(Elgar Advanced Introductions Series) Randall G. Holcombe-Advanced Introduction To The Austrian School of Economics-Edward Elgar Pub (2014)

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Advanced Introduction to
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RANDALL G. HOLCOMBE
DeVoe Moore Professor of Economics,
Florida State University, USA
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For Ross, Mark and Connor: my children,
and students ofAustrian economics.
Contents
Preface ix
The market process 1

1.1 Spontaneous order 2
1.2 Knowledge and economic coordination 6
1.3 Equilibrium: the coordination of individual plans 9
1.4 Equilibrium: the absence of unexploited profit
opportunities 11
1.5 The market as a discovery process 12
1.6 The element of time 14
1.7 The subjective nature of value 16
1.8 The subjective nature of cost 17
1.9 Utility and individual action 18
1.10 Competition 19
1.11 Conclusion 21
2 Decentralized knowledge: the role of firms and markets 22

2.1 The entrepreneurial nature of firms 24
2.2 Entrepreneurship as arbitrage 26
2.3 Profit and loss 27
2.4 Profits are not certain 29
2.5 Profit and progress: a caveat 29
2.6 Opportunity cost and profit-seeking 30
2.7 Cost and price 31
2.8 Information, knowledge and wisdom 32
2.9 Research and development 35
2.10 The division of knowledge and the supply chain 37
2.11 Tacit knowledge and agglomeration economies 39
2.12 Firms as repositories of knowledge 40
2.13 Searching for prices: disequilibrium exchanges 42
2.14 Conclusion 44
vii
viii ADVANCED INTRODUCTION TO THE AUSTRIAN SCHOOL OF ECONOMICS
3 Economic calculation 46
3.1 Ludwig von Mises on economic calculation 46
3.2 The socialists answer Mises 48
3.3 The Austrian school's answer so
3.4 Decentralized knowledge 52
3.5 Complex systems 52
3.6 The mixed economy 54
3.7 Economic progress 55
3.8 The evolution of economic activity 58
3.9 Product differentiation and progress 6o
3.10 Profit: indicator of progress 62
3.11 Welfare: process versus outcome 64
3.12 Conclusion 66
4 Money, banking and business cycles 69

4.1 The money supply and fractional reserve banking 70
4.2 The basic business cycle theory 71
4.3 The causes of the business cycle 73
4.4 Why do borrowers and lenders make these errors? 74
4.5 The structure of capital 77
4.6 The structure of production and business cycles 79
4.7 The capital stock 82
4.8 The coordination of economic activity 85
4.9 Schumpeterian and Kirznerian entrepreneurship 87
4.10 Inflation 89
4.11 Free banking 90
4.12 Conclusion 91
5 The resurgence of the Austrian school 95

5.1 The rise of the Austrian school 95
5.2 The dormant Austrian school in the mid-twentieth
century 97
5.3 The resurgence of the Austrian school 99
5.4 Austrian economics and capitalism 102
s.s The role of government in the economy 105
s.6 The ideology of the Austrian school 107
5.7 The methodology of the Austrian school 109
s.8 Conclusion 112
Rtferences 117
Index 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 knowl-
edge 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 entre-
preneurship 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
ix
X ADVANCED INTRODUCTION TO THE AUSTRIAN SCHOOL OF ECONOMICS
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 associ-
ated with the Austrian school, or the Chicago school, or the post-
Keynesian 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 distinguish-
ing 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 gradu-

ate 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 confer-
ences 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 read-

ers 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 refer-
ences 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 econom-
ics. 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 infor-
mation means that it can never be aggregated in such a way as to pro-
duce 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.
2 ADVANCED INTRODUCTION TO THE AUSTRIAN SCHOOL OF ECONOMICS
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 introduc-
tion 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 under-
stand 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 decentral-
ized knowledge that is possessed by everyone in the economy. The
economic forces that lead markets to clear, so that the quantity sup-
plied 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 second-
ary 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 top-
down 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 specializa-
tion in their economic activities, people found that rather than pro-
ducing 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.
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 trad-
able 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 specializa-
tion and gains from trade, and began trading with each other. As they
did, market institutions, such as money, emerged without anyone plan-
ning 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 financ-

ing economic activity. In the 15oos Europeans began undertaking com-
mercial 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 profit-
ably 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 invest-
ments. 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
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 sell-
ers 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 col-
lapse 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
to be more critical of resource allocation through government plan-

ning 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 pro-
duce a spontaneous order, without anybody planning or designing the
outcome. Everybody makes their own individual plans, and the institu-
tions of the market coordinate these individual plans so that, in gen-
eral, 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 econ-

omies 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 econ-
omy and the way they coordinate people's activities by bringing the
quantity supplied to equal the quantity demanded.
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 con-
tradictory to, the knowledge of other people. Even more, individuals
themselves may have information from different sources that is con-
flicting and contradictory. In what is surely the single most influen-
tial 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 knowl-
edge 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 busi-
ness 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
successful in that line of business. Often, what would make a desir-

able 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 observ-
ers 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 knowl-
edge 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
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 dif-
ficult 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 mecha-
nism 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 coordi-
nated. 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 fac-
tories 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
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 contin-
gencies. 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 equilib-
rium in the sense that all the plans everyone has made will all be real-
ized. 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 indi-
viduals 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 multi-
tude 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.
1.4 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 equi-
librium. 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 equilib-
rium as Kirzner defines it. An economy can be in equilibrium follow-
ing 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 facili-
tating the coordination of people's plans. In a neoclassical competi-
tive 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.
1.5 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 ben-
efit. While economists often talk about equilibrium prices, and many
models are built around the notion that market forces produce equi-
librium 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 will-
ing 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 condi-
tions 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 umbrel-
las 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
heavier sales of umbrellas made on rainy days were made at disequi-

