The Austrian School and the Gossen School

With just two books, Menger had put economic and social thought on completely new foundations. Principles pioneered the application of the empirical method in economic theory, and Investigations had justified the method and clarified the relationship between the resulting theory and other social sciences. Economic science was no longer just the study of visible economic phenomena such as prices, money, production; it had become instead the study of how these phenomena were caused by the interaction between human ideas and an environment offering limited resources for the satisfaction of human needs.

It took some time for both his opponents and his followers to grasp the full impact of the Mengerian revolution. For his contemporaries, the Mengerian project was attractive for reasons other than the grand new vision it implied. In particular, it was Menger's unique analytical method of developing economic theory as a descriptive science of the real world that attracted young disciples.

Menger's “empirical method” fit the ideal of its day. Schools and universities had thoroughly prepared the young scientific elite to appreciate the virtues of empirical research. More than the universities of other countries at that time, Germany's institutions of higher learning insisted on the necessity of empirical investigations in virtually all fields. Surprisingly, this orientation was the product of the “idealist” philosophy of Immanuel Kant, which stressed that knowledge about the objects of the exterior world could only be gained through sensory experience, and in particular through observation. German scientists were more willing than others to leave their armchairs and offices for field research to engage in systematic observation of nature. The famous Alexander von Humboldt was a pioneer of this movement, but others soon began to follow. German science excelled in biology, physics, chemistry, medicine, history, and virtually all other fields of knowledge.⁴⁸

In the field of political economy, however, which was usually taught under the name of government science, the call for an empirical foundation had led to the idealization of historical research. The historicists claimed that there was no other social science but history, and that economic theory, insofar as it had scientific merit at all, had to be a generalization of historical findings. In this context, Menger's approach appeared as an attractive alternative because it showed that economic theory was an independent discipline that could be studied in its own right without abandoning the empirical agenda. The power of this message even attracted scholars of historicist background who had no personal contact with Carl Menger.

A case in point was young Ludwig von Mises. Steeped as he was in the prejudices of interventionism and in the quest for a truly scientific foundation for economic policy, Mises would not have found Ricardo convincing. But Menger convinced him that there was such a thing as a scientific economic theory—a body of propositions about empirical reality, distinctly different from the propositions derived from historical research. Mises yielded to the evidence and became a Mengerian, and he would remain one the rest of his life.

In later works, Mises would modify, generalize, and qualify Menger's views. In particular, he became famous for his interpretation of the epistemological status of the propositions of economic science, that is, for his claim that these propositions are true on a priori grounds and therefore cannot be verified or refuted by the evidence of the senses. But these claims were attempts to clarify the position that Mises had inherited from Menger. The difference between Menger's Aristotelian rhetoric and the Kantian phrasing used by Mises is glaring, but the difference is mainly rhetorical. The principal thread of continuity between Menger and Mises is an adherence to the same scientific program of developing economic theory as a descriptive discipline, distinct from other descriptive disciplines such as biology or history. Both Menger and Mises believed that their theories described certain general features of human action that exist and operate at all times and places. This is what set them fundamentally apart from Wieser and Schumpeter, and this is what still sets Mengerian economists apart from all other economists.

Menger's method is also what most sharply distinguished him from Léon Walras and William Stanley Jevons, two authors with whom Menger is often conflated as co-founders of the marginal-utility approach in price theory. It is true that these three men published at about the same time systematic expositions of price theory based on the subjective and marginal nature of value. But apart from a broad agreement on these basic ideas, Menger's theory does not have much in common with the other two.⁴⁹

Léon Walras, top, and William Stanley Jevons, bottom

Walras and Jevons had to overcome great obstacles in expounding their principles. Neither had the German subjectivist tradition to draw on, and both met with fierce resistance from the academic establishment. As far as originality and scientific merit are concerned, however, they cannot compare with Menger.⁵⁰ Unlike Menger, Jevons and Walras had a specific predecessor, albeit an obscure one, whom they acknowledged and praised: the independent German scholar Hermann Heinrich Gossen had anticipated their central tenets and their approach to price theory.

By following Gossen, Jevons and Walras developed a marginal-utility theory of prices that was markedly less successful at describing observed reality than was Menger's marginal-value approach. The differences between Menger on the one hand, and Gossen, Jevons, and Walras on the other, might seem arcane, but they came to play a major role in the development of Austrian economics, and it is against this background that one must appreciate the significance of Mises's contributions.

Gossen had worked for twenty years on a manuscript that he published in 1854 under the title Entwickelung der Gesetze des menschlichen Verkehrs (Deduction of the Laws of Human Interrelationships).⁵¹ In this work he combined two central ideas into a general treatise on human behavior.

First, Gossen thought that economic science concerned laws that rule human psychology as it relates to human action. The most fundamental psychological laws, he claimed, were two laws of want-satisfaction that later came to be known as Gossen's First and Second Law. According to the First Law, the satisfaction derived from the consumption of any good will at some point reach a maximum. Neither higher nor lower consumption will produce greater satisfaction. According to the Second Law of Gossen, all goods should be consumed in such quantities that the contribution to overall satisfaction through the marginal consumption of each good is exactly equal.

