A Model of Austrian Economics

0:00I'm going to present a model of Austrian economics and I also like to call this project, sometimes I like to call it dynamic, stochastic, general disequilibrium. And this title suggests that the goal of this project is to come up with a framework which is probably just as general as the models that are used in mainstream economics. But in addition we would like to incorporate some of the Austrian insights into such a framework. In order to do so we have to leave the concept of equilibrium, as I will argue in a second. And then the idea is to have such a model and to actually track the patterns that we expect over the business cycle into the system of national accounts, that is GDP and all its sub-components.

0:55Now, how could such a model possibly work? No, that's not it. First of all, the model is agent-based and accounting-based. That is to say, there are many types of agents that act in a completely decentralized fashion on virtual markets, where they exchange money against goods and services. And every agent has a balance sheet, and this balance sheet records its economic status at all times. And then we can simply aggregate those balance sheets and reach some macroeconomic status where we can then basically read out what would this mean to GDP. The model is also behavioral in the sense that these agents, they have certain goals.

1:44That is, they satisfy preferences or they maximize profits and they use algorithms to do this. They're not maximizing utility or something like that because that doesn't exist here. But they use some kind of procedural rationality and very simple algorithms to achieve their goals. And all of this is implemented in a Java language. It's like an object-oriented language where we can simulate the outcomes of such a model. I talked about markets, and this is the core, or the key, to understanding this model. The markets, the way I've designed them is as follows.

2:30A market can be populated by many, many firms, and each of those firms would have a certain quantity on offer, and it sets a price. So the individual supply curve of each firm would be simply a horizontal line. And if we then add them up or aggregate them, we would get something like an upward sloping supply curve. But this is not a Marshallian supply curve. It's simply something which shows us the price spectrum at which some total quantity would be available in a market. And then, on the demand side of the market, there would be some demanders. They enter the market and they have limited information. Information. They don't know this entire supply curve, but they randomly select three offers, then they choose the one with the cheapest price, and then they compare this price with their reservation demand or their reservation price. The reservation price again is behavioral, I'll get to that in a second, but this is what they do. They compare their

3:27willingness to pay with what they have in the market, and if this is okay, then they they make a purchase and then what happens is that the market is updated because one unit of the good has been sold now, the supply curve is actually shortened and the system reaches a new plain state of rest to put it in Misesian terms and this step by step the model goes into the future and there are markets for basically everything that circulates in in this economy. First of all, in every market transaction, money is exchanged against a good or service. And so we strictly separate between the monetary level and the real level of the economy.

4:13And then we can see simply there's a market for consumer goods and for labor and for capital goods and for equity shares and for credit, that is future money. And these are the balance sheets of the agents, like in a representative way. and yeah, we can see here that all the money is basically held by the banks, so this is like a gold standard basically and then they have like the firms and the households they have checking accounts and whenever they buy something they transfer money from one checking account to another. So it's like they act with money substitutes basically. And then they're envisioning their time deposits which can be converted into loans and then they can be used to purchase capital. and all of this is follows like basic accounting standards and so at each point in time, we have like a full-fledged accounting system.

5:13Now, what about the real side of the economy? It's modeled as follows. Here we have a grid and there are different stages of production, right? And then we also have different lines of production in the horizontal direction. And this is like a playground for the firms. The firms can still be settled at one of those nodes. And whenever a firm is settling here, then it can start to produce this good, which is here. This would be like F3. And another firm would settle here and then would produce the good D2. So they're just different goods in the economy. And if there's no firm, then the good is not going to be produced. And now say a firm is here at C2. then it can only use certain production factors as inputs.

6:02That is to say, it can use intermediate goods of the next higher stage and it can use machines, oh, I forgot to mention that here we have machines which are like fixed capital goods and it can use fixed capital goods from its own stage and it has to use labor. Labor needs to be used in any type of production process. So that is just to say that production factors are complementary, you cannot assemble products in a completely arbitrary fashion. Furthermore, there's a production function, which is basically a Leontief type production function. This simply describes a numerical relationship between inputs and outputs. I use one worker to produce one good, for example, or something like that. It's a bit more complicated than that, but I'll spare you the details.

6:47There's a processing capacity, like how many intermediate goods can a firm actually process per time period, and that depends on how much labor and how much capital has it accumulated and all that. In essence, it is a production function which rewards the accumulation of capital, the division of labor, and which most importantly follows the law of returns as stated by Mises. And it has constant returns to scale, just as in other mainstream economics. Okay, let's get to the behavioral section of it. These are the household preferences and I model them simply as sequences of intended actions. That is to say, a household might go about and say, okay, each household has an order in which he desires to purchase goods.

7:42So he starts out and say, I want to buy one unit of good B. And then he starts out, he wants another unit of good B and maybe a unit of good A, and later a savings contract. And in each of these actions, he has a reservation expenditure. And this reservation expenditure, or a reservation price, is, or describes the law of diminishing marginal utility. You could say that the reservation expenditure of each household is defined by his money holdings minus his money demand in each transaction. And the money demand in turn is a function of the numbers of the units of the good in question that he already owns.

8:28And the higher, this is monotonically increasing, so the higher this number, the lower is his willingness to pay for another unit of that good. And that's it, that's basically the law of Diminishing Marginal Utility. In addition, they also have pre-income preferences, so they have to decide, am I going to work in this time period or not? This decision reflects the trade-off that they face between leisure time and real consumption. In order to estimate the real consumption that they will have in the next time period, they first need to estimate the purchasing power of money, because they only know the money that they have in their pockets. And how do they do that? Well, they look at what they spent, what they consumed in the last time period.

