeared in Karl Marx, "Critique of the Gotha Program", an 1875 plan for society to evolve from a capitalist to a socialist system. Marx favored a more rapid revolutionary shift. 3 Some Austrian school economists, in particular those following Rothbard (1973), argue that market activity can replace everything government does, and work more effectively than government. Venturing into political philosophy, Rothbard (1982) also argues that because it is based on coercion, all government action is unethical. These ideas are addressed further in Chapter 5· 4 Boettke (1993) extends the argument in the other direction, arguing that market reforms in the Soviet Union during the 1980s failed because there was not a credible commitment to move sufficiently away from the planned economy toward market institutions. 5 To the extent that people do draw normative conclusions about changes in biological systems, they tend to view any change as undesirable. If an existing species goes extinct, that is viewed as undesirable. If the habitat of an existing species expands so its population grows, that also is typically viewed as undesirable.

4

Money, banking and business cycles

The Austrian school's business cycle theory finds its origins in Ludwig von Mises's 1912 The Theory of Money and Credit, originally written in German and translated into English in 1953. Mises's business cycle theory is built on a monetary foundation, depicting business cycles as the result of fluctuations in the money supply caused by a fractional reserve banking system. From Mises on, the Austrian school's business cycle theory has been closely related to money and banking. Mises's student Friedrich Hayek more fully developed his business cycle theory in the 1930s and published several books in English explaining the theory, so Hayek deserves much credit for his development and exposition of the theory. In the 1930s Hayek's ideas on macroeconomic fluctuations were the most prominent alternative to the macroeconomic ideas developed by John Maynard Keynes. Keynes's ideas won out over Hayek's, and for most of the economics profession, macroeconomics was Keynesian economics up through the 1970s. In the 1970s economists raised significant questions about the Keynesian framework and new alternatives to the then dominant Keynesian paradigm for macroeconomics began to be developed, while older alternatives got a second look. With the renewed recognition of the Austrian school in the 1990s as the socialist calculation debate was reassessed, the Austrian approach to macroeconomics also found increased visibility because it seemed to be descriptive of macroeconomic events in the 1990s and 2ooos. In the early twenty-first century, the most prominent alternatives for analysing the marcroeconomy were the Keynesian framework, the monetarist framework that challenged Keynesian macroeconomics in the 1970s and the general equilibrium macroeconomic approach that was dominant as the twenty-first century began. The stock market bubble in the late 1990s and the housing bubble in the 2ooos did not fit easily within these frameworks. The Austrian approach began to look like a better fit for explaining actual macroeconomic events,

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although it still remains well outside the mainstream of economic analysis.

4.1

The money supply and fractional reserve banking

The outline for the Austrian theory of the business cycle, found in Mises (1912 [1953]), identifies expansions and contractions of the money supply that occur under fractional reserve banking as a cause of business cycles. Austrian business cycle theory is a monetary theory, beyond a doubt, which leaves open the possibility that economic fluctuations could have other causes as well. When Mises wrote his Theory of Money and Credit, the world was on a gold standard, which meant that governments had limited control over the quantity of money in circulation. Banks were (and still are) fractional reserve banks, which meant that they held only a fraction of their deposits on reserve, and lent out the rest. Under a gold standard with fractional reserve banking, even if the amount of gold backing the money supply does not change, the quantity of money in circulation will change depending upon the fraction of their deposits banks hold on reserve. If banks held 100 percent of their deposits on reserve, the quantity of money would equal the amount of gold money that was either circulating as coins or was deposited in banks. But fractional reserve banking is built on the idea that on most days few depositors will want to take all their money out of the bank, and that on average, a day's deposits will approximately equal a day's withdrawals. Thus, a bank can keep only a fraction of its deposits on reserve and lend out the rest, earning interest. When a bank makes loans, it creates new money. Say, for example, that a customer deposits $1oo in gold coins into a checking account in a bank. That $1oo would be a part of the individual's spendable cash balances. Now, if the bank lends $So of that deposit to a borrower, the original depositor has $1oo in the bank deposit, and the borrower has $So, so the money supply has expanded by $so. In this way, by keeping only a fraction of its deposits on reserve, a fractional reserve banking system creates money when it makes loans. Under a gold standard, the gold that backs the money supply is the monetary base, and as the example shows, the monetary base is smaller than the money supply. Monetary institutions changed substantially over the twentieth century, so by the twenty-first century no country was on a gold standard, and government bonds and other financial

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assets made up the bulk of the monetary base. Those financial assets play the same role in contemporary monetary systems that gold played under a gold standard. The key difference is that governments have direct control of the monetary base when the government is able to establish fiat money (money that is not redeemable in real assets) as the medium of exchange, in contrast to a gold standard in which the monetary base is determined by the demands people have to hold gold relative to money. Under a gold standard, the government stands ready to exchange money for gold, or gold for money, at the fixed established price of gold. For example, when Mises wrote The Theory ofMoney and Credit, the US government set the price of gold at $20.67 an ounce. People could bring an ounce of gold to the Treasury and get $20.67 for it, or bring $20.67 to the Treasury and get an ounce of gold. So, the amount of gold in the monetary base was determined by the market forces of supply and demand. This description of the gold standard, and fractional reserve banking, is not unique to the Austrian school. It just provides some background for understanding the Austrian theory of the business cycle, which is built on the effects of an elastic currency under fractional reserve banking. The theory relies on expansions and contractions of the money supply due to fractional reserve banking, and shows that monetaryinduced business cycles can take place even if there is no change in the monetary base.

4.2

The basic business cycle theory

In a stable economy when the economic outlook appears positive, banks will find it advantageous to increase the amount of money they lend, because banks' profit comes from the interest they earn on their loans. With a positive outlook, banks will have reason to believe that they can safely expand their loans, which have a high probability of being repaid because economic conditions are good. With a given size of the monetary base - say, under a gold standard, which was the monetary system under which Mises (1912) was writing- an increase in the amount of money lent by banks will increase the money supply. The increase in the supply of loanable funds will push the interest rate down, making borrowing even more attractive to business. Increased borrowing leads to an expansion of business and an economic expansion. Expanding

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businesses hire more workers so employment increases. This is the boom phase of the business cycle. As long as banks feel comfortable expanding their lending, interest rates remain low and the economic expansion continues. But at some point banks will believe that it is not safe for them to draw down their reserves any further, so the monetary expansion will stop. With the supply of loanable funds no longer increasing, the interest rate, which was pushed down by the monetary expansion, will begin to rise. Businesses will no longer find money so readily available, and at interest rates as attractive as they saw during the boom, so projects that appeared profitable during the boom will no longer look as attractive. Entrepreneurial ventures are always risky, and under any conditions some of them will not pay off. But the change in business conditions due to the end of monetary expansion will mean that a larger number of projects will end in failure. The economic boom will come to an end. Banks will react to the change in economic conditions by reducing their loans. Seeing an increased danger of loans not being repaid, they will want to have more reserves on hand to meet the demands of their depositors. The reduction in loans will contract the money supply because of the fractional reserve banking system, and the monetary contraction that reduces the supply of loanable funds will result in a rising interest rate. As the interest rate rises, an increasing number of projects that once appeared profitable will no longer appear that way. As more investment projects are terminated and businesses contract, unemployment will rise and the bust phase of the business cycle will begin. It has become apparent that many projects initiated during the boom no longer appear economically feasible. When banks have reduced their loan portfolios sufficiently that they feel they have adequate reserves, the monetary contraction will end, and interest rates will begin to fall. Over time, businesses will have liquidated their unprofitable investments, and the economic contraction will end. Businesses will be on a sounder footing, perhaps having delayed some potentially profitable investment due to the higher interest rates during the downturn. As the economy recovers and businesses become more profitable, they will again be more interested in investing, and with the economy on a more solid footing, banks will be more inclined to lend. So, lending will expand, and the increasing supply of loanable funds will push down interest rates encouraging more borrowing. After the economy bottoms out conditions are

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ripe for the monetary expansion that will lead to another boom. The cycle repeats itself, as expansions and contractions in the economy are caused by expansions and contractions in the money supply that are a by-product of fractional reserve banking. This is the basic mechanism behind the Austrian theory of the business cycle.

4.3

The causes of the business cycle

That brief outline of the Austrian business cycle theory shows that the cycle is caused by fluctuations in the money supply. The cycle is completely endogenous to the economy; that is, there is no outside shock that leads to the cycle. Once the cycle starts, economic forces lead to an expansion and contraction of the money supply under fractional reserve banking, and the periodic boom and bust continues as borrowers and lenders respond to changing economic conditions. The boom occurs because businesses make investments that in hindsight are shown to be unprofitable, and during the bust businesses reallocate their resources so that they can resume profitable operation. The boom period, then, is an unhealthy development that is characterized by malinvestment - investment that will eventually be revealed to be unprofitable - and the bust period is the recovery in which investors reallocate resources away from the previous malinvestment. The business cycle has sometimes been likened to a person who goes on a drinking binge and later suffers a hangover. The drinker may have felt good during the drinking binge, but in hindsight that binge inevitably led to the hangover, which was the beginning of the recovery from the excessive drinking. During the business cycle, the boom gives the appearance of good economic conditions, but the reality is that it is built on malinvestment, and like the drinker's hangover, the bust phase of the business cycle is the inevitable result of the malinvestment during the boom. Mises (1912 [1953]) developed his business cycle theory within the framework of the existing monetary institutions when the world was on a gold standard, and under this framework one can see that the business cycle occurs even when the monetary base remains unchanged. Under a gold standard, the amount of gold backing the money supply is the monetary base, and in the theory described above that monetary base can remain constant, and because of fractional reserve banking, the money supply will expand and contract because of increases and

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decreases in banks' desires to lend. They become optimistic and less cautious during the boom, and become pessimistic and more cautious during the bust, causing the money supply to expand and then contract, even with a constant monetary base. As monetary institutions developed over the twentieth century, the world's economies went off the gold standard and central banks now can control the size of the monetary base. So, the expansions that under the theory as originally developed were solely the result of an elastic currency under fractional reserve banking now can be caused by central banks expanding and contracting the monetary base. Even if banks do not lower the fraction of deposits they hold on reserve, a central bank can increase the monetary base, which will lead to an expansion of the money supply even if banks hold their ratio of loans to deposits constant. As governments have gained increasing control over the monetary base throughout the twentieth century, they have also gained an increased ability to cause business cycles through monetary fluctuations that result from their manipulation of the monetary base.

4.4

Why do borrowers and lenders make these errors?

The Austrian business cycle is based on banks lending excessively during the boom period, and businesses borrowing to invest in projects that later are revealed to be unprofitable. If Austrian school economists understand this, why is it that borrowers and lenders apparently do not, and keep making these errors? One would think that business people would have a big incentive to avoid making such errors because they are the ones who ultimately bear the cost of their malinvestments. Look at the lending side of the market. When the economy is booming, borrowers are more likely to be able to repay their loans, so banks looking to retain their profitability have an incentive to lend more as long as the boom continues. Obviously, they do not want to make loans that will eventually find themselves in default, but it may be difficult for bankers, who are experts in banking but not as knowledgeable about other businesses, to be able to separate out investments that have the least potential for success. Ultimately, banks care more about having a borrower who can repay the loan than whether the investment will be successful. The two will be correlated, of course, but not perfectly so. Loans will be made to the most creditworthy borrowers, regardless

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of whether they are overly optimistic about the prospects for their investments. Furthermore, lenders must deal with the actual market conditions they face, not some hypothetical ideal market. A bank could not unilaterally decide that the economy was entering a boom phase of a business cycle, and loans appear to be more risky, so the bank will not make loans. If a bank ceased making loans, it would eliminate its source of profit. So, even if a bank's management recognized that the boom would not last, and that in the future more loans would go into default, the bank could try to be more cautious, but still would have to make loans to remain in business. Indeed, at the peak of the boom banks do become more cautious, and they do stop expanding their lending, which is what brings the boom to an end. Now look at the borrowers in the market. In the basic outline of business cycle theory given above, during the boom phase businesses make malinvestments that later prove to be unprofitable, and so must retrench as the boom comes to an end. But regardless of economic conditions, some investments will, in hindsight, turn out to be profitable and others will result in losses. That is true during any phase of the business cycle, and is true whether or not there is a business cycle. The challenge to entrepreneurs, and to borrowers and lenders, is always to try to identify which investments will be profitable. This is the role of entrepreneurial judgment, but the uncertainty of the future means that the judgments of entrepreneurs will not always be correct. The monetary expansions and contractions that underlie the business cycle present a problem to those entrepreneurs, borrowers and lenders because they distort the price signals that market participants rely on to gather information about economic activity. The price that is most significant in this regard is the interest rate, but the prices of other goods can be affected by monetary fluctuations as well. If an entrepreneur is considering an investment, during the boom when interest rates are lower and the economy is expanding, economic conditions will look more favorable than otherwise. The downturn following the boom generates the economic conditions that reveal which investments were, in hindsight, based on overly optimistic expectations. As the previous chapters emphasized, all entrepreneurial innovation is risky, and there is no way to be certain ahead of time whether an innovation will be profitable. This uncertainty always