Second, Gossen sought to describe human action with algebra and graphs, and relied on several implicit and false postulates in order to attain this goal. For example, he postulated that value is measurable and that the values of different persons can be meaningfully combined.

It was this procedure that made his approach especially contestable in the eyes of the academic establishment of German economists who abhorred speculations disconnected from the observed world. Gossen's book also suffered from grave formal shortcomings, being written in one continuous text, without chapter headings or a table of contents. This format and his excessive use of algebra and graphs made his work a tedious and distasteful reading experience. It fell into oblivion where it probably would have remained were it not for William Stanley Jevons.

When Jevons published the first edition of his Principles of Political Economy (1871), he considered his theory unprecedented. In 1878, Professor Adamson, Jevons's successor at Owens College in Manchester, came across a reference to Gossen's book in a history of economic thought and informed his friend Jevons, who celebrated Gossen in the preface to the second edition of his Principles (1879).⁵²

Walras was even more enthusiastic than Jevons. He compared Gossen to Copernicus and Newton, and translated Gossen's book into French.⁵³ When Menger told him in a letter that he believed there were significant differences between his own approach and that of Gossen, Walras waxed indignant and replied that he found it “odious” to think that Menger would refuse to recognize such an important predecessor.⁵⁴

Gossen had indeed anticipated Jevons's and Walras's theories.⁵⁵ The three men had developed general theories that were analogous to Menger's general theory of value and prices, but differed from it in their psychological orientation and in the exact type of explanation they offered.

In Menger's theory, the term “value” 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.

In the psychological approach of Gossen, Jevons, and Walras, the human psyche was the great common denominator for the economic significance of all goods; in the theory of Menger, there was no such common denominator. In his approach, “value” cannot be independent of the specific circumstances of time and space; it is inseparable from these circumstances and means different things in different economic settings. According to Gossen, Jevons, and Walras, the amount of “utility” derived from a good could be different in different situations, but according to Menger, the entire basis of value is different as soon as the economic context changes—because the good would then be compared to different other goods.

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. It also became conceivable to combine individual utility functions into something like an aggregate utility function: one person's satisfaction and another person's satisfaction can be added into a single quantity representing “their” total satisfaction; and one person's gain added to a different person's loss can be mathematically combined to determine whether there is net gain or loss.⁵⁶

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 “scientific”—and were looking for a plausible hypothesis to justify their preferred approach.⁵⁷ This also explains other fictional stipulations to which they resorted, again, in distinct contrast to Menger's method. In their price theories they avoided one of the great pitfalls of economic theory à la Ricardo, namely, reliance on aggregates. But because they were eager to make political economy a mathematical discipline they fell prey to the other great pitfall, reliance on fictitious ad-hoc postulates. In order to allow for graphical and algebraic representations of utility, demand, and prices, Gossen, Jevons, and Walras assumed that all goods were infinitely divisible. And in order to justify their assumption that the market is in equilibrium, they neglected the existence of error.

Just as the classical economists had done before them, the Gossen School analyzed prices as they would be if certain special conditions were fulfilled: they analyzed hypothetical equilibrium prices rather than actual market prices. It is here, then, that we find the great divide between the Austrian and the Gossen Schools. Menger paved the way for dealing with real-world prices. His work made economics more scientific in the true sense of the word—increasing knowledge about real things—while the writings of Gossen, Jevons, and Walras dealt not with matters of fact, but only conjectures. William Jaffé was entirely right when he wrote:

Carl Menger clearly stands apart from the other two reputed founders of the modern marginal utility theory.... No one familiar with the primary literature can doubt for a moment that Menger's treatment of the structure of wants in relation to evaluation was more profound and more penetrating not only than that of Walras who evinced no particular interest in such questions, but also than that of Jevons.⁵⁸

Jaffé went on to identify the root of the greater profundity in Menger's quest for realism, which prevented him from developing “theory” in the sense of a mental construct that is out of touch with concrete experience:

Menger kept too close to the real world for either the verbal or symbolic formulation of the theory; and in the real world he saw no sharply defined points of equilibrium, but rather bounded indeterminacies not only in isolated bilateral barter but also in competitive market trading.... With his attention unswervingly fixed on reality, Menger could not, and did not, abstract from the difficulties traders face in any attempt to obtain all the information required for anything like a pinpoint equilibrium determination of market prices to emerge, nor did his approach permit him to abstract from the uncertainties that veil the future, even the near future in the conscious anticipation of which most present transactions take place. Neither did he exclude the existence of non-competing groups, or the omni-presence of monopolistic or monopoloid traders in the market.⁵⁹

At the end of his career, Menger enlarged his approach to deal with social problems. In this respect too he was a pioneer. The very term “sociology” had recently been invented (by the French positivist Auguste Comte), and there were not yet any recognized professional sociologists around. Carl Menger became one of the first economists-turned-sociologist. Many other Austrian economists such as Schumpeter and Mises would follow in his footsteps. Mises later explained that this extension of interest is merely a natural consequence of the new viewpoint that Menger had developed in his Principles, for the gist of the new approach was an analysis that focused on individual human action and explained all social phenomena as resulting from the interaction of individuals.⁶⁰