Economics: The Austrian School vs. The Chicago School

Summary

This video explores the Austrian and Chicago Schools of Economics, contrasting their approaches to economic theory. The Austrian School, with roots in subjective value and human action, emphasizes causal realism and rejects mathematical modeling, focusing on concepts like time preference and the business cycle. In contrast, the Chicago School views economics as a hard science, using empirical evidence and mathematical models to analyze resource allocation and advocate for minimal government intervention. Both schools share a commitment to free-market principles, yet diverge on monetary policy and the role of government in the economy.

Takeaways

• 🏛️ The Austrian School of Economics emphasizes individual human action and subjective value, with key figures like Carl Menger, Ludwig von Mises, and Friedrich Hayek.
• 🌐 The Chicago School of Economics, founded by Frank Knight and including economists like Milton Friedman, focuses on the allocation of scarce resources and sees economics as more of a hard science.
• 📊 Austrian economists reject mathematical modeling due to the unpredictable nature of human behavior, unlike the Chicago School which utilizes mathematical models and empirical evidence.
• 💡 The concept of 'demonstrated preference' in Austrian economics highlights that economic value comes from individual choices based on personal preferences.
• 🔄 The Austrian School is known for theories like marginal utility, opportunity cost, and time preference, which emphasize the subjective nature of economic decisions.
• 📉 The Austrian theory of business cycles attributes economic instability to expansionary credit policies, a view contrasting with mainstream economics.
• 💸 The economic calculation problem introduced by Mises argues that central planning cannot efficiently allocate resources due to the lack of market price signals.
• 🌟 Hayek's knowledge problem extends the economic calculation issue, stating that dispersed knowledge in an economy makes centralized decision-making ineffective.
• 📈 Milton Friedman's quantity theory of money from the Chicago School posits that the total money supply influences prices and that central banks can impact economic stability.
• 🔎 The Chicago School's rational expectations hypothesis assumes that people in economic models act rationally, a point of criticism given real-world irrational behavior.

Q & A

What are the four major schools of economics mentioned in the script?

The four major schools of economics mentioned are Marxism, Keynesianism, the Chicago School of Economics, and the Austrian School of Economics.

Who is considered the founder of the Austrian School of Economics?

The founder of the Austrian School of Economics is Karl Menger.

What is the central tenant of Austrian economics regarding value?

The central tenant of Austrian economics is that value is subjective and always subjective.

How do Austrians view the role of mathematics in economics?

Austrians reject the use of mathematical modeling in economics, arguing that human behavior cannot be predicted like physical phenomena and that constant variables are unattainable in the real world.

What is the Austrian theory of the business cycle?

The Austrian theory of the business cycle posits that most boom-bust cycles in the economy are caused by expansionary credit.

What is the economic calculation problem as introduced by Ludwig von Mises?

The economic calculation problem is the argument that in the absence of a market economy, socialist systems would not know how to allocate resources effectively because they lack prices as signals of what people want.

Who introduced the knowledge problem in the Austrian School of Economics?

F.A. Hayek introduced the knowledge problem, which extends the economic calculation problem to include virtually all decisions made by central decision-making units.

What is the Chicago School's view on the use of mathematics in economics?

The Chicago School has no objections to utilizing mathematical models, as they see economics as closer to a hard science, and they use data-driven approaches to refine and revise models for predictive accuracy.

What is the key contribution of Milton Friedman from the Chicago School?

Milton Friedman's key contribution is his quantity theory of money, which posits that the total amount of the money supply dictates real-world prices.

How do the Austrian and Chicago Schools differ in their approach to economic theory?

The Austrian School advances its arguments through a priori rationalism and a causal realist approach, while the Chicago School uses empirical evidence and quantitative approaches, often employing mathematical models.

What is the main difference between the Austrian and Chicago Schools' views on prices?

The Austrian School maintains a consistently subjective approach to prices, based on individual preferences, while the Chicago School, inheriting the neoclassical view, sees production costs as a factor in determining prices.

What is the main similarity between the Austrian and Chicago Schools despite their differences?