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characterizes investments because the future trajectory of the economy cannot be perfectly predicted. But the price and interest rate fluctuations that come with the business cycle make it more difficult to judge the potential profitability of an investment, and the result is that more investments that, in hindsight, prove unprofitable are made. Austrian business cycle theory places heavy emphasis on those investments that are made and later prove to be unprofitable, but with less informative price signals there is also the potential for a reduction in investments that would have been profitable but are not made. Emphasis is on the former - the malinvestments that turn out to be unprofitable because those are the investments that are revealed to be unprofitable in the market. Investments that would have been profitable, but are not made, never reveal themselves in the market, and, indeed, if the investment is not made, there is no way to tell in hindsight whether or not it would have been profitable. Austrian business cycle theory has sometimes been challenged with the criticism that entrepreneurs should be able to understand economic conditions about as well as the economists who developed this theory, so if the theory is descriptive of economic reality, entrepreneurs should anticipate that the investments they make during the boom will turn out badly after the boom ends, and not make those bad investments. The response to this criticism is similar to the response the Austrian school made to their critics in the socialist calculation debate. The economy is more complex than any model of the economy. The previous chapter described the economy as a complex system that cannot be comprehended in its entirety, so even though the business cycle theory indicates that malinvestments will occur more frequently as a result of the monetary expansion, the theory does not identify which investments will be malinvestments, and the market does not provide information to entrepreneurs that would enable them to separate ahead of time which investments will turn out to be unprofitable. The business cycle theory only says that because monetary fluctuations over the cycle distort the price information available to market participants, more investments will turn out, in hindsight, to be unprofitable. Distortions in price signals cause more errors to be made, but there is no information revealed ahead of time to let decision-makers know which of their specific decisions will turn out to be unprofitable. Austrian business cycle theory was developed when the world economy was on a gold standard, and the cycles occur even when the monetary base - then the amount of gold backing the money supply- does

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not fluctuate. In the twenty-first century economy in which central banks control the monetary base, the money supply can expand and contract because of policy decisions made by central bankers, and the expansions and contractions will not be limited by the willingness of banks to draw down or build up their reserves. This makes monetary fluctuations even more difficult to predict than under a gold standard, where the amount of gold in the monetary base placed a limit on the amount of monetary expansion. The business cycle theory still holds, in the sense that it describes the effects of monetary expansions and contractions, but those expansions and contractions can be extended by a central bank's control of the monetary base, and can be shortened by the actions of the central bank as well. This adds another degree of uncertainty to entrepreneurs because to anticipate the future they must anticipate the actions of the central bank. The added uncertainty offers another opportunity to misjudge future economic conditions.

4.5

The structure of capital

Another element of the Austrian business cycle theory that differentiates it from most other theories of macroeconomic fluctuations is that the theory explicitly recognizes the heterogeneity of capital. The malinvestments that occur over the business cycle are not just the result of too much or too little investment but are the wrong type of investment. A macroeconomic model that treats capital as homogeneous cannot take into account the type of malinvestments the Austrian business cycle theory describes. Investment is undertaken to produce specific types of capital, and that capital is limited in how it can be used. A computer is not a good substitute for a tractor, for example, which is not a good substitute for a warehouse. Outside the Austrian school, almost all macroeconomic analysis treats capital as a homogeneous aggregate, which eliminates the possibility of the model representing problems that arise because of overinvestments in one type of capital relative to another. Heterogeneous capital finds its way into the Austrian framework early on. Eugen Bohm-Bawerk (1884, 1889, 1909 [1959]), who was a disciple of Carl Menger, the founder of the Austrian school, developed a framework for understanding the structure of capital and the effect the interest rate has on the types of investment that are undertaken. BohmBawerk described a structure of production that began with land and labor as the original means of production, which then could be used

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to produce other goods. That structure of production can be extended by producing capital goods, which then can be used to produce final goods. Investment allows more roundabout methods of production, to use Bohm-Bawerk's terminology. To see the effect of the interest rate on how roundabout is production, consider a simple example of a distillery producing whiskey. The longer the whiskey is aged, the greater value consumers place on it, but while there is for this reason an incentive to age whiskey longer, while the whiskey is being aged it remains unsold, and the interest rate represents the cost to the distillery of aging the whiskey for a longer period. For example, if the interest rate is 5 percent, aging the whiskey for another year would have to increase its sales price by at least 5 percent to make the additional aging of the whiskey profitable. At the 5 percent interest rate the distillery will continue to age its whiskey as long as the sales price it can command by virtue of being another year older is at least 5 percent greater than the whiskey could command by being sold now. If the interest rate rises to 10 percent, the distillery would find it profitable to hold the whiskey another year only if its sales price would be 10 percent higher than the price it could currently command. As a result, if the interest rate rose from 5 percent to 10 percent, it would be less profitable to hold the whiskey for a longer period, and the result would be that, on average, the length of time the whiskey was held before it was sold would fall. Prices would adjust so that, for example, at the higher interest rate, 12-year-old whiskey would sell for proportionately more relative to 8-year-old whiskey. If the interest rate fell, the prices of 12-year-old whiskey and 8-year-old whiskey would move closer together. The longer the whiskey is aged, the more roundabout is the production.

This simple example applies to more complex production processes as well. Consider the roundabout production process for manufacturing an automobile. In the earlier stages of production, iron ore is mined and sent to steel mills to produce steel, which then goes to the automobile factory to manufacture the automobile. The automobile is then sent to the dealership where it is sold to the final purchaser. This process occurs over time, so if the interest rate is higher that makes it more costly to undertake earlier stages of production relative to later stages. At high interest rates auto manufacturers would have an incentive to design their automobiles to conserve the amount of

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steel, perhaps investing more in the final finishing at the factory, and even in investing in nicer buildings for their dealerships to attract customers. A similar decision arises in deciding how much to automate production processes. A manufacturer can use more labor and less machinery, or automate more by building machinery to substitute for labor later in the production process, creating a more roundabout production process. If the investment is profitable, the firm undertaking the investment will have an advantage over other firms that have not gone to that degree of automation; if not, the firm will be putting itself at a disadvantage. Many factors will affect the profitability of investing in a more roundabout production process. One is the interest rate. Monetary expansion could entice some firms into investing in a more roundabout production process that would later prove unprofitable. The lower the interest rate, the more economical it is to develop a longer structure of production, with- to use Bohm-Bawerk's terminology- a more roundabout production process. A higher interest rate creates the incentive to shorten the structure of production. This concept of a structure of production relies on the recognition that capital is heterogeneous. Outside the Austrian school, macroeconomic analysis almost always depicts capital as a homogeneous aggregate quantity, so is unable to analyse the structure of production, or how it might change.

4.6

The structure of production and business cycles

Austrian business cycle theory rose to prominence in the 1930s when Hayek (1933 [1966], 1935) developed a more complete exposition that emphasized the malinvestment that can occur because of the heterogeneity of capital. During the expansionary phase of the cycle, interest rates are pushed down, which makes a longer structure of production appear more economical. Investment tends to be directed toward those longer-term capital projects, but when the interest rate rises as the expansionary phase ends, some of those projects are revealed to be malinvestments. The primary problem is not that too much (or too little) investment has taken place but that the investment went to the wrong types of capital projects. As the economy readjusts during the contraction, because capital is heterogeneous, it may not be possible to reallocate malinvested capital to more productive uses.

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The problems that reveal themselves during the downturn in the business cycle were created during the upturn in the cycle, when investors invested in the wrong types of capital, creating a structure of production that could not be sustained. This characteristic of the Austrian theory stands in contrast with other schools of thought, and can be illustrated by looking at various explanations different schools of thought have used to explain the downturn that led to the Great Depression. Rothbard (1963), taking an Austrian school approach, describes the cause of the Great Depression as the result of malinvestment that occurred during the 1920s. Monetary expansion during the 1920s led to the boom period described by Mises and Hayek. The Keynesian explanation for the Depression is that aggregate demand declined, largely due to the volatility of investment demand that suffered a substantial reduction after the stock market crash of 1929. The monetarist explanation was that because of problems with the banking system, the money supply declined precipitously following the 1929 stock market crash, and that monetary contraction turned what would have been a much less severe recession into the Great Depression. The Austrian explanation distinguishes itself by tracing the causal factors back to malinvestment during the upturn in the cycle. The problems leading to the business cycle occur during the upturn, and the downturn is the recovery phase, during which dislocations occur as people reallocate their resources away from unsustainable uses, as Horwitz (2ooo, p. 82) notes. The significance of malinvestment as a cause of the downturn naturally focuses attention on the importance of recognizing the heterogeneity of capital. The Keynesian, monetarist and more recent general equilibrium models of the business cycle do not see the causes as being created by malinvestment prior to the downturn because those models do not account for the heterogeneity of capital. Non-Austrian views of the business cycle view a booming economy as a healthy one, whereas the Austrian school sees the downturn as the inevitable consequence of malinvestment during the boom phase. The business cycle is caused by the changes in the money supply that affect relative prices, and most importantly, the interest rate. One might consider why investors do not perceive these misleading price signals, and the reason is that individuals are not in a good position to separate out changes in prices due to changes in underlying supply and demand conditions from changes in prices due to monetary fac-

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tors. In addition to the inevitable uncertainty about the future that has already been noted, as economic progress occurs, people may change their time preference. Increasing incomes can lead individuals to defer some consumption until later, saving more and consuming less in the present. This would increase the supply of loanable funds and lower the interest rate as a result of real changes in preferences rather than changes induced by monetary factors. Savers and investors can respond to market signals, but do not have a good way of separating interest rate changes caused by changes in time preference from changes due to monetary fluctuations. Garrison (2001) discusses changes in the interest rate that might be due to technological advances. If a new technology is developed for producing consumer goods, that technology might require investment in the short term to produce the goods that are anticipated to be profitable in the long run. An increase in investment demand will cause the interest rate to rise in the short run, but that short run might be a period of years before the technology is finally in place and able to deliver the consumer goods. This is an example with the larger point being that the interest rate is a function of the supply and demand for loanable funds. Many factors influence the supply and demand for loanable funds, and the effect of monetary expansion and contraction on the supply of loanable funds is only one factor. Entrepreneurs will, of course, try to discern and separate monetary causes for fluctuations in the interest rate from other causes, but in a complex economy nobody can do this perfectly. Market participants can see the actual market rate but can only conjecture about the importance of various factors that cause that rate to be at its current level. A key distinguishing feature of Austrian business cycle theory is its emphasis on the way that monetary fluctuations cause misleading interest rate signals, which lead investors to invest in what proves to be the wrong types of capital. The structure of production is distorted by interest rate manipulation, leading to malinvestment. When the economic downturn occurs, problems with the structure of production become apparent, but because capital is heterogeneous, capital malinvested in one area of the economy cannot be redeployed to other areas, at least not without some cost. One cannot turn a backhoe into an assembly line or a railroad car into a set of hand tools. Problems with the structure of production can only be seen in a model that depicts capital as heterogeneous.

