Economic Reasoning, Lecture 1

The Austrian Method and How It Applies to Competition and

Monopoly, Part I

Contrast Between Austrian and Neoclassical Economics

●Mainstream economics is often hard to understand.

●Why? Because you have to learn complicated mathematical models. These are used because this is a way to be exact.

●How do we know these models apply to reality? The predictions of the model are tested. This often means further use of math.

Contrast Continued

●Some mainstream economists think that what is important is only whether the model gives true predictions. The axioms of the model don’t have to be true. Milton Friedman said this in a famous article.

●The Austrian view is different. If you use a mathematical model, you don’t really understand why things are true. You just follow the rules of math.

Austrian Method

●Austrians disagree with this. They favor a method where we understand what is going on at each step of the argument

●We all act---we use means to achieve ends.● If we think about what is involved in the

concept of action, we can discover important truths about economics.

●Here is an example. Why does exchange take place? If you trade apples for oranges, you want oranges more than apples. The person you trade with wants apples more than oranges.

Double Inequality

●Every exchange involves a double inequality. Just by thinking, in an everyday way, about what an exchange involves, we have learned an important truth about economics.

●Mises points out that many famous thinkers missed this. Aristotle said that exchange requires equality. Marx also thought this, and the postulate of equality is needed for the labor theory of value.

Deductive Reasoning

●What we have just done is an example of deductive reasoning. We ask, “what do we need to make sense of an exchange?” We then see how exchange requires a double inequality.

●We are drawing out what is involved in the concept “exchange”. If we have done this correctly, the results are true.

Deductive Reasoning and Testing

●Deductive reasoning moves from premises to conclusion. If the premises are true, the conclusion is true.

●All men are mortal●Socrates is a man●Therefore, Socrates is mortal.●We don’t need to test the conclusion to

find out whether it is true.

Austrian Economics and Testing

●In Austrian economics, we know the premises are true because they are about the concept of action. We don’t have to test the conclusions.

●This has made Austrian economics very unpopular with mainstream economists. They think the Austrian method is dogmatic.

An Objection

●Austrian economics starts from premises that we know are true. But doesn’t science sometimes show that common sense beliefs are false?

●E.g. doesn’t it seem that the earth is stationary, and that the sun and planets revolve around it? But it isn’t.

●This example, and others like it, doesn’t show that our “inside” knowledge could be mistaken. It’s given to us in experience that we act.

Another Objection

●I claimed that Austrian economics follows ordinary common sense reasoning.

●But what about all the talk about synthetic a priori truths, analytic statements, etc.? This doesn’t sound like ordinary language.

●But these terms are just part of a philosophical defense of the Austrian method. You don’t have to study them to do Austrian economics.

The Broken Window Fallacy

●Here is another example of common sense reasoning in economics.

●Henry Hazlitt takes over this example from Bastiat. Suppose a young man tosses a brick through a store window.

●Someone argues that the boy is really a public benefactor. The shopkeeper will pay to have his window replaced. Then the glassmaker will spend the money he gets on other products. The result will be an increase in production.

The Fallacy and Common Sense

●We don’t have to use math to find out what is wrong with this reasoning. The argument doesn’t consider everything relevant.

●What would have happened if the boy hadn’t broken the window? The storekeeper would have spent the money he used to replace the window on something else. This in turn would generate more spending. The first situation is worse because there has been destruction of wealth.

The Fallacy Is Alive and Well

●Paul Krugman committed this fallacy after the 9-11 attack. He said that the destruction caused by the attacks would lead to increased spending and more production.

●Many proposals for government spending ignore what people would have done with the money if the government hadn’t taxed it away.

Commonsense Competition

●Austrian economics views competition very differently from neoclassical economics.

●Consumers on the market have dollar votes. Sellers compete for these votes.

●Thus, all sellers of products are in competition for the dollars of consumers. Competition isn’t confined to firms within an industry.

Competition and Democracy

●Mises compares market competition to political democracy. The market is better than political democracy because people with unpopular tastes can still get what they want, as long as people who supply them can cover their costs.

● In political democracy, only the winning party gets what it wants. Even proportional representation leaves many people unsatisfied.

Competition within an Industry

●What about competition within a particular industry or sellers of the same product? E.g, different companies produce cars, sell fruit, etc. People who sell services, e.g., doctors and lawyers, are competing for the consumers’ money.

●People within an industry are more directly in competition with one another than they are with all sellers of products.

Austrian Economics and Competition

●Austrian economics differs very much from neoclassical economics on competition within an industry.

●As we’ll see next week, neoclassical economics imposes strict conditions for a competitive industry. Basically, there must be many firms in an industry for competition to exist. If there isn’t, then we have either monopoly---one seller; oligopoly—a few sellers; or monopolistic competition---more sellers, but not enough for competition.

Austrian Economics Continued

●Austrian economics doesn’t impose these requirements. In the Austrian view, as long as firms are free to enter and leave an industry, it counts as competitive.

●Why this difference? Austrian economics takes people’s choices on the market as given. It doesn’t try to “improve” on people’s choices, by saying that they don’t mean meet the terms of some non-market standard.

Neoclassical Economics and Efficiency

●Neoclassical economists think that they can improve on the market. If the market doesn’t meet their standards for competition, it isn’t efficient.

●What do they mean by efficiency? This means the maximum production at the least cost.

Utility

●To understand what they mean, we have to understand utility.

● In Austrian economics, we start from action. When you act, you try to achieve the goal that you value most highly at the time.

●You can rank economic goods by how they will help you achieve your goals.

More Utility

●Suppose that you have five apples. You ask yourself, what is the best use I have for the first apple? You ask the question for each apple. The value you get from the good is called its utility.

●As you get more and more of a good, you use it to fulfill lower ranking ends. The good has diminishing marginal utility. This means that the marginal, or last, unit decreases in value as you add more units. This is a basic law of economics.

Ordinal vs. Cardinal Utility

●Each person will rank units of goods in order, depending on the uses he has for each unit.

●These units aren’t measured on a common scale. Utility isn’t isn’t a substance that comes in units.

●Goods are just ranked: The first apple ranks above the second etc. This is called an ordinal scale—first, second, third, etc.

●You can’t make comparisons of utility between persons. It doesn’t make sense to say, my first choice ranks higher than your second choice. Higher to whom?

Neoclassicals and Utility

●The neoclassical economists largely accept this. They agree that you can’t measure interpersonal utility.

●They think that they can still show that if their conditions for competition aren’t met, you can increase utility.

●Austrians think that we can’t know other people’s preferences. All we know is that if they act, they prefer what they choose to something else.

Monopoly

●When I said that Austrians take all markets as competitive, so long as there is free entry, you might have wondered, what about monopoly? How can a competitive market have only one seller?

●The seller is still competing with sellers of all other goods.

More Monopoly

●Rothbard says that even with one seller, there is no way to establish that his price is not a competitive price. If you say, wouldn’t the price be lower if there were more firms in the industry, his answer is, why should we say that the price then would be the competitive one? We are imposing an arbitrary standard on the free market.

Mises on Monopoly

●Mises’s position is slightly different. He thinks the notion of a monopoly price makes sense.

●However, monopolies on a free market would arise very rarely. Also, it would be very difficult to show that a firm was charging a monopoly price.