Economics: Chicago, Austria, and me

how I position myself

David Friedman recently debated a topic.

[resolved that] The Austrian economics of Mises and Rothbard contains economic intuitions that are important, correct, and missing from Chicago School economics.

Friedman is on the side of the Chicago school. He writes,

Very nearly any political change one can imagine will benefit some people and harm others. To argue that the net effect is an improvement you need some way of adding up gains and losses. Chicago school economics does it by the concept of economic efficiency. Austrian economics, which rejects that concept, provides no way of judging

I understand why the Austrian school does not respect cost-benefit analysis. A basic principle of Austrian economics is that all costs are opportunity costs. For Anita, the cost of her choice is the opportunity cost of making a different choice. That is something known to Anita and only to Anita. So it is pretentious for an economist to claim to know the cost and to be able to do cost-benefit analysis.

The subjective element of cost is a key component of what Austrians call the knowledge problem. That in turn is central to their argument in the socialist calculation debate.

Friedman also writes,

Since Austrian economists are committed to the idea that economic conclusions must be based on theory not evidence, an Austrian economist qua economist cannot use the fact that policies have had bad effects in the past as evidence that they will in the future. A Chicago economist can.

I also am inclined to dislike the a priorism of Mises. But perhaps I am missing something subtle there.

Here are some of the key elements of my views of economics.

Dynamic efficiency matters

Conventional economics looks at the efficiency of a static allocation of resources. Instead, I follow Douglass North in looking at dynamic efficiency. How well does an economic system improve over time?

I like to talk about the three e’s: experimentation, evaluation, and evolution. A good economic system conducts many experiments. Experiments are evaluated rigorously. And evolution leads to the retention of what works and the discarding of what fails. So if a lot of business initiatives are tried, and they are evaluated by the price system, and then profits and losses drive evolution, that will result in dynamic efficiency.

Institutions influence incentives

I also follow North in his focus on institutions and their effect on incentives. In his Nobel lecture, he said,

The organizations that come into existence will reflect the opportunities provided by the institutional matrix. That is, if the institutional framework rewards piracy then piratical organizations will come into existence; and if the institutional framework rewards productive activities then organizations – firms – will come into existence to engage in productive activities.

I think a lot about organizational behavior and cultural norms. I say that an organization with a lot of titles will select for people who care about titles. I say that a business unit gets the information systems it deserves—a loose and informal business unit is not going to get a rigorous management information system. I say that compensation systems decay over time as workers learn to game them. And so on.

Overhead Matters

In conventional economics, you do not worry much about fixed costs. It is marginal costs that matter.

I think that in the real world, overhead matters. As a result, price discrimination explains everything. That is, many real-world business practices reflect the attempt to extract more revenue from price-insensitive customers.

Thus, my favorite paper from the Chicago school discusses a business where overhead cost dominates. This paper is Walter Oi’s A Disneyland Dilemma: Two-part Tariffs for a Mickey Mouse Monopoly.

Specialization and Trade Matters

Here of course, I follow Adam Smith. I emphasize the difference between a simple, small-scale closed economy and a large, complex open society. And in fact I have a whole book on the topic of specialization and trade.