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Microeconomics

Consumer Choice: Contrasting the Austrian Approach with the Neoclassical

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Abstract

In this chapter we analyze neoclassical concepts such as utility maximization and indifference, in order to identify their difficulties in explaining consumer choice. Thus, we study the process of human action itself, and the problems of indifference analysis. We provide a critique of the neoclassical view of consumer choice and contrast it with the Austrian approach.

Keywords

  • Neoclassical economics
  • Consumers
  • Choice
  • Utility
  • Perfect information

JEL Code

  • D11

A judgment of value does not measure, it arranges in a scale of degrees, it grades. It is expressive of an order of preference and sequence, but not expressive of measure and weight. Only the ordinal numbers can be applied to it, but not the cardinal numbers.

Ludwig Von Mises (1949, 97).

This chapter is based on our paper Futerman, Alan G. and Block, Walter E. 2021. “A Critique of the Neoclassical Approach to Consumer Choice”. Dialogi Polityczne Political Dialogues, No. 30, 2021, pp. 201–228. Available at https://apcz.umk.pl/czasopisma/index.php/DP/article/view/DP.2021.011/28729 (last visited April 13, 2021).

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Diagram 2.1
Diagram 2.2

Notes

  1. 1.

    Ultimately, though, perpetuating to a large extent the premises of neoclassical economics (Laibson and List 2015).

  2. 2.

    We will not analyze this approach, since trying to measure valuations and satisfaction is not feasible given the fact that there is no known way of performing such measurement nor of comparing utility. There is no empirical foundation to claim that there is such a thing as “util”. See also Rothbard (1962, 267).

  3. 3.

    See Boulding (1966), Miller (2013), Nicholson and Snyder (2011), Varian (1992). See also Chiang (1984).

  4. 4.

    For other critiques of this approach, see Barnett II (2003), Block (2009b), Block and Barnett II (2010), Block et al. (2002), Buchanan (1969a, b), Callahan (2003), McChesney (2013), McKenzie and Tullock (1975), and Rothbard (1956).

  5. 5.

    A critic may ask, why is it irrelevant to develop a mathematical model? After all, for instance, Newton’s work was indeed not irrelevant even if planets did not know about the law of gravity. Our answer is that it is irrelevant not because it is a model, but because it makes use of mathematical tools in order to explain a process that is better explained (and understood) in qualitative terms. For example, differentiation and integration require smooth curves, based upon infinitesimally small distinctions. But human action is, instead, discrete, and this is the appropriate subject for economics, we contend. As shown in chapter I, it is indeed possible to illustrate theories with mathematics, but we oppose using them if, instead of clarifying a subject, they sow confusion.

  6. 6.

    Any model, whether stated in mathematical terms or not, is indeed a simplification of reality. However, in this case, the models distort reality, and are thus not helpful to advance our understanding of consumer choice.

  7. 7.

    A critic may say that if it is a duplication of ordinary language, it is not of a different nature. However, we do not object to the assertion, that is why we say that even if...But we do not endorse the possibility, or at least, the convenience.

  8. 8.

    That are of course constrained by a budget, as shown graphically by a budget line.

  9. 9.

    It is true that these authors (Becker 1965, 1968, 1971, 1975, 1981, 1992; Lancaster 1966; Rosen 1974) indeed agree with the Austrian approach. This states that the key to consumer choice is the value the individual expects to get, and not the object itself (Mises 1949, 123). This entire approach affects our understanding from prices to marriage, and the fundamental idea is still the same: expected utility (Schoemaker 1982). However, the mathematical models used induce confusion, in our view. For instance, in the words of Mises (1949, 123): “If a man is faced with the alternative of giving up either one unit of his supply of a or one unit of his supply of b, he does not compare the total value of his total stock of a with the total value of his stock of b. He compares the marginal values both of a and of b. Although he may value the total supply of a higher than the total supply of b, the marginal value of b may be higher than the marginal value of a.”

  10. 10.

    Expected value, as presented by Nicolas Bernoulli (1713), assumes that utility functions are linear (or quadratic), and therefore there is no risk aversion. This is demonstrated in the famous St. Petersburg Paradox. However, as Daniel Bernoulli (Nicolas’ cousin) explained, the concept of expected utility is more tenable, since it involves both risk aversion and a form of decreasing marginal utility. He stated (Barathalon 2014, 204): “There is no doubt that a gain of one thousand ducats is more significant to the pauper than to a rich man though both gain the same amount […] The determination of the value of an item must not be based on the price, but rather on the utility it yields […] the utility is dependent on the particular circumstances of the person making the estimate […] no valid measurement of the value of a risk [a prospect] can be obtained without consideration being given to its utility”. Hence, utility (as later Ludwig Von Mises (1949) definitively explained) is entirely subjective. If the utility function involves risk aversion, and therefore its form is \( u=\sqrt{x} \) instead of u = x, that may solve the challenge of the St. Petersburg Paradox, but it does not answer the problems entailed in dealing with the subject in a mathematical fashion. This is so because multiple factors enter into consideration when dealing with utility and individual choice. How many factors? All that are relevant for the individual, such as risk, decreasing marginal utility, wealth (as in Friedman and Savage 1948), etc. Moreover, this conceptual framework has more applications in economics, not just consumer choice. Take the Markowitz (1952) model, which includes two parameters (risk and expected return). If we use expected utility, the only way to render this model useful is by assuming that investors have quadratic utility functions and that the returns of financial assets have normal distributions, so kurtosis and skewness are irrelevant. However, this is far from the truth. We do not pretend to treat financial models in this present chapter, but it is an example of how a specific theory of utility can affect other areas of economic analysis.

