The Law of Demand and Austrian economics

Lord Keynes has a couple of recent posts concerning the Law of Demand and whether it is universal. Lord Keynes, along with Post Keynesians in general, regard the Law of Demand as something that is really not useful and the reasons why this is so seem pretty valid to me. It should actually be noted that the Austrian criticisms on Lord Keynes’ posts demonstrate how strong of a presence neoclassical economics has in Austrian economics. Ludwig Lachmann, probably the strongest opponent of neoclassical influence in Austrian econ, tried to get Austrian economics in the right direction by rejecting much of neoclassical economics but it seems like he wasted his time in doing so because we still have the neoclassical influence. In fact, most just ignore Lachmann’s warnings on the grounds that since he is this nihilist, he, by definition, is critical of all theory. For example, take Frank Shostak , a Rothbardian who participated in Lachmann’s private seminars in South Africa: 

There is a long-running tendency among Austrians who have discovered the fallacies of mainstream thought to reject not just bad theory, but theory altogether. They conclude from the failure of one formal system of thought that all formal systems of thought must go. They rally around the work of Lachmann and G.L.S. Shackle and end up rejecting the existence of the law of demand, for example.

This is an enormous error. The problem with mainstream economics is not that it is theoretical and formal but that it is based on the wrong foundation and therefore generates crazy conclusions. The right response is to start from the right foundations. If a bridge collapses, you shouldn’t reject the possibility of scientific geometry; you should try to figure out what went wrong with the bridge engineering plan.

Paraphrasing Lachmann, he stated that he is against bad theory, not all theory, so I really do not know how Shostak ended up with this conclusion. Even think about this for a second, if Lachmann was against all theory, then does this mean that he disagreed with Shackle on his theory of uncertainty? No, of course not. Or does this mean that he rejected the theoretical and empirical aspects of capital, which he spent much time researching about? No.

But more importantly to get from the passage, it seems  that Lachmann himself questioned the Law of Demand. Shostak tries to justify why questioning the law of demand is wrong but I find it unconvincing. Shostak is essentially right when he states that the problem of neoclassical economics lies in its wrong foundations, but the foundation is wrong because of its formalization analysis of the real world and of its theoretical analysis on the real world. Thus, I do not get when he states, ” The problem isn’t formalization/ or its theoretical aspects, the problem is the mainstream’s wrong foundations.” To me this is like saying, “The problem is X, not X.”

In Lachmann’s paper, “Carl Menger And The Incomplete Revolution of Subjectivism” (1978), Lachmann criticizes Menger for being a subjectivist that wasn’t able to give up some objectivist aspects. This led Menger to sometimes contradict himself (for example subjective value of a good vs the nature of human needs, or the possibility of exact laws in the real world). Here is Lachmann on Menger’s exact laws:

For a long time students of Menger have been puzzled by the precise meaning of his notion of ‘exact laws’. He regards it as the prime task of economic science to formulate such laws. In Appendix V of the Untersuchungen we are told that ‘in the field of human phenomena exact laws (so-called ‘laws of nature’) are attainable under the same conditions as in that of natural phenomena.’ In this regard, then, there is no difference at all between social and natural sciences. On the other hand, Menger distinguishes sharply between these ‘exact laws’, i.e. ‘laws of the phenomena which are not only valid without exception but which, according to the laws of our thought simply cannot be thought of in any other way but as without exceptions’ (Menger 1963:42), and ‘empirical laws’ which rest on observation and admit of exceptions. Menger uses the ‘law of demand’ as an example for this distinction. According to him the exact law tells us not merely that a rise in demand will lead to a rise in price, but that, under certain conditions, the extent of this price rise is quantitatively exactly determinable (‘dem Masse nach genau bestimmbar’). But he goes on to warn us that these conditions require not only that all participants maximize their satisfaction in the pursuit of which they must be free of all external coercion, but also the absence of error and ignorance. Hence we must not expect to find instances of the exact law in the real world. It is “unempirical when tested by reality in its full complexity. But what else does this prove than that the results of exact research do not find their criteria in experience in the above sense? The above law is, in spite of everything, true, completely true, and of the highest significance for the theoretical understanding of price phenomena as soon as one looks at it from that standpoint appropriate for exact research. If one looks at it from the point of view of realistic research, to be sure, one arrives at contradictions… but in this case the error lies not in the law, but in the false perspective.” (Menger 1963:57)

