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1. Economic Reasoning, Lecture
1
The Austrian Method and How It
Applies to Competition and
Monopoly, Part I

2. Contrast Between Austrian
and Neoclassical Economics
●Mainstream economics is often hard to
understand.
●Why? Because you have to learn complicated
mathematical models. These are used
because this is a way to be exact.
●How do we know these models apply to
reality? The predictions of the model are
tested. This often means further use of math.

3. Contrast Continued
●Some mainstream economists think that what
is important is only whether the model gives
true predictions. The axioms of the model
don’t have to be true. Milton Friedman said
this in a famous article.
●The Austrian view is different. If you use a
mathematical model, you don’t really
understand why things are true. You just
follow the rules of math.

4. Austrian Method
●Austrians disagree with this. They favor a
method where we understand what is going
on at each step of the argument
●We all act---we use means to achieve ends.
●If we think about what is involved in the
concept of action, we can discover important
truths about economics.
●Here is an example. Why does exchange
take place? If you trade apples for oranges,
you want oranges more than apples. The
person you trade with wants apples more

5. Double Inequality
●Every exchange involves a double inequality.
Just by thinking, in an everyday way, about
what an exchange involves, we have learned
an important truth about economics.
●Mises points out that many famous thinkers
missed this. Aristotle said that exchange
requires equality. Marx also thought this, and
the postulate of equality is needed for the
labor theory of value.

6. Deductive Reasoning
●What we have just done is an example
of deductive reasoning. We ask, “what
do we need to make sense of an
exchange?” We then see how
exchange requires a double inequality.
●We are drawing out what is involved in
the concept “exchange”. If we have
done this correctly, the results are true.

7. Deductive Reasoning and
Testing
●Deductive reasoning moves from
premises to conclusion. If the premises
are true, the conclusion is true.
●All men are mortal
●Socrates is a man
●Therefore, Socrates is mortal.
●We don’t need to test the conclusion to
find out whether it is true.

8. Austrian Economics and
Testing
●In Austrian economics, we know the
premises are true because they are
about the concept of action. We don’t
have to test the conclusions.
●This has made Austrian economics very
unpopular with mainstream economists.
They think the Austrian method is
dogmatic.

9. An Objection
●Austrian economics starts from premises that
we know are true. But doesn’t science
sometimes show that common sense beliefs
are false?
●E.g. doesn’t it seem that the earth is
stationary, and that the sun and planets
revolve around it? But it isn’t.
●This example, and others like it, doesn’t show
that our “inside” knowledge could be
mistaken. It’s given to us in experience that

10. Another Objection
●I claimed that Austrian economics follows
ordinary common sense reasoning.
●But what about all the talk about synthetic a
priori truths, analytic statements, etc.? This
doesn’t sound like ordinary language.
●But these terms are just part of a
philosophical defense of the Austrian method.
You don’t have to study them to do Austrian
economics.

11. The Broken Window Fallacy
●Here is another example of common sense
reasoning in economics.
●Henry Hazlitt takes over this example from
Bastiat. Suppose a young man tosses a brick
through a store window.
●Someone argues that the boy is really a
public benefactor. The shopkeeper will pay to
have his window replaced. Then the
glassmaker will spend the money he gets on
other products. The result will be an increase
in production.

12. The Fallacy and Common
Sense
●We don’t have to use math to find out what is
wrong with this reasoning. The argument
doesn’t consider everything relevant.
●What would have happened if the boy hadn’t
broken the window? The storekeeper would
have spent the money he used to replace the
window on something else. This in turn would
generate more spending. The first situation is
worse because there has been destruction of
wealth.

13. The Fallacy Is Alive and Well
●Paul Krugman committed this fallacy after the
9-11 attack. He said that the destruction
caused by the attacks would lead to
increased spending and more production.
●Many proposals for government spending
ignore what people would have done with the
money if the government hadn’t taxed it
away.