  11. 11.

    See on this Barnett (2003), Block (1980, 1999, 2003, 2007, 2009a, 2009b), Block and Barnett (2010), Callahan (2003), Collingwood (2014), Hoppe (2005), Hülsmann (1999), Machaj (2007), Rothbard (1962 [2009]; 265–267), Sotelo and Block (2014).

  12. 12.

    True enough, there are many models which focus on decision under uncertainty, but we are dealing here not only with those that assume perfect knowledge, but also with those that imply it.

  13. 13.

    If we must, we could conceive of illustrating the neoclassical perfect knowledge as a limit where C is knowledge which tends to infinity, and therefore, EU = RU:

    $$ \underset{C\to \infty }{\lim } EU= RU $$
  14. 14.

    We do not regard what we say in the text at this point as very controversial. Full knowledge has always been an integral part of the perfectly competitive model. For example, The Economic Times (Undated) defines perfect competition, in part, as: “Consumers have perfect knowledge about the market and are well aware of any changes in the market.” Here, we are merely applying this “insight” to indifference curve analysis.

  15. 15.

    That is, from the point of view of the consumer, he has some knowledge of his preferences and how much satisfaction would an extra unit of a good give him.

  16. 16.

    Although probability is usually stated in a mathematical fashion, e.g., the mean, variance, standard error, etc. when the individual is choosing, he uses a subjective view of probability, although, to be sure, he can make calculations that deal with specific monetary quantities with regard to his decisions.

    In this respect, in relation to Mises’ case and class probability, Foss and Klein explain:

    “What distinguishes case from class probability, according to Langlois, is the character of the decision-maker’s information about the event. Objective probabilities (in the frequentist sense) are simply special cases of subjective probabilities in which the decision-maker structures the problem in terms of classes of events. Entrepreneurship, in Langlois’ interpretation, can be described as the act of formalizing the decision problem. To use the language of decision theory, a nonentrepreneur (call him, following Kirzner [1973: 32–37], a Robbinsian maximizer) is presented with a decision tree, a set of outcomes, and the probabilities for each outcome, and simply uses backwards induction to solve the problem. The entrepreneur, as it were, redraws the tree, by noticing a possible option or outcome that other agents failed to see. The key distinction, according to Langlois, is not whether the decision tree is populated with objective or subjective probabilities, but whether the tree itself is exogenous (Knightian risk) or endogenous (Knightian uncertainty)” Foss and Klein (2012, 88).

  17. 17.

    This could be related to the concept of subjective expected utility (Savage 1954; de Finettti 1970; Pfanzagl 1967; Pfanzagl et al. 1968; Von Neumann and Morgenstern 1944 [1953]) although there are important differences (mainly, the use of mathematical tools). For a critique of this approach in the mainstream of economics, see Allais (1953).

  18. 18.

    Let us remember here Mises’s concept of rationality as presented in our Chap. 1, supra. Mathematical rationality of the kind in Allais (1953) or Simon (1955) is not necessarily the only expression of rationality. But behavioral economics seems to take it as such (e.g. Ariely et al. 2003, 2005; Ariely 2008). Hence, any deviation appears as “irrational”.

  19. 19.

    The problem of induction. See Popper (1959).

  20. 20.

    Or, at least, indifference analysis.

  21. 21.

    An objection could be made that this equation does not pretend to assign any numeric value to MU, but only to show that in that case MU is the same for each monetary unit spent. For further analysis of this issue, see Sect. 2.4 below.

  22. 22.

    In other models, such as the von Neumann-Morgenstern (1944 [1953]) utility function, based on decision under risk, it could be argued that there is cardinality as determined by the use of probability.

  23. 23.

    Pierre Garello (whom we thank for his valuable comments) has pointed us out that, it is true that according to the von Neumann-Morgenstern framework the cardinality consists in that the utility function representing the preferences of the decision maker are unique up to an affine transformation. Following Celcius, when the temperature goes from 2 °C to 4 °C we cannot claim that it is twice as warm, although the temperature recorded is indeed twice as high, numerically. However, the key is what we regard as affine transformation. In the equation above, it is cardinality, nonetheless.

  24. 24.

