Critique of a Version of Austrian Economics

In December of 2021 I had an online debate with Walter Block comparing the approaches to economics associated with the Chicago and Austrian schools. When I asked him what version of Austrian economics he wanted to defend he pointed me at Man, Economy and State by Murray Rothbard. This post deals with that version of Austrian economics.

There are others.

Two Approaches to Doing Economics

Rothbard starts with an axiom from Ludwig von Mises: Human action is purposive behavior, the first sentence of chapter 1 of his Human Action. I start by defining economics as that way of understanding behavior that starts from the assumption that individuals have objectives and tend to choose the correct way to achieve them, the third paragraph of Chapter 1 of my Price Theory. The wording is different, the idea very nearly the same. The two approaches share many theoretical tools, differ in how they derive and use them.

The Chicago approach, as I understand it, is to use the theoretical structure to form a conjecture, something we think likely but not certain to be true, and test it against real world evidence. An example is the claim that increasing the minimum wage reduces the demand for the sort of labor that receives it. We expect that to be true because increasing the cost of an input normally makes it in the interest of firms to use less of it. To test the conjecture we look for occasions when the minimum wage rate increased substantially and nothing else relevant was changing and see what happened to employment in labor markets that consist largely of low paid labor, such as teen-aged workers. If it decreased, that is evidence in favor of our conjecture.

What if it didn’t? That might be because we missed something else important that was changing at the same time or looked at the wrong segment of the labor market. It might be because the conjecture was false due to a mistake in our logic, perhaps factual assumptions implicit in our argument not true of the situation we were looking at.

That is the Chicago approach: Form conjectures based on economic theory, test the conjectures against the real world, confirm or revise them accordingly. Accept that you are, at best, coming up with good reasons to believe something, not certainty.

The approach portrayed by Rothbard in Man, Economy and State is simpler. Deduce a theoretical structure from axioms with certainty. Use that structure to derive conclusions about the real world with certainty. There is no need to test the conclusions since you know they are true; real world facts may provide useful illustrations of your conclusions but cannot contradict them.

The problem is that it cannot be done; there are no real-world conclusions that can be deduced with certainty from economic theory alone. Since the theory does not tell us what people’s objectives are,¹ any action could be purposive behavior. “Why am I standing on my head on the table with a burning thousand-dollar bill between my toes? Because I want to stand on my head on the table with a burning thousand-dollar bill between my toes.”

Consider again the case of a minimum wage law. Imagine a world where most consumers have a strong aversion to buying things made by workers receiving a low wage, so strong that they will not buy such goods unless they are sure the workers are making at least ten dollars an hour. Further assume that the process by which goods get from the original producers to the consumers is sufficiently complicated so that  a seller cannot prove to his customers what wages were paid to the workers who produced the goods he sells. In that world, absent a minimum wage law, consumers avoid goods produced with the use of unskilled labor. Impose a minimum wage law and the demand for goods produced by unskilled labor goes up, as does the employment of workers who make such goods.

That case depends on the actors having objectives that are implausible but not impossible. For a less exotic example, imagine an economy where the employers of unskilled labor are monopsonies, each the only employer of unskilled labor in its town, and where workers are reluctant to move to a different town for higher wages. Just as a monopoly finds it in its interest to hold down the amount it produces in order to hold up the price it receives, a monopsony finds it in its interest to hold down the amount it purchases in order to hold down the price it must pay. Even if the marginal revenue product, the increase in the firm’s income from hiring another worker, is ten dollars an hour, the firm may be better off paying only eight. It loses out on the opportunity to make money on the additional workers it could hire at ten but doing so would raise its costs by two dollars an hour on the labor it is already hiring. Impose a ten dollar minimum wage and the firm no longer has an incentive to hold down its hiring in order to hold wages down, so doesn’t. Employment of unskilled workers goes up instead of down.

This is a better example than my first because it depends not on an objective invented for the purpose but on a set of facts that, while implausible in the U.S. in the twenty-first century, could easily enough exist in another place and time.

The solution to the limited power of economic theory is to combine it with knowledge about the real world and then test the conclusions. I do not know with certainty what objectives other humans have but, being myself a human and having observed other humans, I know that they are unlikely to include a strong desire to dramatically burn thousand-dollar bills. I am a little less confident that they do not include a preference to buy only goods produced by well paid workers but if such a preference were common I think I would have noticed. I do not know what all labor markets are like in all times and places but in the modern American economy I observe that unskilled workers are employed in multiple industries, that each industry consists of multiple firms, and that workers move from one place to another in response to higher wages. Hence I have good reason, although reason short of certainty, to expect that increasing the minimum wage rate will reduce employment opportunities for the sort of people who get paid minimum wage.