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4.7 The capital stock All of the economy's capital, aggregated together, is the capital stock. Because capital is heterogeneous, it makes little sense to say that an economy has a certain quantity of capital. How would one add up an assembly line, a warehouse and a delivery van to come up with some quantity of capital? One could add up the value of the capital stock by adding up the value of an assembly line, the value of a warehouse, the value of a delivery van and so forth, but to do so requires that a money value be calculated for each of the components of the capital stock. The value of the capital stock could be approximated in a market economy because the capital market places a value on capital. The total value of an economy's capital stock might be of some interest, perhaps to see if it is rising or falling, and by how much, but of more interest for economic calculation is the value of the individual components of the capital stock. Investment goods are often depreciated according to some fixed schedule for accounting purposes, but this will give at best a rough approximation of the economic value of a capital good. Recall from Chapters 1 and 2 that the value of investment goods is determined by the value of the final goods they produce. A factory that produces a good with a high market value will be a valuable asset, whereas a factory that produces a good people do not want - perhaps because the good has become obsolete or out of fashion - is worth little. The factory may have some value if it can be reconfigured to produce something else, but may be worthless if it can only produce some specific good that has seen a decline in demand. Calculating the value of capital goods would be relatively straightforward if one could know in advance the value of the final goods that would be produced with those capital goods, but capital goods are durable, and such a calculation would require not only estimating the physical lifetime of the capital good but also its economic lifetime, and the value of the output it would produce over that lifetime. A capital good may be in good physical condition but obsolete and worthless, and even if it is worth something, its value depends on the always uncertain value of the final goods it produces. If the market value of the final goods goes up, so will the value of the capital goods that produce the more valuable final goods. If the market value of the final goods goes down, the value of the capital goods that produce the less valuable goods will go down also, perhaps to zero. To add to this uncertainty,

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it may be that capital goods deployed to produce one good might be able to be used in the production of other goods, so those capital goods would not be so dependent upon the future market value of one particular type of final good. Because capital goods are durable, uncertainty about future economic conditions makes it difficult to value capital goods. In a market economy, this uncertainty is dealt with in capital markets. Capital is valued by buyers and sellers who use their best judgment to place a money value on capital. Economic knowledge is decentralized, with every individual having some specific knowledge, and the knowledge is often tacit. In capital markets, investors evaluate capital goods that can be purchased, using the knowledge they have. Of course, with the future being uncertain, the judgment of those investors will not always be correct in hindsight, but as new information becomes available, capital markets allow individuals to apply the best knowledge they have to buy capital they believe is undervalued, and sell capital when others place a higher value on the capital they own. This happens most transparently in a stock market where shares of companies are bought and sold continually as people re-evaluate the prospects for the total capital stock of the firm. At a lower level, firms can buy and sell divisions of their companies, and can buy and sell individual capital goods. Such transactions happen all the time, and these market transactions determine the value of capital. Capital is valued through the market process. An understanding of the way the process works makes it clear why capital markets are necessary for rational economic calculation, and why a Central Planning Board would be unable to work the same way. The knowledge that goes into valuing capital is decentralized, is often tacit and different individuals will make different judgments about the prospects for different types of specific capital. On any given day it is easy to envision, for example, one person entering the stock market to sell stock A to buy stock B while another sells stock B to buy stock A. The future is uncertain, and the first person views the prospects for company B to be better than for company A, while the second person holds the opposite view. The same thing happens with individual capital goods. Firm A buys a used truck from firm B for $2o,ooo, believing the truck is worth more than the $2o,ooo, while the firm that sells the truck believes the

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$2o,ooo is worth more than the truck. Of course, both firms could be correct because the value of the truck could be higher for one firm compared to the other, and both could reap gains from trade. The point is that the value of the capital good is determined by the market. The capital market provides a way for capital to be valued, based on the disaggregated valuations placed on capital goods by everyone in the market. As the previous section indicated, the value of different types of capital goods might change differently depending on changes in preferences, or due to monetary fluctuations. A rise in the interest rate would make capital goods in the early stages of the structure of production more valuable relative to capital goods that are in the later stages. To capture these types of changes in an economic analysis, the analytical framework must represent capital as heterogeneous. As this chapter has noted, one feature that differentiates the Austrian school's approach to macroeconomic phenomena from other approaches is that the Austrian approach does explicitly represent capital as heterogeneous. The ability to place a value on specific capital goods is essential for rational economic calculation, but there is little reason to aggregate the value of individual capital goods to quantify the total capital stock. While superficially it might appear that investing more than the capital stock depreciates would increase the capital stock, somehow measured, and investing less than depreciation would lower the quantity of capital, such a calculation ignores the many changes that occur in an economy that make some capital goods increase in value while at the same time other capital goods decrease in value. As Lachmann (1956) notes, what is really important in capital theory is not aggregate measures of capital but gaining an understanding about what specific types of capital will be most profitable, and how the heterogeneous capital in an economy can be allocated as profitably as possible. Uncertainty in the economy precludes thinking that capital could ever be allocated "efficiently" to its highest-valued uses. Rather, owners of capital seek to employ their capital as profitably as they can, which is why capital markets are essential, and why capital must be recognized as heterogeneous. Hayek (1941) grappled with issues of capital theory, never reaching a theory of capital that completely satisfied him, and Lachmann (1956) envisioned his work as extending the Hayekian framework of heterogeneous capital. Lewin (1999), building on Lachmann, views firms as specializing through a division of capital,

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much as Adam Smith analysed the division of labor. 1 In a simpler framework that depicts capital as homogeneous, one might envision capital as a stock that produces a flow of income determined by the interest rate (or, for a given flow of income, the interest rate determines the value of the capital stock), but when one recognizes the heterogeneity of capital, the return on capital depends on the ability of its owner to use it productively. Capital produces no return by itself; rather, when the owners of capital employ their capital in specific uses, the capital earns a return based on its productivity. Capital can be employed in different ways, so the return to capital depends on how it is used.

4.8

The coordination of economic activity

The market mechanism coordinates everyone's economic activity, not only in the present by clearing markets but into the future by allowing people to make plans that have a good chance of being realized. Consumers can save some of their income today with the expectation of making future purchases, and investors can invest in capital goods today with the expectation of producing output that can be sold in the future. Despite the obvious uncertainty in making future plans, market prices provide information that decision-makers can use to judge whether their future plans can be realized. Consumers who are saving for a new car, or a vacation or to put a down-payment on a house can use current prices (and perhaps price trends), along with their expectations about their future incomes, to judge whether their plans are feasible. Similarly, investors can use current prices of inputs and outputs as a guide, and entrepreneurs can use their best judgment about future events to try to ensure that the plans they make today can be realized in the future. Hayek's view of economic equilibrium is that an economy is in equilibrium when everyone's plans can be realized. During the boom period of a business cycle, entrepreneurs make investments that turn out to be unprofitable. Some of their plans cannot be realized. As noted earlier, this malinvestment happens all the time, not just during business cycle booms, but it happens more frequently during booms because price signals are distorted, so are providing less reliable information about what can be expected in the future. The coordination of economic plans breaks down, and some people are not able to realize their plans.

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One way that people can facilitate realizing their plans is to make them flexible. Entrepreneurs can try to make their investment plans scalable so that if future demand for their products is less than anticipated, they can scale back their operations and remain profitable; if future demand is greater than anticipated, they can scale up their operations. They may be able to wait to finalize many aspects of their production and product characteristics, so their plans can evolve as the economic future reveals itself. Similarly, consumers might save for a vacation, waiting to make plans as to exactly where to go and how much to spend depending on how the economic future unfolds. Flexible plans make it more likely that those plans can be realized. At some point, however, people make commitments that are not easily reversible. If economic conditions change, even the most flexible of plans will not be able to be realized. When the manufacturer discovers that the demand for a product is less than forecast, the manufacturer will slow down production, perhaps laying off some workers and perhaps closing down an entire facility. The malinvestment suggests that the capital would be better employed producing something else. (However, nobody can know this for sure. Just because the bicycle factory shuts down because of lack of demand while sales of skateboards are booming does not mean that if the bicycle factory is reconfigured to produce skateboards, it will be more profitable than if it had continued to make bicycles. It may be that by the time the factory is reconfigured, the demand for skateboards will have fallen and the demand for bicycles will have risen. The future is always uncertain.) Entrepreneurs will use their judgment to decide how their underutilized capital can best be deployed. For example, a skateboard manufacturer might offer to purchase a now-closed bicycle factory, using market prices for final goods and for capital goods as a guide as to whether this would be a good move. Again, it is apparent that a capital market is crucial to the rational allocation of economic resources. The redeployment of capital will take time. Meanwhile, the economy will be less productive because of the time it takes for people to adjust their plans to new economic conditions, as those conditions reveal themselves over time. This same scenario plays out for labor. If bicycle factories are closed, the people who worked there will search for new employment, but during that search they will be unemployed. The plans that workers

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made based on their assumptions about employment will not be realized as they go through that spell of unemployment. The adjustment may be rapid if as a bicycle factory closes, a skateboard factory that wants workers with those skills opens up across the street. But the adjustment will be less rapid if the new jobs require different skills, or if the new jobs are in a location geographically separated from the jobs that are lost. Coordination of individual plans will then be further disrupted, and the economy may go into a recession as the adjustment takes place. The economy does a remarkable job of coordinating the economic plans of literally billions of people across the globe, but it is not surprising that this coordination can be less than perfect when considering that everyone makes their own individual plans, so the planning is decentralized, and that the future is inherently uncertain so forecasts will never be perfect. Many things can happen to upset the coordination of individual plans. One that was emphasized earlier in the chapter is the monetary fluctuations that generate the Austrian business cycle.

4.9

Schumpeterian and Kirznerian entrepreneurship

Joseph Schumpeter (1934, 1947) described the effects of entrepreneurship on the economy as creative destruction. Imagine an economy that finds itself in equilibrium, and an entrepreneur introduces an innovation into the economy that disrupts the existing state of affairs. Existing products and businesses may become obsolete, and resources will have to be reallocated to support new products and businesses that are ushered in as a result of the innovation. The old order is destroyed as an entrepreneurial economy creates a new one in its place. Israel Kirzner (1973) depicts entrepreneurship differently. The entrepreneur spots previously unnoticed profit opportunities and acts on them to equilibrate markets. Kirzner (1973, p. 127) clearly contrasts his vision of entrepreneurship with Schumpeter's, saying, For Schumpeter the entrepreneur is the disruptive, disequilibrating force that dislodges the market from the somnolence of equilibrium; for us the entrepreneur is the equilibrating force whose activity responds to the existing tensions and provides those corrections for which the unexploited opportunities have been crying out.

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As Kirzner describes it, Schumpeterian entrepreneurship disequilibrates the market; Kirznerian entrepreneurship equilibrates it. At their foundations, these two types of entrepreneurship describe the same motivations and actions of entrepreneurs. 2 In both cases entrepreneurs are acting on profit opportunities they perceive by buying at lower prices to sell at higher prices. As Chapter 2 noted, two obstacles that stand in the way of realizing this profit are production and time. Entrepreneurs believe they can purchase inputs at one point in time, combine them in a production process and then sell the output for more than the cost of the inputs. The distinction between Schumpeterian and Kirznerian entrepreneurship does lend some insight into the business cycle, and more generally, the coordination of economic activity. Schumpeterian entrepreneurs disrupt the coordination of individual plans by introducing unanticipated innovations into the economy, making it more difficult for individuals to realize their plans. Schumpeterian entrepreneurs are disequilibrating, as Kirzner describes them, because they disturb the coordination of individual plans. Disequilibrium brings with it profit opportunities, and Kirznerian entrepreneurs discover and act on those profit opportunities to lead the economy toward a new equilibrium. The profit opportunities Schumpeterian entrepreneurs act on interfere with the coordination of individual plans, and the profit opportunities Kirznerian entrepreneurs act on facilitate the coordination of individual plans. The distinction is somewhat artificial because the economy is constantly evolving, not tending toward an equilibrium. Entrepreneurs of both types are making decisions that determine the trajectory of the economy. But there is some insight the distinction offers because it distinguishes actions that disrupt people's plans from those that help them adjust to new conditions. People's plans are disrupted- they lose their jobs, for example, because of a reduction in the demand for what they produce -by Schumpeterian entrepreneurs. Kirznerian entrepreneurs look for opportunities to productively employ those individuals, and to put idled capital to productive use. The distinction is helpful because if the disruption caused by Schumpeterian entrepreneurship happens more rapidly than resources can be redeployed to productive use by Kirznerian entrepreneurs, unemployment will increase and the economy may slow down as

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resources dislodged from one activity remain idle before they find a use elsewhere in the economy. Schumpeter (1939) identifies this as a cause of business cycles. In the process of creative destruction, unemployment will result if existing economic activities are destroyed by entrepreneurial innovation more rapidly than Kirznerian entrepreneurs can redeploy the displaced resources to create new opportunities. While entrepreneurship creates the economic progress that increases people's standards of living, it can also temporarily leave the economy with unemployed resources. Schum peter's view of business cycles identifies economic progress and business cycles as two components of the same process with the same underlying causes. The same entrepreneurial activity that generates economic progress can also temporarily disrupt the coordination of plans sufficiently to cause business cycles. Entrepreneurs both disrupt the allocation of resources- Schumpeterian entrepreneurship - and help to coordinate the allocation of resources - Kirznerian entrepreneurship. That is the value in making the distinction. Unemployment and recession can result when Schumpeterian entrepreneurship disrupts the economy more rapidly than Kirznerian entrepreneurship can reallocate resources. But the artificial aspect of the distinction can be illustrated by referring back to an example used earlier in the chapter. When the bicycle factory closes because of the shift in demand from bicycles to skateboards and the skateboard factory opens to produce more skateboards, the entrepreneur who produces skateboards is both disrupting the activities of those employed in making bicycles and at the same time creating new opportunities for former bicycle workers to start making skateboards. The same entrepreneur is at once Schumpeterian - destroying jobs in bicycle manufacturing, and Kirznerian - creating opportunities to manufacture skateboards - which moves toward coordinating the plans of people who now want more skateboards and fewer bicycles.