    In other words, commercial transactions are predicated upon inequations, not equations. If someone buys an apple for $10, and we present the following equation: 1 Apple = $10, that explains nothing about the value that the consumer places on the apple, nor why he is buying it. All we can know is that he values the apple he obtains more than the money he pays for it. About the $10 for an apple, we can only say that such was the agreed rate of exchange, in other words, the price.

  25. 25.

    Joke: the centipede was asked how he locomotes. He looked down, and couldn’t do it anymore.

  26. 26.

    Otherwise, no transaction would take place.

  27. 27.

    And not only optimality or maximization.

  28. 28.

    See on this a discussion on the concept of equilibrium in the work of James M. Buchanan in Wagner (2017, 20–21).

  29. 29.

    It is said that peanut butter and jelly are complements, and that beer and wine are substitutes. But even the most thorough chemical analysis of these four items will not yield any such truth. Rather, this situation stems, solely, from the tastes of most people. Nor need this claim be true for all. Some people might like to mix these two beverages and drink them together. In that case, beer and wine would be complements!

  30. 30.

    Buchanan was not an avowed Austrian economist in general, but insofar as praxeological subjectivism is concerned, he could indeed be categorized in this manner. See on this Buchanan (1969a), and Buchanan and Thirlby (1981)

  31. 31.

    We reject the notion that marginal utility constitutes an additional unit of satisfaction adding to “total utility”. To say that is to acquiesce in the concept of cardinal, not ordinal utility. Friedrich Hayek’s concept of utility is similar to the one we regard as correct. That is, the services rendered by an object or a person correspond to the use that the consumer thinks of the service he can extract from the object or person. In this respect, if the consumer acts freely, has a stable pattern of preferences and engages in rationality, he will stop his commercial activity as soon as the subjective opportunity cost of an additional purchase exceeds the expected gain from such action. A quantitative analysis, we must add, is an extrapolation from monetary costs (which explains the neoclassical economics derivation of demand curves by resorting to utility functions, and supply curves by using cost functions). But it is not necessary in order to make sense of utility or consumer choice in this respect.

  32. 32.

    For an analysis of “Revealed Preference Theory” (which is quite different than the Austrian sense of “preference reveals itself through action”), see Samuelson (1938). For a critique of the Austrian approach to microeconomics, see Caplan (Undated, 1999, 2001, 2003), and their rebuttals by Block (1999, 2003, 2007).

  33. 33.

    On the concept of indifference in the context of specific classes of goods, see Zanotti (1990, 22).

  34. 34.

    For an analysis of Utility and Price, see Kirzner (1963, 45–141).

  35. 35.

    And even if we would concede that this should logically be the case, this would only occur at equilibrium (in the sense of the “general equilibrium model”), but in the real world we are never at equilibrium, only always tending in that direction.

  36. 36.

    Translated from the original in Spanish by the first mentioned author of the present chapter.

  37. 37.

    Using the concept here in that sense.

  38. 38.

    Although the consumption of a unit implies the consumption of all the parts of such unit, this is not relevant to the individual at the time of making economic decisions.

  39. 39.

    We refer here to our discussion of the implicit use of cardinality in the model, as discussed above.

  40. 40.

    A critic may say that this type of analysis does not pretend to be realistic, but rather useful to understand some aspects of reality. However, we reject both claims.

  41. 41.

    According to Friedman (1953 [1966]), unrealistic assumptions should be no bar to economic theories; prediction, not accuracy, is the desiderata. One would be hard pressed, however, to come up with a prediction based on indifference curve analysis. In this regard, even when public finance literature uses this technique to make predictions, such as that people save more given higher interest rates, this is hardly a conclusion that can be reached only by means of indifference analysis. For support of Friedman, see Boland (1979). For a critique, see Rappaport (1986).

  42. 42.

    The Austrian approach on ordinal utility is different. See Klein (2012), Menger (1871), Menger (1973), Mises (1933), and Rothbard (1962).

  43. 43.

    The consumer may indeed say that he enjoyed the cheese more than the bread of the pizza, but he cannot quantify it by separating their “utilities”. Only an ordinal analysis is correct, coherent, not a cardinal one.

  44. 44.

    Another example is to assume that the utility reported by the use of a pair of shoes implies that, if only one shoe would be used then it will report half of the latter’s utility, when it most likely be useless without the other shoe. Therefore, it would provide low or zero utility.

  45. 45.

    Translated from the original in Spanish by the first mentioned author. Other critics of Nozick on this matter include Block (1980). Hoppe (2005) reject’s Block’s analysis. Block (2009a) and Barnett and Block (2010) respond to Hoppe (2005).

  46. 46.

    We owe this distinction to Pierre Garello.

  47. 47.

    See Rothbard (1957, 1997), Selgin (1988) and Smith (1999).

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Futerman, A.G., Block, W.E. (2021). Microeconomics. In: The Austro-Libertarian Point of View. Springer, Singapore. https://doi.org/10.1007/978-981-16-4691-1_2

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