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    George Mason UniversityDepartment of EconomicsWorking Paper No. 12-41

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    2/57Electronic copy available at:

    Labor Economics from anAustrian Perspective

    Peter J. Boettke George Mason University

    William J. Luther Kenyon College


    The compelling case offered by Austrians regarding the recent economic downturn

    has no doubt encouraged many to take a closer look at the broader Austrian perspective. Similarly, the jobless recovery has prompted some soul searching inlabor economics. We briefly review the history and methodology of the Austrianschool and describe major contributions to labor economics from those working in theAustrian tradition. Then, we offer a sketch of the Austrian theory of labor marketsand discuss its implications. In doing so, we hope to have helped the interested readeralong both lines.

    JEL Codes: B53, E00, E2, E3, E4, E5, E6, J00, J2, J3, J5, J6, J7, J8

    Keywords: Austrian, Austrian business cycle theory, Bhm-Bawerk, entrepreneurship,

    Hayek, labor, labor theory of value, marginalism, Mises, search, uncertainty,unemployment

    Email: [email protected] Address: Department of Economics, George Mason University, MSN 3G4,Fairfax, VA 22030 Phone: 703.993.1149 Email: [email protected] Address: Department of Economics, Kenyon College, Ascension Hall #305,Gambier, OH 43022 Phone: 740.222.1242

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    Austrian Labor


    The US has experience persistent high unemployment in recent years. According to the

    Bureau of Labor Statistics, the unemployment rate, which averaged roughly 5.3 percent

    from January 2002 to January 2008, grew steadily from 5.0 percent in January 2008 to

    10.0 percent in October 2009. Having declined somewhat, it remains significantly higher

    than the pre-recession average. The unemployment rate hovered around 8.2 percent

    during the first five months of 2012. With GDP increasing on average since June 2009,

    many economists, journalists, and pundits have described the end of the Great Recession

    as a jobless recovery . Although everyone seems to agree that the US is experiencing a

    jobless recovery, there is considerably less agreement as to why this is the case.Speculation surrounding the jobless recovery stands in sharp contrast to the strong

    consensus that has emerged concerning the proximate causes of the housing bubble and

    subsequent recession. Although some continue to blame a global savings glut, structural

    change, and/or lack of financial regulation, most economists now accept that the Federal

    Reserve held interest rates too low from 2001 to 2006, thereby generating an

    unsustainable bubble. John Taylor (2009a, 2009b) and the late Anna Schwartz (2009)

    have been particularly influential in promoting this view among mainstream economists.

    However, as Scott Sumner (2009) notes, the position advanced by Schwartz (and,

    therefore, Taylor) more closely resembles the Austrian business cycle theory than the

    Monetarist view she and Milton Friedman once popularized. 1

    Several economists explicitly linked to the Austrian tradition have offered

    commentary on the recent boom and bust. Boettke and Luther (2009), Horwitz (2009a),

    Horwitz (2009b), Horwitz and Boettke (2009), Horwitz and Luther (2011), White (2008),

    1 Were he alive today, Sumner (2009) writes, Friedman would be horrified by the neo-Austrian views ofAnna Schwartz. For a concise review of the differences between Austrian and Monetarist perspectives, seeGarrison (2006).

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    and White (2009), among others, generally accept the view put forward by Taylor and

    Schwartz regarding the origins of the bubble 2 If disagreement exists between

    Taylor/Schwartz and the Austrians, it concerns the nature of capital and labor specificity,

    the need for a period of adjustment following the boom, andmore generallywhat

    could and/or should be done to get out of the present mess. As a result of these works and

    others, the Austrian business cycle theory is once again a contender in the realm of


    Given that the Austrian explanation of the recent recession is so compelling, a

    natural question follows: What do the Austrians have to say about unemployment, in particular, and labor economics, in general? After briefly reviewing the methodological

    framework of the Austrian school, we survey contributions to labor economics from

    traditional and modern Austrian economists. In Section 2, we sketch a model of labor

    markets from an Austrian perspective. Implications of this model are made explicit in

    Section 3. Our primary aim is to familiarize the reader with the Austrian perspectivenot

    to answer all questions arising from within the Austrian tradition or between Austrian and

    mainstream economists. We hope the interested reader will follow the sources contained

    herein to address such questions.

    1. Survey

    Austrian economics originated in Vienna in the 1870s with the publication of Carl

    Mengers Principles of Economics . Although the ideas expressed by Menger contrasted

    sharply with those held by many of his German-language colleagues, they were firmly in

    the tradition of mainline economics stemming from Adam Smith, David Hume, and Jean- 2 The historian Tom Woodss (2009) also takes the Austrian position.

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    Baptiste Say. Along with William Stanley Jevons and Lon Walras, Menger contributed

    significantly to the marginal revolution in economic thought. As a result, early

    Austriansincluding Eugen Bhm-Bawerk, Friedrich Wieser, Hans Mayer, Ludwig von

    Mises, Gottfried Haberler, Friedrich A. Hayek, Fritz Machlup, Oskar Morgenstern, and

    Paul Rosenstein-Rodansaw themselves as contributing to the principle body of

    economics. They held prestigious positions in the academy, published in the top journals

    of the day, and were highly regarded in the profession.