These views will no doubt strike many of us as odd, but the main reason for it is that we have come to take it for granted that ours is a world of relentless positivism. (Lachmann 1994: 209)

Basically, the point to be made here is that this exact law (the law of demand) is unempirical when looking at the real world because it is impossible to determine price from the law of demand. Keep in mind that Lachmann is quoting Menger here, Menger is basically admitting the flaw of emphasizing the law of demand when looking at the real world. At the same time though, Menger is admitting that under certain assumptions, the exact law is completely true, which I am not so sure I agree with that. Nevertheless, from the point of view of realistic research, this law has contradictions.

Now I (unlike the majority of Austrians) do not think too heavily on Menger’s exact law concept, specifically because in order for these exact laws to be completely true, we must assume out some of the complexities of the real world. I have a feeling that Lachmann felt the same way.

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23 responses to “The Law of Demand and Austrian economics

  1. I made a few comments on Lk’s blog on this topic but did a bad job of getting my point across. Let me try again here.

    Firstly I agree with LK that the “law of demand” as generally understood is based on a set of unrealistic assumptions and is inadequate as a foundational law in economics.

    However I feel that Post-Keynsians go way too fast from these easy criticisms of the law of demand to (selectively) rejecting those parts of the wider body of economic theory that they feel is based upon this law and that doesn’t suit their overall project.

    I suspect that it is possible to build a more robust “law of demand” based on subjectivist principals that would avoid the contradictions in the generally accepted version (I think the Austrians probably already have done this, I need to research more)

    Of course just because a more robust version of the law of demand may exists that would help us identify the conditions needed for a general equilibrium it does not mean that the economy would ever reach that equilibrium. Economic data (and people’s subjective view of that data) would change before such a state could be reached. Lachmann may even be right and there may not even be anything operating in the economy that would lead to the equilibrating forces outweighing the dis-equilibrating ones, so there may not even be a tendency to equilibrium in the economy.

    However even if that is the case I think it unnecessary to concede that the law of demand, restated in subjectivity terms, is unable to play a role in describing whatever processes are at work in the economy.

    • “However I feel that Post-Keynsians go way too fast from these easy criticisms of the law of demand to (selectively) rejecting those parts of the wider body of economic theory that they feel is based upon this law and that doesn’t suit their overall project.

      Can you give an example of this? I am not sure what you mean.

      • Yes

        I asked LK what he thought the implications were of the assumptions behind the law of demand not holding in the real world and he replied

        “(1) The belief that all or most markets have prices determined by supply/demand dynamics (in reality, price setting/price administration exists in many important markets).

        (2) the belief that all product markets have equilibrium prices. ”

        on (1) I think it is a leap too far from going from the existence of some goods where demand would increase if the price increases to believing that “supply/demand dynamics” have no bearing on price , which it is claimed are generally set administratively.

        on (2) I am sure that one can derive an equilibrium price even with revealed preference showing a demand that increases with price.

        More anecdotally many post-Keynesians seem to believe in models (such as Minsky’s debt-deflation model) that seem to have equilibrium prices as implicit assumptions.

        • “on (2) I am sure that one can derive an equilibrium price even with revealed preference showing a demand that increases with price.”

          I guess this should be “equilibrium prices” in some cases.

        • I agree with LK on point 1 and I do not think you understand the position held by him. The issue is not whether S+D influences price (of course they do), the issue is whether S+D determines price. In other words, it is not LK’s position that ” “supply/demand dynamics” have no bearing on price”. And this is Menger’s and Lachmann’s point, in the real world (or in the point of view of realistic research as Menger said), price is not determined by S+D, for the only way it can be determined is to assume away some of the complexities of this world, or as Blaug said (a point highlighted by LK) we must hold an ‘everything else equals’ assumption on taste, expectations, and future states. This ‘everything else equal’ assumption dampens the importance of human action in economics, a thing that Austrians should have an issue about.