librium 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 eco-
nomic 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 com-
plex 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 through-
out 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 manufactur-
ing 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
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 decentral-
ized 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 pro-
cess 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 par-
ticipants. 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 con-
tingencies 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 antici-
pated 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 prefer-
ences, 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
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 condi-
tions. 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 informa-
tion 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 uncer-
tain, 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, assign-
ing 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 knowl-
edge, people's expectations about the future tend to be roughly cor-
rect 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
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 evalu-

ation of people who purchase them. That subjective value may vary
from person to person, and may vary for the same person at differ-
ent 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 will-
ing 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 inexpen-
sive, 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
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 increas-
ingly 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 par-
ties 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 will-
ing to pay for goods and services, the market reveals this informa-
tion 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, subjec-
tively. 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.
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 subjec-
tively 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 audi-
ences 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 ser-
vices 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, main-

stream economics ascribes utility functions to individuals that require
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 guar-
antee 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 individu-
als 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 equi-
librium 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 equilib-

rium 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 mar-
kets. 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
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 con-
clusion 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 produc-
ers decide what production technologies to use, and what character-
istics 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 hind-
sight, 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 "dis-
equilibrium" 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 qual-
ity, 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.
Competition is an ongoing process that brings with it continual changes

in prices, production processes and product characteristics. These con-
tinual 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 com-
petitive 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 produc-
tion processes, and gain information about their economic activities
and the activities of others. Producers not only discover better pro-
duction 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 circum-
stances 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 anal-
ogy 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 rela-
tive 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 pro-
duce 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 formula-
tion leaves out the land that was mentioned above, and depicts capital
and labor as homogeneous. Combine certain amounts of capital and
22
DECENTRALIZED KNOWLEDGE: THE ROLE OF FIRMS AND MARKETS 23
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 addi-
tion 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
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 com-
ponents: 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 dif-
ferent 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 pro-
duction 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 automo-
biles is the prototypical example of a change in the production process.
Assembly lines had been used before Ford used them, but not for pro-
ducing 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.
Kirzner (1973) emphasizes the pure observation of the profit opportu-

nity 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 prod-
uct 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 sub-
stantial 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 suc-
cesses 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 produc-
tion 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 condi-
tions are always changing, so firms must change in response, or find
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 imper-
fectly 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 entrepre-
neurship 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 distinguish-
ing 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 pur-
chased for $0.75 and sold for $1. To actually engage in the entrepre-
neurial 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 oppor-
tunity 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.
Consider a more complicated case of manufacturing a new automo-

bile. 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 program-
mers and traders are a cost of engaging in such arbitrage, and condi-
tions 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 oppor-

tunities 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 pur-
chasing 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
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 entre-
preneurs 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 entre-
preneurial 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 sur-
vive and grow while unprofitable firms eventually run out of assets and
go out of business.
Profits and losses are indicators of whether entrepreneurs are success-

ful 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 prof-

itable, there is a selection process that eliminates unprofitable firms
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 innova-

tive activity only if they anticipate that the reward in terms of antici-
pated profit outweighs the potential for loss. For this reason, profits
are necessary for economic progress. If profits were immediately com-
peted 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 activ-
ity 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 par-
ticipants. 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 assur-
ance that output purchased with tax dollars is worth more than it
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 differ-
ent 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 custom-
ers found the bakery's pricing to be unpredictable and started shop-
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 subjec-
tive 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, prepar-
ing, 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
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 play-
ers 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 pro-
cess 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 informa-
tion 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 produc-
ing radios should use gold wire rather than copper. But the price of
gold relative to copper indicates that copper wire would be more prof-
itable 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 com-
mand 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 con-
veys 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
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 prod-
uct 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 pro-
gram will be sold. If the program is designed to run on today's comput-
ers, 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 compet-
ing 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-
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 knowl-
edge 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 informa-
tion 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 dif-
ferent 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
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 twenty-

first 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 assem-
bly 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 inven-
tions 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
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 poten-
tial 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 manage-
ment aspects of the firm rather than its entrepreneurial activities. The
survival of the firm depends on its being able to keep up with develop-
ments 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.
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 activi-
ties. 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 effi-
ciently 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 concentra-
tion of specialized knowledge they can sell to other firms, and to final
consumers. One might view firms as specializing in producing particu-
lar 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.
2.11 Tacit knowledge and agglomeration economies
Hayek (1945) emphasizes the difference between what he calls scien-

tific 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 explana-
tion, 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 match-
ing 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 experi-
ence 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 comput-
ers 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 indus-
try, 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
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 empha-
sizes 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 identifi-

cation 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
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 com-
peting 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 spe-
cialized 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 supe-
rior 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.
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 prof-
itable, 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 knowl-
edge 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 communi-
cated 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 entrepre-
neurial innovation, which is why entrepreneurs benefit from organ-
izing 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 insuf-
ficiently 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
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 suf-
ficient disincentive to look for another restaurant, and regular custom-
ers 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 trans-
actions they can make. Some sellers may charge more for a given phys-
ical 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
accurate term would be market-clearing price because underlying con-

ditions are always changing, often because of factors that create per-
manent 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 infor-
mation 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 prob-
lem 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 effec-
tively used by everyone. The market is a mechanism that coordinates
the economic activity of its participants. Market prices provide infor-
mation to market participants, but the market mechanism also gener-
ates 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 allo-
cate 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 remark-
able array of goods and services that people can consume today com-
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 attrac-
tive 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 col-
leagues 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, entrepre-
neurs 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 incen-
tives 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 pro-
vided 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 twen-
tieth 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 calcula-
tion, 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 incen-
tive to engage in productive activity would be eroded. Marx's socialist
46
ECONOMIC CALCULATION 47
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 social-
ism 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 inter-
est, 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 so-
called public servants an incentive to live up to that name and further
the public interest. So, there are many reasons why government alloca-
tion 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 eco-
nomic 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 com-
prehensive 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
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 soci-
ety, 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 eco-
nomic 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 phe-
nomena. 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 preced-
ing 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 gener-
ates that information about the value of goods and services, so the
information does not exist without a market to create it. This is espe-
cially 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 cal-

