economics

Austrian Economics 101
Austrian Economics 101 Jonathan Poland

Austrian economics is a school of economic thought that originated in Austria in the late 19th century with Carl Menger, professor of political economy at the University of Vienna from 1873 to 1903. Later Fredrick Hayek, Ludwig von Mises, and Murray Rothbard would demonstrate the mastery Austrian style of analysis can have over today’s economy.

The theory is based on the idea that individuals, rather than governments or other large organizations, are the primary drivers of economic activity. Austrian economists believe that prices, wages, and other market signals reflect the underlying value of goods and services, and that these prices should be allowed to adjust freely in response to changes in supply and demand. They also place a strong emphasis on the role of entrepreneurship and innovation in driving economic growth. Austrian economics is often associated with classical liberalism and libertarianism, and it has influenced a number of economic theories and policies.

Some Axioms:

  • Human Action – All humans seek to improve their situation from their viewpoint.
  • Action Scarcity – The factors available for improving human’s situations are scarce.
  • Human Fallibility – Humans make mistakes.
  • Human Rationality – All humans are rational beings.
  • Action Time – All human actions take time.
  • Action Consequences – All human actions have consequences.
  • Action Choices – Humans choose those actions they believe will best improve their situation.
  • Action Ideas – The ideas human’s hold determine their actions.

Two important modern theorists in the Austrian school are Ludwig von Mises and Friedrich von Hayek. Mises received widespread attention from other economists in the 1920s with his challenge that socialism was totally impossible in a modern economy because of its lack of market prices, for him the indispensable means of rational resource allocation. Both Mises and Hayek have contributed significantly in molding the Austrian theory into an integrated whole. Their explanation of cyclical swings in business as resulting from uncontrolled credit expansion at the hands of government added another significant block to the Austrian structure.

Economic Efficiency
Economic Efficiency Jonathan Poland

Economic efficiency refers to the ability of an economy to produce the maximum possible value using its available resources, such as capital and labor. In other words, it is a measure of how well an economy is using its resources to generate wealth and satisfy the needs and wants of its citizens. A more efficient economy is able to produce more goods and services with a given level of resources, while a less efficient economy will produce fewer goods and services with the same resources. Improving economic efficiency can lead to increased productivity, competitiveness, and overall prosperity.

Allocative efficiency refers to the production of goods and services that meet the needs and preferences of consumers in the most effective way possible. In a free market, this is driven by competition between producers, who strive to offer the best products at the most competitive prices in order to attract customers. For example, competition between fashion firms may result in the production of trendy and fashionable clothing items that appeal to teenagers.

Allocative efficiency also requires that producers do not produce too much of a particular good or service, leading to excess supply and unsold inventory. This is a challenging aspect of allocative efficiency to achieve, as it requires producers to accurately forecast consumer demand and adjust their production levels accordingly. This is one of the primary reasons that centrally planned economies tend to be less efficient than market-based economies, as they often struggle to effectively allocate resources and meet consumer demand.

Productive efficiency refers to the ability to produce goods and services at the lowest possible cost while maintaining a certain level of quality. This can be achieved through factors such as economies of scale, productivity, and efficiency. For example, a large firm that produces toothbrushes at a large scale using automated processes and highly productive workers may be able to achieve a low cost per unit that is difficult for smaller competitors to match.

When an economy is operating at productive efficiency, all goods and services are being produced at the lowest possible cost, given the quality standards demanded by the market. This can lead to increased competitiveness, as firms are able to offer their products at lower prices, and can also lead to increased economic growth and prosperity. However, achieving productive efficiency can be challenging, as it requires firms to continuously improve their processes and find ways to reduce costs while maintaining quality.

Distributive efficiency refers to the allocation of goods and services to those who need them most. In an economy that is distributively efficient, resources are distributed in a way that allows all members of society to participate in production and benefit from its rewards.

For example, an economy where all products and services are consumed by a small, wealthy elite while the majority of the population is unable to afford the basic necessities of life would be viewed as inefficient and unfair by those who are excluded from the system. Such an economy may be vulnerable to social unrest and conflict, as those who are disadvantaged may be motivated to overthrow the system in order to improve their own circumstances.

Ideally, a system that is distributively efficient allows all members of society to participate in production and share in its rewards, ensuring that everyone has access to the resources and opportunities they need to live a fulfilling and meaningful life. This can help to promote social cohesion and stability, and can contribute to the overall prosperity of an economy.

