Synonyms

Austrian Economics

Introduction

The Austrian tradition is distinct in emphasizing the role of uncertainty and ignorance of the individual in decision-making. Austrian scholars emphasize that the knowledge in society is fragmented and dispersed across individuals. Therefore, the main problem faced in society is one of coordination and social cooperation. The essential and distinctive feature of the Austrian school of law and economics is its emphasis on both economic and legal processes. The Austrian emphasis on processes can be applied to both these branches of law and economics: individual behavior within institutions, as well as individual behavior, leading to the emergence of institutions. This encyclopedia discusses some of the important representative ideas in the Austrian tradition such as spontaneous orders, individuals coping with decentralized knowledge and uncertainty, and coordination.

Origin of Institutions

The Austrian law and economics is most closely associated with Nobel Laureate Friedrich Hayek and his work on the origins of legal institutions. Hayek described evolved law as “conceived at first as something existing independently of human will” and distinguished it from legislation, which was “the deliberate making of law” by few individuals (Hayek 2011 [1960], pp. 118–119; and Hayek 1973, pp. 72–73). Hayek’s analysis is the direct outgrowth of the earliest Austrian insights as well as those of the Scottish Enlightenment of the eighteenth century. Carl Menger, the founder of the Austrian approach, stated that social scientist must explain “how can it be that institutions which serve the common welfare and are extremely significant for its development come into being without a common will directed toward establishing them” (Menger 1963 [1883], p. 146). Menger’s question links the Austrian approach to Scottish enlightenment scholars, who explained the spontaneous orders as “the result of human action, but not the execution of any human design” (Ferguson 1782[1767], p. III, S.2). This line of enquiry has continued in the Austrian tradition where modern scholars like Mario Rizzo and Gerald O’Driscoll ask, “How can individuals acting in the world of everyday life unintentionally produce existing institutions?” (O’Driscoll and Rizzo 1996, p. 20).

Menger argued that the emergence of money is one such example of spontaneous development of institutions. To solve the problem of the double co-incidence of wants, individuals find more highly valued commodities to exchange and therefore, add an exchange value to the use value of these goods, increasing the demand. As more individuals participate in such exchange, they converge to one or two generally accepted media of exchange, which we call money (Menger 1892).

In the same spirit of Menger’s explanation for the emergence of money, Ludwig von Mises, one of the most prominent scholars in the Austrian tradition, attempted to explain the emergence of legal rules. Mises argued that property law originally arose from recognition of simple possession and contract law from primitive acts of exchange within localized areas. While the former may have had as its primary motive the avoidance of violence and the creation of peaceful conditions, the latter was almost bound to arise under conditions of de facto property in order to pursue the gains from exchange. But ultimately the world created by these early efforts produced institutions that could be viewed as “a settlement, an end to strife, an avoidance of strife” and thus “their result, their function” is to produce peace within a community (Mises 1981 [1922], p. 34).

Hayek applied spontaneous order analysis, not just to specific legal institutions, but to the entire legal tradition of common law. Hayek described it as “deeply entrenched tradition of a common law that was not conceived as the product of anyone’s will but rather as a barrier to all power” (Hayek 1973, p. 84). Scholars have written about the role of litigants, judges, lawyers, etc., in the emergence of common law rules. Some have described the efficiency of common law as a result of private interests of litigants to resolve the dispute. On the supply side, Zywicki (2003) describes the common law system in the Middle Ages as polycentric law-making and attributes the emergence of efficient rules to courts and judges competing for litigants and fees in overlapping jurisdictions. Since the evolution of legal rules and institutions is a continual process, institutional entrepreneurs have an important role in finding opportunities to resolve conflicts and form more efficient, context-specific rules. This may inadvertently give rise, not only to the development of the specific rule, but the entire legal tradition.

Time and Ignorance

Perhaps the most important contribution of Austrian economics, as exemplified especially in the work of F.A. Hayek, is the understanding that individual behavior and social cooperation takes place in the face of decentralized knowledge. However, individuals have limited knowledge, and social knowledge is dispersed or decentralized. Furthermore, this knowledge may not be costless to acquire, or even exist in the form required for decision-making.

In his essay The Use of Knowledge in Society, Hayek notes “economic problem of society is thus not merely a problem of how to allocate ‘given’ resource … It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only those individuals know” (1945, pp. 519–520). So, for Hayek, the function of the law is to provide dispersed economic decision-makers the “additional knowledge” or, more exactly, surrogates for the knowledge necessary to rationally plan (Ibid, p. 521).