culation, 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-
ered by Lange and Taylor (1938, pp. 57-8), who claim "to be grate-
ful to Professor Mises ... " for his "powerful challenge that forced the
socialists to recognize the importance of an adequate system of eco-
nomic 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 plan-
ning 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 man-
agers 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 social-
ist 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 equi-
librium prices in all markets, so the central planning board could, if
they wanted to, exactly duplicate in a socialist economy the resource
allocation that would be produced by a capitalist economy. This frame-

work is often referred to as market socialism because central planning
duplicates the operation of the market. The consensus among aca-
demic economists by the mid-twentieth century was that the frame-
work 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 wel-
fare, 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 rec-
ognizes 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.
One criticism of socialism is that it blunts the incentive to be pro-

ductive. 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 inno-
vative 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 equi-
librium 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 econ-
omy 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.
3.4 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 founda-
tion 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 advan-
tage 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 knowl-
edge 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 informa-

tion that they have about the economic activities of others, and based
on their own knowledge. They get feedback on the value of their eco-
nomic 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 quantifi-

able facts. It is subjective, always incomplete and necessarily specula-
tive 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
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 inno-
vations 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 value-
reducing 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 infor-
mation 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 neces-
sarily make decisions based on incomplete and possibly contradictory
information, depicts a trajectory of the economy that is not determin-
istic 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.
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 unan-
ticipated 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 combi-
nation of market production for some goods and services and govern-
ment 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 interven-
tion 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 prob-
lems, and these new problems will then result in a demand for addi-
tional 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-
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 hierarchi-
cal decision-making process of government. Economic calculation
becomes less rational, and the resulting problems lead to increasing
government intervention. Economic institutions are important deter-
minants of the ability to engage in rational economic calculation, as
Harper (1998) emphasizes, and a movement away from market institu-
tions 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 econo-
mists 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 eco-
nomic 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 produc-
tion decisions and their consumption decisions. Everyone is looking for
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 increas-
ingly behind those who do. In contrast with a depiction of markets in
equilibrium, economic conditions are always changing, and the big-
gest 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 prof-
itable, 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 dis-
cover how profitable it is to produce A, but will not discover how prof-
itable 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 decid-
ing 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 modify-
ing 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 innova-
tions that might appear in the meantime from other producers in that
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 judg-
ment 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 infor-
mation, 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 mislead-
ing. 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 knowl-
edge that is always uncertain.
The market process rewards with profit entrepreneurs whose judg-

ments 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 com-
mand 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
beginning. Local travel evolved from horse-drawn carriages to auto-

mobiles, 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 tele-
phone 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 tend-
ing 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
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-distinc-
tion 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 dif-

ferentiation, 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 intro-
duced into the economy.
By 500 AD civilization had advanced well beyond a primitive exist-

ence, 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 hierarchi-
cal 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 eco-

nomic 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 profit-
able 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
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 suc-
cesses of profitable firms and imitate them. Thus, entrepreneurial suc-
cesses 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 judg-
ments 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-
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 mini-
mum average total cost. Thus, product differentiation results in higher-
cost 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 character-
istics 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 differ-
entiation 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 higher-
cost output. For example, if a new variant of a product is introduced
that gives purchasers higher utility than the products previously avail-
able, 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
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 prod-
ucts 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 evolu-
tion. 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 inef-
ficient. 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
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 com-
puter represented.
Why did IBM decide to go through the expense of designing, manu-

facturing 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 differ-
ent 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 well-
being 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 entre-
preneurs 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.
One way to differentiate the market process approach from the equi-
librium 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 effi-
cient 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 pro-
cess 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 optimal-
ity after the same Pareto who, according to Lange and Taylor, devel-
oped 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 wel-
fare 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 entrepre-
neurial 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,
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 preda-
tion, but beyond this, any static inefficiencies in the market alloca-
tion 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 effi-

ciency beyond the values the market places on goods and services.
Public policy toward externalities is often presented within a frame-
work where government policy corrects a market failure, but informa-
tion 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 gener-
ate 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 vol-

untary exchanges occur, welfare is enhanced because all parties agree
to the exchanges, signifying that they are better off. When govern-
ment intervenes to try to correct inefficiencies that people may per-
ceive, there is no guarantee that welfare is increased because people
are being coerced through taxation, regulation or both. The fact that
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 interven-
tion 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 maxi-
mization overlooks the fact that inefficiencies in resource allocation
present a profit opportunity for entrepreneurs. Over time, entrepre-
neurial innovation can overcome inefficiencies and generate economic
progress. Second, the static equilibrium view of welfare maximiza-
tion is overly optimistic about the prospect of government interven-
tion 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 cal-

culation is one of the features that distinguishes Austrian economics
from other schools of thought. The Austrian school's ideas on eco-
nomic 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 contrast-
ing 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
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 ration-
ally allocate resources means it can never be aggregated and known
to a single entity. The economy is a complex system in which differ-
ent 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 argu-
ments 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 pro-
vided 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 break-
up 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 econo-
mies it appeared to many that the Austrian school had more insight
into the problems of central economic planning than did the former
conventional wisdom.
The Austrian school of economics is often associated with the sup-

port 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 decen-
tralized, and is in a form that prevents it from being aggregated. The
market mechanism coordinates all this decentralized knowledge with-
out 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 pro-
duces 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 govern-
ment. 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 unde-
sirable. 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 devel-
opment 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 econom-
ics 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,
69
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 fluc-
tuations 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 bank-
ing, 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 circulat-
ing 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 inter-
est. 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
MONEY, BANKING AND BUSINESS CYCLES 71
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 bank-
ing. The theory relies on expansions and contractions of the money
supply due to fractional reserve banking, and shows that monetary-
induced 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 mone-
tary 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
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 inter-
est 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 contrac-
tion will end. Businesses will be on a sounder footing, perhaps having
delayed some potentially profitable investment due to the higher inter-
est rates during the downturn. As the economy recovers and busi-
nesses 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 increas-
ing supply of loanable funds will push down interest rates encourag-
ing more borrowing. After the economy bottoms out conditions are
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 com-
pletely 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 borrow-
ers and lenders respond to changing economic conditions.
The boom occurs because businesses make investments that in hind-