    Only in the late 1930s and 1940sduring the two great debates of that erawas

    the uniqueness of the Austrian perspective revealed. Debates over the causes of and proper response to fluctuations in economic activity with John Maynard Keynes and the

    feasibility of economic calculation in the absence of private ownership of the means of

    production with Oskar Lange and Abba Lerner showed that Austrians were more keen to

    view the market as a process of interaction and less accepting of aggregate conceptions

    than their non-Austrian colleagues. 3 As the profession moved toward mathematical

    formalism and empiricism in the 1950s and 1960s, and Austrians more clearly articulated

    their views of the market process and radical uncertainty in the 1970s and 1980s, the

    distinction became sharper. Over the last two decades, Austrian economics has occupied

    a somewhat peculiar domain between the mainstream profession and approaches that are

    clearly heterodox. Nonetheless, many Austrians still see themselves as working in the

    mainline tradition of economics. 4

    Before reviewing contributions to labor economics from those working in the

    Austrian tradition, it is useful to summarize the core methodological components of the

    3 See Lavoie (1985) and also Boettke (2001) and (2012, chapter 16).4 Boettke (2007) distinguishes between mainline and mainstream economics. See also: Boettke (1996),Boettke, Fink, and Smith (2011), and Boettke (2012).

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    Austrian school for those readers less familiar with the approach. In addition to enabling

    one to identify common themes in the various works presented in this section, clarifying

    our conception of Austrian economics will also provide some context for the theory of

    labor markets articulated in Section 2 and the implications of that theory discussed in

    Section 3. As our summary of the Austrian core is intentionally brief, the interested

    reader is directed to Boettke (1997), Boettke and Leeson (2002), Caldwell (1994),

    Kirzner (1997), Lavoie (1994), Martin (2009), Selgin (1988), and White (2003). 5

    1.1 The Austrian Core

    Since the schools inception, Austrian economists have strictly adhered to

    methodological individualism. Economics is first and foremost the science of human

    actionthe study of choosing between scarce resourcesand Austrians maintain that,

    ultimately, the individual is the only entity capable of such choosing. 6 To the extent that

    one speaks of a corporation, government, or other group making decisions, it is merely

    shorthand for a process in which individuals act. Moreover, individuals are presumed to

    act purposively, a term designating a weak form of rationality wherein individuals

    choose means they believe will satisfy their given ends. Hence, Austrian economists can

    be said to employ a rational choice framework at the level of the individual.

    Although Austrians employ a rational choice framework, they differ from many

    mainstream economists in that they are thoroughly subjectivist. Rationality, to an

    Austrian economist, denotes intention rather than omniscience. So long as one chooses

    5 Backhouse (2000) provides a non-Austrians perspective on Austrian economics.6 There has been some disagreement regarding whether theories of group selection put forward by Hayekare in fact consistent with methodological individualism. See Caldwell (2001, p. 548-51) and the citationscontained therein.

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    the means he believes are best suited to accomplish his ends, he is acting rationally.

    Austrians commonly assume experiences inconsistent with expectations lead individuals

    to revise their beliefs. Nonetheless, holding objectively false beliefs is not typically seen

    as irrational.

    The value theory accepted by Austrians is similarly subjectivist. Goods are

    valuable insofar as individuals find them useful. Goods are not endowed with a fixed

    amount of usefulness. Early Austrians bucked hard against the labor theory of value and

    similar input-based approaches. Rather than being determined by objective costs, supply

    curves in the Austrian framework reflect the subjective valuation of foregoneopportunities. Whereas demand curves depict the price one is willing to pay for an item,

    as governed by the value the item has to potential buyers relative to other goods that

    might be obtained, supply curves depict the price one must be compensated in order to

    give up an item, similarly governed by the usefulness of the item to the seller relative to

    alternatives. They are marginal benefit and marginal cost curves, where benefits and costs

    refer to the subjective valuations of individuals.

    Perhaps the most salient feature of Austrian economics is its treatment of

    information, which is presumed to be decentralizedspecific to individuals of a

    particular time and place. In two important essays, Hayek laid the foundation for the

    modern Austrian view. First, Hayek (1937) explains that the information required for

    equilibrium was far greater than any single individual needed to conduct the pure logic of

    choice. Whereas the latter required an individual have a subjective interpretation of the

    data surrounding his decision, the former required consistency in the subjective

    interpretations of all acting agents since, in equilibrium, all planned courses of action

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    must be compatible. The question, then, is how the spontaneous interaction of a number

    of people, each possessing only bits of knowledge, brings about a state of affairs in which

    prices correspond to costs [] and which could be brought about by deliberate direction

    only by somebody who possessed the combined knowledge of all those individuals (p.

    49). In a second essay, Hayek (1945) offers an answer to this question. Rather than

    depicting the market as a field of information over which individuals optimize, Hayek

    expresses it as a process of social interaction through which the necessary information is

    communicated. 7 Although information is decentralized and a change in relative scarcity is

    only known by the man on the spot (p. 524), prices can act to coordinate the separateactions of different people in the same way as subjective values help the individual to

    coordinate the parts of his plan (p. 526). In abbreviated form, by a kind of symbol,

    Hayek (1945, p. 527) explains, only the most essential information is passed on and

    passed on only to those concerned. Hence, prices emerge from bid-ask patterns, which

    are based on individual-specific information; and these prices communicate the

    individual-specific information necessary to obtain equilibrium to all market participants.

    The out-of-equilibrium dynamics described by Hayek requires the process of

    entrepreneurshipan idea of central importance to Austrians. Entrepreneurship occurs

    when one identifies a profit opportunity, musters the resources necessary to seize it, and,

    through the exploitation of that profit opportunity, brings the economy closer to

    equilibrium. As Kirzner (1973) explains, entrepreneurs are alert to potential profit

    7 In Hayeks (1945, p. 526) own words: The whole acts as one market, not because any of its memberssurvey the whole field, but because their limited individual fields of vision sufficiently overlap so thatthrough many intermediaries the relevant information is communicated to all. The mere fact that there isone price for any commodityor rather that local prices are connected in a manner determined by the costof transport, etc.brings about the solution which (it is just conceptually possible) might have been arrivedat by one single mind possessing all the information which is in fact dispersed among all the peopleinvolved in the process.