One way that modern economies can be inefficient is by causing harm to common resources and communities through externalities. Externalities refer to the costs or benefits of an economic activity that are not reflected in the price of a good or service, and can include negative impacts on the environment, such as air and water pollution, and negative impacts on the quality of life of communities.

For example, a firm that engages in activities that damage the air, water, land, or ecosystems may incur costs that are not reflected in the price of its products. These costs may be passed on to society at large, rather than being internalized by the firm. This can lead to a situation where the firm is able to optimize its profits by engaging in activities that are harmful to the environment and communities, even though those activities may not be socially optimal.

To address this issue, many modern economies have implemented policies and regulations designed to internalize externalities, such as taxes on pollution or fines for environmental violations. These policies can help to ensure that the costs of economic activities are fully accounted for, and can help to promote economic efficiency and sustainability.

Barter
Barter Jonathan Poland

Barter is a system of exchange in which goods or services are traded for other goods or services, rather than for money. It is a form of trade that has been used by humans for thousands of years, and it is still used in some parts of the world today. One of the main benefits of barter is that it allows people to trade goods and services without the need for a common currency. This can be especially useful in situations where there is a lack of currency, such as in times of economic instability or in areas where a formal currency is not widely used.

Another benefit of barter is that it allows people to trade directly with each other, rather than going through intermediaries such as banks or other financial institutions. This can help to reduce transaction costs and make it easier for people to access the goods and services that they need.

However, barter also has its limitations. One of the main challenges is that it can be difficult to find someone who is willing to trade the goods or services that you have for the ones that you need. Additionally, barter can be inefficient, as people may need to spend a lot of time negotiating the terms of a trade, and it can be difficult to determine the value of the goods or services being traded.

In conclusion, barter is a system of exchange that has been used by humans for thousands of years, and it continues to be used in some parts of the world today. While it has its benefits, such as allowing people to trade without the need for a common currency, it also has its limitations, including the challenge of finding someone to trade with and the difficulty of determining the value of the goods or services being traded. The following are illustrative examples.

Commodities
Export firms in two different countries develop a contract to exchange 400 tons of wheat for 300 tons of soybeans without payment.

Products
Neighbors agree to exchange a boat for a motorcycle.

Services
A carpenter builds a garage for an electrician in exchange for some electrical work at the carpenter’s summer house.

Assets
The exchange of a small house in the city for 200 acres of land in the countryside.

Multilateral
A barter transaction can involve multiple parties. For example, a carpenter does work for an electrician so that the electrician will do work for a solar installer so that the solar installer will do work for the carpenter.

Hyperinflation
Barter transactions become more common in an environment of hyperinflation whereby local currency is rapidly losing its value. For example, workers at a bread factory may demand to be paid in bread as money becomes relatively worthless.

Deflationary Spiral
Severe deflation causes the value of money to increase with time. This motivates people to hoard money and can inspire barter transactions. For example, trades of used goods such as a television for a bicycle.

Markets
Two-sided markets for trading goods and services such as a digital platform for trading collectable items.

Compensated Trade
A transaction that uses money to compensate for the difference in value between two barter goods. For example, a boat for a motorcycle plus $500.

Reuse
Barter may be inspired by the ethic of reusing things to reduce the impact of production on the environment. For example, reuse enthusiasts who exchange bicycle parts at a repair cafe.

Value of Offerings
Value of Offerings Jonathan Poland

Value is a concept that refers to the usefulness, worth, and importance that customers assign to products and services. This value is derived from how well a product or service meets the needs and preferences of customers.

Value is not a fixed attribute of a product or service, but rather it is subjective and varies from person to person. Different customers may place different values on the same product or service, depending on their individual needs and preferences.

Value is also influenced by the reputation and perceived prestige of a brand. Customers may be willing to pay a premium for products or services from a brand that they perceive as high-quality or prestigious, even if the product itself is not significantly different from cheaper alternatives.

In summary, value is the perceived usefulness, worth, and importance of a product or service in the minds of customers, and is influenced by how well it meets their needs and preferences, as well as their regard for the brand. The following are illustrative examples of marketing value.

Functionality & Features
What a product or service can do and how it does it. For example, a baby stroller that can be quickly adapted to weather conditions such as rain, wind, snow or intense sunshine.

Customer Experience
The end-to-end experience of discovering, buying and using a product or service. For example, the experience of un-packaging a product.

