Austrian Economics Austrian Foundations of Marginal Analysis an other Austrian Contributions

Historical Links A. Forerunners of Marginal Analysis (1 st Generation) 1. Concept of Utility Aristotle - use value 310 BC Jeremy Bentham – concept of utility in utilitarian philosophy end of 18 th century 19 th century writers - concept of diminishing marginal utility, marginal productivity theory

2 nd Generation marginal utility theorists - Jevons, Menger and Walras (Menger - 1 st generation Austrians) A. A Revolution in Theory? All 3 thought they had developed a revolutionary analysis of the forces explaining the determination of prices (stressed demand side). Jevons - application of marginal analysis to the side of demand Walras - application of marginal analysis to both demand and supply, and the formulation of a general equilibrium model of the

2 nd Generation marginal utility theorists - Jevons, Menger and Walras (Menger - 1 st generation Austrians) A. A Revolution in Theory? Menger - application of marginal analysis to both the demand and supply side

Inadequacies in the Classical Theory of Value 1. Classical theory of value found inadequate to explain the forces of prices (stressed supply side). a) Cost of Production theory - lacked generality b/c could not analyze prices some goods 1) Labor theory of value (Ricardo) and cost of production theories (Senior & Mill) required separate explanation for goods with fixed supply b/c value did not depend on production cost. 2) Theory suggested prices comes from cost incurred in the past. Jevons, Menger and Walras said large production costs will not necessarily result in high price.

Inadequacies in the Classical Theory of Value b) Marginal utility theory - value depends on utility (consumption) and comes from the future. 1) dead stock - goods for which  demand so that prices < cost of production. 2) Value of factors of production determined by marginal utility received from consuming final product

Inadequacies in the Classical Theory of Value C)Classicals used total or average utility (diamond-water paradox), but it is marginal utility that is significant theory - value depends on utility (consumption) and comes from the future.

What is Utility? 1. Utility - a psychological phenomenon with unspecified units of measurement. 2. Jevons, Menger and Walras did not use term “marginal utility” 3. Menger used “importance of satisfactions” instead of “utility”

What is Utility? 1. acquired utility -utility of goods consumed indirectly (acquire utility from the consumption of goods for which they are finally exchanged. 2. diminishing marginal utility -as the consumption of a good increases, its marginal utility decreases

What is Utility? 3. continuous functions - have smooth curves when plotted (arise from continuously divisible quantity of goods consumed and continuously divisible quantity of utility. 4. discontinuous functions - have steplike curves when plotted (arise from nondivisibility)

Comparisons of Utility Interpersonal comparisons of utility - comparing the utility of different persons for a good (e.g., and additional amount of income given to a person with high income and to a person with low income). Jevons, Menger and Walras maintained interpersonal comparisons not possible

Utility Functions Jevons, Menger and Walras : marginal utility depends only on the quantity of a good consumed and does not depend on the quantity of other goods consumed (substitute or complementary) a) T herefore total utility is an additive function: total utility = f 1 (Q a ) + f 2 (Q b ) + f 3 (Q c ) +.. b) Modern however assumes: total utility = f (q A, q B, q C,... )

Utility, Demand, and Exchange 1. What distinguished Jevons, Menger and Walras from predecessors (except Gossen): a) Attempted to determine the conditions that would hold when a consumer is maximizing utility b) Attempted to develop a theory of exchange c) J. & W. investigated the relationship between utility and demand

Utility, Demand, and Exchange What distinguished Jevons, Menger and Walras from predecessors (except Gossen): d) Walras most successful of the 3 in these attempts b/c of greater mathematical ability & better understanding of interrelatedness of various sectors of economy

Utility, Demand, and Exchange 2. Gossen’s 2 nd Law: A consumer maximized utility by spending a limited income so that the last unit if money spent for any particular good yields the same marginal utility as the last unit spent for any other good. a MU A = MU B = MU C P A P B P C d) Walras most successful of the 3 in these attempts b/c of greater mathematical ability & better understanding of interrelatedness of various sectors of economy

Utility, Demand, and Exchange 2. Gossen’s 2 nd Law: A consumer maximized utility by spending a limited income so that the last unit if money spent for any particular good yields the same marginal utility as the last unit spent for any other good. MU A = MU B = MU C P A P B P C

The Value of Factors of Production Jevons and Menger: Factors of production are price-determined; price of factors of production (called intermediate goods or good of higher order) depends on the utility of the produced final good. Causal relationship treated in partial equilibrium framework Walras: Saw causal relationships more complex and formulated consideration of value in general equilibrium analysis

Classical versus the Emerging Neoclassical Theory of Value Classical cost of production theory on inelastic supply (vertical): Price depends on supply and demand and cost of production may have no influence on supply Jevons and Menger position on inelastic supply: A Assume supply is fixed and price depends only on demand. All failed to see interdependence of variables of marginal utility, supply and demand.