Both the Austrian and Chicago Schools support the free market, oppose government interventions and regulations, and are opposed to socialism. They also broadly accept Hayek's insights about the knowledge problem, which allows them to analyze various aspects of life beyond traditional economic topics.

Outlines

00:00

📚 Introduction to Economic Schools: Austrian vs. Chicago

The video introduces the four major schools of economics, focusing on the Austrian and Chicago schools. The Austrian school, founded by Carl Menger, emphasizes subjective value, purposeful human action, and the importance of time in economic decisions. It rejects mathematical modeling and government intervention in the market. Key Austrian economists include Menger, Eugen von Böhm-Bawerk, Friedrich von Wieser, Ludwig von Mises, and F.A. Hayek. The Chicago School, in contrast, views economics as the study of resource allocation, is more empirical and data-driven, and does not oppose mathematical models. It was founded by Frank Knight and includes notable economists like James M. Buchanan, George Stigler, and Milton Friedman.

05:02

🌟 Key Concepts of Austrian Economics

Austrian economics is characterized by its focus on subjective value, demonstrated preference, and the causal realist approach. It argues that value is inherently subjective and that economic actions are driven by individual preferences. Austrians believe that production costs do not determine prices, which are instead based on subjective preferences. They also reject the idea of economics as a hard science due to the unpredictable nature of human behavior. The school emphasizes the importance of time in economic decisions and is known for contributions like marginal utility, opportunity cost, and the theory of the business cycle, which attributes economic fluctuations to expansionary credit policies.

10:03

📈 The Chicago School's Empirical Approach to Economics

The Chicago School takes a more empirical and quantitative approach to economics, seeing it as the study of scarce resource allocation. It is open to mathematical modeling and views economics as closer to a hard science. The school's contributions include Milton Friedman's quantity theory of money, which posits that the money supply dictates prices, and the concept of rational expectations, which assumes model agents are rational. Other contributions include Gary Becker's work on the economics of the family, George Stigler's theory of regulatory capture, and James M. Buchanan's public choice theory, which analyzes government functions and failures.

15:03

🤝 Similarities and Differences Between Austrian and Chicago Schools

Despite their differences, both the Austrian and Chicago schools share a commitment to free-market principles and opposition to socialism. They also agree on the importance of the knowledge problem in economic decision-making. The Austrian school emphasizes a priori rationalism and the role of time, while the Chicago School relies on empirical evidence and mathematical models. The Austrians are consistently subjective in their view of prices, whereas the Chicago School considers production costs as a factor in price determination. Macroeconomically, the Austrians focus on the business cycle and credit expansion, while the Chicago School follows Keynes in considering aggregate statistics but emphasizes the money supply over aggregate demand.

Keywords

💡Austrian School of Economics

The Austrian School of Economics is a heterodox economic theory that emphasizes the importance of individual choice, time, and the subjective nature of value. In the video, it is contrasted with the Chicago School, highlighting its founders like Carl Menger and its notable proponents such as Ludwig von Mises and Friedrich Hayek. The Austrian School is characterized by its causal-realist approach, focusing on human action and purposeful behavior, as exemplified by the concept of 'demonstrated preference.'

💡Subjective Value

Subjective value in the Austrian School refers to the idea that the value of goods and services is determined by the individual's preferences and is not an objective quality inherent in the goods themselves. The video explains this concept by contrasting personal preferences for coffee versus tea, showing how these subjective valuations drive economic decisions. This is central to the Austrian School's view that economic value is not measurable and is always based on personal preferences.

💡Demonstrated Preference

Demonstrated preference is a concept from the Austrian School that refers to the choices individuals make when faced with alternatives, revealing their preferences. In the video, it is used to illustrate how economics is concerned with the actions chosen rather than the psychology behind those choices. An example given is choosing between $10 or $100, where the choice made reflects the individual's demonstrated preference.

💡Opportunity Cost

Opportunity cost is a fundamental economic concept discussed in the video, which represents the value of the next best alternative that is foregone when making a decision. It is introduced as a key Austrian contribution to economic theory by Friedrich von Wieser. The video uses the example of choosing between seeing a movie with friends or studying for an exam to illustrate the loss associated with each choice.