The problem of decentralized knowledge and uncertainty is at the very core of the Austrian approach to economics, especially the Austrian approach to law and economics. Karen Vaughn, while describing the overall Austrian approach, wrote, it is “impossible to think of Austrian economics as anything but the economics of time and ignorance” (Vaughn 1994, p. 134). Rizzo clarifies that it is the economics of individuals coping with real time and radical ignorance (O’Driscoll and Rizzo 1996, p. xiii). If individuals were not continuously faced with uncertainty and ignorance, a system of legal rules would be quite different. If one takes seriously the fact that all knowledge is decentralized, institutions must have certain characteristics to solve the problem of dispersed knowledge in society.

The knowledge problem may take a static or dynamic form. The static knowledge problem is the utilization of the current stock of dispersed factual knowledge so that individuals can coordinate their actions and plans at a particular time. The dynamic knowledge problem is the growth of new knowledge, not currently in the system, so that improved forms of coordination can occur through time (Kirzner 1973, 1992; Leoni 1991[1961]). Given static and dynamic knowledge problems, legal institutions are important in the coordination of different individuals at a point in time, and over a period of time.

Ludwig Lachmann argued that legal institutions act as “signposts,” because these institutions as they help individuals overcome problems of exchange by enabling individuals to form expectations and coordinate plans. And the most important characteristic of these legal institutions is their stability. He argues that incremental changes of rules, especially in their application to particular new conflicts, must not change the predictable nature of legal rules. “If institutions are to serve us as firm points of orientation their position in the social firmament must be fixed. Signposts must not be shifted” (Lachmann 1971, p. 50). However, this does not mean that a specific legal rule cannot or should not change. It is that the system of rules must be predictable. Lachmann’s unchanging signposts are about the stability of the system, rather than the stability of each particular rule. This echoes Hayek’s argument that laws “are intended to be merely instrumental in the pursuit of people’s various individual ends. . . . They could almost be described as a kind of instrument of production, helping people to predict the behavior of those with whom they must collaborate, rather than as efforts toward the satisfaction of particular needs” (Hayek 1944, pp. 72–73).

In a world filled with ever-changing and complex interactions, what is required is a simple system of rules to guide individual behavior. Epstein (1995) argues that simple legal rules can act as signposts in a complex world that is uncertain and dynamic. As systems go from hierarchical orders to spontaneous orders, the degree of coordination required, and the inherent complexity in mutual compatibility of plans, magnifies. Once it is appreciated that in referring to legal rules we are referring to inputs into individual decision-making, it becomes evident that the more decentralized and complex a system is the more critical it is that rules are simple.

Coordination and Optimality

The emphasis on ignorance, decentralized knowledge, and uncertainty leads us to the Austrian emphasis on coordination in society. It is important to understand the difference between coordination and the neoclassical concept of optimality. In the Austrian approach, the focus is on coordination, and not on optimality.

The fundamental meaning of coordination is simply the mutual compatibility of plans. This requires two things. First, each individual must base his plans on the correct expectation of what other individuals intend to do. Second, all individuals base their expectations on the same set of external events (Rizzo 1990, p. 17). In this basic meaning, the existing dissemination of knowledge has led to a state of affairs where each party is able to implement his plans. All offers to buy are accepted by sellers. All offers to sell are accepted by buyers. This is to be distinguished from the process of coordination whereby through trial and error learning and entrepreneurial discovery agents are able to make their plans compatible or more nearly compatible with those of others.

Coordination is analytically different, though not incompatible, with the concept of optimality. Pareto optimality implies that individuals exhaust all the potential gains from trade. This is a special case of coordination. However, there can be coordination, or the execution of mutually compatible plans, which do not exhaust all potential gains from trade. “...these plans are mutually compatible and that there is consequently a conceivable set of external events, which will allow all people to carry out their plans and not cause any disappointments” (Hayek 1937, p. 39). A state of mutually compatible plans “represents in one sense a position of equilibrium, it is however clear that it is not an equilibrium in the special sense in which equilibrium is regarded as a sort of optimum position” (Hayek 1937, p. 51). Everyone within a system may have mutually compatible plans, and yet there may be better trading opportunities out there so that at least some parties can improve their positions by alternative trades. Thus, if there is a sense in which the mutual compatibility of plans is an optimum, it is only a local optimum, that is, between the direct parties to an exchange.