sight 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 character-
ized by malinvestment - investment that will eventually be revealed to
be unprofitable - and the bust period is the recovery in which inves-
tors 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 inevi-
tably 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 busi-
ness 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
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 con-
tract, 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 mon-
etary 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 econo-
mists 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 boom-
ing, 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
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 unilater-
ally 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 busi-
ness 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 profit-
able 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 entre-
preneur 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 opti-
mistic expectations. As the previous chapters emphasized, all entrepre-
neurial innovation is risky, and there is no way to be certain ahead of
time whether an innovation will be profitable. This uncertainty always
characterizes investments because the future trajectory of the economy

cannot be perfectly predicted. But the price and interest rate fluctua-
tions 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 invest-
ment 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 eco-
nomic conditions about as well as the economists who developed this
theory, so if the theory is descriptive of economic reality, entrepre-
neurs 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 sepa-
rate 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 partici-
pants, 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 econ-
omy was on a gold standard, and the cycles occur even when the mon-
etary base - then the amount of gold backing the money supply- does
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 differenti-

ates it from most other theories of macroeconomic fluctuations is that
the theory explicitly recognizes the heterogeneity of capital. The mal-
investments 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 disci-
ple 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. Bohm-
Bawerk described a structure of production that began with land and
labor as the original means of production, which then could be used
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 produc-

tion, 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 profit-
able 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 propor-
tionately 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 manufac-
turing 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
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 produc-

tion processes. A manufacturer can use more labor and less machin-
ery, or automate more by building machinery to substitute for labor
later in the production process, creating a more roundabout produc-
tion 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 hetero-
geneous. 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 hetero-
geneity of capital. During the expansionary phase of the cycle, interest
rates are pushed down, which makes a longer structure of produc-
tion 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.
The problems that reveal themselves during the downturn in the busi-
ness 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 sub-
stantial 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, monetar-
ist 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 down-
turn 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-
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 separat-
ing 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 prof-
itable 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 fluctua-
tions 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 produc-
tion 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.
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 sched-

ule for accounting purposes, but this will give at best a rough approxi-
mation 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 straight-

forward 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,
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 par-
ticular type of final good.
Because capital goods are durable, uncertainty about future economic

conditions makes it difficult to value capital goods. In a market econ-
omy, 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 indi-
vidual 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
$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 frame-
work 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 meas-
ured, 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 meas-
ures 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 recog-
nized as heterogeneous. Hayek (1941) grappled with issues of capi-
tal 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,
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 deter-
mines 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 allow-
ing 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 invest-

ments 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.
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 bicy-
cle factory is reconfigured to produce skateboards, it will be more prof-
itable 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 under-

utilized capital can best be deployed. For example, a skateboard manu-
facturer 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 them-
selves 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
made based on their assumptions about employment will not be real-

ized 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 surpris-
ing 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 coordina-
tion 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 entrepreneur-

ship 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 exist-
ing tensions and provides those corrections for which the unexploited
opportunities have been crying out.
As Kirzner describes it, Schumpeterian entrepreneurship disequili-

brates 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 entre-
preneurs 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 entrepre-

neurship does lend some insight into the business cycle, and more
generally, the coordination of economic activity. Schumpeterian entre-
preneurs 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 indi-
vidual plans.
The distinction is somewhat artificial because the economy is con-

stantly 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 entrepre-
neurs 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
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, unemploy-
ment will result if existing economic activities are destroyed by entre-
preneurial innovation more rapidly than Kirznerian entrepreneurs can
redeploy the displaced resources to create new opportunities. While
entrepreneurship creates the economic progress that increases peo-
ple'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 distinc-
tion. 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 fac-
tory opens to produce more skateboards, the entrepreneur who pro-
duces 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 entre-
preneur is at once Schumpeterian - destroying jobs in bicycle man-
ufacturing, 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
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 alloca-
tion 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.
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 mon-
etary 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 government-
issued 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 distin-

guishes it from other schools of thought in several ways. The Austrian
emphasis on the heterogeneous nature of capital lies at the founda-
tion of the school's macroeconomic thinking. Austrian business cycle
theory depicts business fluctuations as the result of monetary distur-
bances. The theory was developed when the world was on a gold stand-
ard, and those disturbances were the result of monetary expansions
and contractions caused by fractional reserve banking. In the twenty-
first 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 under-
take 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
incentives for the wrong types of investments. Even if market partici-

pants 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 mis-
takes 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 inevi-
table 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 exam-
ple. 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 capi-
tal 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 highest-
valued 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 compo-
nent 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
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, unemploy-
ment results as the economy adjusts to recoordinate economic activi-
ties. The Austrian approach to macroeconomic disruptions depicts
them as breakdowns in plan coordination, and macroeconomic dis-
ruptions can only be depicted this way when the framework for analy-
sis 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 repre-
sent 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 frame-
work, 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 prob-

lems that are created by monetary disturbances. This does not imply
that all macroeconomic fluctuations emanate from monetary distur-
bances. 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, regard-
less 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.
NOTES
1 Peter Lewin has done a substantial amount of work building on Lachmann's framework of hetero-
geneous 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.
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 dis-
missal 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 publi-