Brand Image
Brand image is everything a customer thinks and feels about a brand. This is influenced by factors such as advertising, word of mouth and customer experience. For example, a customer may perceive one brand of soap as a luxury item and another as low quality.

Social Status
A product or service that sends social signals such as a surfboard brand that’s respected by locals on a particular beach.

Identity
A customer who personally identifies with your products or services will place more value on them. For example, music that speaks to an individual.

Convenience
Products that save time or make things easier such as a hotel directly beside a major attraction.

Accomplishment
Products that give the customer a sense of accomplishment. In some cases, this is the opposite of convenience. For example, a customer may gain a sense of accomplishment from assembling furniture such that they end up placing more value on the product.

Comfort
Products that increase the customer’s sense of well being such as a hotel with comfortable beds.

Safety
Products that feel safe such as a bank with a reputation for diligent management of security and financial resources.

Visual Appeal
Products and environments that are visually appealing to the customer such as a hotel lobby that is perceived as visually stunning.

Sensory Appeal
The taste, smell, sound and sensation of products or environments such as bread that smells good.

Engagement
Products and services that are fun or stimulating to use such as a magazine that a customer reads cover to cover.

Usability
Products and services that feel intuitive and easy to use. For example, a game that you can immediately play and learn as you go.

Reliability
Reliability such as a product that is durable or service that always meets customer expectations.

Productivity
A tool that allows the customer to produce more with their time such as a mobile device that runs fast.

Efficiency
A product or service that consumes few resources relative to its output. For example, a sports car that goes a great distance on a single battery charge.

Performance
The performance of a product or service such as a stock trading app that always loads quickly.

Compatibility & Integration
Products that connect with other things. For example, a stock trading account that allows an investor to buy stocks on a foreign market.

Values
A product or service that fits a customer’s sense of right and wrong such as a cosmetic product that doesn’t pollute the environment.

Refinement
A product or environment that is perceived as well designed. For example, a mobile device that a customer views as a work of art such that it is almost priceless to them.

Rule of Three
Rule of Three Jonathan Poland

The rule of three is an economic theory that posits that large, mature markets tend to be dominated by three major competitors. This theory suggests that in an industry with many competitors, there will be a process of consolidation through mergers, acquisitions, and other shakeouts, which will result in the emergence of three dominant firms.

According to the rule of three, a firm that dominates an industry with few competitors may become vulnerable to new competition. This is because large, dominant firms often become less responsive to customer needs and less innovative, creating opportunities for other firms to enter the market and challenge their dominance.

In general, the rule of three suggests that markets tend to evolve towards a state of equilibrium with three dominant players, each vying for a share of the market. These three firms may be able to sustain their positions through economies of scale, strong brand recognition, and other advantages. However, the rule of three does not dictate that these three firms will remain dominant indefinitely, as market conditions and technological advances can disrupt the status quo and create new opportunities for other firms to emerge as leaders.

What is Supply?
What is Supply? Jonathan Poland

Supply refers to the amount of a product or service that is available for purchase at a given price. In economics, the concept of supply is used to understand and analyze various economic phenomena, including production, prices, business cycles, and a range of economic conditions and theories. Firms and individuals who produce goods or provide services are willing to offer them for sale in a market at a certain price, which is known as the supply of that product or service.

Supply Curve

Supply is typically modeled as a curve that shows the quantity of a good that market participants are willing to supply at a particular price level.

Supply & Demand

Supply curves are often modeled together with a demand curve that depicts the quantity that the market is willing to buy at a price. The point where these two graphs intersect is known as an equilibrium price. This represents the price and quantity that would be produced by an efficient market.

Business Cycles

As the price of a good goes up, firms and individuals have incentive to increase supply. This can take time and doesn’t happen immediately as it can require building factories and other facilities such as mines. In many cases, it takes an industry years to adjust to higher prices by increasing supply. Multiple producers may invest in new capital when a price goes up. This can result in a sharp increase in supply months or years later that collapses the price resulting in declining capital investment. Industries commonly go through a cycle of high prices and undersupply followed by investment and a period of low prices and oversupply.

Supply Shocks

A supply shock is a sudden drop in supply due to factors such as war, trade wars, disruptions, disasters or the exit of firms from a market . This can result in a large price increase that occurs quickly.

Types of Supply

Supply can include goods, services, labor, assets, securities and currency.