In a fully or perfectly coordinated state of affairs, each individual correctly takes into account: (1) the actions being taken by everyone else in the set and (2) the actions which the others might take, if one’s own actions were to be different (Kirzner 2000, p. 136). The latter ensures that no buyer transacts at a price higher than that which a potential seller would offer. And that no seller transacts at a price lower than that which a potential buyer would offer. In this sense, the Austrian idea of coordination is compatible with the neoclassical concept of Pareto optimality. If each individual fully takes account of the actions (and potential actions) of every other individual, all courses of action, which might be preferred by any one participant without hurting anyone else, must already have been successfully pursued. In this sense, Pareto-optimality corresponds to perfect coordination (Kirzner 2000, p. 144).

The importance of law to basic and perfect coordination is indirect. Legal rules obviously cannot affect a state of affairs in which plans are mutually compatible and all arbitrage opportunities are eliminated. Nevertheless, they can, by facilitating exchange and protecting or ensuring the right to entrepreneurial (arbitrage) profit, make the discovery processes that move the system toward mutual compatibility and full coordination more likely to be unleashed. Lachmann emphasizes the aspect of institutions that aid the formation of expectations and argues that institutions “enable each of us to rely on the actions of thousands of anonymous others about whose individual purposes and plans we can know nothing. They are nodal points of society, coordinating the actions of millions whom they relieve of the need to acquire and digest detailed knowledge about others and form detailed expectations about their future action. But even what knowledge of society they do provide in highly condensed form may not all be relevant to the achievement of our immediate purposes” (1971, p. 50).

More generally in the field of law and public policy, simply to assume that the lawmakers, paternalist, or central planner each has the relevant knowledge to bring out his stated goals is to assume the knowledge problem away (e.g., Rizzo and Whitman 2009, p. 905). The task is actually the opposite, to solve the problem of decentralized knowledge. When lawmakers act on the basis of a pretense of knowledge to which they have no access, they increase uncertainty relative to attainment of individuals’ goals.

Legal Order

Economic activity takes place within the framework of a “given” legal order. However, some explanation is required to produce clarity about the meaning of such “givenness.” Something can be given in the objective sense, in which the legal rules are given to the omniscient observing economist. This is a conceptual expedient for the creation of narrowly specified and limited models. More important is the subjective sense, in which they are given to the individuals whose actions we are trying to explain (Hayek 1937, p. 39). Givenness in this second sense means that the framework, at least insofar as it affects the plans of the individual, is predictable.

However, it is impossible for any system of legal rules to be completely defined, specified, unambiguous, and hence perfectly predictable either in theory or in application. If ignorance and genuine uncertainty is taken into account, then it is problematic to assume a completely specified set of legal rules. While legal institutions may help individuals cope with ignorance in the market, these institutions are themselves subject to the knowledge problem. Hayek emphasized the knowledge problem not only in the context of the market, but extended it to other orders. The language of rules and legal decisions is always characterized by some ineradicable degree of uncertainty or vagueness, and therefore even if it were conceptually possible to define all rules clearly, it would be prohibitively costly (Whitman 2002, p. 6).

Whitman argues that it is inaccurate to see law as a process of one-way causation where a given set of exogenous legal rules resolves conflicts (2002, p. 3). In this area, an important aspect of the Austrian approach to law and economics is to endogenize the system of legal rules. Especially in a legal system in which judges make law by establishing, modifying, overturning, and reaffirming precedents, the actions of participants play a pivotal role in determining the direction of the law. Even when the there is no new legal rule, or a novel application of an old legal rule, the law still changes as a result.

If the legal rules are and constantly evolving, then what do we mean by the “givenness” of rules to the agents in the system? If the rules are constantly challenged and modified, then how do they provide any kind of guidance for human action? And more importantly, how does a constantly evolving system of rules act as a constraint for individual behavior? Within any legal system, there is a tension between the need to produce certainty of the laws with the need for the law to evolve and be relevant to new situations. This is particularly the case in common law. The question is often posed as a tradeoff between certainty and flexibility of the law.