When you have good reason short of certainty to believe something the obvious thing to do is to find ways of testing it. If the evidence supports your conjecture you now have an even better reason to believe it. If not, perhaps you should think through the argument that led you to your conclusion more carefully.

False Proofs

Thus, if no units of a good (whatever the good may be) are available, the first unit will satisfy the most urgent wants that such a good is capable of satisfying. If to this supply of one unit is added a second unit, the latter will fulfill the most urgent wants remaining, but these will be less urgent than the ones the first fulfilled. Therefore, the value of the second unit to the actor will be less than the value of the first unit. Similarly, the value of the third unit of the supply (added to a stock of two units) will be less than the value of the second unit. … Thus, for all human actions, as the quantity of the supply (stock) of a good increases, the utility (value) of each additional unit decreases. (p. 24²)

This is Rothbard’s proof of the principle of declining marginal utility. To see why it is wrong, consider tires for my car. The marginal utility of the third tire, the benefit of having three tires instead of two, is less, not more, than the marginal utility of the fourth tire. Rothbard’s proof works as long as each unit is used for a different and unrelated purpose, since you rationally choose to achieve the most important purposes first. It breaks down any time having the earlier units makes it possible to use later units in ways they before could not have been used.

Rothbard responds to this argument, using eggs instead of tires:

It is possible that a man needs four eggs to bake a cake. In that case, the second egg may be used for a less urgent use than the first egg, and the third egg for a less urgent use than the second. However, since the fourth egg allows a cake to be produced that would not otherwise be available, the marginal utility of the fourth egg is greater than that of the third egg.

This argument neglects the fact that a “good” is not the physical material, but any material whatever of which the units will constitute an equally serviceable supply. Since the fourth egg is not equally serviceable and interchangeable with the first egg, the two eggs are not units of the same supply, and therefore the law of marginal utility does not apply to this case at all. To treat eggs in this case as homogeneous units of one good, it would be necessary to consider each set of four eggs as a unit. (pp. 73-4)

The fourth egg is not equally serviceable with the first because having the first three eggs increases the options for the fourth — it can be used to make a cake. The second glass of water is not equally serviceable with the first because it is not needed to quench my thirst. The fact that possession of earlier units changes what later units can be used for is what makes marginal utility decline — or, in the case of eggs and tires, increase.

Later in the book, Rothbard writes:

This individual has, of necessity, a diminishing marginal utility of money, so that each additional unit of money acquired ranks lower on his value scale. This is necessarily true.

It is not true if the best use of the money happens, in his example, to be buying eggs, since the money that lets him buy the fourth egg is worth more than the money that lets him buy the first, second, and third. To avoid that conclusion he would have to consider a sum of money that will buy four eggs not as more money than a sum smaller by the price of one egg but as an entirely different good.

Rothbard offers a parallel argument for the declining marginal utility of leisure.

Leisure, like any other good, is subject to the law of marginal utility. The first unit of leisure satisfies a most urgently felt desire; the next unit serves a less highly valued end; the third unit a still less highly valued end, etc. The marginal utility of leisure decreases as the supply increases (p. 45)

Again, this assumes that the first hour satisfies one desire, the second another and unrelated desire, and so on. But suppose what I want to do with my leisure is to play a video game that takes two hours to complete. Quitting half-way through is frustrating, so the value to me of two hours instead of one is greater than the value of one hour instead of none. Rothbard might argue, along the lines of the previous quote, that the unit of leisure is now two hours — but that is a claim about the marginal utility of plays of the video game not of time spent playing it. And it might not be true for the game — it could be more fun the second time I play it.

Another and different error:

A fundamental and constant truth about human action is that man prefers his end to be achieved in the shortest possible time. Given the specific satisfaction, the sooner it arrives, the better. This results from the fact that time is always scarce, and a means to be economized. The sooner any end is attained, the better. (p. 15)

The third sentence, which I have italicized, is Rothbard’s proof that time preference is always positive, that faced with the choice between a pleasure now or the identical pleasure in the future you will always prefer the pleasure now. It confuses two different senses in which one uses time. Using an hour for labor means you have one less hour for leisure. But whether I have an ice cream cone now or this time tomorrow, I will have the same twenty-four hours available to divide among labor, leisure, and sleep. Labor uses up scarce time. Leisure uses up scarce time. Delaying a pleasure does not use up scarce time. If time preference is always positive that is an observed fact of human psychology not a deduction from the fact that time is scarce.