💡Time Preference

Time preference is a concept introduced by Eugen von Böhm-Bawerk, which reflects an individual's preference for consuming now versus later. The video explains this by presenting a scenario where one must choose between receiving a sum of money today or in the future, indicating a preference for immediate gratification over delayed rewards. This concept is integral to understanding saving, investment, and interest rates.

💡Business Cycle Theory

The Austrian theory of the business cycle, as mentioned in the video, posits that economic fluctuations are caused by the expansion of credit and monetary policy. This theory, first outlined by Ludwig von Mises, is a cornerstone of Austrian macroeconomics and is used to critique the effectiveness of central banking and credit expansion as economic tools.

💡Economic Calculation Problem

The economic calculation problem, introduced by Ludwig von Mises, is a critique of central planning and socialism, arguing that without market prices, a planned economy cannot efficiently allocate resources. The video discusses this concept as a significant contribution of the Austrian School, highlighting the importance of market signals in a functioning economy.

💡Knowledge Problem

The knowledge problem, introduced by F.A. Hayek, extends the economic calculation problem to include the dispersed and localized knowledge in an economy. The video explains that this knowledge is too vast for any central authority to gather and process effectively, thus emphasizing the importance of decentralized decision-making in a market economy.

💡Chicago School of Economics

The Chicago School of Economics, as discussed in the video, is a neoclassical approach to economics that emphasizes the efficiency of markets and the importance of empirical evidence. It is contrasted with the Austrian School, with notable figures like Milton Friedman and George Stigler. The Chicago School is known for its quantitative and data-driven approach, utilizing mathematical models to predict economic outcomes.

💡Rational Expectations

Rational expectations is a concept from the Chicago School that assumes economic agents in models make decisions based on rational calculations of their best interests. The video mentions this as a basis for the Chicago School's modeling approach, which has been criticized for not accounting for the irrational behavior that can occur in real-world economic decisions.

💡Regulatory Capture

Regulatory capture is a term coined by George Stigler, discussed in the video, which refers to the phenomenon where regulatory agencies end up serving the interests of the industries they are supposed to regulate. This concept is used to critique the effectiveness of government regulation and to argue for more market-oriented solutions.

Highlights

Marxism advocates for government control until a new utopia is achieved.

Keynesianism supports government intervention in the economy.

The Chicago School of Economics favors minimal intervention in the market.

The Austrian School of Economics promotes no intervention and total laissez-faire.

Austrian economics focuses on purposeful human action and demonstrated preferences.

Value in Austrian economics is considered subjective and based on individual preferences.

Austrians reject the idea that economics can be a hard science due to unpredictable human behavior.

Austrian economics emphasizes the importance of time in economic decisions and actions.

Marginal utility, a concept by Karl Menger, is a key contribution of the Austrian School.

Opportunity cost, introduced by Friedrich von Wieser, is a central concept in Austrian economics.

The Austrian School's theory of the business cycle attributes economic fluctuations to expansionary credit.

Ludwig von Mises introduced the economic calculation problem regarding resource allocation in socialist systems.

F. A. Hayek's knowledge problem highlights the dispersed nature of economic decision-making knowledge.

The Austrian School has split into branches following Hayek and Mises-Rothbard with differing views on the state's role.

The Chicago School views economics as the study of the allocation of scarce resources with alternative uses.

Chicago economists use empirical evidence and mathematical models to analyze economic policies.

Milton Friedman's quantity theory of money posits that the money supply dictates real-world prices.

The Chicago School's rational expectations theory assumes rational behavior within economic models.

George Stigler's work on regulation and regulatory capture is a significant contribution to the Chicago School.

James M. Buchanan's Public Choice theory analyzes government functions and challenges market failure claims.

The Chicago School has expanded economic analysis to various aspects of life beyond traditional economic topics.

Both Austrian and Chicago Schools support free markets and oppose socialism and government interventions.

The Austrian School uses a priori rationalism, while the Chicago School relies on empirical evidence.

Austrians see prices as subjective, whereas the Chicago School considers production costs in price determination.

The Austrian School rejects the distinction between micro and macroeconomics, focusing on the business cycle theory.

