[Cross-posted at Organizations and Markets]
Austrian economists eschew empirical analysis in favor of deductive, a priori reasoning. They don’t believe in prediction. Neoclassical economists, by contrast, endorse the “scientific method” of rigorous empirical testing. You know that, right?
Then you might be surprised to learn that Carl Menger (1840-1921), founder of the Austrian school, called his approach the “empirical method,” as distinguished from Léon Walras’s “rational method.” Menger was a prominent economic journalist before turning to scientific work and his primary interest, as a scholar, was to explain the actual pricing processes he observed in the marketplace, processes that did not at all resemble those described in contemporary textbooks. Menger’s purpose, writes Guido Hülsmann in Mises: Last Knight of Liberalism, was
to demonstrate that the properties and laws of economic phenomena result from these empirically ascertainable “elements of the human economyâ€ such as individual human needs, individual human knowledge, ownership and acquisition of individual quantities of goods, time, and individual error. Menger’s great achievement in [Principles of Economics, 1871] consisted in identifying these elements for analysis and explaining how they cause more-complex market phenomena such as prices. He called this the “empirical method,â€ emphasizing that it was the same method that worked so well in the natural sciences.
This empirical method does not involve the use of abstract (and deliberately unrealistic) postulates to formulate testable hypotheses, as is appropriate for the study of natural phenomena. Rather, for the social sciences, empirical analysis involves the systematic construction of a causal theory based on observation of basic empirical phenomena such as human wants, stocks of goods, technical knowledge, and so on.
In a 1884 letter to Walras Menger criticized the use of mathematics in economic analysis. The merit of a theory, Menger observed,
always depends on the extent to which it succeeds in determining the true factors (those that correspond to real life) constituting the economic phenomena and the laws according to which the complex phenomena of political economy result from the simple elements. . . .
A researcher who arrives by the way of analysis at such elements that do not correspond to reality or who, without any true analysis, takes his departure from arbitrary axioms — which is only too often the case with the so-called rational method — falls necessarily into error, even if he makes superior use of mathematics.
The quotes (and their translations) are provided by Hülsmann, whose discussion of Menger (pp. 101-40 of Last Knight) provides a valuable overview of, and commentary on, the Austrian approach. Hülsmann is influenced by William Jaffé’s important work on the differences between Menger, Walras, and Jevons but goes beyond Jaffé in important ways. For example, Hülsmann emphasizes the much overlooked influence of Hermann Heinrich Gossen on Walras’s and Jevons’s systems. While Menger’s approach emphasized causal explanation and real phenomena such as preference, Gossen focused on an abstract, psychological concept of utility (“want-satisfaction”) that is measurable and comparable across individuals. As Hülsmann explains (pp. 131-33):
In Menger’s theory, the term “valueâ€ does not refer to a psychological feeling, but rather to the relative importance for an individual of the marginal unit of good X — that is, to the importance of X in comparison to the marginal units of other goods Y and Z. The market price of a good results from the interplay of sellers and buyers, for whom the goods bought and sold have different relative importance. In contrast, in the theories of the other three authors, the price of a good results from the interplay of sellers and buyers whose feelings or well-being are differently affected by control of the good. While Menger explained the pricing process as resulting from the importance of a good relative to the importance of other goods, Gossen, Jevons, and Walras explained the pricing process as the impact of a marginal quantity of a good on the psychology of the actor — an impact they called want-satisfaction (Gossen), utility (Jevons), and satisfied needs (Walras). Jevons’s marginal utility thus played structurally the same role that marginal value played in Menger’s theory — it delivered an explanation of market prices — but where marginal utility explains the price of a good by the good’s direct impact on human feelings, Menger’s marginal value explains the price of a good by how the good ranks in importance compared to other goods, according to the needs of the individuals involved in the pricing process. . . .
Whatever else one might think of the merits of the psychological approach, it had at least one great attraction, namely, that it allowed the possibility of a mathematical price theory based on marginal utility. With the human psyche as the common denominator of all economic values, it became conceivable to represent the want-satisfaction or utility derived from the consumption of a good as a mathematical function of the quantities consumed; it became conceivable to scale satisfaction and utility into units with which one could perform economic calculation completely disconnected from market prices. . . .
These considerations probably played a role in prompting Gossen, Jevons, and Walras to choose the psychological approach. They did not begin with observation and then adopt algebraic and geometric techniques as the most adequate tools for representing what they observed. Rather, they began with an agenda — the need to apply mathematics in economics to make it more “scientificâ€ — and were looking for a plausible hypothesis to justify their preferred approach.