9:16This is the real consumption in the last time period. And divide this by what they spent on this consumption, and then this gets them an estimate of the purchasing power of money. And then they multiply this with their current money holdings, and this is what they get as their expected real consumption, if abstaining from work. And then this enters the reservation wage function. And again, this is monotonically increasing, so the higher the expected real consumption, the less they're inclined to work. And as a side note, this is obviously an adaption of the regression theorem that I've just shown here. Now the firms, what do they do? I'm not going into all algorithms that I've developed, but how do the firms determine price and quantity?

10:01What they do is, first of all, the sales strategy of firms is only about revenue maximization. Because investment always precedes sales and so all these costs are sunk costs, doesn't matter. So it's only about revenue. But they don't know the revenue maximizing combination of quantity and price and they use therefore a process of try and error. And what they do, they have limited information there, it's an environment of radical uncertainty, so they only monitor their own balance sheet, their inventories, what they did not sell, and they always try to withhold a certain quantity from the market. So if, in particular, they have a target range of inventories, which is proportional to the quantity that they offer, and whenever they sell too much, then they raise the price.

10:59When they sell too little, then they lower the price, and that's sheer like this. In addition, if they sell too much with respect to their target and they were able to produce as much as they wanted, so they're not investment-constrained, then they also raise the offering target. And if the sales are low and they were still also investment-constrained, then they lower and the security offering target. So this is like a process of trial and error, like where do I end up in the market? And there are many firms who do this and they're competing with each other. Finally, investment, well that's actually quite easy. What they do is they go to the market, they look at all possible capital combinations that they could use and they calculate the unit costs.

11:51And they know the unit costs because they know the production function These are the prices that they find in the markets, and that's the unit cost, and whenever this is sufficiently low, below their sales price, then they make the investment because they expect to earn a profit. Finally, there's bankruptcy, I'm not going into the details of that, but this simply means that if they cannot pay that, then they go bankrupt, and then new firms are being created, and this gives the system some flexibility to changing conditions. Here is like simply how can we imagine this and we can imagine the demand by some kind of imaginary demand curve which is probably a bit more complex than that and here is the unit cost curve and what happens now in the system when it's interdependent is that the prices they will converge in some way.

12:51If there's monopoly, okay, then okay, it can always withhold quantity from the market and it will raise prices above unit costs. But say there's competition, then there can be two situations. Either the prices are competed down to the cost level, and that will be the case whenever the production factors are abundant, or the prices of the production factors actually bid up some to where the price level is and that will be the case when the production factors are scarce. And so here we have some interdependency and this is how it works. These are two possible capital combinations of a or capital resource allocations of an in Economy. So here we have a line of production, and this economy works with 14 workers. We have nine here, three here, one, one. And the goods that they produce are indicated in red, they go in this direction, and the money goes in the other direction. And then we have dividends and wages going back to the households.

14:11And here we have a different capital configuration, which is more capital intensive, we have more workers at the higher stages of production. Now how can this, is this possible, yes it is, but in order to become more capital intensive they need machines up here because otherwise they could not process all the goods that now arrive up here, much more goods arriving here now. And so we have, all together, we have a more roundabout production structure here, which is characterized by higher capital intensity, higher division of labor, a more complex assembling of goods. And how can we get from A to B? I mean, that's a critical question.

14:57And the answer is only by savings. Because these companies down here, they have very little revenue, yeah? They only get 24 monetary units as revenue, and they could never even afford an additional worker. So they can only expend if they have credit. So from A to B, we only get by savings. And the question is, can we show that? Yes, we can. I'll show you this, and this is how the model then will end. This is just a very simple version of it, but this is how it looks.

15:42You can run this and it will be running on our website, so it's possible to illustrate this and to track all the components of an economy. We can look at nominal consumption, real consumption, we can look at the labor market, at the price levels and so on and so on. We can look here at the allocation, and now this is a very simple economy, right? There's only one consumer good, this is here B1, there's one intermediate good and one machine, very simple. But we see that firms, okay, this computer is a bit slow so I have to pause it so that we can see the full picture. The firms are settling here at these nodes and they're trading in these goods and then they produce goods and so on.

16:28Converges quite slowly, that is caveat, but you can track over time what happens with these quantities and in 2000, well it's a bit slow, in 2040 there will be a shock and and then the production structure is expanded and we will see that then real consumption will actually rise. Let's go back to the topics because I'm running out of time. I'll show you how the result of this later. Now in essence, every spending pattern by the household sustains a certain production structure. And when this spending pattern changes, the preferences change for instance, Then we can show how the capital structure follows.

17:25So we have the principle of consumer sovereignty implemented here. And when there's an increase in savings, we have a lengthening of the production structure, which will eventually lead to higher output. And if there's credit expansion, then we don't have, We don't have, we have basically the same consumption pattern, but we have more money coming from the side basically, like being simply provided to firms, and then this will also lengthen the production structure, and it will raise output for a while, but as we know it will all come to an end, and finally when this credit expansion ceases, or when the money is being more equally distributed, then we have a breakdown.

18:17That's it. And the good thing is that we can track this, we can see how the macroeconomic magnitudes are actually reflect such a cycle. And we can look at the patterns, the macroeconomic patterns that would show up in such a cycle. To close this, this is just a comparison between what other economists do and what we have in this model here and I think this list could even be extended and I'm just saying that, as I said, we break with many of the metaphors that are actually usually being put forward and we replace this by some new metaphors but I think they are more realistic and they are more in line with Austrian economics.

19:09and Economics. So, I pause this here, yeah, and you can see there was a shock in 2040, the structure is now lengthened, and real consumption has gone up, thank you.