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    opportunities. Like Hayeks man on the spot, the entrepreneur possesses information of

    a particular time and place and, therefore, is in a unique position to recognize when

    changing preferences or technology create an opportunity for arbitrage. By acting on this

    information, the entrepreneur captures the profit made possible by the arbitrage

    opportunity and produces a new order in which no profit remains.

    Regarding entrepreneurship and the market process, three additional items are

    worth mentioning. First, viewing the market as a process of social interaction leads to a

    distinct view of competition. Rather than denoting a state of affairs (e.g., the absence of

    profit opportunities), Austrians use the term competition to refer to the rivalrous activityof contestation that brings about such a state. Second, entrepreneurs live in a world of

    radical (or Knightian) uncertainty that is distinguishable from mere risk. To put it

    succinctly, entrepreneurs do not know what they do not know; there is genuine discovery

    and genuine surprise. Their behavior cannot be reduced to optimization because they do

    not know the underlying functions over which they would like to optimize. Finally,

    Austrians view disequilibrium as the usual state of markets. Genuine discovery and

    surprise implies preferences and technologies constantly change. Before entrepreneurship

    can fully restore equilibrium, changing fundamentals generate additional profit

    opportunities to be remedied. For this reason, Austrians prefer to think the economy

    tending toward (as opposed to being in ) equilibrium.

    Although it is not strictly part of the Austrian core, the aforementioned tenets are

    usually accompanied by a cynical view of the state. 8 The general distrust of government

    held by many Austrian economists primarily stems from the beliefs that purposeful

    individuals are more likely to know what is in their own interest and more likely to

    8 Along these lines, Boettke (1995) asks, Why are there no Austrian Socialists?

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    possess the decentralized information necessary to accomplish their ends. In contrast,

    governments are viewed as a group of distant individuals perhaps possessing some notion

    of the average individuals interests but without specialized knowledge of time and place.

    As a result, economists working in the Austrian tradition are generally skeptical that

    government action (or, more correctly, the actions of individuals comprising government)

    can more effectively accomplish the ends of specific individuals than those individuals

    could on their own.

    Modern Austrians have also been influenced, to varying degrees, by the Public

    Choice tradition pioneered by James Buchanan and Gordon Tullock.9

    Whereas traditionalAustrians largely accepted postulates of government benevolence in order to highlight the

    knowledge problem, Public Choice economists call into question the motives of

    government agents. Public Choice economists decry the bifurcation of human behavior

    wherein individuals acting in the private sector are presumed to be self-interested while

    those in the public sector are presumed to aim at improving social welfare. Drawing on

    both approaches, many modern Austrians believe government action is plagued by both

    information and incentives problems. That is, government agents possess neither the

    information nor incentives to improve upon the decisions of decentralized acting agents.

    1.2 Traditional Austrian Labor Literature

    In large part, the contributions of early Austrian economists to labor economics merely

    reflect the time in which they were writing. As Galloway and Vedder (2003) explain,

    labor economists in the early twentieth century were almost exclusively concerned with

    9 Boettke and Leeson (2004) explore early Austrian contributions to the economics of politics and discussthe prospect of synthesizing Austrian and Public Choice approaches. See also: Boettke and Lopez (2002),Ikeda (2003), and Boettke (2012, chapters 4; 8-11; 17).

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    labor unions. Following in the footsteps of John Stuart Mill, Karl Marx, and others, some

    early twentieth century economists held closely to an objective labor theory of value,

    viewed low wages and the resulting income distribution as a problem, and sought a

    solution in labor unions. At the same time, the development of marginal utility theory in

    the late nineteenth century allowed an alternative view to gain traction, wherein existing

    wages were thought to reflect the marginal productivity of labor. It was this conversation

    that early Austrians found themselves in; and, as they were a product of the marginal

    revolution, these Austrians tended to reaffirm the marginalist view.

    Eugen Bhm-Bawerk was arguably the first Austrian economist to seriouslygrapple with questions in the realm of labor economics and, in particular, offer a

    systematic rebuttal of then-popular socialist views regarding labor. In the first of a three-

    volume work on Capital and Interest , Bhm-Bawerk (1884) took on the exploitation

    theory of interest as expounded by the German economist Johann Karl Rodbertus.

    Adhering strictly to the labor theory of value, Rodbertus had reasoned that any value of

    the final product paid to a non-working owner implied workers were paid less than the

    full value of their contribution to the product. Bhm-Bawerk rejected the labor theory of

    value, but believed the analysis proffered by Rodbertus also failed to account for the

    temporal nature of production. Even if labor were the only productive input, Bhm-

    Bawerk argued, observing a sum of wages paid to workers less than the value of the final

    product need not imply that workers were paid less than their contribution to the product,

    since the production process takes place over time and payments to workers are rendered

    prior to the completion of the product. As Bhm-Bawerk explained, present goods are

    more valuable than future goods. Therefore, wages paid in the present should equal the

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    present discounted value of the workers contribution to the final product. Hence,

    differences in the sum of wages (at earlier periods) from the value of the final product (at

    a later period) need not be the product of exploitation, even if labor is the only input in

    the production process.

    Although Bhm-Bawerks lasting contribution to Austrian economics concerned

    production as a roundabout process taking place over time with the interest rate

    coordinating the time-structure of production, his forays into labor economics did not

    cease with the remarks on Rodbertus discussed above. Indeed, Bhm-Bawerk (1986)

    took to task the entire Marxian system and was widely regarded in the broader politicaleconomy literature for doing so. 10 Since it is only of tangential interest to the present

    work, his argument against Marx can be described succinctly. First, Bhm-Bawerk

    explains how the law of value put forward by Marx in Volume III of Capital contradicts

    his theory of value from Volume I. He then addresses the arguments put forward by Marx

    to reconcile the supposed contradiction. Finding these arguments unsatisfactory, Bhm-

    Bawerk pronounces the labor theory of value as the source of error in the Marxian system

    and criticizes Marx for not employing a subjective theory of value.

