The Austrian search for realistic foundations.

• Author: Caplan, Bryan

I cannot believe that there is really anything to be ashamed of in orthodoxy. The important thing is not whether a doctrine is orthodox or the latest fashion, but whether it is true or false.

Ludwig von Mises (1980a, p. 31)

[T]here is no Austrian economics - only good economics, and bad economics.

Milton Friedman (quoted in Dolan 1976, p. 4)

1. Introduction

   A persistent criticism of neoclassical economic theory is that it is founded on severely unrealistic assumptions.(1) Friedman's (1953) reply that unrealistic assumptions are acceptable if they yield correct predictions leaves many unsatisfied. Some of this dissatisfaction stems from hostility to theory as such; critics of the realism of neoclassical assumptions rarely put forward theories of their own. One project the Austrian school of economists has pursued, however, is to rebuild economics on realistic, nonneoclassical assumptions.

   Not all Austrians share this ambitious project. F. A. Hayek, the best-known member of the Austrian school, expressed unease with certain aspects of modem economics, but in large part, he viewed his work as a complement to, rather than a substitute for, the neoclassical approach. He offered a bundle of insights on information economics, the theory of the firm, monetary economics, and comparative systems (Hayek 1984) rather than new and better foundations for economic analysis. Perhaps to counter misunderstanding of his work, late in his career, Hayek expressed his desire to

   ... avoid giving the impression that I generally reject the mathematical method in economics. I regard it as indeed the great advantage of the mathematical technique that it allows us to describe, by algebraic equations, the general character of a pattern even where we are ignorant of the numerical values determining its particular manifestation. Without this algebraic technique we could scarcely have achieved that comprehensive picture of the mutual interdependencies of the different events in the market. (Hayek 1979, p. 28)

   Yet others within the Austrian tradition - specially Hayek's mentor Ludwig von Mises, Mises' close adherent Murray Rothbard,(2) and to a lesser extent Mises' student Israel Kirzner - advance stronger claims. Mises and Rothbard together reject much of the core of neoclassical economics: for starters, utility functions, indifference analysis, continuous preferences, and nearly all of welfare economics. They then develop positive alternative foundations of economic analysis. Kirzner's project is less radical, but his disagreements with the neoclassical view of uncertainty still lead him to take issue with several basic neoclassical conclusions and offer original alternatives (Boettke 1994a).

   If valid, the economics of Mises and Rothbard would require a paradigm shift for the entire discipline of economics. As Rothbard (1974) puts it, "Ludwig von Mises offers to us nothing less than the complete and developed correct paradigm of a science that has gone tragically astray over the last half-century. Mises' work presents us with the correct and radically divergent alternative to the flaws, errors and fallacies which a growing number of students are sensing in present-day economic orthodoxy" (p. 140). Embracing Kirzner's conclusions would require a similar if less dramatic transformation of the economics profession (Boettke 1994b). However, this paper argues that no paradigm shift is warranted, The objections of Mises, Rothbard, and Kirzner to standard neoclassical foundations - though often ably defended - are unsound. Nevertheless, much can be learned by taking their arguments seriously. As both Rosen (1997) and Yeager (1997) maintained in a recent debate, at least in the short-run, important imperfections may be found in the market for ideas: Imagine the intellectual analog of a speculative bubble. When critics thoughtfully argue that the market for ideas has strayed from the right path, fundamental analysis - reexamining basic premises - is the strongest answer.

   This paper is divided into four sections. The next section examines and critiques the work of Mises and Rothbard on utility theory and the Mises-Rothbard and Kirznerian approaches to choice under uncertainty. The third section analyzes Rothbard's effort to reconstruct welfare economics along lines consistent with Misesian foundations; it also considers Kirzner's coordination norm. It further shows how Rothbard's revised welfare theory leads him to implausibly deny the coherence of the theory of public goods. The fourth section concludes the paper.