Perfect Competition
Perfect Competition Jonathan Poland

Perfect competition is a theoretical market structure in which a large number of buyers and sellers participate and no single participant has the ability to influence the price of a good or service. In a perfectly competitive market, all participants are price takers, meaning that they have no control over the price at which they can sell their goods or services and must accept the market price.

There are several characteristics that define a perfectly competitive market. These include:

  1. A large number of buyers and sellers: In a perfectly competitive market, there are so many buyers and sellers that no single participant can influence the market price.
  2. Homogeneous products: All participants in a perfectly competitive market sell the same product, so there is no differentiation between the goods or services being offered.
  3. No barriers to entry or exit: In a perfectly competitive market, there are no barriers to entry or exit, so new firms can easily enter the market and existing firms can easily exit.
  4. Perfect information: In a perfectly competitive market, all buyers and sellers have complete and accurate information about the market, including the prices and quantities of goods and services being offered.

In a perfectly competitive market, the market price is determined by the intersection of the supply and demand curves. As the price increases, the quantity supplied by sellers increases and the quantity demanded by buyers decreases, leading to a decrease in the market price. Conversely, as the price decreases, the quantity supplied by sellers decreases and the quantity demanded by buyers increases, leading to an increase in the market price.

While perfect competition is a theoretical concept and may not fully reflect real-world markets, it serves as a useful benchmark for understanding how markets function and how price is determined.

Inferior Good
Inferior Good Jonathan Poland

An inferior good is a type of consumer good for which the demand decreases as the consumer’s income increases. In other words, as the consumer’s income rises, they are less likely to purchase inferior goods and are more likely to substitute them with higher-quality or more expensive goods.

There are several factors that can contribute to a good being classified as inferior. One factor is the availability of substitutes. If there are good substitutes available, then the demand for the inferior good is likely to decrease as the consumer’s income increases, since they can choose to purchase the substitute instead. Another factor is the consumer’s taste and preferences. If a consumer has a preference for higher-quality or more expensive goods, they may be less likely to purchase inferior goods as their income increases. These goods may be less expensive than higher-quality brands, but they may also be perceived as being of lower quality or less desirable. As a result, consumers may choose to purchase higher-quality brands as their income increases, leading to a decrease in the demand for inferior goods.

Here are some examples of inferior goods:

  1. Generic or lower-quality brands of food: As a consumer’s income increases, they may be more likely to purchase higher-quality brands of food or to eat out at restaurants, leading to a decrease in the demand for generic or lower-quality brands of food.
  2. Lower-quality clothing: As a consumer’s income increases, they may be more likely to purchase higher-quality or more expensive clothing brands, leading to a decrease in the demand for lower-quality clothing.
  3. Used cars: As a consumer’s income increases, they may be more likely to purchase new cars or higher-quality used cars, leading to a decrease in the demand for lower-quality used cars.
  4. Public transportation: As a consumer’s income increases, they may be more likely to purchase a car or to use a ride-sharing service, leading to a decrease in the demand for public transportation.
  5. Cheap or low-quality household items: As a consumer’s income increases, they may be more likely to purchase higher-quality or more expensive household items, leading to a decrease in the demand for cheap or low-quality items.

It’s important to note that these are just examples, and not all consumers will behave in the same way. Some people may continue to purchase inferior goods even as their income increases, while others may switch to higher-quality or more expensive brands regardless of their income level.

Market Value
Market Value Jonathan Poland

The value of an asset or good in a competitive market, where buyers and sellers can freely participate, is known as its market value. This value is determined through fair and open competition. The following are illustrative examples.

Supply & Demand

Market value is driven by supply and demand. Increases in demand increase market value. Increases in supply decrease market value. For example, if home builders increase supply of new homes by 700% in an area this would drive prices down unless demand also increases.

Public Markets

A public market is a market that is open and accessible to the public such as a stock market. Prices on a liquid public market are considered a prime example of a market value. For example, a stock market with thousands of buyers and sellers of a stock competing at the same time to achieve the best price.

Perfect Information

Market value assumes that buyers and sellers are both in possession of the facts that are relevant to a transaction. For example, if insiders sell a stock because they know there is a problem at a company before investors, this may not be considered a market value for the stock.

Arms Length Transaction

Market value assumes that buyers and sellers have no relationship that could influence price. For example, if the CEO of a company buys assets from her company this would not be considered a market price unless the asset was put up for sale to the public with the CEO offering the highest price from multiple bidders.