A second argument for why time preference must always be positive comes from Ludwig Von Mises, a major influence on Rothbard:

If he were not to prefer satisfaction in a nearer period of the future to that in a remoter period, he would never consume and so satisfy wants. He would always accumulate, he would never consume and enjoy. He would not consume today, but he would not consume tomorrow either, as the morrow would confront him with the same alternatives (Human Action p. 484)

Suppose I have neutral time preference, am indifferent between a pleasure now and a pleasure next year. If I spent all my money next year and none this year, the pleasure I would get from a dollar spent next year would be much less than from a dollar this year, due to declining marginal utility. I would instead divide my income equally between this year and next year, assuming the opportunities to get value by spending money were the same in each year. Expand the argument to N years and I spread my expenditure out evenly across them.

Next suppose I have negative time preference: I prefer a pleasure next year to the same pleasure this year. I will spend more of my money next year than this year but not all of it, again because of declining marginal utility. A dollar spent next year, when I am spending lots of dollars, gets me a rib eye steak instead of a sirloin steak. A dollar spent this year gets me hamburger instead of baked beans. I prefer a pleasure in the future to an equal pleasure in the present but a dollar of present consumption produces more pleasure than a dollar of future consumption. Expand the argument to N years and my expenditure rises year by year by just enough so that the declining marginal utility balances the negative time preference.

Hence Mises’ claim is false.

In a variant of the same argument, applied to investment rather than saving, Rothbard writes:

It is obvious that the factor which holds every man back from investing more and more of his land and labor in capital goods is his time preference for present goods.

Even if a man had an unlimited ability to get a return on investments of unlimited length, shifting consumption from the present to the future would raise the marginal utility of present consumption, lower that of future consumption, so he would only invest until the utility of a unit of current consumption is just equal to the present utility of the larger number of units of future consumption that he would get by investing that unit.

Missing Tools

Rejecting the usual mathematical presentation of economics, where demand, supply and utility are all treated as continuous functions, Rothbard writes:

Such a treatment is fallacious and misleading, however, since human action must treat all matters only in terms of discrete steps  … It is this mistaken substitution of mathematical elegance for the realities of human action that lends a seeming importance to the concept of “elasticity of supply,” comparable to the concept of elasticity of demand. (Fn27)

Many goods are continuous. You can buy a gallon of water, two gallons, but also 1.436 gallons. You can work for an hour, two hours, 1.32 hours. Time is continuous and we are often interested in demand and supply in terms of rates of production or consumption. Hence it makes sense to treat demand and supply curves in the general case as continuous functions of price, lumpy goods as a special case. Rothbard instead insists on treating all choice in terms of number, not quantity.

Contrary to Rothbard’s claim, elasticity of supply is a useful concept for the same reasons elasticity of demand is. It plays the same role in the ability of a monopsonist to profit by reducing how much he buys that elasticity of demand plays in the ability of a monopolist to profit by reducing how much he sells. Further …

Rothbard writes:

An income tax cannot be shifted to anyone else. The taxpayer himself bears the burden. He earns profits from entrepreneurial activity, interest from time preference, and other income from marginal productivity, and none can be increased to cover the tax. Income taxation reduces every taxpayer’s money income and real income, and hence his standard of living. His income from working is more expensive, and leisure cheaper, so that he will tend to work less. (p. 1164)

If a tax on the income of doctors results in doctors working less that pushes up the price of medical services, pushes up the wages of doctors, hence some of the burden is born by consumers of medical services in higher prices, some by doctors in lower after tax income. If the supply of physicians’ services is perfectly inelastic or the demand perfectly elastic the burden of the tax is born entirely by the physicians. In less extreme cases the division of tax burden between buyer and seller is determined by the relative elasticities of supply and demand. Not only is Rothbard’s claim false, correcting it uses the tool that he claims to be of no importance.