4.10

Inflation

Most analyses of economic fluctuations look at prices in the aggregate, and analyse inflation as a general rise in the price level. The Austrian school's approach places the emphasis on changes in individual prices rather than on the aggregate level of prices. Prices convey information about the costs of some goods and services relative to others, and

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changes in the quantity of money affect some prices sooner, and in a different way, from others. Thus, inflation causes prices to lose some of their informational content, which interferes with the efficient allocation of economic resources. Most economists, including those in the Austrian school, recognize that a rising general price level creates a disincentive for holding money because its value is depreciating, but the Austrian school places heavier emphasis on inflation's effects on relative prices rather than changes in the overall price level. When Ludwig von Mises published The Theory of Money and Credit in 1912, governments were not computing and publishing price level information like they do today, so information on changes in the aggregate level of prices was not readily available. When Mises referred to inflation, he was referring to an increase in the quantity of money, not any change in an aggregate level of prices. This was the way the term was commonly used at the time. Economists generally recognize that there is a close relationship between changes in the quantity of money and changes in the aggregate level of prices, but members of the Austrian school often use the term inflation in its earlier meaning, as an increase in the quantity of money rather than as an increase in prices. The use of the term in this way makes some sense when one recognizes that changes in the quantity of money affect some prices differently from others, so an inflation of the money supply can have real economic effects even if those effects do not show up in a measure of the aggregate price level.

4.11

Free banking

The Austrian business cycle theory was originally developed by Mises and Hayek with a gold standard in mind where the monetary base was composed of gold. While monetary systems around the world left the gold standard for fiat money in the twentieth century, one line of research followed by some members of the Austrian school has been to analyse a completely market-driven monetary system in which banks issue their own money and government plays no role in the issuance of money or the determination of monetary standards. White (1984) shows how this system of free banking worked in Britain, and White and Selgin (1987) and Selgin (1988) further describe the foundations of this idea.

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For people to value the money banks issue, banks must promise to redeem it for something, and the free banking framework shows why banks would have an incentive not to over-issue currency, which would place their banks in jeopardy. A free banking system would allow monetary expansion and contraction to meet a fluctuating demand for money, and would remove the inflationary tendencies that permeate central banking and fiat currency. This research in free banking is more an application of the Austrian school's ideas about the operation of markets than a foundational idea for the school, but offers interesting ideas. In a world of governmentissued fiat currency it is sometimes difficult to imagine that people would accept currency issued by private banks, but consider that around the world merchants accept credit cards issued by private firms and it is not so difficult to see that under free banking people would just as easily accept Visa or MasterCard money as they do those firms' credit cards.

4.12

Conclusion

The Austrian school's approach to macroeconomic activity distinguishes it from other schools of thought in several ways. The Austrian emphasis on the heterogeneous nature of capital lies at the foundation of the school's macroeconomic thinking. Austrian business cycle theory depicts business fluctuations as the result of monetary disturbances. The theory was developed when the world was on a gold standard, and those disturbances were the result of monetary expansions and contractions caused by fractional reserve banking. In the twentyfirst century, when central banks control the money supply, monetary disturbances are more likely the result of central bank policy and the disturbances they create may be even greater because it is difficult to forecast the policies of central banks, which have the power to undertake monetary expansions (and contractions) for indefinite periods of time. Under a gold standard, the relatively constant monetary base put limits on the degree to which monetary expansions could take place. Building on the foundation of heterogeneous capital, the Austrian business cycle theory emphasizes the effect of distortions in prices - and especially interest rates - on the nature of investment. When interest rates are pushed down during monetary expansions, not only is there the temptation to overinvest, the distorted signal also creates

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incentives for the wrong types of investments. Even if market participants realize that price signals may be distorted, they have no good way to know what the undistorted set of prices would be, so malinvestment takes place during the boom phase of the business cycle. More mistakes are made when the information underlying people's decisions is less reliable. The economic boom, typically viewed as beneficial to the economy, is viewed less favorably by the Austrian approach to business cycles because malinvestment during the boom means that an inevitable correction must come, which will liquidate those misallocated resources. A macroeconomic approach that assumes homogeneous capital, aggregating the capital stock into a total quantity of capital, can depict overinvestment or underinvestment but assumes away the malinvestment that is an integral part of the Austrian theory. Austrian business cycle theory has seen a renewed interest in the twenty-first century because of events around the turn of the century that appear consistent with the theory. The "dot-com" bubble in the late 1990s, in which a substantial amount of resources flowed into new internet businesses, appears to be an example of malinvestment. Similarly, the housing bubble in the 2ooos appears to be another example. Low interest rates deliberately designed by central banks made housing look like a relatively attractive investment, creating a housing bubble that, when it burst, revealed an excessive investment in that sector. In these examples, the issue was not too much investment in general but rather malinvestment in which excessive investment took place in sectors that later would prove to be unprofitable. Recognizing the heterogeneity of investment is important because it emphasizes that the right types of investment have to be made for the economy to remain healthy, and to avoid unemployed resources. A rational allocation of capital can only take place if there is a capital market that establishes market prices for capital goods. Capital goods are heterogeneous and long-lived, and an efficient allocation of capital requires that capital goods be allocated to their highestvalued uses. But this cannot occur unless entrepreneurs and investors know the value of capital. In the socialist calculation debate, where Mises emphasized the necessity of market prices to rationally allocate resources, market prices for capital goods were an essential component of Mises's claims. In the Austrian framework, the macroeconomy will be stable and resources will be fully employed when the plans of all economic actors

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are coordinated. The essential function of the market economy is to coordinate people's plans. When the coordination of people's plans is disrupted, so people's plans are not mutually consistent, unemployment results as the economy adjusts to recoordinate economic activities. The Austrian approach to macroeconomic disruptions depicts them as breakdowns in plan coordination, and macroeconomic disruptions can only be depicted this way when the framework for analysis represents the disaggregated nature of the economy. A Keynesian approach to macroeconomics, for example, represents demands in an aggregated fashion, as consumption demand, investment demand and government demand. By aggregating in this way, the framework can depict aggregate demand as too high or too low, but cannot represent the problems of coordination that lead to malinvestment or that create unemployment because of shifts in demand from some firms or industries to others. The aggregate demand-aggregate supply framework, common in contemporary macroeconomics, assumes away the heterogeneity that provides the foundation for the Austrian approach to macroeconomics. Austrian business cycle theory emphasizes the coordination problems that are created by monetary disturbances. This does not imply that all macroeconomic fluctuations emanate from monetary disturbances. Schumpeter emphasized the disruptions that can be caused by entrepreneurial innovation, and other causes are plausible as well. Contemporary macroeconomic theory tends to model disturbances as caused by unanticipated shocks to the economy, and it is easy to see, within the Austrian framework, that an unanticipated shock, regardless of its source, can cause plans to be less coordinated because people must deal with something they did not anticipate. The Austrian theory emphasizes how policy changes designed to stabilize the economy can often be destabilizing. During the recession that began in 2002 central banks kept interest rates low to try to cushion the economy, and commentators at the time said one thing that kept the recession from being worse was a healthy housing market. The bursting of the housing bubble in 2008 showed why that thinking was wrong. This offers an example of why an Austrian approach to macroeconomics, which rests on a foundation of heterogeneous capital, can lend substantial insight into understanding macroeconomic phenomena.

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NOTES Peter Lewin has done a substantial amount of work building on Lachmann's framework of heterogeneous capital. See, for example, Lewin and Phelan (2ooo) and Lewin and Baetjer (2011). 2 In personal conversation with Kirzner, he has said that there are not two types of entrepreneurship, and that the entrepreneur he was describing is the same as the one Schumpeter was describing. What follows is consistent with that conversation, notwithstanding the quotation from his book in which he draws a strong contrast between his ideas and Schum peter's.

1

5

The resurgence of the Austrian school

After almost vanishing in the mid-twentieth century, the Austrian school is enjoying increased visibility in the twenty-first century. The Austrian school traces its origin to the publication of Carl Menger's Principles of Economics in 1871, and rose in prominence through the 1930s, but by the end of the 1930s had almost disappeared. By the mid-twentieth century the Austrian school was not much more than just Ludwig von Mises. His students kept the school from vanishing completely, and by the mid 1970s the school had attracted additional followers. The Austrian school gained additional credibility after the collapse of the Berlin Wall in 1989, followed by the break-up of the Soviet Union in 1991, which caused scholars to reconsider their dismissal of Mises's claim that rational economic planning cannot take place without market prices. Despite its renewed prominence, the Austrian school still remains a minor presence in academic institutions.

5.1

The rise of the Austrian school

Economics underwent a major revolution in the 1870s led by the publication of three books that challenged the existing orthodoxy. Referred to as the marginal revolution, all three of those books challenged the cost of production theory of value that was the standard view at the time with a utility theory of value that depicted market prices as determined by the value consumers placed on the last unit - the marginal unit - of each good. William Stanley Jevons published his The Theory of Political Economy in 1871, Leon Walras published his Elements of Pure Economics in 1874 and Carl Menger published his Principles of Economics in 1871. None of the authors were aware of the works of the others when their books were published. Jevons wrote in English, Walras in French and Menger in German, and neither Walras's nor Menger's books were translated into English until the 1950s. The marginal revolution ushered in a major change in economic theory, and Menger's book began the Austrian school.

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In German language economics the primary alternative to Menger's ideas came from the German historical school, which labeled Menger and his followers as the Austrian school to emphasize the difference between Menger's ideas and the ideas of the German historical school that represented the mainstream of German language economic thought at that time. Menger's ideas were attacked by members of the German historical school, and Menger attacked back, arguing the weaknesses of the historical approach in several publications. But while Menger's ideas were at odds with the German historical school, they were comfortably within the mainstream of economic thought as it was developing outside Germany. Menger was appointed to the chair of political economy in Vienna, and his students continued the development of the Austrian school. Friedrich von Wieser developed Menger's ideas, and assumed Menger's chair in political economy when Menger stepped down in 1903. Eugen Bohm-Bawerk, another of Menger's disciples, was also a major figure in Vienna who added to the Austrian tradition following Menger, especially in his development of capital theory. The Austrian school was already well established when Ludwig von Mises enrolled at the University of Vienna in 1900, where he attended lectures by BohmBawerk and was heavily influenced by Menger's work. The distinctive identity of the Austrian school began with Menger, but certainly owes at least as much to Mises. Mises was employed as the secretary of the Vienna Chamber of Commerce from 1909 to 1934, but also taught at the University of Vienna during his entire tenure at the Chamber of Commerce. His first book, The Theory of Money and Credit, published in German in 1912, established his reputation as one of the leading monetary theorists at that time, and as noted in the previous chapter, laid the foundation for the Austrian theory of the business cycle. But, as described in Chapter 3, after Mises presented his paper on the impossibility of rational economic planning without market prices in 1919, followed by his publication of Socialism in 1922, his reputation within the economics profession remained linked to the socialist calculation debate. Mises's most visible supporter in that debate was his student, Friedrich Hayek. 1 Hayek was born in Vienna and received doctorates in law and political science at the University of Vienna in the early 1920s. Hayek and Mises founded the Austrian Institute of Economic Research in 1927, and Hayek moved to the London School of Economics in 1931, where he

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continued his work on business cycles, which was described in Chapter 4. Through the 1930s Hayek was best known for his development of business cycle theory, and Hayek's business cycle theory was the most prominent alternative to Keynes's ideas on macroeconomics as the world languished in the Great Depression of the 1930s. Ultimately, Keynes's ideas won out in the view of the economics profession, and Keynesian economics became macroeconomics through the 1970s. The dominance of Keynesian macroeconomics relegated the Austrian business cycle theory to an episode in the history of economic ideas, and the Austrian school faded from prominence. Hayek (1949) collects a set of articles that give a good foundation for understanding the Austrian school's ideas on the operation of markets, and provides support for Mises's claim that rational economic planning requires markets and market prices. Perhaps the most prominent of those articles is his 1945 article, "The use of knowledge in society," whose ideas provided the foundation for the discussion of knowledge in Chapter 2. Into the 1940s Mises and Hayek were the two major intellectual figures who continued to defend the idea that rational economic calculation is not possible through central economic planning. Hayek's very prominent book, The Road to Serfdom (1944), further associated the ideas of the Austrian school with its criticism of central economic planning. Socialism is the road to serfdom, according to Hayek. The Austrian school was well within the mainstream of economic ideas through the 1930s, but faded rapidly from prominence in the 1940s. Through the 1930s the Austrian school was best known for its ideas on the business cycle, and for the claims of its leaders, Mises and Hayek, that rational economic calculation was not possible under socialism. With the rapid ascension of Keynesian macroeconomics the Austrian business cycle theory ceased to be considered seriously by the mainstream, and the consensus on the socialist calculation debate was that the Austrian school was on the losing side. By the middle of the twentieth century, the ideas most visibly associated with the Austrian school appeared irrelevant to contemporary economics in the eyes of most economists.