2. Austrian Alternatives to Neoclassical Consumer Theory

   Neoclassical consumer theory makes a number of normally uncontroversial assumptions: that agents can be indifferent between two alternatives; that agents' preferences can be represented with continuous utility functions; and that agents' ignorance and imperfect knowledge can be captured using probability theory. Mises and Rothbard reject all three of these assumptions and try to rederive economic theory without them; Kirzner focuses mostly on the neoclassical view of imperfect knowledge. Both positions are a sufficient basis for an alternative Austrian paradigm. However, Mises, Rothbard, and Kirzner reject the foundations of modern neoclassical consumer theory too quickly, and their substitutes are inadequate.(3)

   Indifference

   Perhaps the most basic assumption of consumer choice theory is that, given two choices a and b, an agent can strictly prefer a to b (a [greater than] b), can strictly prefer b to a (a [less than] b), or can be indifferent between a and b (a [similar] b). While Mises and Rothbard accept the first two cases of strict preferences, they argue that the third case of perfect indifference is nonsensical because it cannot be demonstrated in action. Mises (1980a) indicated his aversion to this concept when he strongly criticized Irving Fisher's anticipation of indifference curve analysis (pp. 55-7).(4) Rothbard, writing after indifference analysis had come to maturity, elaborated upon Mises's argument in greater depth.

   Rothbard tightly ties his argument against indifference to Mises' analysis of the relationship between preference and action. As Mises (1966) argues, "The scale of values manifests itself only in real acting; it can be discerned only from the observation of real acting" (p. 102). Yet it is impossible for action to demonstrate indifference. Action demonstrates preference, not indifference. Rothbard (1962) puts it thusly: "The crucial fallacy is that indifference cannot be a basis for action. If a man were really indifferent between two alternatives, he could not make any choice between them, and therefore the choice could not be revealed in action" (p. 265). It is important to note that Rothbard is not saying that it is difficult to distinguish action based on strict preference from action based on indifference; rather he is saying that every action is necessarily based on strict preference. In other words, "not only are alternatives ranked ordinally on every man's value scale, but they are ranked without ties; i.e., every alternative has a different rank" (Rothbard 1962, p. 267).

   The crucial assumption - shared by both Mises and Rothbard is that all preferences can be revealed in action. But why assume this? Mises and Rothbard repeatedly disavow behaviorism; introspection yields insight in the social sciences even if it does not in the natural sciences. In his introduction to Mises' Theory and History, Rothbard writes,

   One example that Mises liked to use in his class to demonstrate the difference between two fundamental ways of approaching human behavior was looking at Grand Central Station behavior during rush hour. The "objective" or "truly scientific" behaviorist, he pointed out, would observe the empirical events: e.g., people rushing back and forth, aimlessly at certain predictable times of day. And that is all he would know. But the true student of human action would start from the fact that all human behavior is purposive, and he would see the purpose is to get from home to the train to work in the morning, the opposite at night, etc. It is obvious which one would discover and know more about human behavior, and therefore which one would be the genuine "scientist." (Mises 1985, p. xiv)

   This critique of behaviorism in the social sciences suggests an equally cogent defense of indifference analysis. Just as there is more to my action than my behavior, there is more to my preferences than my action. I have all sorts of preferences that are not - and cannot be - revealed in action. For example, my preference for ice cream at the current instant cannot be revealed since, by the time I managed to find an ice cream vendor, the current instant would have passed. Buying ice cream 10 minutes from now only reveals a preference for ice cream then. And yet, I have introspective knowledge that I want some ice cream right now. Similarly, in a perfectly competitive market, I will never reveal my preference for products at prices other than the market price, but by introspection I can know them.

   In precisely the same way, I know that I am sometimes indifferent. I am often indifferent between the colors of clothes; though I pick one color, I know that I would not mind flipping a coin to decide. The behaviorist might deny the reality of my mental states, but clearly that is not the route Mises or Rothbard would want to take. Indeed, McCulloch's (1977) formal treatment of Austrian marginal utility theory argues that behaviorism is a defect of standard consumer theory that the Austrian theory avoids:

   The indifferent approach suffers from the positivistic prejudice that science can only take note of "observable" phenomena, and must never attribute human-like motives to its objects of study. The Austrian school, on the other hand, realizes that there is nothing unscientific about attributing human-like motives to human beings. (p. 270)

   But isn't Mises' and...