          On point 2, I already find it hard enough for people to justify an equilibrium price in the real world. I do not deny that we can derive an eP from demand curves, but this is only after given specific (unrealistic) assumptions such as assuming human action to be static. As an Austrian, I cannot accept that.

          “More anecdotally many post-Keynesians seem to believe in models (such as Minsky’s debt-deflation model) that seem to have equilibrium prices as implicit assumptions.”

          Can you provide a source to this. As far as I know, debt deflation is a non-equilibrium theory

          • Thanks for your reply.

            I think I must be expressing myself badly on this because I agree that a theory that required an “‘everything else equals’ assumption on taste, expectations, and future states” would not be adequate to describe how prices get set in the real economy because of course all things are constantly changing precisely because of human actions driven by subjective valuations

            However even with these things I feel it is possible to describe a theoretical equilibrium which in subjective turns would be the state where all human plans are aligned with one another. Such an equilibrium, however fleetingly it might exists before the data changed, would also have to consist at the level of the real economy of supply and demand being aligned at the current price level,

            I see the economy consisting of some processes (consumers revealing their preferences by buying goods they value the most, movement of capital to areas where profits are greatest and movement of labor to areas where wages are highest) as equilibrating and other forces (those changing “taste, expectations, and future states” as well as frictions that prevent the equilibrating processes working effectively ) as dis-equilibrating.

            Somewhere in all of that I see simple supply and demand analysis (even with weird shaped curves) as playing a foundational role in understanding these processes and feel we should not be too quick to throw away a valuable tool by taking a few complexities and packaging it up into a “supply and demand is dead” story.

            On Minsky: I agree that it is a non-equilibrium theory in terms of the macro-economy, but I bet it has some implicit assumptions that are not wildly different from those in the “law of demand”. I don’t have any references but when I have time I plan to look into that.

            • “However even with these things I feel it is possible to describe a theoretical equilibrium which in subjective turns would be the state where all human plans are aligned with one another. Such an equilibrium, however fleetingly it might exists before the data changed, would also have to consist at the level of the real economy of supply and demand being aligned at the current price level”

              This sounds like plan coordination theory (essentially late Hayek’s version of equilibrium), so yes it is possible to create a theoretical equilibrium model, which might in turn help find out what different ‘exact laws’ in which, according to Menger, are something completely true, but only after we assume out reality. As Menger states: ‘exact laws’ turn out to be contradictory when you look in the point of view of realistic research. But as I stated in another comment, I care more about the emphasis of ’empirical laws’ than ‘exact laws’. In other words, if reality tells me that there is no such thing as an eP, even though we can establish theoretically that there is, I am going to take the advise of the former rather than latter.

              “Somewhere in all of that I see simple supply and demand analysis (even with weird shaped curves) as playing a foundational role in understanding these processes and feel we should not be too quick to throw away a valuable tool by taking a few complexities and packaging it up into a “supply and demand is dead” story.”

              I personally have my doubts about S+D analysis, but there are Post Keynesians that don’t share the same view, even though we can agree on LK’s post on LOD. For example here is Unlearning econ experimenting on a view of S+D graphs: http://unlearningeconomics.wordpress.com/2013/01/17/the-market-which-market-alternative-theories-of-demand-and-supply/

              Note that the first commentor is a Post Keynesian that basically agrees that S+D analysis may serve useful.

              • yes, Unlearning provides a good example of how S+D analysis can be used meaningfully. There are clearly ..many implicit and explicit assumptions in ULs model that would not hold in the real world but I at least still found his charts useful in framing the issue.

  2. Spot on Isaac! Indeed the neo-classical influence is omnipresent in Austrian economics and Lachmann was absolutely right in criticizing it, by driving the subjectivist tenets to their logical ends, viz. applying subjectivism to the whole, rather than the parts.