5.2

The dormant Austrian school in the mid-twentieth century

Both Mises and Hayek moved to the United States in the midtwentieth century. Hayek took a position at the University of Chicago

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in 1950, and his work increasingly turned toward social philosophy, law and constitutional issues, and away from the subject matter that had defined the Austrian school in the first half of the twentieth century. Hayek's work remained insightful and consistent with the ideas of Austrian economics (see, for example, Hayek, 1960, 1973, 1976, 1979), but went beyond the scope of Austrian economics. As Hayek's work increasingly moved away from the core issues in economics, it is hardly an exaggeration to say that by the mid-twentieth century the Austrian school had narrowed to a single individual: Ludwig von Mises. Mises moved to New York in 1940 and began teaching as a visiting professor at New York University in 1945. He published Human Action, his most prominent book, in 1949. Subtitled A Treatise on Economics, the book was intended to be a treatise in the sense that it begins with first principles and lays out the foundations for the entire body of economics, as Mises understood the discipline. In Human Action, Mises lays out the ideas that support his contention that rational economic calculation cannot occur under central planning, but the book was not written to promote that idea, or to add to the socialist calculation debate. Rather, the idea develops naturally from an understanding of economic principles as Mises presents them. In his seminars at New York University, Mises kept the ideas of the Austrian school alive. Mises continued to hold true to his claim about the impossibility of rational economic planning under socialism, to the point where that idea defined both Mises and the Austrian school through the second half of the twentieth century. Among prominent economists, Mises and Hayek were the only two who continued to argue that position. Other prominent supporters of the free market - Milton Friedman provides a good example - argued that in general markets allocate resources better than government, but this is quite a different argument from saying that central economic planning cannot work. The reputations of both Mises and the Austrian school suffered from being associated with that view. Most academic economists would say that the argument was settled in the 1930s, and Mises lost the debate. Meanwhile, the centrally planned Soviet Union was hailed as a superpower, and the consensus among economists was that economic growth was greater in the Soviet Union than in the market economies of the West- and that greater growth was a product of central planning, where resources can be allocated by experts rather than being left to the uncertainties of the market. One response to Mises's claim

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that central economic planning cannot work was for critics to point to the Soviet Union and say "Look, it is working, and working even better than capitalism!" The association of the Austrian school with the socialist calculation debate is not unfair to the school. The ideas of the Austrian school regarding economic calculation, the way that the market mechanism coordinates the decentralized knowledge of its participants, and the critical role of capital markets and entrepreneurship, were all developed and refined in the process of laying out the Austrian school's position in that debate. However, the economic framework on which the school's conclusions on central economic planning rested tended to be overshadowed by the view of most of the mainstream in the economics profession that the school was clinging to an idea that had clearly been demonstrated to be wrong. There was little reason to study the ideas of the school if it was apparent that those ideas led to faulty conclusions. So, the Austrian school remained mostly dormant, narrowed to Ludwig von Mises and his students. Mises retired from teaching in 1969 and passed away in 1973, with the bulk of the economics profession still believing that Mises was clinging to a faulty idea. One must seriously question whether the Austrian school would be anything more today than a topic in the history of economics had Mises not continued to promote his ideas, and teach his seminar, through the 196os.

5.3

The resurgence of the Austrian school

By 1950, the Austrian school of economics had narrowed down to a single individual, Ludwig von Mises, and the school's resurgence began with Mises's students at New York University. The two most prominent students of Mises, and the two most responsible for the school's resurgence, were Israel Kirzner and Murray Rothbard. Both were academic economists, and deserve credit on a number of levels for the school's resurgence. First, as academic economists working in the Austrian school tradition, their work was well outside the mainstream, and required a substantial commitment on their part to push ideas they believed were right, but that they knew would be a hard sell to most of the profession. Second, they were entrepreneurial in their selling of the Austrian school's ideas, and did succeed in returning the school to contemporary relevance.

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Kirzner received his PhD from New York University in 19 57, where he studied under Ludwig von Mises, and is well known for his work on entrepreneurship, which was at best an afterthought in economic analysis in 1973, when he published Competition and Entrepreneurship. He remained at New York University as a professor until he retired in 2001. While at New York University he established a program in Austrian economics, oversaw the hiring of several additional professors for that program and mentored a number of PhD students in the Austrian tradition. Murray Rothbard earned his PhD in economics at Columbia University in 1956, but was a student of Mises at his New York University seminar and a self-proclaimed disciple of Mises. Rothbard was extremely prolific, but one work worth emphasizing is his Man, Economy, and State (1962, 2004), which began as a project to explain the ideas in Mises's Human Action, but ended up being a major treatise on economics in the Austrian school tradition. Unlike Kirzner- also a self-proclaimed disciple of Mises - whose work remained within the confines of academic economics, Rothbard's writing was much broader. His extensive academic writing journeyed into history, philosophy, politics and public policy. He wrote for a general public audience in addition to writing for an academic audience. And, he was well known for promoting his libertarian political views. With the migration of Mises and Hayek to the United States, Vaughn (1994) notes that the Austrian tradition in economics also had migrated to the United States, and with the school effectively narrowed to one person in the 1950s- Mises- his students Kirzner and Rothbard were the two individuals most instrumental in starting the resurgence of the school. Their published work had generated sufficient interest in the Austrian tradition in economics that they began to develop a following of younger economists who were graduate students or young faculty members. This interest among young scholars further propelled the Austrian school's resurgence. Kirzner and Rothbard, along with Ludwig Lachmann, served as faculty for a conference on Austrian economics held in South Royalton, Vermont, in 1974. The South Royalton conference, attended by 47 individuals including the speakers, has often been cited as a major turning point in the resurgence of the Austrian school, and with good reason. Many of the scholars who made up the next generation of the Austrian school were in attendance. That conference was the first of

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many conferences aimed primarily at graduate students and designed to further the ideas of the Austrian school. Dolan (1976) edited a volume containing the lectures of Kirzner, Rothbard and Lachmann from the conference. 2 Moving into the 198os, three universities offered PhD programs that allowed students to pursue an emphasis on Austrian economics. In addition to the program at New York University led by Israel Kirzner, George Mason University established its Center for Market Processes in 1980 and brought in a number of Austrian-oriented economists to teach in its graduate program, and Auburn University had a PhD program with an Austrian emphasis. The Auburn program was associated with the Ludwig von Mises Institute, which was established in Auburn in 1982. These programs produced people with PhDs who went on to faculty positions, where they passed the ideas of the Austrian school on to their students, and also provided a congenial environment for academic research in the Austrian tradition. The Austrian school's resurgence had gained considerable momentum through the 1970s and 198os. The only Austrian school program that has thrived into the twentyfirst century is the one at George Mason University, which is the academic center of the Austrian school in the early twenty-first century. With Israel Kirzner's retirement in 2001 the Austrian program at New York University has been de-emphasized, although the university does (as of 2013) have Mario Rizzo and David Harper, two well-recognized scholars in the Austrian tradition, on its faculty. The PhD program at Auburn lost support at the university level, and the Mises Institute that was a significant participant in that program moved off-campus and no longer has an affiliation with the university. The Mises Institute itself is well established, and offers conferences and student programs promoting the Austrian school, but it is no longer associated with any university and does not offer a degree program. 3 Murray Rothbard was closely associated with the Mises Institute until his death in 1995, although he was never a faculty member at Auburn University. The reputation of the Austrian school received a major boost in the 1990s, following the collapse of the Berlin Wall in 1989, followed by the break-up of the Soviet Union in 1991. There was a fear during the Cold War that even a slight strategic political miscalculation might set off a hot war, ending in a destructive massive nuclear exchange. Indeed, it was difficult to foresee how the Cold War might end. As it turned out, the Cold War's end was not determined by the military

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might of the two sides, but by the superiority of the capitalist economies of the West over the centrally planned economies of the East. Even into the 1980s reputable economists in the United States and elsewhere were touting the advantages of central planning, and predicting that the Soviet Union's economy would overtake the economy in the United States, contrary to Mises's claim throughout his life that rational economic planning requires a market economy. Ultimately, it was the citizens of those centrally planned economies who could see how much better-off people in capitalist economies were who led the charge for reform. The demise of those centrally planned economies, as they turned away from central planning and toward markets, led economists to reevaluate the ideas of Mises and the Austrian school, and to grudgingly admit that Mises may have been right after all. The socialist calculation debate, which in many ways defined the Austrian school in the second half of the twentieth century, rapidly changed from a reason the Austrian school was dismissed to a reason people thought they should take a closer look at the school's ideas. While the Austrian school remains outside the mainstream of economic ideas in the early twenty-first century, it does get some recognition, and also gets some notice in the financial press.

5.4

Austrian economics and capitalism

The Austrian school is often associated with the support of capitalism and free markets, and opposition to government intervention in the economy. The background on the ideas of the Austrian school reveals why this is the case. An economist could not be considered a member of the Austrian school without seeing the economy as a complex order, which cannot be comprehended in its entirety by any one individual or group of individuals. This not only rules out central planning as a productive way to organize an economy but also government interventions designed to produce particular results. In a complex order, the actual results of a government intervention cannot be foreseen ahead of time. Some can be foreseen, of course, but as Reisman (1998) notes, there will be unintended consequences in a complex order that will be difficult to anticipate. Consider the Social Security program in the United States as an example of the unintended consequences of government planning

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within a complex order. When it was established (with an initial tax rate of 1.5 percent on employees and 1.5 percent on employers!) its creators envisioned that a growing working population would continue to put enough revenues into the system so that they could fund retirees on a pay-as-you-go system. What happened? Among other things, birth rates slowed and life expectancies went up, substantially raising the ratio of retirees to workers. Partly, the reduction in birth rates may have been because elders no longer had to rely so much on their children for support, with guaranteed Social Security payments, so the program itself was responsible for at least some of the decline in the birth rate, which contributed to its funding difficulties. The program's creators also did not foresee the political pressures generated by older voters to increase the generosity of the program. Without considering whether the program is, overall, desirable, it is apparent that it is not working as its creators intended because they did not foresee its consequences within the context of the complex economic order. 4 Consider the US government's sugar program that limits acreage devoted to sugar and restricts imports of foreign sugar. It was originally established to protect the interests of US sugar interests in Cuba, but that rationale disappeared in 1959 when Castro's revolution appropriated those sugar farms. The program persists into the twenty-first century because of a new set of interests it created. In addition to domestic sugar farmers, because the price of sugar in the United States is substantially higher than in the rest of the world, producers of soft drinks and other sweets are using corn sweeteners in place of sugar, which has created a constituency of corn farmers who support that program, for their benefit. This unintended consequence of the original program has been a contributing factor to the program's perpetuation, despite the elimination of the program's original motivation more than half a century ago. Example after example could be given to illustrate the point that in a complex order, all of the consequences of a government intervention into the economy cannot be foreseen. Some of those consequences will, undoubtedly, be undesirable, which will give rise to additional government interventions to address those unforeseen consequences, as Ikeda (1997) has argued. These additional interventions lead to increasingly inefficient allocations of resources. The recognition of the economy as a complex system pushes Austrian economists to view government interventions into the economy unfavorably.