    Despite Bhm-Bawerks efforts, many early twentieth century intellectuals

    continued to view prevailing wages as too low and sought remedies in labor unions or

    outright socialism. Having attended Bhm-Bawerks lectures at the University of Vienna

    between 1904 and 1914 (when Bhm-Bawerk died), Ludwig von Mises took up the battle

    where his teacher had left off. Regarding socialism, Mises (1920) stressed the

    impossibility of economic calculation in the absence of private property over the means

    10 For example, consider that Thorstein Veblen (1906, p. 576)while reviewing the socialist system ofMarx in the Quarterly Journal of Economics cites Bhm-Bawerks work as the point of view of classicaleconomics.

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    of production. 11 Then, as part of his influential book Human Action , Mises (1949)

    returned to the question of labor unions.

    In addressing the garbled ideas that form the main ideological foundation of

    labor unionism, Mises (1949, p. 591) reaffirms the marginalist view wherein wages

    reflect the marginal product of labor. Two characteristics of his exposition stand out.

    First, he clarifies that labor is heterogeneous. A uniform type of labor or a general rate

    of wages do not exist. Labor is very different in quality, and each kind of labor renders

    specific services (p. 590). What is sold and bought on the labor market is not labor in

    general, but definite specific labor suitable to render definite services (p. 594). Second,he describes the decentralized market process that brings the marginalist result about (p.


    As with all other sectors of the market, the labor market is actuated by theentrepreneurs intent upon making profits. Each entrepreneur is eager to buy allthe kinds of specific labor he needs for the realization of his plans at the cheapest

    price. But the wages he offers must be high enough to take the workers away fromcompeting entrepreneurs. The upper limit of his bidding is determined by

    anticipation of the price he can obtain for the increment in salable goods heexpects from the employment of the worker concerned. The lower limit isdetermined by the bids of competing entrepreneurs who themselves are guided byanalogous considerations. It is this that economists have in mind in asserting thatthe height of wage rates for each kind of labor is determined by its marginal

    productivity. Another way to express the same truth is to say that wage rates aredetermined by the supply of labor and of material factors of production on the onehand and by the anticipated future prices of the consumers' goods.

    It is important to recognize that, in contrast to the standard price taker model, the view

    put forward by Mises is a price maker model. Entrepreneurs, in competition with one

    another, bid up wages of imperfectly-substitutable laborers in order to accomplish the

    distinct projects they believe will be profitable upon completion. As we show below,

    11 Mises (1951) takes an even broader view of socialism, considering its economic and sociologicalcharacteristics.

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    thereby encouraging entrepreneurs to invest in projects that take too long to complete.

    When the prevailing interest rate returns to its natural level, entrepreneurs realize these

    projects are unsustainable. However, the investments made during the boomlike all

    investmentsrequire specific capital (i.e., it is not perfectly substitutable with the capital

    required for other, less lengthy projects). A painful adjustment process occurs wherein

    the capital employed during the boomwhich Austrians label malinvestment is

    retooled and reallocated to sustainable projects. Without the appropriate capital to

    produce desired goods and services during the process of adjustment, output and

    employment stall.The Austrian business cycle theory, as formulated by Mises and Hayek, places

    central attention on physical capital. Indeed, Garrison (2001) describes the Mises-Hayek

    view as capital-based macroeconomics, in contrast to the labor-based macroeconomics of

    John Maynard Keynes. 12 Ballante (1983) and others have argued that specialization over

    time has placed human capital on or near equal footing with physical capital. Hence,

    entrepreneurs making malinvestments in human capitalin much the same way as with

    physical capitalmight be more relevant today than in the past. In a slightly modified

    version of the Austrian business cycle theory, expounded on in Section 2.1.2 below, the

    costly adjustment process requires retraining and/or relocating of labor in addition to the

    retooling and reallocating of physical capital. 13

    12 See also: Garrison and Bellante (1988).13 Although Austrians have traditionally offered a relatively tight theoretical model of the business cyclewith capital and interest at center stage, the idea of extending the theory to explain the particular depthand/or extent of an economic downturn is in no way new. Rothbard (1963), for example, goes beyond thenarrow confines of the Austrian business cycle theory in considering the role of policies enacted underHoover and Roosevelt.

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    1.3 Modern Austrian Labor Literature

    Perhaps surprising to those associating Austrian economics with a rejection of

    empiricism, much of the modern Austrian labor literature is empirical in nature. For

    example, Bellante and Picone (1999) empirically demonstrate flaws with the difference-

    in-difference approach employed in the famous Card and Krueger (1994) case study.

    They also show that using the original approach with improved data yields only one

    statistically significant result: the New Jersey minimum wage law decreased employment

    for young workers. 14 Although empirical in nature and often similar to work conducted

    by mainstream economists, the Austrian labor literature has a distinct flavor. Specifically,modern Austrians working in the field of labor economics tend to focus on the

    heterogeneity of labor, differences between public and private sector employment, and/or

    the mutually beneficial nature of exchange.