cation 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 deter-
mined 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 mar-
ginal revolution ushered in a major change in economic theory, and
Menger's book began the Austrian school.
95
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 Bohm-
Bawerk 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 eco-
nomic planning without market prices in 1919, followed by his pub-
lication 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
THE RESURGENCE OF THE AUSTRIAN SCHOOL 97
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 plan-
ning 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 intel-
lectual 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 mid-
twentieth century. Hayek took a position at the University of Chicago
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 cen-
tury. 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 visit-

ing 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 plan-
ning, where resources can be allocated by experts rather than being
left to the uncertainties of the market. One response to Mises's claim
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 devel-
oped 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 main-
stream, 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.
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 anal-
ysis 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 profes-
sors 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 pro-
lific, 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 aca-
demic economics, Rothbard's writing was much broader. His exten-
sive 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 promot-
ing 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 fac-

ulty 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
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 fac-
ulty 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 twenty-
first century is the one at George Mason University, which is the aca-
demic 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
might of the two sides, but by the superiority of the capitalist econo-
mies 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 pre-
dicting 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 re-
evaluate the ideas of Mises and the Austrian school, and to grudgingly
admit that Mises may have been right after all. The socialist calcula-
tion 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 interven-
tions 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
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 con-
tinue 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 pay-
ments, 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 origi-
nally established to protect the interests of US sugar interests in Cuba,
but that rationale disappeared in 1959 when Castro's revolution appro-
priated 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 origi-
nal program has been a contributing factor to the program's perpetua-
tion, 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.
Closely related is the Austrian depiction of the economy as a mecha-

nism that allows individuals to coordinate their decentralized knowl-
edge 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 macro-
economics 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 inter-
est rate do more than just affect aggregate investment, they affect the
types of investment that take place. Again emphasizing decentral-
ized knowledge, markets are required for the efficient allocation of
resources, and investors find themselves handicapped when the inter-
est rate - a market price - is altered through government interven-
tion. Manipulation of the macroeconomy through monetary and fiscal
policy tends to be destabilizing within the Austrian framework, point-
ing 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 hetero-

geneous, 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 inter-
net infrastructure, and then housing - that were later revealed to be
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 govern-
ment. 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 capi-
talist society. If people are to engage in exchange, they must have prop-
erty 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 vol-
untary 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 entrepre-
neurial individuals to look for ways to gain favorable legal treatment
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 effec-
tive 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 gov-
ernment 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 viola-
tions. How about courts? Rothbard also explains how private arbitra-
tion, 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 gov-
ernment to surrender, it would be effectively impossible to go house-
to-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 govern-
ment regulation to direct the allocation of resources leads to an ineffi-
cient outcome, so members of the Austrian school consistently support
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 gov-
ernment in the economy but this can be analysed separately from the
role of government more generally. Take an issue like income redis-
tribution, 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 productiv-
ity 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
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 para-
graph. 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 eco-
nomic 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 gov-
ernment. So, libertarian political views do not necessarily imply an
association with the Austrian school of economics, even though liber-
tarian 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.
5.7 The methodology of the Austrian school

Economic analysis has become more "scientific" throughout its his-
tory, increasingly relying on sophisticated mathematical analysis and
advanced statistical techniques. The Austrian school is much less reli-
ant 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 under-
lie 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 mar-
kets 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 indi-
vidual 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 math-
ematical 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 prob-

lem if the limitations they imply are understood, but often they are
not, and mathematical models are taken to be a realistic representa-
tion 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
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 econ-
omy. 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 frame-
work that depicts a deterministic future. The problem with mathemati-
cal 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 decentral-
ized 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 informa-
tion, so those individual decisions are unpredictable and subject to
change. The law of demand states that there is an inverse relation-
ship 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
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 mem-

bers 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 out-
side 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 skep-
tical 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 intel-
lectually 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.
Robust empirical results that hold up to many different specifications,

and that are found by many different researchers, provide better evi-
dence 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 skepti-
cism 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 sophis-
tication, the scholarly research done by members of the Austrian
school often looks less sophisticated than what appears in the lead-
ing 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 tech-
nically 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 twenty-
first century. As the Austrian school developed early in the twentieth
century and up through the 1930s, it became best known for its busi-
ness cycle theory, and for its arguments on the necessity of markets
for rational economic calculation. In both of these areas the school
had fallen out of favor by the middle of the century. Keynesian macro-
economics had eclipsed the Austrian business cycle theory, and the
consensus among economists was that the Austrian argument on eco-
nomic 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 twenty-
first century than they have been since the 1930s.
As economic analysis has advanced over the decades, it is worth con-

sidering what the Austrian school has to contribute. In a number of
areas the ideas of the Austrian school differ from mainstream eco-
nomic 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 distin-

guishes 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 pro-
gress 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 find-
ing an equilibrium set of prices and quantities but rather a discovery
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 entrepre-
neurs 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 produc-
tion 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 entre-
preneurship 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 communi-

cated among individuals, and is often uncertain. Firms are organiza-
tions 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 frame-
work. Profit is viewed as a sign of inefficiency within the neoclas-
sical 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-
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 com-
prehend the way that the process works, we cannot understand the
details because they are based on individual knowledge, and on entre-
preneurial 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 calcula-
tion 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 maxi-

mizing behavior, the Austrian school recognizes that because deci-
sions 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 avail-
able 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 profit-
able, 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.
The Austrian theory of the business cycle is another distinguish-

ing 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 calcu-
lation 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 instabil-
ity 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 distin-
guishes 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 resur-
gence since the 1970s that has continued into the twenty-first cen-
tury. 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 pro-
vided 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 Buchanan, James M . 21, 31