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Closely related is the Austrian depiction of the economy as a mechanism that allows individuals to coordinate their decentralized knowledge without the knowledge having to be communicated to others, or aggregated. Decentralized knowledge can be used most effectively by those who possess it because much knowledge is tacit and cannot be fully communicated to others. Mises's critics in the socialist calculation debate depicted markets as a mechanism for finding market-clearing prices and quantities, and while the Austrian school recognizes that function of markets, the role of markets in coordinating the use of decentralized knowledge that is disbursed among all economic actors requires that the knowledge remains decentralized, making the market mechanism a requirement for rational economic calculation and the efficient allocation of resources. Support for the market mechanism over government planning also extends to the Austrian school's macroeconomic analysis. As macroeconomics developed in the twentieth century, heavy emphasis was placed on the use of government interventions through monetary and fiscal policy to stabilize the economy. In the United States the Federal Reserve uses interest rate manipulation as a routine tool to affect the macroeconomy. Austrian business cycle theory is built on the framework of heterogeneous capital, so manipulations of the interest rate do more than just affect aggregate investment, they affect the types of investment that take place. Again emphasizing decentralized knowledge, markets are required for the efficient allocation of resources, and investors find themselves handicapped when the interest rate - a market price - is altered through government intervention. Manipulation of the macroeconomy through monetary and fiscal policy tends to be destabilizing within the Austrian framework, pointing toward another reason why economists in the Austrian school tend to support capitalism and free markets. In typical macroeconomic models that do not treat capital as heterogeneous, an economy can be depicted as having too much or too little investment, but the Austrian school's framework with heterogeneous capital allows for the possibility that investors will make the wrong kinds of investments, and this malinvestment will later be revealed to be unprofitable. The dot-com bubble in the late 1990s and the housing bubble in the 2ooos fit the Austrian framework well because in both cases it does appear that the problem was investors overinvesting in certain types of investments - first, internet firms and associated internet infrastructure, and then housing - that were later revealed to be

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unprofitable. The problem was investment in the wrong types of assets, not just too much or too little investment. Just as the collapse of the Berlin Wall lent credibility to Mises's views on economic calculation, these episodes of malinvestment have lent support to the Austrian school's business cycle theory. The Austrian school emphasizes the importance of entrepreneurship, and again, entrepreneurs can only make rational economic calculations when market prices reveal to them the likely costs of inputs and values of outputs they contemplate. Because the future is always uncertain, there will always be a degree of entrepreneurial error in the economy, but manipulation of markets distorts market signals, which raises the likelihood of entrepreneurial error. For many reasons, the way that the Austrian school understands the market process leads its members to favor capitalism and free markets. This is not an ideological position but rather one that follows directly from the economic analysis of the school.

5.5

The role of government in the economy

This advocacy of capitalism and free markets by the Austrian school does not necessarily mean that its members are opposed to all government. For markets to work effectively, property rights must be clearly defined and protected, and people must operate under a system of rule of law. Both Mises and Hayek saw a role for government in achieving these ends, and possibly doing even more in an economy. The defining and protecting of property rights is an obvious requirement for a capitalist society. If people are to engage in exchange, they must have property rights in what they are exchanging. If investors create a capital market in which capital is bought and sold - and valued - the owners of capital must have property rights in those capital goods. Property rights must be protected so that property changes hands through voluntary exchange rather than theft and coercion. Otherwise, a market economy will not function. Rule of law means that everyone is treated the same under an objective body of law. With rule of law, people have an incentive to engage in productive activity for their own benefit. If some people are treated more favorably under the law, this creates the incentive for entrepreneurial individuals to look for ways to gain favorable legal treatment

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rather than engage in productive activity. Members of the Austrian school support clearly defined and enforced private property rights and rule of law because they are the necessary foundation for the effective operation of a market economy, but this support for protection of property rights and rule of law is certainly not unique to the Austrian school. Whereas some members of the Austrian school see these activities as the role of government, others argue that market institutions developed without the coercion of government can also protect property rights and establish rule of law, and do so more effectively than government. The most prominent proponent of this position is Murray Rothbard. Rothbard (1973) explains how markets can work to do everything government does, and more effectively, and Rothbard (1982) explains why the elimination of government is the only ethical way to organize a society. One can envision how markets could provide goods like roads and schools, because the economy has private roads and private schools already. How about police protection? Rothbard (1973) explains how private security firms could emerge to protect people's rights, and how they would deal with each other in cases of accused rights violations. How about courts? Rothbard also explains how private arbitration, which is already widely used, would be a superior alternative to government courts. How about national defense? Rothbard has a two-pronged argument here, saying that first, wars are fought among nations' governments, and if there were no governments, that would eliminate much of the motivation for wars. Second, without a government to surrender, it would be effectively impossible to go houseto-house and conquer everyone in an area. 5 The interested reader is invited to take a closer look at Rothbard's ideas. The purpose here is not to explain or defend them but rather to point out that some members of the Austrian school advocate the market mechanism to the extent of saying that any government activity is unnecessary and undesirable. Whether the successful operation of a market economy requires some role for government to protect property rights and enforce laws is a matter of debate within the Austrian school. The framework for the Austrian school does imply that government production and government regulation to direct the allocation of resources leads to an inefficient outcome, so members of the Austrian school consistently support

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public policies that limit the role of government in economic activities. This is not an ideological position on public policy but one that follows from the way the Austrian school understands the operation of the economy. Can this logic be extended to everything government does? Some members of the Austrian school would argue that it can.

5.6

The ideology of the Austrian school

This libertarian anarchy espoused by Rothbard and others in the Austrian school, along with the more general issue of the appropriate role of government in a market economy, naturally raises the question about the ideology of the school, and the degree to which Austrian economics and libertarian political philosophy are connected. The answer to this question depends on the degree to which one thinks that economic and political institutions depend on one another. One view is that economics and political science are separate areas of intellectual inquiry, and that the operation of the economy can be analysed independently from politics and government. Yes, the Austrian school draws conclusions about the appropriate role of government in the economy but this can be analysed separately from the role of government more generally. Take an issue like income redistribution, for example. A member of the Austrian school might favor income taxation to fund transfer payments to less fortunate members of the society. An economic analysis would indicate that taxes on productive members of a society would reduce their incentives to be productive, and that payments to poor people would lessen their incentives to take actions to elevate themselves out of poverty. Most economists - whether or not they consider themselves members of the Austrian school - would agree with this conclusion. However, even though economic analysis shows that the economy's productivity will be lower as a result of income transfer programs, a member of the Austrian school could still favor them. An economic analysis simply recognizes that there are costs associated with government programs like these. Another view is that economic and political institutions are closely connected. The economy is a complex system that is affected by the political system in ways that cannot be foreseen in advance. Essentially, the economic system and the political system are two elements of a larger interconnected complex social system. Following the ideas of

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Hayek (1944), Ikeda (1997) and Reisman (1998), interventions into a market economy lead to unanticipated negative consequences, which lead to the popular demand for more interventions to address those negative consequences, so the connection between economic policy and politics implies the desirability of limited government in general. Consider again the example of redistribution in the previous paragraph. The original motivation was political rather than economic, but after the initial intervention, economic inefficiencies will lead to the call for additional interventions. Government must be limited in all spheres for a market economy to function. One can dismiss this idea, much as the economics profession dismissed Mises's arguments on rational economic calculation through most of the twentieth century, noting the coexistence of market economies with government-run health care systems, substantial welfare states and even a fair amount of regulatory oversight of markets, but if economic and political systems are interdependent, this suggests that the growth of the welfare state through the twentieth century might lead to the slowing (or ending) of economic progress in the twenty-first. Two views can be entertained on whether Austrian economic analysis implies libertarian politics, but the connection can run the other way as well. People with libertarian political views should find themselves naturally sympathetic to the economic views of the Austrian school. Other schools of economic thought are consistent with libertarian political views; for example, Milton Friedman and the Chicago school of economics are often associated with an advocacy for limited government. So, libertarian political views do not necessarily imply an association with the Austrian school of economics, even though libertarian political views have led many individuals toward the Austrian school. Economic purists might argue that Austrian economics and libertarian politics are completely separate, but casual observation confirms that self-proclaimed members of the Austrian school tend to have more libertarian political views than the general population. This connection follows from the idea that the economy, and society more generally, is a self-regulating complex system that is the result of human action but not of human design, and that attempts to intervene in that system are likely to result in negative unintended consequences.

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5.7 The methodology of the Austrian school Economic analysis has become more "scientific" throughout its history, increasingly relying on sophisticated mathematical analysis and advanced statistical techniques. The Austrian school is much less reliant on mathematical and statistical analysis, and is often suspicious of the economic analyses that rely on them. Austrian economics tends to take more account of the historical and institutional details that underlie human action, and recognizes that the world is not as deterministic as much mathematical and statistical analysis would seem to imply. Mathematical models in economics have tended to be heavily oriented toward depicting the properties of an economy in equilibrium. There is value in understanding the properties of an economy in which markets clear, but a focus on equilibrium obscures several aspects of the economy. The market process approach to understanding economics taken by the Austrian school notes the importance of the individual decisions and entrepreneurial actions that direct economic activity, whereas mathematical models of equilibrium tend to obscure these features of the economy. Individual behavior tends to be depicted as a mathematical representation of a utility function in which individual choices are predetermined by the form of the utility function. Individuals maximize utility and firms maximize profits, rather than viewing individuals and firms as trying to make the best decisions they can under uncertainty. The entrepreneurship that drives economic progress is left out of equilibrium models. Another issue is that mathematical models tend to have deterministic solutions, whereas in the real world, entrepreneurial action today affects the trajectory of the economy in the future. Yet another issue is that mathematical models represent the economy in such a way as to make it appear that the entire economy can be understood as a system of equations, whereas the Austrian view of the economy as a complex system emphasizes that the economy is too complex and too uncertain to be comprehended by any one individual or group. These features of mathematical modeling are not necessarily a problem if the limitations they imply are understood, but often they are not, and mathematical models are taken to be a realistic representation of the entire economy. Mises's critics in the socialist calculation debate are an example. They countered Mises by demonstrating that a Central Planning Board could find equilibrium prices the same way they are found in a general equilibrium model, neglecting aspects of

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the economy that were not represented in the model. While central economic planning has fallen out of favor, this same issue arises on a smaller scale when policy-makers, basing their analysis on economic models, try to plan components of the economy, such as the health care market or the energy market. Models are useful pedagogical devices, but the idea that the results of a model translate into parallel results in the real world is, to use Hayek's (1988) description, the fatal conceit. The deterministic nature of mathematical models makes it appear that economic conditions today imply the future trajectory of the economy. This ignores the entrepreneurship that is the driving force of the economy, and does not recognize that future conditions depend on the decisions that people make today, based on incomplete and uncertain information. Economic progress cannot be understood within a framework that depicts a deterministic future. The problem with mathematical models is not the models themselves but that those who use them take them to represent economic processes that are not incorporated into the models. One cannot understand economic growth, which is a component of economic progress, in a model that does not represent the entrepreneurship that causes economic progress, to give but one example. Mathematical models can help their users to understand the way that markets coordinate the decentralized decisions of market participants, but models cannot depict the actual results that will emerge from the market process because the models cannot contain the decentralized and often tacit knowledge upon which individual decisions are based. The Austrian school's depiction of the economy as a complex system that coordinates decentralized and tacit knowledge makes its members suspicious of any specific results that mathematical models produce. Members of the Austrian school also tend to be suspicious of the way that the economics profession often uses statistical results. Economies are composed of autonomous individuals who make choices based on incomplete and often contradictory information, so those individual decisions are unpredictable and subject to change. The law of demand states that there is an inverse relationship between price and quantity demanded, so how will individuals respond when they see a price of a good go up? One individual might decide that at the higher price, she will buy less. Another individual might decide that with the price going up, he would be better off to

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buy more now, before the price goes up even more. Both individuals are obeying the law of demand. The second individual is comparing the present price with a forecast higher future price and deciding to buy more now rather than have to pay even more later. Of course, the price may not go up later, so the individual's forecast may be wrong. But this is the nature of economic decision-making, and this simple example shows how a price increase could cause some individuals to buy less and others to buy more, with both individuals' behaviors being consistent with the law of demand. There may be empirical regularities that could be discovered through statistical analysis. The Austrian school is not opposed to the use of statistics, viewing statistics and econometric analysis as a method of better understanding historical facts. Statistical analysis can uncover empirical regularities and correlations in data that are not readily apparent without it. However, there is no guarantee that because a statistical regularity existed in the past, it will continue to exist in the future. One would have to understand the statistical regularity through the lens of economic theory to make such a judgment. Econometric analysis is often presented as a test of a theory, and members of the Austrian school are especially skeptical of econometrics used this way. The primary reason for this skepticism is that the human action that generated the historical data for the test might change in the future, in response to changes in future conditions that lie outside the econometric model. In the physical world, one can count on physical phenomena repeating themselves because atoms do not make decisions or change their minds. People do, and as they learn, as their tastes change and as external conditions change, empirical regularities that occurred in the past can disappear in the future. This skepticism is based on the understanding of the economy as a complex system. There are other reasons members of the Austrian school are skeptical of statistical tests of theories, based not so much on Austrian economics but the way those tests are undertaken. Researchers often mine through data to find results that support their hypothesis, they do specification tests and they often discard empirical tests that do not support their hypotheses. These activities are not necessarily intellectually dishonest; they are just a matter of trying to find the right specification. An empirical test that fails to get statistically significant results is often viewed as not publishable, so it will be discarded by the researcher.