Second-Generation Austrians A. Friedrich von Wieser ( ) Austrian school - began with Carl Menger at University of Vienna late 1800s 1. Wieser was a student of Menger, became professor at University of Vienna (along with Eugen von Bohm-Bawerk) and both taught Ludwig von Mises and Joseph Schumpeter. Used (Robinson Crusoe) verbal models instead of mathematics

Second-Generation Austrians A. Friedrich von Wieser ( ) First to use the term “marginal utility” Imputation -process by which factors of production receive value from final goods (price-determined) Intramarginal final goods - have higher relative marginal utility in a set a goods; value depends on cost of production (price- determining)

Second-Generation Austrians A. Friedrich von Wieser ( ) Marginal good - the good with the lowest marginal utility in a set of goods; value depends on marginal utility

Eugen von Bohm-Bawerk Fellow student, friend and brother-in-law of Wieser; became better known in Britain and U.S. than Wieser Used verbal models instead of mathematics

Eugen von Bohm-Bawerk Profits and Interests. Bohm-Bawerk perceived that marginal productivity theory failed to explain profits and interest. 1. Difference between profits and interest had not yet been distinguished. a) Roles of capitalist and entrepreneur were combined in classical economic theory.

Eugen von Bohm-Bawerk B. Profit Theory 1. Classical economists recognized 3 element of profits:  a payment for the use of capital (now classified as interest)  a payment to the entrepreneur for management services rendered a payment that compensated for the risks of business activity 2. J.B. Clark called payment for entrepreneur’s management services and the assumption of risk a wage, not profit.

Eugen von Bohm-Bawerk Eugen von Bohm-Bawerk saw a relationship between profits and interest rates He then dwelt on why interest were at the level they were and concluded that there was three psychological levels determining interest rates

Eugen von Bohm-Bawerk Present goods are worth more than an equal amount of future goods ($1 today is preferred to $1 a year from now b/c $1 received today could be lent and thus worth more in the future.

Eugen von Bohm-Bawerk 3 reasons for interest rates: Different circumstances of want and provision in the present and in the future. Marginal utility decreases as goods increase. Systematic underestimation of future wants, and the goods to satisfy them. Lack of imagination and willpower in individuals, and uncertainty regarding length of life.

Eugen von Bohm-Bawerk 3 reasons for interest rates: Interest exists b/c of the technical superiority of present good over future goods. Goods produced by roundabout (capitalistic) method gain technical superiority at every stage of production and increases the flow of final goods as opposed to the direct method (e.g., catching a fish by hand involving no capital goods).

Joseph Alois Schumpeter ( ) born in Austria and emigrated to America Student of B  hm-Bawerk at the University of Vienna He was finance minister of Austria Left Austria in order to avoid Hitler’s onslaught

Joseph Alois Schumpeter Taught at Harvard University Important works: Theory of Economic Development, 1911 (translated to English in 1934). Business Cycles, 1939 Capitalism, Socialism, and Democracy, 1950 (3 rd. edition) Ten Great Economists, History of Economic Analysis, E.B. Schumpeter (ed.), 1954.

CONCEPTS DISCUSSED BY SCHUMPETER He argued studying the history of economic thought was important in that it presented the ways of the mind. Creative Destruction is the internal mechanism by which the market continuously improves on it self.

CONCEPTS DISCUSSED BY SCHUMPETER Innovation vs. invention. While inventions are helpful, it is the act of applying innovation that actually improves the society. Some of the ways in which he described innovation:

CONCEPTS DISCUSSED BY SCHUMPETER Some of the ways in which he described innovation: creation of new product or new quality product creation of new method of production opening of new market the capture of new source of supply

CONCEPTS DISCUSSED BY SCHUMPETER Some of the ways in which he described innovation: new organization of industry (i.e. creation or abolition of market power) He also described the difference between Entrepreneur vs. Manager

CONCEPTS DISCUSSED BY SCHUMPETER Business Cycles and the importance of the Tax system cutting off the incentive for the entrepreneur. Failure of the market system stems from its successfulness

Ludwig von Mises ( ) born in Austria and emigrated to America Student of B  hm-Bawerk at the University of Vienna

Ludwig von Mises Mayor Works  Human Action (1st edition, Yale, 1949; 2nd revised edition, Yale, 1963; 3rd revised edition, Regnery, 1966).  Bureaucracy (Yale, 1944; Arlington House, 1969).  Omnipotent Government (Yale, 1944; Arlington House, 1969).  Socialism (Yale, 1951; Jonathan Cape, 1969).  The Theory of Money and Credit (Yale, 1953; Foundation for Economic Education, 1971).

Ludwig von Mises Mayor Works  The Anti-Capitalistic Mentality (Van Nostrand, 1956; Libertarian Press, 1972).  Theory and History (Yale, 1957; Arlington House, 1969).  Epistemological Problems of Economics (Van Nostrand, 1960).  The Free and Prosperous Commonwealth (Van Nostrand, 1962).  Planning for Freedom (2nd edition, Libertarian Press, 1962).  The Ultimate Foundation of Economic Science (Van Nostrand, 1962.)  The Historical Setting of the Austrian School of Economics (Arlington House, 1969).

Ludwig von Mises While he had many contributions one of his most important comes from his explanation of the value of money: Marginal Utility of Money comes from two sources:  Value from the value of the goods it can buy.  Value from the subjective use value of its own because it can be held for future purchases. (today that would be called the “purchasing power”)

Ludwig von Mises His importance can be seen today by the fact that Auburn University has established a well know institute in this country under his name: Ludwig Von Mises Institute.