agglomeration economies 39-40 business cycles 69-70, 97, 104-5, 113, 116
aggregation problem 1, 52, 59, 67-8, 104, basic theory 71-3
144 causes of 74-7
allocative efficiency 64, 90, 92, 104 and entrepreneurial innovation 88-9
antitrust law 62, 65 and structure of production 79-81
Apple 8, 24, 36
arbitrage, entrepreneurship as 26-7 capital costs 56-7
Armentano, Dominick T. 6o capital goods, value of 32, 48, 82-4, 92
Arthur, W. Brian 6o capital markets 82-4, 86, 92, 105
Auburn University 101 capital redeployment 81, 86-9
Austrian Institute of Economic Research capital stock 82-5
96 capital structure 77-81
Austrian School capitalism s-6, 25, 67, 102-5
ideology 107-8 Carnegie, Andrew 36
methodology 109-12 central banks, control of monetary base
in mid-twentieth century 97-9 74. 77. 91-3
resurgence of 99-102 central economic planning s-6, 46-51,
rise of 95-7 66-8, 83, 109-10
automated production processes 24, 36, and complex systems 52-4
79 demise of 101-2
automobile production process 24, 27, impact of mixed economy 54-5
36,78-9 see also socialist calculation debate
Chicago schoolw8
Baetjer, Howard 94 Cold War 101-2
baking analogy 22-3, 30-31 collective ownership 46-7
banks comparative advantage 41
causes of investment errors 74-7 competition 19-21, 63
responses to economic conditions 71-7 Competition and Entrepreneurship
see also central banks (Kirzner) 100
biological evolution s8-6o, 62 competitive equilibrium 11, 21, 42
Boettke, Peter J. 68 complex systems 52-5, 67-8, 76, 102-3,
Bohm-Bawerk, Eugen 77-9, 96 107-11, 115
borrowers computer industry 24, 34, 36, 38-9, 62-3
causes of investment errors 74-7 consumer choice 61
responses to economic conditions 71-7 consumer surplus 63
Boudreaux, Donald J. 24 contingency planning 9-10, 14
121
continuous innovation 6o-62 and economic progress 40, 44-5,

contradictory information 1, 7, 14-15, 21, 50-51, 53, 55-S, 109
35, 51-3, 110 Schumpeterian and Kirznerian S7-9
Cordato, Roy E. 65 equilibrating forces S7-9
cost and price 31-2 equilibrium
cost, subjective nature of 17-1S as absence of unexploited profit
creative destruction 21, S7-9 opportunities 11
credit cards 5, 91 as coordination of individual plans
crowding out 29 9-10
equilibrium prices 6, 9, 11-14, 20, 43-4,
decentralized knowledge 52 49-51, 57-9, 67, 104
decentralized planning, and spontaneous exact coordination 10
order 2-6 externalities 65
Desrochers, Pierre 39
deterministic models 53-4, 6o, 109-10 fatal conceit 54-5, 110
discovery process S, 12-14, 51, 113-14 fiat money 71, 90-91
disequilibrating forces, entrepreneurs as final goods, value of 17-1S, 31-2, 4S, S2-3
S7-9 firms
disequilibrium prices 12-13, 20, 42-4, 64 entrepreneurial nature of 24-6
division of capital S4-5 geographical proximity 39-40
division of knowledge and supply chain impact of size on knowledge base 42
37-S, 40 as repositories of knowledge 40-42
Dolan, Edwin G. 101 flexible plans 10, 22, S6-7
dot-com bubble 92, 104-5, 113 Ford, Henry 24, 36
Dutch East India Company 4-5 Foss, Nicolai J. 25-6, 40
fractional reserve banking 70-74, 91
economic conditions 1-2, 7-14,21, 26-7 free banking 90-91
bank and borrower responses 71-7 Friedman, Milton 9S, 1oS
economic coordination and knowledge
6-9 Garrison, Roger W. S1
economic evolution 11, 25-6, 5S-6o, 62 Gates, Bill 36
economic progress 23-6, S9, 110 general equilibrium models 1-2, 15, 1S-19,
and business cycles S9 30, 49-51, 53, 69, So, 109-10, 115
and entrepreneurship 40, 44-5, 50-51, George Mason University, Center for
53, 55-S, 109 Market Processes 101
and innovation 36-7 German historical school 96
and product differentiation 6o-62 gold standard 70-71, 73-4, 76-7, 90-91
profit as indicator of 29-30, 62-4 goods of the first order 17, 31-2
and welfare maximization 64-6 government
economic selection 2S-9, 59-60 control of monetary base 74, 77, 93
Elements ofPure Economics (Walras) 95 role in economy 54, 66, 105-S
employment 72, S6-9 unintended consequences of
entrepreneurial judgment 15-16, 25-6, 2S, intervention 29-30, 47, 54-5,
34, 52-3, 56-7, 6o, S3 65-6, 102-3, 1oS
entrepreneurial nature of firms 24-6 government mandates 30
entrepreneurship graphical user interface 36
as arbitrage 26-7 Great Depression So, 97
INDEX 123
Harper, David A. 2S, 55, 101 information asymmetries 65