Fair Market Price

Fair market price is a reasonable estimate of market price that is used for legal, accounting and tax purposes. For example, a CEO might buy an asset from a company at a fair market price based on independent and reputable assessments of a reasonable market value.

Reference Prices

Reference prices are data about recent prices that are used to estimate a fair market price. For example, data for home sales may be compiled to create reasonable estimates of the market price for homes based on market conditions, location, size, type, features and other factors.

Appraisal

An appraisal is a formal opinion of a fair market price formed by an expert in a particular market. This may make use of reference prices, models and other formal methods. Alternatively, it may be based on the expert judgement of an individual based on their experience.

Law of Supply and Demand
Law of Supply and Demand Jonathan Poland

The Law of Supply and Demand is one of the fundamental principles of economics. It states that the quantity of a good or service that a seller is willing to supply is directly related to the price at which they can sell it, while the quantity of a good or service that a buyer is willing to purchase is directly related to the price at which they can buy it. In other words, the higher the price, the more willing sellers are to supply a good or service, and the lower the price, the less willing they are to supply it. Similarly, the higher the price, the less willing buyers are to purchase a good or service, and the lower the price, the more willing they are to purchase it.

There are several factors that can influence the supply and demand for a good or service. Some of these include the availability of resources, the cost of production, and the overall level of economic activity. For example, if there is a shortage of a particular resource, it may become more expensive to produce a good or service, which could lead to a decrease in the supply of that good or service. On the other hand, if there is an increase in the cost of production, it may become less profitable for sellers to produce a good or service, which could also lead to a decrease in supply.

The interaction between supply and demand determines the market price of a good or service. When the supply of a good or service is greater than the demand, the market price will tend to be lower, as sellers will be willing to lower their prices in order to attract buyers. Conversely, when the demand for a good or service is greater than the supply, the market price will tend to be higher, as buyers are willing to pay more in order to obtain the good or service.

The Law of Supply and Demand plays a central role in determining the allocation of resources in a market economy. By setting prices and determining the quantities of goods and services produced and consumed, it helps to ensure that resources are used efficiently and that the needs and preferences of consumers are met. The following are illustrative examples of the implications of this fundamental economic principle.

Price Decreases Demand
The basic direction of a demand curve points down as people generally demand less of a good when it is more expensive.

Price Increases Supply
The basic direction of a supply curve points up as market participants will find ways to increase supply as a higher price is offered.

Demand Increases Supply
More demand increases the price, creating more supply. For example, a television show talks about the health benefits of a particular fruit. Other media outlets pick up on the idea and a large number of people start buying the fruit. Demand increases dramatically, driving up prices. Farmers see these prices and begin to allocate land, labor and capital to producing the fruit. In the following years, the supply of the fruit doubles.

Supply Decreases Price
Increased supply results in a lower price. For example, if there were 10,000 computer science graduates each year they might each have multiple job offers and be in a good position to negotiate a high salary. However, if the number of computer science graduates suddenly jumped to 1 million, salaries would drop as competition for each position would become more intense.

Supply Increases Demand … Sometimes
In many cases, more supply ends up creating more demand by pushing prices down. This isn’t always true because if you’re supplying something people don’t want it will not impact demand. However, a product with healthy demand will generally see an increase in demand when supply increases. For example, if the supply of apples doubled next year prices would tumble and some consumers would buy more apples based on price comparisons with other foods.

Business Cycles
The law of supply and demand explains the cycles of boom and bust experienced by many industries. A rising price causes capital investment to increase supply. Depending on the industry, it can take months or years for the new supply to show up. When supply does finally increase it causes prices to decline. The declining prices cause supply to drop as firms reallocate resources or exit the industry. The price begins to increase again due to less supply and the cycle repeats.

Inflation
Extremely high inflation can cause the laws of supply and demand to break down. For example, inflation causes people to buy goods more quickly because money loses its value. This is a situation whereby higher prices may actually stimulate more demand as it simply causes people to fear the prices of tomorrow.

Giffen Goods
Giffen goods are a category of goods that people buy more as the price rises. This is another exception to the laws of supply and demand. For example, in some nations rice may be a giffen good. When the price of rice increases, people may buy less meat as they need to conserve their food budget. The decline in meat consumption results in more rice consumption as people need to replace the calories.

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