    Austrian labor economists have been quick to point out that the labor force is

    comprised of heterogeneous agents. In the context of North-South pay differentials,

    Bellante (1979) uses labor heterogeneity to explain the high correlation between in-

    migration and out-migration. Assuming homogenous labor, many observers were puzzled

    that migration from the low-wage South was largely offset by migration from the high-

    wage North. In contrast, Bellante (1979) argues that laborers with particular

    combinations of raw labor, formal education, on-the-job training, and experience move to

    areas where their real wage is highest (as opposed to where the average real wage is

    14 Bellante and Picone (1999) criticize Card and Krueger (1994) for (1) failing to consider substitution between table service and fast food restaurants, (2) failing to control for differences across the two statesconsidered, and (3) restricting analysis to too narrow a time period. To overcome the perceivedshortcomings of the original study, the authors consider (1) the entire food and drink industry, (2) thedifference between Pennsylvania and New York (since both are outside the purview of the New Jerseyminimum wage law), and (3) a longer time period. On Card and Kruegers work from a market process

    perspective also see Glen Whitman (1996).

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    highest). Hence, the observed cross movements of the labor force increase efficiency by

    improving the mix of labor types in each region.

    Following Becker (1957), Bellante, Kogut, and Moncars (1991) consider the

    relative supplies of particular types of labor in the context of discrimination. Specifically,

    they examine the effect of Hispanic population density on the relative earnings of Blacks.

    The authors find support for the Becker model in that, as the population density of

    Hispanics increases, the relative earnings of Blacks decrease. 15 Furthermore, they suggest

    regional differences in the relative earnings of Blacks disappear once one accounts for the

    population density of Blacks in the South. Along these lines, Bellante and Kogut (1996)argue that intra-regional differences in typically unobserved variables exaggerates the

    difference between the relative earnings of Blacks in the South and Non-South. Again,

    the idea is to trace the effects of heterogeneity in the labor force.

    Austrian labor economists have made important contributions to the literature

    regarding differences in public and private sector employment. Using the University of

    Michigans Panel Study for Income Dynamics , Bellante and Link (1981) find that public

    sector employees are more risk averse than private sector employees with similar levels

    of human capital. The result, as they point out, is consistent with the widely-held view

    that public sector employment is relatively stable. Belante and Long (1981) improve

    upon earlier studies considering pay differences between public and private sectors by

    including non-monetary compensation. Exemplifying the influence of Public Choice on

    many modern Austrians, the authors make use of a competitive rent-seeking model to

    explain their results. Ramoni and Ballante (2004) survey the literature concerning public

    sector wage premia. More recently, Ramoni-Perazzi and Ballante (2007) apply propensity

    15 On the relative earnings of immigrants, see Bellante and Kogut (1998).

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    score matching methods to control for selection bias and the comparability of units. They

    find that public sector workers earn 3.5 to 11.1 percent more than their private sector


    Bellante and Porter (1992) explain the simultaneous decline of private sector

    unionization and growth of public sector unionization. Consistent with methodological

    individualism, the authors first clarify that collective bargaining in both public and

    private sectors actually takes place between a corporate or government representative and

    a union representative. As such, both sides suffer from a principal-agent problem. 16

    According to the authors, the ability to transfer a corporationand, in doing so, captureany value that extends into the futureencourages entrepreneurial corporate managers to

    discover and implement institutions that reduce agency costs. In contrast, an employees

    right to work under a union-negotiated contract is non-transferable (i.e., it ends with

    employment). Assuming some benefits of agency-cost-reducing institutions are realized

    beyond the horizons of current union members, they will be less alert to such institutions

    and have less incentive to implement them when there are costs to changing the status

    quo. If (1) corporate managers are more likely to discover and implement agency-cost-

    reducing institutions and (2) returns to collective bargaining depend on the bargaining

    power of the employers agent relative to the bargaining power of the employees agent,

    then one should expect corporations to reduce agency costs at a quicker rate and thereby

    reduce the returns to unionization in the private sector. As the returns to unionizing fall,

    16 As Bellante and Porter (1992, p. 246) explain, part of the problem stems from labor force heterogeneity:In addition, union members have different ages and work-life expectations, different marginal rates ofsubstitution between wage and fringe benefits, different levels of skill, and they differ in their willingnessto accept risk. There is a natural tendency to value activities differently. This increases the control problem

    by diminishing the consistency of the signal that principals send to their agent and diffusing the monitoringefforts of the principals. The principal-agent problem becomes a many principal-agent problem.

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    the practice of unionizing should decrease as well. Indeed, the authors show that private

    sector union membership in the US fell from 38.8 percent in 1956 to 12.9 percent in


    Having explained the downward trend in private sector unionization, the authors

    then employ the same framework to explain the upward trend in public sector

    unionization. Like unions, public sector enterprises often involve non-transferable claims

    and are therefore less inclined than corporations to reduce agency costs. Furthermore, the

    authors claim the relationship of unions and politics is symbiotic. Since union members

    and government bureaucrats seek higher wages and employment, the collective bargaining environment in the public sector is less adversarial than that of the private

    sector; and, relative to rationally ignorant voters ability to punish, it is easy for unionized

    labor to reward public office-holders for rents. These factors increase the returns to

    unionization. Consistent with this view, the authors show that public sector union

    membership in the US increased from 13.4 percent in 1956 to 45.5 percent in 1988.

    Bellante and Porter (1998) extend their analysis of private and public sector

    employment to account for the overall growth of government. Many theories of the

    ratchet effectthe idea that an increase in the size of government cannot be turned

    back, even after the causes that brought it about are no longer presentrely on

    ideological shifts (e.g., Higgs 1987), which are difficult to quantify. In contrast, Bellante

    and Porter (1998) point to differences between public and private sector employment

    some of which have been discussed aboveand, in particular, how these differences lead

    to asymmetries across the two sectors over the business cycle. In the private sector, the

    authors argue, employers can let go of trained workers with known abilities during

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    recessions since the higher level of unemployment increases the likelihood that these

    workers will still be available in the future. In expansions, however, private sector

    employers are hesitant to bear the costs of screening and training since lower levels of

    unemployment increase the likelihood that these workers will leave the position. Hence,

    employment in the private sector is more sensitive to downturns than upturns.