Hayek, Friedrich A. innovation
and business cycle theory 69, 79 effects of S7-9, 93
contribution to Austrian school 96-S incentives for 2S, 36-7, 42-3, 45-7, 51,
on economic equilibrium 9-11, S5 59-60, 7S-9, 105-7
on knowledge and economic and invention 35-7
coordination 7-S, 35, 39, 44, 51 inputs
on role of government 105, 1oS cost of 24, 27-S, 31-4, 43
and socialist calculation debate 54-5, optimal mix 22-4
110 substitution 13-14, 23-4, 33
Herbener, Jeffrey M. 65-6 and supply chain 37-S, 41
heterogeneous capital 77-S2, S4-5, 92-3, value of 17-1S, 27-S, 32-3
104, 116 interest rates
higher-cost output and product effect on investment type 77-9
differentiation 61-2 fluctuations 71-3, 75-6, So-S1, S4,
higher-order goods 17, 32 91-3
Holcombe, Randall G. 24, 33, 6o-61 manipulation of 104
homogeneity 19, 22-3, 61, 77, 79, S5, 92, international exchange market trading 27
116 invention and innovation 35-7
Horwitz, Steven 44, So investment
housing bubble 92-3, 104-5, 113 causes of errors 74-7
Human Action (Mises) 47-S, 9S, 100 see also malinvestment
invisible hand 6, 2S
IBM 62-3 iPhone S
ideology 107-S
Ikeda, Sanford 51, 54-5, 65, 103, 1oS Jevons, William Stanley 95
imitation 40, 45, 6o, 63 Jobs, Steve 36
incentives
knowledge sharing 45 Keynesian economics 69, So, 97, 113
price changes 42-3 Kirzner, Israel M. u, 25-6, 37, 45
profit and loss as 2S, 36-7, 59-60 contribution to Austrian school
and rule oflaw 105-6 99-101,113
and taxation 107 Kirznerian entrepreneurship S7-9, 94
under socialism 46-7, 51 Klein, Peter G. 25-6, 33
income growth 57-S knowledge 1-2, S, 32-5, 37-S, 56
income redistribution 107-S and agglomeration economies 39-40
incomplete information 1, 7-S, 14-15, aggregation problem 1, 52, 59, 67-S,
33-5, 52-3, no, 114 104,144
individual action, and utility 1S-19 and economic coordination 6-9,51-2,
individual plans, coordination of 3, 6, 55,104, 110
9-11, S7-S, 115-16 firms as repositories of 40-42
individual preferences 1, S, 14-15, 19, 21, and supply chain 37-S
47, 53, S1, S4, 109 see also decentralized knowledge
individual price levels, changes in S9-90 Kahn, Meir 21
Industrial Revolution 5, 36, 59
inflation S9-91 Lachmann, Ludwig M. 5S-9, S4, 1oo-1o1
information 32-5 laissez-faire policies 6S
Lange, Oskar 49-50, 57, 64, 67 mixed economy, dynamics of 54-5

Langlois, Richard N. 33, 45 monetarism 69, So
language development 2 monetary base 70-71, 73-4, 76-7, 90-91
Lerner, Abba 49-50, 67 money, and spontaneous order 3-4
Lewin, Peter 9, 84-5, 94 money supply
libertarian politics 106-8 fluctuations 69, 71-4, 76-7, So-81,
London School of Economics 96-7 90-91,116
loss leaders 43 and fractional reserve banking 70-71
Ludwig von Mises Institute 101 monopoly power 62-4
mainstream economics 18-19, 70, 96-7, national defense 106

99, 102, 113 natural price 31
malinvestment 73, 85-6, 92-3, 104-5, 116 neoclassical economics 11, 18-19, 42-3,
and capital structure 77-81 59, 114
causes of 74-7 New York University 98-101
Man, Economy and State (Rothbard) 100
management function 24, 26, 37, 44 O'Driscoll, Gerald P. 9-10, 53, 59
management knowledge 7, 39, 43 opportunity costs 30-31, 56
marginal revolution 95
market failure 54, 65 Pareto optimality 64
market institutions 4-6, 55, 106 path-dependency 6o
market mechanism 2, 6, 8-10, 19, 21, 44, pattern coordination 10
52-4, 67-8, 85, 99, 104, 1o6, 113-15 pencils, production of 13-14
market price 19-20, 31-2, 42-3 Penrose, Edith 35
as source of information 12, 32-3, perfect information 11, 19-20, 34-5
46-50, 55, 65 Phelan, Steven E. 94
market rewards 8, 27-9, 31, 52-3, 57, police protection 106
59-60 political institutions, connection with
market socialism 50-51 economic institutions 107-8
market value 12-14, 82-3 Pongracic, Ivan Jr. 45
market-clearing 6, 9,11-14, 20,43-4, price and cost 31-2
50-51, 57-9, 67, 104 price signals 32-3, 49
Marshall, Alfred 31, 58 distortion of 75-6, So-81, 85, 91-2,
Marx, Karl46-7, 68 105,116
mathematical models 109-10 erosion of 65
Menger, Carl4, 16, 31-2, 77,95-6 price-takers 19-20
mentoring 7, 39 prices, searching for 42-4
methodology 109-12 Principles ofEconomics (Menger) 16-17,
Microsoft 36 95
Mises, Ludwig von private ownership 48
and business cycle theory 70-71, 73-4 product characteristics 20-21, 32-3
contribution to Austrian school improvements in 23-5, 28, 37, 56-7,
97-100, 113 60-61
on inflation 90 product differentiation 20, 59, 114
and socialist calculation debate 46-8, and economic progress 60-62, 115
51, 66-9, 96, 98-9, 102, 104-5, product substitution 13-14, 19, 77
109,115 production costs and price 31-2
INDEX 125
production function 20, 22-5, 32, 37, 114 Social Security programs 102-3
production structure Socialism (Mises) 46, 96
and business cycles 79-S1 socialist calculation debate 66-S, 92,
and interest rates 77-9 g6-g, 102, 109-10, 115
professional basketball players 1S, 32 Austrian school in 50-51
profit and loss S, 27-9, 31, 52-3, 57, 59-60 Ludwig von Mises on 46-S
profit opportunities socialists answer to Mises 4S-5o
discovery of 24-S South Royalton conference (1974)
role of information, knowledge and 100-101
wisdom 32-5, 37 Soviet Union
unexploited opportunities and central economic planning 4S, 67,
equilibrium u gS-g
profits demise of 5,101-2,113
competed away 27, 40-41, 45, 63 specialization
as indicator of economic progress benefits of 3-5, 3S, 40-42
29-30,62-4 and division of capitalS4-5
maximization and opportunity costs spontaneous order 2-6
30-31 static equilibrium 19, 61-2, 64-6
property rights 65, 105-6 statistical analysis uo-12
public choice 4 7 stock markets
bubbles and crashes 69, So
Read, Leonard E. 13 development of 4-5
Reisman, George 51, 102, 1oS market process 20, S3
replication 59-60 subjectivism 16-1S, 31-2, 4S, 53, 6o, 65
research and development 36-7 subsidies 29
return on capital S5 sugar program 103
Richardson, G.B. 34, 3S supply and demand 1-2, 6-7, 9-10, 12,
Rizzo, Mario J. 9-10, 53, 59, 101 31-2, 43-4, 49, 51, 67, 71
Road to Serfdom (Hayek) 97 supply chain 37-S, 41
Robertson, Paul L. 45
Rothbard, Murray N. 65, 6S, So, 106 tacit knowledge 7-9, 13-14, 41-3, 45,
contribution to Austrian school 51-2, 57, 59, 67, S3, 104, no, 114
99-101, 113 and agglomeration economies 39-40
roundabout production methods 7S-9 taxation 29-30, 66-7, 103, 107
rule oflaw 105-6 Taylor, Fred M. 49-50, 57, 64, 67
technological advances, and interest rate
Sautet, Frederic E. 40, 42 changes S1
scarcity and subjective value 16-17 Teece, David J. 34
Schumpeter, Joseph A. 21, 25-6, 35-6 Theory ofMoney and Credit (Mises)
Schumpeterian entrepreneurship S7-9, 69-71, go, 96
93-4 Theory ofPolitical Economy (Jevons)
scientific knowledge 7, 36, 39 95
Selgin, George 90 time 10, 14-17, 26-7, 34, 61
Silicon Valley 40 time preferences S1
Smith, Adam 6, 2S, 31, 3S, S5 tradable goods 3-4
social interaction and spontaneous order trading ships, financing 4-5
3 transaction costs 40
un1brellas12-13,16 Vaughn, Karen I. 100