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Robust empirical results that hold up to many different specifications, and that are found by many different researchers, provide better evidence that there is an empirical regularity, and if supported by a solid theory, the Austrian school finds merit in this type of empirical work. Still, it cannot be viewed as a test of a theory, for the reasons given above. It must be supported by a plausible theory, and can then be taken as historical evidence consistent with the theory. The Austrian school is not opposed to mathematical or statistical analysis, but for many reasons its members tend to view with skepticism the conclusions that many economists draw from such analysis. That skepticism tends to lead members of the Austrian school away from making their analysis more mathematical and statistical. In a profession that often judges academic work by its technical sophistication, the scholarly research done by members of the Austrian school often looks less sophisticated than what appears in the leading academic journals, so their work tends to be discounted as less scientific than what is done at the cutting edge of economic research. From the standpoint of the Austrian school, much of the economic analysis that is wrapped in mathematical and statistical sophistication obscures the fundamental economic processes the analysts are trying to understand, and gives them a false sense of understanding. They understand the model, but if the model does not correspond with the economic processes they are trying to understand in the real world, the model hinders rather than helps understanding the real-world economy. The reasons why members of the Austrian school tend not to use technically sophisticated mathematical and statistical techniques should be clear, but the widespread use - and admiration - of those techniques among the economics profession as a whole remains a barrier to a greater academic acceptance of the school's ideas.

5.8

Conclusion

The momentum of the Austrian school has been building since the 1970s, and the school is having a continuing resurgence in the twentyfirst century. As the Austrian school developed early in the twentieth century and up through the 1930s, it became best known for its business cycle theory, and for its arguments on the necessity of markets for rational economic calculation. In both of these areas the school

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had fallen out of favor by the middle of the century. Keynesian macroeconomics had eclipsed the Austrian business cycle theory, and the consensus among economists was that the Austrian argument on economic calculation was wrong. Through the 1930s the Austrian school was well within the mainstream of economic thought. By mid century the school's ideas had fallen out of favor. Ludwig von Mises was the only economist keeping the Austrian school alive, and his move to the United States moved the school with him. Mises's American students - Israel Kirzner and Murray Rothbard in particular - oversaw the resurgence in the school that began in the 1970s. The collapse of the Berlin Wall in 1989 followed by the demise of the Soviet Union in 1991 shifted the economics profession's view on the school's criticism of central economic planning from ridicule to grudging respect, and the malinvestments that occurred during the dot-com bubble in the 1990s and the housing bubble in the 2ooos cast some favorable attention on Austrian business cycle theory. While the Austrian school remains outside the mainstream of economic analysis, its ideas are more recognized and more favorably viewed in the twentyfirst century than they have been since the 1930s. As economic analysis has advanced over the decades, it is worth considering what the Austrian school has to contribute. In a number of areas the ideas of the Austrian school differ from mainstream economic analysis, and contribute insights into economic analysis that mainstream economics tends to overlook. This book's organization has divided those distinctly Austrian insights into four broad, and perhaps somewhat arbitrary, categories. The Austrian school emphasizes the market process, which distinguishes itself from contemporary economic analysis that has a heavy emphasis on depicting the properties of economic equilibrium. Some might view this emphasis on the process as a more nuanced way for understanding how an economy arrives at the equilibrium outcome that mainstream economic models tend to depict. This way of looking at the market process understates the distinctiveness of the Austrian school, however, because an economy characterized by economic progress never arrives at an equilibrium. There is good reason to focus on the process, which is always ongoing, rather than the equilibrium that never arrives and is always changing. More than this, by focusing on the process, the market mechanism is depicted not as a means for finding an equilibrium set of prices and quantities but rather a discovery

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process that coordinates the decentralized and imperfect knowledge of the economy's participants. In the face of decentralized and imperfect knowledge, the Austrian school depicts firms as economic organizations that allow entrepreneurs to act on profit opportunities they perceive, and to capture the profit from their entrepreneurial actions. Economic analysis typically depicts firms as combining a given set of inputs using a given production function to produce a given output, emphasizing the managerial function of the firm in combining inputs to produce output efficiently. The Austrian school emphasizes the firm as an institution that allows individuals within the firm's boundaries to combine their knowledge to produce output. The entrepreneurial nature of firms means that they bring innovations to market rather than working within a given production function to produce some given type of output. This entrepreneurship generates the economic progress that is so much a part of a market economy that it is often taken for granted (by the general public, and in economic analysis). Knowledge is decentralized, is often tacit and so not easily communicated among individuals, and is often uncertain. Firms are organizations that enable people to combine their knowledge productively. The Austrian school emphasizes the role of firms combining knowledge to produce output rather than combining inputs to produce output. The best way to use this decentralized knowledge is to allow the individuals who have it to make best use of it, and the market mechanism works to coordinate this decentralized knowledge without having to aggregate it. Indeed, because of the nature of economic knowledge, it cannot be aggregated. Firms are repositories of knowledge and the essential activity of the firm is the combining of the knowledge of those who work there to engage in production. The neoclassical model of the firm depicts those who run firms as managers who use resources efficiently to produce output, whereas the Austrian school emphasizes the entrepreneurial nature of firms. Product differentiation, often depicted by economists as increasing costs, is the engine of economic progress in the Austrian framework. Profit is viewed as a sign of inefficiency within the neoclassical economic framework because it results from monopoly power or disequilibrium, whereas the Austrian framework depicts profit as necessary for efficiency because the lure of profit is what drives entrepreneurship. The Austrian school offers a distinc-

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tive vision of the role that firms and profits play within a market economy. Economic calculation lies at the foundation of Austrian economics. The socialist calculation debate serves to illustrate the distinctive ideas of the Austrian school. The critics of Mises's arguments in that debate worked from an equilibrium model of the economy to demonstrate how central planners could calculate equilibrium prices. The Austrian school's response was to note that an economy is a complex system that cannot be comprehended in its entirety, so while we can comprehend the way that the process works, we cannot understand the details because they are based on individual knowledge, and on entrepreneurial decisions that can only be made by the individuals who have their specific knowledge of time and place. Markets coordinate the economic activity of individuals because prices convey information about the economic activities of others. People do not have the knowledge of others, but prices give them information about it so they can benefit from the knowledge of others without having it. Market prices are required for rational economic calculation. This economic calculation does much more than just find equilibrium prices and quantities. Conditions are always changing, so people constantly need to update their economic calculations to reflect those changing conditions. The market mechanism provides the information to allow individuals to do so. The economic calculation of entrepreneurs generates economic progress, and the market mechanism allows individual plans to remain coordinated as this progress occurs. Whereas much economic analysis is based on the assumption of maximizing behavior, the Austrian school recognizes that because decisions are made under uncertainty, and because one can never know the outcome of choices not taken, individuals and firms can never know whether they have made the utility maximizing or profit maximizing choice. They can only make what appears to be the best choices available to them at the time they choose. After a firm chooses a course of action, it can tell whether that course of action turns out to be profitable, but it can never know whether another course of action would have been more profitable. The market process allows individuals to evaluate their options and make their choices, but nobody can know if their choices were "optimal" because the outcomes of options not taken can never be known.

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The Austrian theory of the business cycle is another distinguishing feature of the school. The theory depicts economic fluctuations caused by expansions and contractions in the money supply that affect prices, and in particular, the interest rate. Rational economic calculation requires market prices, and when price signals are distorted by monetary fluctuations, those distorted prices lead to increases in errors in economic calculation. A key component of Austrian business cycle theory is heterogeneous capital. Typical macroeconomic models assume a homogeneous stock of capital, and when they do, those models cannot depict malinvestments that occur because the wrong types of investment are being undertaken. Macroeconomic instability arises because of a breakdown in the coordination of individual plans, and Austrian macroeconomics emphasizes that an important part of that breakdown occurs because of malinvestment. This distinguishes the Austrian approach to macroeconomics from most other approaches. In fact, in the real world we see macroeconomic problems being caused by investments that, in hindsight, have been made in the wrong type of capital, so the potential contribution of the Austrian framework to macroeconomics is apparent. The ideas of the Austrian school differ from other schools of thought in economics, and contribute insights into economic processes beyond what other schools have to offer. The Austrian school has seen a resurgence since the 1970s that has continued into the twenty-first century. One small piece of evidence on the contemporary interest in the Austrian school of economics is that you have taken the time to look through this book! NOTES 1 See Holcombe (1999) for a more detailed discussion of Mises and Hayek, and an overview of the

Austrian school. 2 Karen Vaughn (1994, pp. 103-11) attended the South Royalton conference and gives an account of the proceedings. 3 Individuals interested in the ideas of the Austrian school can find a wealth of information at the Mises Institute's website, http://www.mises.org. The website has a large number of books in the Austrian tradition, including many classic Austrian works, and also has a substantial amount of material with a libertarian political orientation. It offers many programs and seminars aimed at students, faculty and the general public. 4 When the program was established with the 1.5 percent tax rate on employees, information provided to citizens from the Social Security Administration assured them "This is the most you will ever pay". 5 While this argument may at first seem implausible, one might look at the invasions of Iraq and Afghanistan by the United States in the early 2ooos to see the difficulty the most powerful nation in the world had in trying to take control of two small and poor nations.

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Index

administered prices 49-50 agglomeration economies 39-40 aggregation problem 1, 52, 59, 67-8, 104, 144 allocative efficiency 64, 90, 92, 104 antitrust law 62, 65 Apple 8, 24, 36 arbitrage, entrepreneurship as 26-7 Armentano, Dominick T. 6o Arthur, W. Brian 6o Auburn University 101 Austrian Institute of Economic Research 96 Austrian School ideology 107-8 methodology 109-12 in mid-twentieth century 97-9 resurgence of 99-102 rise of 95-7 automated production processes 24, 36, 79 automobile production process 24, 27, 36,78-9 Baetjer, Howard 94 baking analogy 22-3, 30-31 banks causes of investment errors 74-7 responses to economic conditions 71-7 see also central banks biological evolution s8-6o, 62 Boettke, Peter J. 68 Bohm-Bawerk, Eugen 77-9, 96 borrowers causes of investment errors 74-7 responses to economic conditions 71-7 Boudreaux, Donald J. 24

Buchanan, James M . 21, 31 business cycles 69-70, 97, 104-5, 113, 116 basic theory 71-3 causes of 74-7 and entrepreneurial innovation 88-9 and structure of production 79-81 capital costs 56-7 capital goods, value of 32, 48, 82-4, 92 capital markets 82-4, 86, 92, 105 capital redeployment 81, 86-9 capital stock 82-5 capital structure 77-81 capitalism s-6, 25, 67, 102-5 Carnegie, Andrew 36 central banks, control of monetary base 74. 77. 91-3 central economic planning s-6, 46-51, 66-8, 83, 109-10 and complex systems 52-4 demise of 101-2 impact of mixed economy 54-5 see also socialist calculation debate Chicago schoolw8 Cold War 101-2 collective ownership 46-7 comparative advantage 41 competition 19-21, 63 Competition and Entrepreneurship (Kirzner) 100 competitive equilibrium 11, 21, 42 complex systems 52-5, 67-8, 76, 102-3, 107-11, 115 computer industry 24, 34, 36, 38-9, 62-3 consumer choice 61 consumer surplus 63 contingency planning 9-10, 14