Judging Outcomes

Rothbard writes:

We simply conclude that the relative extent of areas within or between firms on the free market will be precisely that proportion most conducive to the well-being of consumers and producers alike. (p. 65)

And

As a result, any existing situation on the free market will tend to be the most desirable for the satisfaction of consumers’ demands (including herein the nonmonetary wishes of the producers). (p. 645)

What do those statements mean? A different arrangement would make some consumers and some producers better off — a steel tariff, for example, might make steel workers better off — so for this statement to be meaningful you need some way of adding up costs and benefits across people. The solution in neoclassical economics is economic efficiency, variously justified by arguments from Marshall, Pareto, or Hicks and Kaldor. Rothbard offers nothing along those lines.

There are arguments against the concept of economic efficiency, discussed in an earlier post. But without economic efficiency or some similar concept many of the things Rothbard writes, such as the two quotes above, are meaningless. It becomes impossible to answer important questions economists are asked, such as whether minimum wage laws or tariffs are a good or bad thing.

Rothbard’s response is found not in Man, Economy and State but in “Toward a Reconstruction of Utility and Welfare Economics.” For example:

But what about Reder’s bogey: the envious man who hates the benefits of others? To the extent that he himself has participated in the market, to that extent he reveals that he likes and benefits from the market. And we are not interested in his opinions about the exchanges made by others, since his preferences are not demonstrated through action and are therefore irrelevant. How do we know that this hypothetical envious one loses in utility because of the exchanges of others? Consulting his verbal opinions does not suffice, for his proclaimed envy might be a joke or a literary game or a deliberate lie. We are led inexorably, then, to the conclusion that the processes of the free market always lead to a gain in social utility. And we can say this with absolute validity as economists, without engaging in ethical judgments.

He is trying to avoid the problem of interpersonal comparison with a unanimity rule; “X leads to a gain in social utility” means “X makes everyone better off.” Since he cannot prove that everyone is better off with the free market he redefines “is better off” to mean “cannot be proved with certainty by a priori arguments to be worse off.”

Monopoly

If the consumers were really opposed to the cartel action, and if the resulting exchanges really hurt them, they would boycott the “monopolistic” firm or firms, they would lower their purchasing so that the demand curve became elastic, and the firm would be forced to increase its production and reduce its price again. (p. 635)

This is supposed to show that cartel pricing cannot make consumers worse off. The argument assumes that members of a group will act in the group interest even if each individual knows that his action by itself will make him worse off.

Yet Rothbard also writes:

The “problem” of “oligopsony”—a “few” buyers of labor—is a pseudo problem. As long as there is no monopsony, competing employers will tend to drive up wage rates until they equal their DMVPs.

If consumers always act in their group interest, why won’t employers do the same?

In the course of a long discussion of monopoly, Rothbard repeatedly puts the argument he claims to be rebutting in terms of  morality:

The producers, other things being equal, are attempting to maximize the monetary income from their factors of production. This is no more immoral than any other attempt to maximize monetary income. (p. 634)

He never mentions the conventional economic argument against monopoly, that the monopolist’s gain from charging more than the competitive price is less than the consumers’ loss, hence we would be on net better off if the monopolist charged the lower price. It has nothing to do with morality.

Rothbard writes:

The answer is: Of course, consumers would prefer lower prices; they always would. In fact, the lower the price, the more they would like it. Does this mean that the ideal price is zero, or close to zero, for all goods, because this would represent the greatest degree of producers’ sacrifice to consumers’ wishes?

In Summary

As I think I have shown, Rothbard’s version of economics cannot prove the things he claims. It does not imply declining marginal utility of either consumption or leisure nor positive time preference, tools Rothbard uses in his arguments. It does not provide any way of showing what economic arrangements are best.  It cannot, and Marshallian economics can, answer questions such as the desirability or undesirability of minimum wage laws, tariffs, cartels or monopolies.³

The Marshallian approach gives answers but with less than certainty. Economic improvement is, as Marshall himself recognized, an imperfect proxy for utility increase, hence the observation that a tariff or minimum wage law reduces efficiency does not tell us with certainty that it reduces total utility hence is not, even for a utilitarian, a proof that it is undesirable. Further, the tools used to show a reduction in efficiency depend on factual assumptions not known with certainty to be precisely true, as I have demonstrated in the case of the effect of a minimum wage law. What Marshallian economics gives us is not a proof that a tariff or a minimum wage law is a bad thing but only a good reason to think it is.

To reject the approach on that basis is to make the best the enemy of the good.

1. As Rothbard himself writes, “It is important to realize that economics does not propound any laws about the content of man’s ends.” Man, Economy and State, p. 72

2. Quotes are from Man, Economy and State unless another source is stated.

3. This is true for Marshallian economics in general, not only the variant associated with Chicago.