The Chicago School follows Keynes in considering the economy as a whole but emphasizes the money supply over aggregate demand.

Transcripts

the four major schools of economics are

Marxism which is generally for

government control at least until the

new utopia Keynesianism which is

generally for government intervention

the Chicago School of Economics which is

generally for minimal intervention in

the market and they've been hit

government and the Austrian School of

Economics which is generally for no

intervention in the market at all hence

total laissez-faire in this video I will

be concentrating on the differences

between the Austrian school and the

Chicago School let's start with the

Austrians the founder of the school was

karl menger who was writing in the 1870s

he had two outstanding students

Eugene bomba Berk and Friedrich von

visor

each of whom had their own outstanding

students in Ludwig von Mises and F a

Hayek respectively

so that's who they are but what is

Austrian economics the starting point is

the study of purposeful human action we

all way up alternatives and make

decisions upon which we act but

economics is not concerned with the

psychology of such choices but with

which actions were chosen such actions

are called demonstrated preference or

revealed preference if I offer you $10

or $100 whichever one you actually take

is your demonstrated preference this is

purposeful action a central insight of

Austrian economics then is that

everything that happens in an economy is

driven by real human beings

demonstrating their preferences through

these purposeful actions hence their

description of the economy is said to be

causal realist the only ones making

anything happen are people the central

tenant of Austrian economics is that

value is subjective and that it is

always subjective you

prefer coffee and I might prefer tea you

might like coffee an awful lot whereas I

might like tea only marginally more than

I like coffee

four austrians prices in the real

economy are always based on these

subjective preferences which we

inherently cannot measure indeed your

own preference for coffee might change

over time I didn't drink it when I was

17 but I do know for example for more on

this see my video pricing a cup of

coffee

Austrians argue that other economists

despite claiming to believe that value

is subjective end up forgetting this

when modelling prices in their hidden

assumption that production costs

determine crises Austrians insist that

production costs do not determine prices

only subjective preferences because we

cannot know what people's subjective

preferences and valuations of things are

Austrians reject the idea that economics

can be a hard science like for example

physics they argue you cannot predict

what people may or may not do because

human beings are not like stones which

react to conditions in predictable ways

and besides you can never get constant

variables in the real world anyway

therefore Austrians reject mathematical

modeling in economics and the final

feature of Austrian economics is that

they never forget the role of time

because humans must act in a world bound

by time time is a constant feature of

our economic affairs which is often

overlooked by other economists this is

important when considering such things

as pricing inflation and the role of the

entrepreneur and I have videos on these

topics if you're interested

the key Austrian contributions to

economic theory have been marginal

utility which was advanced by karl

menger and concerns the subjective

theory of value I have already discussed

imagine you are thirsty in a desert in

the baking Sun what would you give for a

glass of water now imagine you've just

finished drinking a whole pint of water

what would you give for the next class

I'd warrant it will be considerably less

than you'd give if you were thirsty in

the desert

another key austrian contribution this

time from friedrich von wieser is the

idea of opportunity cost which is simply

put the loss of other alternatives when

one alternative is chosen which face

such choices all the time in real life

imagine the choice between seeing a

movie with your friends or studying hard

to get a good grade for the examination

you have the next day the opportunity

cost for studying hard is forgoing the

enjoyment of the movie and spending time

with your friends however the cost of

seeing the movie is a lower grade on the

exam next there is the concept of time

preference introduced by Eugene Bambara

if I offer you the choice between 100

dollars today or 100 dollars in one

month's time the chances are you'll go

for the 100 dollars today this is your

preference for having something now

instead of in the future if I offer you

10 pounds today or 100 dollars in one

month's time you might have a more

difficult choice can you forego the ten

dollars now to make the hundred dollars

in a month this would be a low time

preference if you take the ten dollars

today we'd say that you have a high time

preference you prefer to consume the ten

dollars now than have a hundred in a

month one of the theories for which the

Austrian school is famous is their

theory of the business cycle which

argues that most of the boom-bust cycles

we see in the modern economy are caused