121

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continuous innovation 6o-62 contradictory information 1, 7, 14-15, 21, 35, 51-3, 110 Cordato, Roy E. 65 cost and price 31-2 cost, subjective nature of 17-1S creative destruction 21, S7-9 credit cards 5, 91 crowding out 29 decentralized knowledge 52 decentralized planning, and spontaneous order 2-6 Desrochers, Pierre 39 deterministic models 53-4, 6o, 109-10 discovery process S, 12-14, 51, 113-14 disequilibrating forces, entrepreneurs as S7-9 disequilibrium prices 12-13, 20, 42-4, 64 division of capital S4-5 division of knowledge and supply chain 37-S, 40 Dolan, Edwin G. 101 dot-com bubble 92, 104-5, 113 Dutch East India Company 4-5 economic conditions 1-2, 7-14,21, 26-7 bank and borrower responses 71-7 economic coordination and knowledge 6-9 economic evolution 11, 25-6, 5S-6o, 62 economic progress 23-6, S9, 110 and business cycles S9 and entrepreneurship 40, 44-5, 50-51, 53, 55-S, 109 and innovation 36-7 and product differentiation 6o-62 profit as indicator of 29-30, 62-4 and welfare maximization 64-6 economic selection 2S-9, 59-60 Elements ofPure Economics (Walras) 95 employment 72, S6-9 entrepreneurial judgment 15-16, 25-6, 2S, 34, 52-3, 56-7, 6o, S3 entrepreneurial nature of firms 24-6 entrepreneurship as arbitrage 26-7

and economic progress 40, 44-5, 50-51, 53, 55-S, 109 Schumpeterian and Kirznerian S7-9 equilibrating forces S7-9 equilibrium as absence of unexploited profit opportunities 11 as coordination of individual plans 9-10 equilibrium prices 6, 9, 11-14, 20, 43-4, 49-51, 57-9, 67, 104 exact coordination 10 externalities 65 fatal conceit 54-5, 110 fiat money 71, 90-91 final goods, value of 17-1S, 31-2, 4S, S2-3 firms entrepreneurial nature of 24-6 geographical proximity 39-40 impact of size on knowledge base 42 as repositories of knowledge 40-42 flexible plans 10, 22, S6-7 Ford, Henry 24, 36 Foss, Nicolai J. 25-6, 40 fractional reserve banking 70-74, 91 free banking 90-91 Friedman, Milton 9S, 1oS Garrison, Roger W. S1 Gates, Bill 36 general equilibrium models 1-2, 15, 1S-19, 30, 49-51, 53, 69, So, 109-10, 115 George Mason University, Center for Market Processes 101 German historical school 96 gold standard 70-71, 73-4, 76-7, 90-91 goods of the first order 17, 31-2 government control of monetary base 74, 77, 93 role in economy 54, 66, 105-S unintended consequences of intervention 29-30, 47, 54-5, 65-6, 102-3, 1oS government mandates 30 graphical user interface 36 Great Depression So, 97

INDEX

Harper, David A. 2S, 55, 101 Hayek, Friedrich A. and business cycle theory 69, 79 contribution to Austrian school 96-S on economic equilibrium 9-11, S5 on knowledge and economic coordination 7-S, 35, 39, 44, 51 on role of government 105, 1oS and socialist calculation debate 54-5, 110 Herbener, Jeffrey M. 65-6 heterogeneous capital 77-S2, S4-5, 92-3, 104, 116 higher-cost output and product differentiation 61-2 higher-order goods 17, 32 Holcombe, Randall G. 24, 33, 6o-61 homogeneity 19, 22-3, 61, 77, 79, S5, 92, 116 Horwitz, Steven 44, So housing bubble 92-3, 104-5, 113 Human Action (Mises) 47-S, 9S, 100 IBM 62-3 ideology 107-S Ikeda, Sanford 51, 54-5, 65, 103, 1oS imitation 40, 45, 6o, 63 incentives knowledge sharing 45 price changes 42-3 profit and loss as 2S, 36-7, 59-60 and rule oflaw 105-6 and taxation 107 under socialism 46-7, 51 income growth 57-S income redistribution 107-S incomplete information 1, 7-S, 14-15, 33-5, 52-3, no, 114 individual action, and utility 1S-19 individual plans, coordination of 3, 6, 9-11, S7-S, 115-16 individual preferences 1, S, 14-15, 19, 21, 47, 53, S1, S4, 109 individual price levels, changes in S9-90 Industrial Revolution 5, 36, 59 inflation S9-91 information 32-5

123

information asymmetries 65 innovation effects of S7-9, 93 incentives for 2S, 36-7, 42-3, 45-7, 51, 59-60, 7S-9, 105-7 and invention 35-7 inputs cost of 24, 27-S, 31-4, 43 optimal mix 22-4 substitution 13-14, 23-4, 33 and supply chain 37-S, 41 value of 17-1S, 27-S, 32-3 interest rates effect on investment type 77-9 fluctuations 71-3, 75-6, So-S1, S4, 91-3 manipulation of 104 international exchange market trading 27 invention and innovation 35-7 investment causes of errors 74-7 see also malinvestment invisible hand 6, 2S iPhone S Jevons, William Stanley 95 Jobs, Steve 36 Keynesian economics 69, So, 97, 113 Kirzner, Israel M. u, 25-6, 37, 45 contribution to Austrian school 99-101,113 Kirznerian entrepreneurship S7-9, 94 Klein, Peter G. 25-6, 33 knowledge 1-2, S, 32-5, 37-S, 56 and agglomeration economies 39-40 aggregation problem 1, 52, 59, 67-S, 104,144 and economic coordination 6-9,51-2, 55,104, 110 firms as repositories of 40-42 and supply chain 37-S see also decentralized knowledge Kahn, Meir 21 Lachmann, Ludwig M. 5S-9, S4, 1oo-1o1 laissez-faire policies 6S

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Lange, Oskar 49-50, 57, 64, 67 Langlois, Richard N. 33, 45 language development 2 Lerner, Abba 49-50, 67 Lewin, Peter 9, 84-5, 94 libertarian politics 106-8 London School of Economics 96-7 loss leaders 43 Ludwig von Mises Institute 101

mixed economy, dynamics of 54-5 monetarism 69, So monetary base 70-71, 73-4, 76-7, 90-91 money, and spontaneous order 3-4 money supply fluctuations 69, 71-4, 76-7, So-81, 90-91,116 and fractional reserve banking 70-71 monopoly power 62-4

mainstream economics 18-19, 70, 96-7, 99, 102, 113 malinvestment 73, 85-6, 92-3, 104-5, 116 and capital structure 77-81 causes of 74-7 Man, Economy and State (Rothbard) 100 management function 24, 26, 37, 44 management knowledge 7, 39, 43 marginal revolution 95 market failure 54, 65 market institutions 4-6, 55, 106 market mechanism 2, 6, 8-10, 19, 21, 44, 52-4, 67-8, 85, 99, 104, 1o6, 113-15 market price 19-20, 31-2, 42-3 as source of information 12, 32-3, 46-50, 55, 65 market rewards 8, 27-9, 31, 52-3, 57, 59-60 market socialism 50-51 market value 12-14, 82-3 market-clearing 6, 9,11-14, 20,43-4, 50-51, 57-9, 67, 104 Marshall, Alfred 31, 58 Marx, Karl46-7, 68 mathematical models 109-10 Menger, Carl4, 16, 31-2, 77,95-6 mentoring 7, 39 methodology 109-12 Microsoft 36 Mises, Ludwig von and business cycle theory 70-71, 73-4 contribution to Austrian school 97-100, 113 on inflation 90 and socialist calculation debate 46-8, 51, 66-9, 96, 98-9, 102, 104-5, 109,115

national defense 106 natural price 31 neoclassical economics 11, 18-19, 42-3, 59, 114 New York University 98-101 O'Driscoll, Gerald P. 9-10, 53, 59 opportunity costs 30-31, 56 Pareto optimality 64 path-dependency 6o pattern coordination 10 pencils, production of 13-14 Penrose, Edith 35 perfect information 11, 19-20, 34-5 Phelan, Steven E. 94 police protection 106 political institutions, connection with economic institutions 107-8 Pongracic, Ivan Jr. 45 price and cost 31-2 price signals 32-3, 49 distortion of 75-6, So-81, 85, 91-2, 105,116 erosion of 65 price-takers 19-20 prices, searching for 42-4 Principles ofEconomics (Menger) 16-17, 95 private ownership 48 product characteristics 20-21, 32-3 improvements in 23-5, 28, 37, 56-7, 60-61 product differentiation 20, 59, 114 and economic progress 60-62, 115 product substitution 13-14, 19, 77 production costs and price 31-2

INDEX

production function 20, 22-5, 32, 37, 114 production structure and business cycles 79-S1 and interest rates 77-9 professional basketball players 1S, 32 profit and loss S, 27-9, 31, 52-3, 57, 59-60 profit opportunities discovery of 24-S role of information, knowledge and wisdom 32-5, 37 unexploited opportunities and equilibrium u profits competed away 27, 40-41, 45, 63 as indicator of economic progress 29-30,62-4 maximization and opportunity costs 30-31 property rights 65, 105-6 public choice 4 7 Read, Leonard E. 13 Reisman, George 51, 102, 1oS replication 59-60 research and development 36-7 return on capital S5 Richardson, G.B. 34, 3S Rizzo, Mario J. 9-10, 53, 59, 101 Road to Serfdom (Hayek) 97 Robertson, Paul L. 45 Rothbard, Murray N. 65, 6S, So, 106 contribution to Austrian school 99-101, 113 roundabout production methods 7S-9 rule oflaw 105-6 Sautet, Frederic E. 40, 42 scarcity and subjective value 16-17 Schumpeter, Joseph A. 21, 25-6, 35-6 Schumpeterian entrepreneurship S7-9, 93-4 scientific knowledge 7, 36, 39 Selgin, George 90 Silicon Valley 40 Smith, Adam 6, 2S, 31, 3S, S5 social interaction and spontaneous order 3

125

Social Security programs 102-3

Socialism (Mises) 46, 96 socialist calculation debate 66-S, 92, g6-g, 102, 109-10, 115 Austrian school in 50-51 Ludwig von Mises on 46-S socialists answer to Mises 4S-5o South Royalton conference (1974) 100-101 Soviet Union central economic planning 4S, 67, gS-g

demise of 5,101-2,113 specialization benefits of 3-5, 3S, 40-42 and division of capitalS4-5 spontaneous order 2-6 static equilibrium 19, 61-2, 64-6 statistical analysis uo-12 stock markets bubbles and crashes 69, So development of 4-5 market process 20, S3 subjectivism 16-1S, 31-2, 4S, 53, 6o, 65 subsidies 29 sugar program 103 supply and demand 1-2, 6-7, 9-10, 12, 31-2, 43-4, 49, 51, 67, 71 supply chain 37-S, 41 tacit knowledge 7-9, 13-14, 41-3, 45, 51-2, 57, 59, 67, S3, 104, no, 114 and agglomeration economies 39-40 taxation 29-30, 66-7, 103, 107 Taylor, Fred M. 49-50, 57, 64, 67 technological advances, and interest rate changes S1 Teece, David J. 34 Theory ofMoney and Credit (Mises) 69-71, go, 96 Theory ofPolitical Economy (Jevons) 95 time 10, 14-17, 26-7, 34, 61 time preferences S1 tradable goods 3-4 trading ships, financing 4-5 transaction costs 40

126

ADVANCED INTRODUCTION TO THE AUSTRIAN SCHOOL OF ECONOMICS

un1brellas12-13,16 uncertainty 7-9, 15, 25, 28, 33-4, 53-4, s6-7, 6o, 82-3, 115 unen1ployn1ent 72, 86-9 University of Chicago 97-8 University of Vienna 96

us econon1ic progress 57-8 Social Security progran1102-3 sugar progran1 103 utility 16-19, 32, 61, 95, 109, 115 value added 8, 27-8, 30, 38, 52-3, 57-8, 61-5 value, subjective nature of 16-18, 32, 48, 6s

Vaughn, Karen I. 100 von Weiser, Friedrich 96 Wagner, Richard E. 3, 54 Walras, Leon 95 water 16-17 welfare n1axin1ization, process versus outcon1e 64-6 whiskey production process 78 White, Lawrence 90 willingness to pay 16-18, 30, 34, 62-3 wisdon1 33-5 Witt, Ulrich 35 Xerox36