    Drawing on their earlier work, Bellante and Porter (1998, p. 615-16) maintain that

    public sector employeesat least relative to their private sector counterpartsare

    organized and politically active, creating a source of demand for labor that is

    independent of the demand for its product. During recessions, when the private sectorexperiences higher unemployment, the effective wage premia experienced by public

    sector employees grows. Public sector employees respond accordingly, expending more

    resources to protect rents. The ability to organize for political activity, the authors claim,

    is an advantage for those already employed in the public sector. As a result, it is more

    costly politically to lay off public sector employees when demand for their services

    decreases than it is beneficial to hire new employees when demand warrants (p. 616).

    Hence, public sector employment grows relative to private sector employment in

    recessions, while tracking closely during expansions. The combined result, as the authors

    demonstrate empirically, is a smooth ratcheting up of the size of government.

    Many modern Austrians address labor issues arising in the context of developing

    countries. For example, some ask whether employment at sweatshops could possibly

    constitute a mutually beneficial exchange. Powell and Skarbek (2006) find that most

    sweatshop jobs provide an above average standard of living for their workers. Similarly,

    after conducting interviews with sweatshop workers in El Salvador, Skarbek et al (2011)

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    conclude that non-monetary compensation of factory employment is perceived to be

    more desirable than alternatives along several margins. Although no one to our

    knowledge denies the harsh working conditions of sweatshops, empirical work conducted

    by Austrians suggests those employed in sweatshops fare better on average than they

    would in the absence of such jobs. Powell and Zwollinski (2012) discuss the current state

    of the debate.

    Leeson and Hall (2007) take a comparative historical political economy approach

    to examining labor standards in developing countries. Presuming a tradeoff exists

    between income and labor standards, they focus attention on the optimal timing ofadoption for various labor standards. Specifically, they use incomes of highly developed

    countries at the time labor standards were adopted to estimate a safe income threshold for

    developing countries contemplating the adoption of similar labor standards today. For

    example, GDP per capita (1990$) in 2001 equaled just $3,813 in Namibia, comparable to

    that of the US in 1899. Since the US had banned indentured servitude in 1885, when

    GDP per capita (1990$) equaled $3,106, the authors conclude it is safe for Namibia to do

    likewise. In contrast, the US did not permit collective bargaining prior to the National

    Labor Relations Act of 1935, when GDP per capita (1990$) equaled $5,467. This

    suggests adoption of similar standards in Namibia today might be premature. Hall and

    Thorson (2010) use the approach to analyze labor standards adopted in Guatemala in

    2001. As with the work on sweatshops reviewed above, Austrians examining the

    adoption of labor standards in developing countries insist on relevant comparisons.

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    2. Modeling Labor Markets from an Austrian Perspective

    Having reviewed the major contributions of Austrians to labor economics, we turn our

    attention to expositing a model of labor markets we believe many Austrians would find

    agreeable. The task of modeling labor markets from an Austrian perspective is somewhat

    unusual given the skepticism toward formal modeling typically expressed by Austrian

    economists. In order to accomplish this task while maintaining the substance and flavor

    of the Austrian tradition, we first consider a simple model of labor markets. Using this

    model as a foilas Austrians are apt to doenables us to articulate those features of the

    market process commonly emphasized by Austrians. Our approach also facilitatescomparisons with the standard view, which the non-Austrian reader may find helpful.

    Given their widespread use in labor economics, it is natural to start with a simple

    search model. 17 The model developed by Stigler (1961) and applied to labor markets

    shortly thereafter suffices in this respect. In Stiglers (1962) formulation, the net payoff to

    a worker from search is , where and correspond to

    the respective amount of search and wage in the two periods and is the average cost of

    search. With wages given as a function of search, the worker need only calculate the

    amount of search in each period that maximizes . Employers, searching for workers,

    engage in a similar calculation. In Stiglers view, agents on both sides of the market

    merely choose the sample size that maximizes the expected return to search.

    In general, Austrians reach similar conclusions while expressing concerns with

    the Stiglerian approach. Many Austrians doubt acting agents possess the requisite

    information to search efficiently. In order to engage in optimal search, agents must

    17 Luther (2012a) argues the search-theoretic models commonly employed in modern monetary economicsare similar to the equilibrium construct used by Mises (1949); but whereas Mises used a frictionless modelas a foil, modern authors attempt to imbed specific frictions into the model. See also: Luther (2012b).

    ! = w 1 + w 2 ! " (n 1 + n 2 ) n 1, n 2 w 1, w 2



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    already know the underlying functional relationships; they must know, for example, how

    much an additional unit of search will increase their wage. How do they know the

    underlying functional relationships? Is this information also the product of search? If so,

    the problem is pushed up another level and the question remains: how do the agents know

    what they know? Furthermore, Stiglers approach merely considers whether an agent

    should convert an unknown known to a known known; it leaves no space for unknown

    unknowns. 18 The Austrians, as Boettke (2002, p. 267) writes, want to emphasize not

    just the procient use of existing information, but the discovery and use of new

    knowledge that comes into being only because of the context in which actors ndthemselves acting. The absence of radical (Knightian) uncertainty removes the prospect

    of genuine discovery (i.e., acquiring new knowledge). Similar concerns arise in the

    context of the sequential search models pioneered by Gronau 1971, McCall 1970, and

    Mortensen 1970, wherein agents choose an optimal stopping point.

    In contrast to the standard approach, we put forward a competitive market process

    approach. 19 We allow for radical uncertainty, genuine discovery, labor heterogeneity, and

    capital specificity. We discuss the role of entrepreneurship in coordinating economic

    activity. Non-cyclical unemployment is addressed in Section 2.1.1. Unemployment

    arising in the context of the Austrian business cycle theory is discussed in Section 2.1.2.