In the first place, at the moment of choice, a certain framework of rules is given. Today’s market transactions must be executed within the framework of rights as given today, but that framework is itself the unintended result of the past actions of many individuals. These rules of the game are the “relics” of successful plans of earlier generations that have “gradually crystallized” into institutions (Lachmann 1971, pp. 68–69). Second, legal rules are not being changed in entirety, but the change is marginal. “A change in the law can be marginal in the sense that it is perceived as deviating only slightly from precedent” (Rizzo 1980a, p. 651). Third, Rizzo further argues that certainty of the law and its flexibility are not incompatible and that the “law endures by changing” (1999, p. 499). The law must have a certain plasticity to survive through economic changes. A rigid or static framework would break apart. These considerations imply that the “system” of rules is relatively stable, while marginal changes to specific rules adapt to the new or changing circumstances. This is the idea of the decomposability of the system of rules.

The most important factor that enhances the predictability of law, even as it adapts and changes to new circumstances, is the nature of the process involved. To see this we must distinguish between two forms of coherence in the law. Rizzo (1999) differentiates logical coherence of the law, from the praxeological coherence, or the coordination, which arises from the law. For Rizzo, and the Austrian approach more generally, it is praxeological coherence, or coordination in society, which is at the forefront of analysis. The logical consistency of laws is neither necessary nor sufficient for such coordination.

Another related reason for the emphasis on praxeological coherence of rules is the recognition that there is no one single correct set of legal rules. If the moral intuitions of individuals are not completely consistent or if they have gaps, then there may be more than one right answer in a particular case. All of these may be in the range of expectations of the agents. Presumably, this does not unduly disturb the order of actions as long as the acceptable range is within ordinary limits.

The process of rule-evolution or generation in a common law system is based on trial and error (Hayek 2011 [1960], pp. 122–125). Therefore, at any given point in time some rules or application of rules will simply be wrong. In other words, they will be ripe for revision as the process continues. For Hayek the primary focus is on the overall system. The system is or should be the primary object of normative evaluation. Its mistakes are in a sense simply part of the process.

Entrepreneurship

An important and recurring theme in Austrian economics is the role of entrepreneurial alertness in seizing profit opportunities and thereby enhancing the level of coordination in the market. Krecké argues that the Austrian concept of entrepreneurship is, in principle, applicable to legal decision-making. Decisions on which course to follow in a given case, and on which sources to rely, can be supposed to involve entrepreneurial judgments (2002, p. 8). Legal entrepreneurs, like their counterparts in the market, are alert to the “flaws, gaps and ambiguities in the law” (Krecké 2002, p. 10). Whitman (2002) also extends the idea of entrepreneurship to the role played by lawyers and litigants. He examines how legal entrepreneurs discover and exploit opportunities to change legal rules – either the creation of new rules or the re-interpretation of existing ones to benefit themselves and their clients. Harper (2013) believes that the entrepreneurial approach lays the groundwork for explaining the open-ended and evolving nature of the legal process – it shows how the structure of property rights can undergo continuous endogenous change as a result of entrepreneurial actions within the legal system itself.

The most important differentiating factor separating the entrepreneurship of the market process from legal entrepreneurship is the absence of the discipline of monetary profit and loss in the latter case. Although money may change hands in the process of legal entrepreneurship, its outputs may not be valued according to market prices, especially when there is a public-goods quality to the rule at issue. Whether effective feedback mechanisms exist in the contexts is therefore an open question. Martin argues that, in such structures, the feedback mechanism in polities is not as tight as feedback in the market mechanism, and therefore, ideology plays a greater role in such decision-making (Martin 2010).

Legal entrepreneurship can be coordinating and yet also increase uncertainty and conflicts in society. It all depends on the kind of legal order in operation and the mechanism by which it is generated and maintained. Rubin (1977) and Priest (1977) originally analyzed how the openly competitive legal process tends to promote economic efficiency.

Conclusion

Austrian scholars extend the themes of ignorance, uncertainty, and fragmented knowledge, to the legal order; and this has important implications for their approach to law and economics. First, the legal rules cannot be assumed to be exogenously given; they must be evolved and discovered through a process. Second, legal systems can become important signposts enhancing expectational certainty, even if they are constantly evolving. And third, entrepreneurship is no longer restricted to within a given set of rules; entrepreneurs also operate in legal and political spheres attempting to create, change, and evolve rules. Finally, through these forces, legal institutions evolve spontaneously without a central mastermind.

Cross-References