by expansionary credit this was first

outlined by Ludwig von Mises in 1912 in

his landmark book called the theory of

money

crédit lots of people instinctively know

the Austrians are correct about this and

yet very little has been done to stop

boom and bust cycles in the hundred

years since Mises first introduced the

theory another famous concept introduced

by Mises is the economic calculation

problem Mises argued that in the absence

of a market economy socialist systems

would not know how to allocate resources

effectively because they are missing

prices as signals of what people want

and first argued this in his book

socialism in 1922 and would be proven

correct by the collapse of virtually

every socialist government in the next

80 years of the 20th century finally F a

Hayek introduced the knowledge problem

this is an extension of the economic

calculation problem to include virtually

all decisions made by central

decision-making units Peck argues that

the knowledge required to make effective

decisions in the economy are dispersed

among thousands of people on the ground

and no one person can possibly acquire

the data to make even a semi informed

call as to what to do now probably the

most accessible book on the knowledge

problem was written by Thomas Sol it is

called knowledge and decisions today the

Austrian School of Economics has split

into two different branches roughly

speaking between followers of FA Hayek

and followers of the Ludwig von Mises

and his American protege Murray Rothbard

the followers of Hayek tend to analyze

real world institutions and policies

emphasizing the miss allocations of

resources and avert able disasters

caused by interventionism and promoting

the efficacy of the market mechanism

which produce accountability and

feedback loops the Hayek Ian's have a

stronghold at George Mason University

and the meketa Center I've listed some

of them there the followers of nieces

and Rothbard

meanwhile are more radical in their

advocacy of laissez-faire and in their

opposition to the state

the Rothbard Ian's have a stronghold at

the Ludwig von Mises Institute and argue

for the strongest free market positions

including their opposition to central

banking and the Federal Reserve System

fiat currency as against the hard

commodity money such as gold and

fractional reserve banking which they

want to abolish across the Austrian

school

however opinions range on how large the

state should be from mini kists and

contraction Asst who want a limited

government or a night watchman state to

full anarcho-capitalists who believe all

functions would be better handled by

private enterprise the Chicago School

was founded chiefly in the 1940s under

Frank Knight at the University of

Chicago Knight had three extraordinary

students James M Buchanan who went on to

found a sub branch of political economy

known as public choice George Stigler

who wrote the seminal book on price

theory as well as developed the economic

theory of regulation and finally perhaps

one of the most famous economists of all

time Milton Friedman who was the driving

force of monetarism in the late 20th

century in contrast to the Austrian

school which as we have seen emphasizes

human action the Chicago School sees

economics as studying

the allocation of scarce resources which

have alternative uses the focus on

resources as opposed to people may seem

maya but it does have major consequences

one consequence is that unlike the

Austrians the Chicago School see

economics as being closer to a hard

science resources can be recorded as

data hard data can be analyzed as

empirical evidence and thus economists

can study the economic effects of

various policies almost like scientists

in a lab as a result of this the Chicago

School develops an almost entirely

data-driven view of the world and of

economics

whereas Austrian economists tend to a

their arguments a priori using reason

from first principles Chicago school

economists are more likely to say things

like show me the evidence partly as a

result of this nearly entirely

data-driven view of the world the

Chicago School has no objections to

utilizing mathematical models the test

of any model is if it can predict what

happens in the real world if the model

gets it wrong then refine and revise

until it gets it right

so what contribution has the Chicago

School made to economics first there is

of course Milton Friedman's quantity

theory of money in which the total

amount of the money supply is said to

dictate real world prices Friedman held

that central bank's exacerbated the

Great Depression in the 1930s by

restricting the supply of money they

should have printed more he said he also

argued that the Keynesian focus on

aggregate demand was misplaced and that

the government intervention should be

restricted to controlling the money

supply this is in contrast to the

Austrian view which as I mentioned

chiefly holds expecially credit as

responsible for recessions and not the

supply of money another contribution of

the Chicago School is what is typically

called rational expectations that is

when they build their models Chicago

economists assume that agents within the

models are rational agents of course

these models have been criticized