    18 Whereas converting an unknown known to a known known can be accomplished by searching,discovering an unknown unknown is the product of browsing (Evans and Friedman 2011).19 Given the aforementioned criticisms of the standard approach, it is somewhat ironic that two self-ascribed Austrian economists (Peter Lewin and Walter Block) earned their advanced degrees under GaryBecker.

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    2.1 A Market Process Approach to Labor Markets

    Entrepreneurship is central to the Austrian approach to labor economics. In search of

    hitherto unrealized profits, entrepreneurs initiate a process of discovery whereby

    individuals acting in disequilibrium acquire the beliefs necessary to sustain equilibrium.

    Although the process of entrepreneurial action is usually discussed in the context of the

    overall economy, it is just as applicable to an individual market like the market for labor.

    For convenience, we discuss entrepreneurs as distinct individuals acting on both sides of

    the market. In reality, individuals often play multiple roles simultaneously (e.g., working

    on a project while overseeing the work of others and coordinating other inputs in the production process). Nonetheless, we present the process of action for entrepreneurial

    producers and entrepreneurial workers separately before considering their interaction.

    Entrepreneurial producers devise plans to coordinate scarce resources in order to

    produce distinct goods demanded by (1) consumers or (2) other producers intending to

    use the goods as inputs to a more complex production process. The profit motive

    encourages the entrepreneur to find less expensive combinations of capital and labor

    capable of producing the desired output. At the same time, demand from other

    entrepreneurs for these resources puts upward pressure on rental and wage ratessince

    resources must be bid away from alternative uses. Some producers will be unsuccessful

    in bringing their plan to fruition (perhaps because their plan conflicted with the plans of

    others and they were unable to secure resources at the market rate) and must devise a new

    plan. Others will see their plan through. After coordinating complementary labor and

    capital, producing distinct goods, and delivering them to buyers, producers receive

    valuable feedback from the profit and loss mechanism. Those experiencing losses revise

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    their plans and, in attempting to bring these revised plans to fruition, bid up the prices of

    resources they would like to employ. Those producers experiencing profits continue

    employing the same strategy. However, the realization of profits has revealed to others

    the success of the strategy, which is reflected by higher wage and rental rates for the

    inputs to the successful production process. Having fully exploited the profit opportunity,

    the successful producer continues with the production process earning a normal rate of

    return. A diagram of the entrepreneurial production process is included as Figure 1.

    On the other side of the labor market, entrepreneurial workers must make

    strategic human capital investments in order to be compatible with the future plans of

    entrepreneurial producers. The profit motive encourages the worker to invest in specific

    forms of human capital with higher returns. After acquiring skills, they seek employment.

    Workers that have acquired undesirable skills find it difficult to secure a position at an

    agreeable wage and must revise their plan, which may require retraining or relocating.

    Successful workers find employment and begin working, where on-the-job training and

    experience might further improve their general, firm-, or industry-specific human capital.

    Workers possessing highly desirable skills in short supply see their wages bid up by

    entrepreneurial producers, enabling these workers to experience a greater than normal

    Devise Plan SecureResourcesProduce



    L o s s e


    N or m al

    R e t ur n

    Figure 1 The Entrepreneurial Production Process

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    rate of return on their human capital investments. The profit experienced in the short run

    encourages other workers to make similar human capital investments, thereby increasing

    the supply of labor with those specific skills and pushing the wage of such workers back

    down to the point where they no longer earn an above average rate of return. A diagram

    depicting the process of the entrepreneurial worker is included as Figure 2.

    In this simple model of the economy, equilibrium results when all plans are

    compatible. Equilibrium of the production process is characterized by a continuous

    perpetuation of the sequence Secure Resources ! Produce Goods ! Deliver

    Goods, wherein the mix of goods produced and deliveredas well as the process of

    producing and delivering these goodsremains fixed and the producer earns a normal

    rate of return. Labor market equilibrium can be characterized by the continuous

    perpetuation of the sequence Seek Employment ! Work ! Invest in Human

    Capital, wherein the employment of each worker at a particular point in the production

    process is unchanged, the only human capital acquired is on-the-job experience, and

    workers earn a normal rate of return on human capital. Disturbances from changing

    preferences and technology render some plans incompatible and generate profit

    Devise PlanInvest inHumanCapital

    SeekEmployment Work


    N or m al

    R e t ur n

    L o s s e s

    Figure 2 The Entrepreneurial Worker

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    opportunities to be exploited by alert entrepreneurs. As a result, changing fundamentals

    will lead some entrepreneurs on both sides of the market to revise their plans, thereby

    initiating an equilibration process towards the new equilibrium.

    Of particular interest in the present context are the interactions occurring where

    producers attempt to Secure Resources and workers attempt to Seek Employment

    while the economy is tending toward (but has not yet reached) the long-run equilibrium.

    Although these interactions might properly be characterized as searching in the Austrian

    theory of labor markets, it differs subtly from the Stiglerian optimization problem

    discussed above. The view expressed by Alchian (1969) comes closer to what we have inmind. Like Stigler, Alchian (1969, p. 109) starts by recognizing that collating

    information about potential exchange opportunities is costly. However, he goes further

    by (1) adopting a market process approach and (2) clarifying that the task of collating

    information, or searching, can be performed in various ways. We discuss each in turn.