14. Commonsense Competition
●Austrian economics views competition
very differently from neoclassical
economics.
●Consumers on the market have dollar
votes. Sellers compete for these votes.
●Thus, all sellers of products are in
competition for the dollars of
consumers. Competition isn’t confined
to firms within an industry.

15. Competition and Democracy
●Mises compares market competition to
political democracy. The market is better than
political democracy because people with
unpopular tastes can still get what they want,
as long as people who supply them can cover
their costs.
●In political democracy, only the winning party
gets what it wants. Even proportional
representation leaves many people
unsatisfied.

16. Competition within an Industry
●What about competition within a particular
industry or sellers of the same product? E.g,
different companies produce cars, sell fruit,
etc. People who sell services, e.g., doctors
and lawyers, are competing for the
consumers’ money.
●People within an industry are more directly in
competition with one another than they are
with all sellers of products.

17. Austrian Economics and
Competition
●Austrian economics differs very much from
neoclassical economics on competition within
an industry.
●As we’ll see next week, neoclassical
economics imposes strict conditions for a
competitive industry. Basically, there must be
many firms in an industry for competition to
exist. If there isn’t, then we have either
monopoly---one seller; oligopoly—a few
sellers; or monopolistic competition---more
sellers, but not enough for competition.

18. Austrian Economics
Continued
●Austrian economics doesn’t impose these
requirements. In the Austrian view, as long as
firms are free to enter and leave an industry,
it counts as competitive.
●Why this difference? Austrian economics
takes people’s choices on the market as
given. It doesn’t try to “improve” on people’s
choices, by saying that they don’t mean meet
the terms of some non-market standard.

19. Neoclassical Economics and
Efficiency
●Neoclassical economists think that they
can improve on the market. If the
market doesn’t meet their standards for
competition, it isn’t efficient.
●What do they mean by efficiency? This
means the maximum production at the
least cost.

20. Utility
●To understand what they mean, we
have to understand utility.
●In Austrian economics, we start from
action. When you act, you try to achieve
the goal that you value most highly at
the time.
●You can rank economic goods by how
they will help you achieve your goals.

21. More Utility
●Suppose that you have five apples. You ask
yourself, what is the best use I have for the
first apple? You ask the question for each
apple. The value you get from the good is
called its utility.
●As you get more and more of a good, you use
it to fulfill lower ranking ends. The good has
diminishing marginal utility. This means that
the marginal, or last, unit decreases in value
as you add more units. This is a basic law of

22. Ordinal vs. Cardinal Utility
●Each person will rank units of goods in order,
depending on the uses he has for each unit.
●These units aren’t measured on a common
scale. Utility isn’t isn’t a substance that comes
in units.
●Goods are just ranked: The first apple ranks
above the second etc. This is called an
ordinal scale—first, second, third, etc.
●You can’t make comparisons of utility
between persons. It doesn’t make sense to
say, my first choice ranks higher than your

23. Neoclassicals and Utility
●The neoclassical economists largely accept
this. They agree that you can’t measure
interpersonal utility.
●They think that they can still show that if their
conditions for competition aren’t met, you can
increase utility.
●Austrians think that we can’t know other
people’s preferences. All we know is that if
they act, they prefer what they choose to
something else.

24. Monopoly
●When I said that Austrians take all
markets as competitive, so long as
there is free entry, you might have
wondered, what about monopoly? How
can a competitive market have only one
seller?
●The seller is still competing with sellers
of all other goods.

25. More Monopoly
●Rothbard says that even with one seller,
there is no way to establish that his
price is not a competitive price. If you
say, wouldn’t the price be lower if there
were more firms in the industry, his
answer is, why should we say that the
price then would be the competitive
one? We are imposing an arbitrary

26. Mises on Monopoly
●Mises’s position is slightly different. He
thinks the notion of a monopoly price
makes sense.
●However, monopolies on a free market
would arise very rarely. Also, it would
be very difficult to show that a firm was
charging a monopoly price.