The Austrian school of economics, pioneered by Carl Menger, Eugen von Böhm-Bawerk, and Ludwig von Mises in the late 19th and early 20th centuries, is known for its subjective and dynamic view of economic phenomena such as prices, production, and entrepreneurship. In particular, the Austrian understanding of how prices emerge and function in a market differs significantly from the neoclassical perspective that has dominated mainstream economics. This has important implications for analyzing and evaluating government efforts to regulate prices through interventions like minimum wage laws, rent controls, and commodity price supports. By exploring the Austrian view of price formation, we can gain critical insight into the effects and limitations of price regulation policies.
The Austrian school views prices as emerging from the subjective valuations of market participants as they exchange goods and services. Prices are not mechanically determined equilibrium points as in neoclassical models, but rather are formed through an entrepreneurial process of rivalry and discovery (Ebeling, 2004). In the neoclassical view, prices are signals that allocate resources efficiently in response to supply and demand conditions. In contrast, Austrians see prices as conveying essential information that helps coordinate the plans of producers with the demands of consumers. This coordination occurs through the incentives and signals provided by profit and loss (Richman, 2012). The intentions and judgments of entrepreneurs are central to this process, while the role of prices is overlooked in neoclassical theory.
Several elements of the Austrian understanding of prices are relevant to analyzing price regulation policies:
Role of entrepreneurship and economic calculation
A key factor in the Austrian view is the entrepreneur, who imagines new ways of arranging production to better serve consumer preferences. By committing resources based on their anticipation of future prices, entrepreneurs test their commercial judgments. Profits and losses then provide feedback on the quality of those judgments (Ebeling, 2004). This process requires economic calculation using the structure of money prices to compare the costs of different inputs to estimate the value consumers will place on final goods. Price regulation disrupts this entrepreneurial process by distorting the accuracy of calculations and profit/loss signals (Murphy, 2007).
Prices as exchange ratios
The Austrians recognize that prices emerge from the voluntary exchanges between market actors. They are ratios representing the terms on which two parties find it beneficial to trade. By contrast, the neoclassical focus on mathematically modeling resource allocation treats prices as external parameters determined by hypothetical supply and demand curves (Richman, 2012). This overlooks the exchange process central to real-world price formation.
Knowledge problem
In the Austrian view, market prices encapsulate the dispersed and tacit knowledge of individuals about their own preferences, circumstances, and local market conditions. No central planner can aggregate this knowledge (Hayek, 1945). Hence, government attempts to dictate prices necessarily lack the localized insights built into market prices through exchange. Regulators suffer from a fatal pretense of knowledge.
Market process
Austrians see the market as a dynamic process of discovery, adjustment, and coordination driven by entrepreneurship. In contrast, the neoclassical model describes an equilibrium end state. For Austrians, intervention disrupts the market's ability to adjust towards better satisfying consumer wants (Lachmann, 1977). Prices regulated by government decree short-circuit this process.
These elements suggest an inherent problem with price regulation from the Austrian perspective:
A. Price ceilings cause shortages by preventing exchange at market-clearing prices. This leads to arbitrary non-price rationing.
B. Price floors create unsold surpluses by blocking exchange at what would have been equilibrium prices. This distorts production.
C. Both distort resource allocation and production plans away from reflecting consumer preferences.
D. Entrepreneurs receive inaccurate profit/loss signals and are unable to effectively guide production through rivalrous discovery.
Price regulation subverts the coordination function of prices and the incentives guiding entrepreneurial decisions. Planners cannot possess sufficient knowledge of preferences and circumstances. Their administered prices suppress the market process by which prices ordinarily facilitate the alignment of production with consumer demand (Murphy, 2007). The pretended knowledge involved in controlling prices inevitably disrupts economic calculation and coordination.
Applying the Austrian understanding of prices casts doubt on the logic and efficacy of various price control policies frequently used today:
Minimum wage laws aim to raise pay rates for low-skilled labor above market-clearing levels. Austrian theory predicts this will cause unemployment through a surplus of labor at the regulated wage. This constitutes a price floor restricting certain mutually beneficial exchanges.
Rent control intends to improve affordability by capping prices below equilibrium. However, this suppresses the market price signals that would direct investment to expand the housing supply. The resulting shortages and misallocation exemplify the Austrian arguments against maximum prices.
Farm price supports like those in the U.S. aim to keep agricultural commodity prices artificially high through government purchases. This encourages overproduction of supported crops while distorting production away from meeting consumer demands. The Austrian view suggests that this disconnects farm output from what market prices would signal about consumer preferences.
The informed skepticisms of the Austrians toward price regulation do face some limitations:
The model of market coordination through prices relies on assumptions about competition, information flows, and rational decision-making that may not fully hold in all contexts.
There are situations where price controls could be welfare-enhancing, especially if implemented alongside other policy changes. For example, rent control paired with loosening of housing supply restrictions.
Behavioral factors like sticky wages and prices, money illusion, and decision biases may constrain the coordinating role of market prices and effectiveness of profit/loss signals to entrepreneurs in some circumstances.
However, the domains where the Austrian knowledge and incentive arguments likely apply against price regulation include:
Labor markets - due to localized nature of worker and job heterogeneity.
Complex consumer goods and services where quality is hard to monitor.
Dynamic and innovative industries where market prices guide entrepreneurial discovery.
So while the Austrian view may not warrant blanket opposition to price controls, it provides incisive reasons to expect regulation to disrupt coordination and distort production in many important cases.
The Austrian school's distinctive understanding of price formation suggests an inherent problem with government attempts to control prices. By viewing prices as arising from the decentralized market process, Austrians see regulation as disrupting the signaling and discovery role of prices. This undermines economic calculation and suppresses the incentives guiding entrepreneurial decisions to align production plans with consumer preferences. While the Austrian critique does not necessarily condemn all price regulation categorically, it offers powerful reasons to expect interventions like price ceilings and floors to produce distortions, shortages, surpluses, and misallocations within the economy. When combined with a perspective that emphasizes localized knowledge and unintended consequences, the subjectivist Austrian view of prices provides crucial insight into both the logic and limits of regulating prices in place of market-determined exchange ratios. This can lead to greater skepticism toward price controls in situations where market prices ordinarily perform an indispensable coordinating function. The Austrian emphasis on price formation through exchange and entrepreneurial discovery remains relevant to improving our understanding of when and how price regulation can disrupt the market process.
Ebeling, R. M. (2004). Austrian economics and the political economy of freedom. The Freeman. https://www.libertarianism.org/publications/essays/austrian-economics-political-economy-freedom
Hayek, F. A. (1945). The use of knowledge in society. American Economic Review, 35(4), 519-530.
Lachmann, L. M. (1977). Capital, expectations and the market process. In Capital, expectations and the market process (pp. 65-89). Essay originally published 1943.
Murphy, R. P. (2007). Price controls. Library of Economics and Liberty. https://www.econlib.org/library/Enc/PriceControls.html
Richman, S. (2012). Austrian economics hits the headlines. The Freeman. https://fee.org/articles/austrian-economics-hits-the-headlines/