    The law of demand is similar to all truths of apodeictic reasoning, in that it holds true in a realm where subjects, time and an interweaving web of factors (e.g. institutions) are not present, or if they are, they are irrelevant to the operation of the law. Once these are brought in, the law starts to reveal inconsistencies and contradictions, meaning that it can no longer be a ‘law’ in the sense of standing as the robust, objective terminus of all action and creation.

    PS. I discovered your blog a few months ago and enjoy reading your posts. I am a radical subjectivist myself, even though I only recently came to read Lachmann’s “Capital and its Structure” (a theoretical work by the way)—my world-view has been influenced from other subjectivist thinkers, such as Cornelius Castoriades.

    • “The law of demand is similar to all truths of apodeictic reasoning, in that it holds true in a realm where subjects, time and an interweaving web of factors (e.g. institutions) are not present, or if they are, they are irrelevant to the operation of the law. ”

      Yup, this is a good way of saying it. This is why I do not think too strongly of what Menger meant by exact laws, which he stated, the object of economics was to seek out exact laws. It may be the case that Austrian economics is split what to emphasize more ‘exact laws’ or ’emirical laws’. We can sure see the ‘exact law’ approach in Mises (praxeology) and Hayek (pure logic of choice) and the emirical approach in Lachmann, Rodan, Shackle, and Wiseman (theories on expectations and uncertainty).

      Also, Chapter 2 of Capital and Its Structure is probably the backbone to the whole book

      • Indeed Mises and Hayek do blend and confound their theories with certain essentially objectivist propositions.

        I agree with the ‘exact vs empirical’ (a priori vs a posteriori?) dichotomy in Austrian economics, however what I also appreciate in Lachmann is his recognition that an ‘eclecticist’ approach is, or may be, necessary in interpreting, understanding and dealing with given phenomena (I think he makes explicit reference to eclecticism in Capital and Its Structure, Chapter 7: Capital in The Trade Cycle). A thoroughgoing application of this approach, may leave little to no space for robust constants (‘natural’ laws) in the economic realm. It also introduces an element of skepticism, of not being perfectly certain about ‘the’ truth, which I personally appreciate.

        As for Ch.2, I agree with you and I also find his insights—and the inferences to be drawn from them—to be very useful in questioning the validity, or at least the universality, of a number of theories, Austrian ones included.

  3. Quick question Isaac. Suppose demand does rise in relation to price increases of a particular good, but how does that relate to the demand of other goods consumed by individuals assuming little relative change in income? Would demand for other goods fall in order to maintain consuming a good whose price is increasing?

  4. You and Lord Keynes are so concerned about not always thinking in so called neoclassical methods that I think it blinds you both.

  5. Interesting that Frank Shostak defends the Law of Demand, but in another article he indicates that supply and demand curves are “detached from the facts of reality. The real-world economy is far too complex to be faithfully rendered on simple graphs that take no account of uncertainty, entrepreneurial speculation, and the ceaseless change of the market economy.”

    see article here http://mises.org/daily/931

    • Thats the way a lot of Austrians work, especially the Rothbardian branch. Its like saying, “We aren’t neoclassicals, we hate their framework too! Now let’s move on to explain why minimum wage increases are bad by using a basic neoclassical textbook example.”

  6. Supply and demand curves only actually exist if firms and consumer are price takers, anyway, which begs the obvious question “who is setting the price?” In many ways perfect competition and Walrasian equilibrium require a central planner.

    My main takeaway from all the problems surrounding demand and supply curves is simply that reductionism doesn’t work. For your average commodity I’d expect we can observe a negative relationship between demand and price. For supply it’s harder to find examples of upward slopes – generally they’re likely to be horizontal or downward sloping due to returns to scale. In any case, there is no need to invoke reductionism.

    If anyone’s interested, I recently commented on how demand-supply curves might look in different markets:

    http://unlearningeconomics.wordpress.com/2013/01/17/the-market-which-market-alternative-theories-of-demand-and-supply/

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