If you carry the popular impression that data-hungry economists are always busy with complex formulas and not with outside-the-box thinking then you should take a look at the Austrian school. Just like monks living in their monastery, the economists of this school strive to solve complex economic issues by conducting "thought experiments." The Austrian school believes that it is possible to discover the truth simply by thinking aloud. Interestingly, this group does have unique insights into some of the most important economic issues of our times. Read on to find out how the Austrian school of economics has evolved and where the Austrian school stands in the world or economic thought.

An Overview of the Austrian School
What we know today as the Austrian school of economics was not made in a day. This school has gone through years of evolution in which the wisdom of one generation was passed on to the next. Though the school has progressed, and incorporated knowledge from outside sources, the core principles remain the same.

Carl Menger, an Austrian economist, who wrote "Principles of Economics" in 1871, is considered by many to be the founder of the Austrian School. The title of Menger's book suggests nothing extraordinary, but its contents became one of the pillars of marginalist revolution. Menger explained in his book that the economic values of goods and services are subjective in nature. That is: what is valuable for you may not be valuable for your neighbor. Menger further explained that with an increase in the number of goods, their subjective value for an individual diminishes. This valuable insight lies behind the concept of what is called diminishing marginal utility.

Later on, Ludwig von Mises, another great thinker of the Austrian School, applied the theory of marginal utility to money in his book "Theory of Money and Credit" (1912). The theory of diminishing marginal utility of money may in fact help us in finding an answer to one of the most basic questions of economics: how much money is too much? Here also, the answer would be subjective. One more extra dollar in the hands of a billionaire would hardly make any difference although the same dollar would be invaluable in the hands of a pauper.

Other than Carl Menger and Ludwig von Mises, the Austrian school also includes other big names like Eugen von Bohm-Bawerk, Friedrich Hayek and many others. Today's Austrian school is not merely confined to Vienna but its influence spreads across the world.

Over the years, the basic principles of the Austrian school have given rise to valuable insights into numerous economic issues like the laws of supply and demand, the cause of inflation, theory of money creation, and operation of foreign exchange rates. On each of the issues, the views of Austrian school tend to differ from other schools of economics.

Main Ideas and Key Differences
Some of the main ideas of the Austrian school and their differences with other schools of economics are examined below:

  • Methodology
    The Austrian school uses logic of a priori thinking - something that a person can think on his/her own without relying on the outside world - to find out economic laws of universal application, whereas other mainstream schools of economics, like the neoclassical school, the new Keynesians and others, make use of data and mathematical models to prove their point objectively. In this respect, the Austrian school can be more specifically contrasted with the German historical school that rejects universal application of any economic theorem.
  • What determines the price?
    The Austrian school holds that prices are determined by subjective factors like an individual's preference to buy or not to buy a particular good, whereas the classical school of economics holds that objective costs of production determine the price and the neo classical school holds that prices are determined by the equilibrium of demand and supply. Austrian school rejects both the classical and neo classical views by saying that costs of production are also determined by subjective factors based on value of alternative uses of scarce resources, and the equilibrium of demand and supply is also determined by subjective individual preferences.
  • What determines interest rates?
    The Austrian school rejects the classical view of capital which says that interest rates are determined by supply and demand of capital. Austrian school holds that interest rates are determined by subjective decision of individuals to spend money now or in future. In other words, interest rates are determined by the time preference of borrowers and lenders.
  • Why does inflation affect different people differently?
    The Austrian school believes that any increase in money supply that is not supported by an increase in the production of goods and services leads to an increase in prices, but the prices of all goods do not increase simultaneously. Prices of some goods may increases faster than others, leading to greater disparity in the relative prices of goods. For example, Peter the plumber may discover that he is earning the same dollars for his work, yet he has to pay more to Paul the baker, when buying the same loaf of bread. The changes in relative prices would make Paul rich at the cost of Peter. But why does it happen like that? If the prices of all goods and services were to increase simultaneously then it would have had hardly mattered. But the prices of those goods through which the money is injected into the system adjust before other prices; say if the government is injecting money by purchasing corn then the prices of corn would increase before other goods leaving behind a trail of price distortion.
  • What causes business cycles?
    The Austrian school holds that business cycles are caused by distortion in interest rates due to the government's attempt to control money. Misallocation of capital takes place if the interest rates are kept artificially low or high by the intervention of the government. Ultimately, the economy goes through recession in order to restore the natural progress.
  • How do we create markets?
    The Austrian school views the market mechanism as a process and not an outcome of design. People create markets by their intention to better their lives, not by any conscious decision. So, if you leave a bunch of amateurs on a deserted island, sooner or later their interactions would lead to the creation of a market mechanism.

The Bottom Line
The economic theory of the Austrian school is grounded in verbal logic which provides a relief from the technical mumbo jumbo of mainstream economics. There are considerable differences with other schools, but by providing unique insights into some of the most complex economic issues, the Austrian school has earned a permanent place in the complex world of economic theory.

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