because people in the real world

are not always rational for example let

us take Gary Becker's rotten kid theorem

imagine you have an altruistic parent

who gives two siblings $10 each one

sibling is mean and decides to bully the

other one therefore next time a parent

decides to give the victim sibling $20

and give the bully nothing the

incentives are such them but bullying is

punished and being a victim is

compensated in Gary Becker's terms the

parent has transferred utility from the

wrongdoer to the victim but apply this

to any real family

we be sure if it would have the desired

effect George Stigler has made the

contribution to the Chicago School is

his work on regulation and especially

the phrase a regulatory capture which is

the insight that once set up regulatory

bodies have incentives to grow far

beyond their original ream it's again

I'd recommend the book knowledge and

decisions by Thomas Sowell on this

incidentally soul was stigler's doctoral

student in this book he essentially

combines stigler's insights on

regulation with earth a Hayek's

knowledge problem James M Buchanan's

Virginia School of Public Choice which

grew out of the Chicago School developed

a robust way of analyzing the functions

of government and government departments

and agency to push back against

Keynesian claims of market failure by

pointing out the hundreds of examples of

government failure finally one of the

chicago schools most lasting

contributions is how they were able to

turn the tools of economics to focus on

topics other than trade or money popular

examples include hidden order by David

Friedman or Freakonomics by Steven

Levitt and Stephen Dubner the Chicago

School has strongholds in where else but

the University of Chicago but also at

think tanks such as the Hoover

Institution in Stanford you can see some

are Chicago economists listed here and

as with the Austrian school opinions

range within the Chicago School from

mini kiss or contraction ists and those

who want limited government or

Nightwatchman state to full

anarcho-capitalists in closing i want to

review the similarities and differences

of the chicago school and the Austrian

school the Austrian school advances its

arguments through a priori rationalism

taking a causal realist approach which

emphasizes the role of time the Chicago

School in contrast advances its

arguments through empirical ever

using a quantitative approach which

utilizes mathematical models in addition

the two schools differ in their view of

prices the Austrians are consistently

subjective in their approach where is

the Chicago School inherit the

neoclassical view of seeing production

costs as a factor in determining prices

finally the two schools differ on

macroeconomic theory the Austrians

reject the distinction between

microeconomics and macroeconomics

entirely and insist that most recessions

can be explained by their theory of the

business cycle and expansion Airy credit

the chicago school meanwhile follow john

maynard keynes in considering the

economy as a whole

zoomed out in aggregate statistics but

differ from keynes in their emphasis on

the money supply rather than demand for

goods as being the area in which

government should focus their

intervention however despite these

differences let us not forget how many

similarities there are between these two

schools both Austrians and Chicago

advocates support the free market they

are generally opposed through government

interventions and regulations they are

utterly opposed to socialism both also

broadly accept Hayek's insights about

the knowledge problem which enable them

to branch out in order to analyze

aspects of everyday life as well as

things we typically think of as

economics such as trade or money now

people often ask me if I'm more towards

the Austrian school or the Chicago

School my personal view is that on the

substantive areas of disagreement such

as on monetary policy or pricing the

Austrian school is generally correct in

fact whenever the two schools disagree

it seems to me that the offspring of you

is more consistently and rigorously

argued however I tend to disagree with

the Austrian insistence on a priori

rationalism the chicago school ended up

winning many more battles in the real

world because they had the data to back

them up its most persuasive to be backed

by statistic

and I see no reason why Austrians

shouldn't engage in empirical analysis

of historical data themselves they can

maintain their objections to predictive

models as being impossible where humans

are concerned but think about their own

general theories which is the business

cycle and the economic calculation

problem which have been borne out in the

real world I mean these is predicted

both of those things correctly so not

pointing this out with robust at data

analysis is to cede the ground to their

opponents on issues where they should

win easily anyway I hope you learned

something here now get out and a very

special thanks to Sir Percy Blakeney the

crimson Satya the ambivalent onion Andy

Swenson Bailey in Aurora David vishesh a

Christopher Shirley home natural rights

binary surfer holy spatula horny toad

Jones Kosta Michael Tainan time stealer

Toyotomi Amy tragic vision William Angus

Blake Burroughs and Edward Dara