uncertainty 7-9, 15, 25, 28, 33-4, 53-4, von Weiser, Friedrich 96
s6-7, 6o, 82-3, 115
unen1ployn1ent 72, 86-9 Wagner, Richard E. 3, 54
University of Chicago 97-8 Walras, Leon 95
University of Vienna 96 water 16-17
us welfare n1axin1ization, process versus
econon1ic progress 57-8 outcon1e 64-6
Social Security progran1102-3 whiskey production process 78
sugar progran1 103 White, Lawrence 90
utility 16-19, 32, 61, 95, 109, 115 willingness to pay 16-18, 30, 34,
62-3
value added 8, 27-8, 30, 38, 52-3, 57-8, wisdon1 33-5
61-5 Witt, Ulrich 35
value, subjective nature of 16-18, 32, 48,
6s Xerox36

(Elgar Advanced Introductions Series) Randall G. Holcombe-Advanced Introduction To The Austrian School of Economics-Edward Elgar Pub (2014)

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(Elgar Advanced Introductions Series) Randall G. Holcombe-Advanced Introduction To The Austrian School of Economics-Edward Elgar Pub (2014)

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Elgar Advanced Introductions are stimulating and thoughtful introductions

The aims of the series are two-fold: to pinpoint essential principles of a

Titles in the series include:

International Political Economy International Conflict and Security Law

The Austrian School of Economics Comparative Constitutional Law

Elgar Advanced Introductions

All rights reserved. No part of this publication may be reproduced,

Edward Elgar Publishing, Inc.

A catalogue record for this book

Library of Congress Control Number: 2013958020

ISBN 978 1 78195 573 4 (cased)

Typeset by Servis Filmsetting Ltd, Stockport, Cheshire

The market process 1

2 Decentralized knowledge: the role of firms and markets 22

4 Money, banking and business cycles 69

5 The resurgence of the Austrian school 95

The Austrian school of economics, nearly extinct in the middle of the

A school of thought is defined by the ideas of its members, and there is

half of the twentieth century, Milton Friedman gave an after-dinner

In keeping with Friedman's advice, all of the ideas I have included in

My own introduction to the Austrian school came when I was a gradu-

As an introduction to the Austrian school, this book is aimed at those

and ideas. The volume is "advanced" because it assumes that read-

I gratefully acknowledge the comments of those who have read all or

Economic analysis, as it has developed through the twentieth century

The Austrian approach to economic analysis recognizes that there are

Conceivably, if the knowledge base of all market participants remained

Austrian school economists do refer to equilibrium concepts, but

1.1 Spontaneous order

and efficient outcome without anyone planning it out, or even being

Spontaneous order emerges in many social activities, both within

Money is another result of human action but not of human design. In

Some goods are naturally more acceptable in exchange than others

The market economy is itself a spontaneous order: the result of human

One example is the development of stock markets to facilitate financ-

To deal with the risk, a group of individuals in Amsterdam got together

Innovations that facilitate market exchange continually happen that

The market economy that has produced such a profound increase

to be more critical of resource allocation through government plan-

The most significant lesson economics has to offer is that people's

A comparison of the outcomes of the centrally planned socialist econ-

1.2 Knowledge and economic coordination

The main function of a market economy is to coordinate the economic

Taking a longer view of the economic process, economic conditions

Much of the knowledge people have is tacit knowledge, which means

Tacit knowledge is possessed by everyone in the economy, not just

successful in that line of business. Often, what would make a desir-

Not only is knowledge often decentralized and tacit, people with

In the face of this type of uncertainty, and with decentralized and

In an economy where underlying conditions are unchanging -

allocating resources would be almost trivial. Prices of goods for which

1.3 Equilibrium: the coordination of individual plans

Hayek (1937 [1949]) depicts economic equilibrium as the coordination

Everyone recognizes that the future is uncertain, so they make plans

unforeseen changes in circumstances, prefer to call the coordination

When the passage of time is considered in this way, equilibrium

Equilibrium seems to imply a determinate outcome toward which the

1.4 Equilibrium: the absence of unexploited profit

Kirzner (1973) depicts equilibrium as the absence of unexploited

Hayek and Kirzner are both prominent Austrian school economists,

Hayek's idea of equilibrium as the coordination of individual plans

1.5 The market as a discovery process

People interact with each other in markets by exchanging goods and