    Alchian employs a market process approach in that he considers the out-of-

    equilibrium dynamics whereby individuals discover equilibrium-consistent beliefs. In

    equilibrium everyone has equal marginal rates of substitutions, Alchian (1969, p. 109)

    writes, but how is that equilibrium approached? Unlike Stigler, Alchian does not

    require equilibrium-consistent beliefs of the underlying functional relationships from the

    outset. Instead, he claims beliefs over the underlying functional relationships are the

    product of genuine discovery and might therefore be inconsistent in the short run. Rather

    than jumping from the old equilibrium to the new equilibrium following a change in

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    market fundamentals, a gradual transition occurs wherein individuals discover the new

    equilibrium-consistent beliefs. 20

    That Alchian takes a market process approach will not surprise those readers

    familiar with his work. In an earlier article, Alchian (1950, p. 121) incorporate[s]

    incomplete information and uncertain foresight and dispenses with profit

    maximization to exposit an evolutionary approach to economics. He describes how the

    economic system functions as an adoptive mechanism which chooses among

    exploratory actions generated by the adaptive pursuit of success or profits. Agents

    are in no sense omniscient; they are characterized by [a]daptive, imitative, and trial-and-error behavior in the pursuit of positive profits. They are not expected to select

    successful strategies at the outset. Rather, the system selects those strategies that are

    revealed to be successful. In this way, Alchian elaborates on a market process with

    (merely) purposive agents.

    In addition to adopting a market process approach, Alchian (1969) clarifies that

    searching can be accomplished in many ways and, importantly, that the costs of search

    may differ across its various forms. Specialization, in some cases, reduces the costs of

    gathering and disseminating information about goods, jobs, or workers. This extension

    suggests some unemployment is merely self-employment in information collection and

    also gives scope for institutions to emerge which facilitate and economize on search

    institutions entirely absent and, indeed, unnecessary in Stiglers model (p. 111). Brokers

    and middlemen serve to illustrate the point. Since the middleman is a successful

    20 In Alchians (1969, pp. 109-110) own words: Discovery of the variety of bids and offers and the best path or sequence of actual exchange prices toward an equilibrium requires costly search over the population ( emphasis added ).

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    specialist in search, Alchian (1969, p. 112) remarks, his search costs are, by definition,

    lower [] than for a nonmiddleman, nonspecialist. Stable prices, unemployment, and

    queues are also considered means whereby costs are incurred to reduce search and other

    marketing costs even more (113).

    Comparisons with Section 1.1 reveal that the search theory espoused by Alchian

    is consistent with the Austrian approach. Economic actors in Alchians model are

    purposive (but not omniscient) individuals with subjective values and beliefs.

    Information is decentralized and costly to acquire; and prices convey important

    information to the individual regarding the relative scarcity of goods. Disequilibriumdynamics are of central importance and, as with the Austrians, the competitive market

    process according to Alchian results from individuals (which Austrians label

    entrepreneurs) pursuing profit opportunities in a world marked by uncertainty.

    With a model of the labor market and a better understanding of the Austrian

    conception of search, we consider potential causes of unemployment. We divide the

    analysis into two sections. The first concerns non-cyclical unemployment. The latter

    deals with unemployment associated with monetarily induced aggregate economic

    fluctuation (i.e., the Austrian business cycle theory). In both cases, we offer comparisons

    with the standard view.

    2.1.1 Non-cyclical Unemployment

    As discussed above, frequent changes in preferences and/or technology lead

    entrepreneurs to revise their plans. Recall that plans require specific forms of capital and

    labor. Inputs currently employed in a production process may be ill suited for an

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    entrepreneurs revised plan. Hence, disturbances in the underlying fundamentals not only

    result in revised plans, but also prompt the reallocation of available inputs. Some inputs

    are unemployed during the reallocation process. Since the economy, according to

    Austrians, tends toward (but never fully reaches) equilibrium, some unemployment (of

    both capital and labor) is observed in what might be considered normal times (i.e., in the

    absence of business cycles). Hence, similar to mainstream economists, Austrians believe

    the natural rate of unemployment (of labor) is greater than zero.

    Mises (1949, p. 598) makes a distinction between two types of non-cyclical

    unemployment: catallactic and institutional. Catallactic unemployment is a market phenomenon. It results from the market process. From the perspective of the unemployed

    worker, catallactic unemployment is more desirable than employment. Unemployment

    in the unhampered market, Mises (p. 596-7) writes, is always voluntary. In the eyes of

    the unemployed man, unemployment is the minor of two evils between which he has to

    choose. Individuals choose catallactic unemployment when they are unwilling to work

    at the prevailing, market clearing, wage. In contrast, institutional unemployment results

    from interferences with the market economy. When legal restrictions push wages above

    or hold the quantity of labor below their market clearing levels, a surplus of labor results.

    Unlike catallactic unemployment, institutional unemployment is less desirable to the

    unemployed worker than employment. Workers experiencing institutional unemployment

    are willing but unable to work for the market-clearing wage. Individuals are worse off on

    average by the unrealized gains from trade.

    Although non-economists might find it strange to think individuals ever choose to

    be unemployed, the motivations underlying catallactic unemployment will be familiar to

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    most economists. According to Mises (1949, p. 596), there are at least three cases where

    one might prefer unemployment. First, unemployment might be preferred if it facilitates

    acquisition of a better job in the future. Accepting a job today might preclude

    employment in a particular field at a later point in time. A watchmaker working

    temporarily as a lumberman, Mises explains, might lose his dexterity, making it difficult

    if not impossible to return to watchmaking in the future. Furthermore, looking for new

    employment opportunities while working might take longer than if all efforts were

    devoted toward the task; and one might need to break an existing contract when a

    preferred position becomes available. Since these activities are costly, the costs mightmore-than-offset the benefits of remaining employed.

    The second reason offered by Mises concerns seasonal variability. Some jobs are

    characterized by seasonal fluctuation. Snowplow drivers are of little use in the summer

    and retail stores often hire temporary workers during the busy holiday season. If seasonal

    fluctuations are not fully offsetsay, by relocating regularly such that ones job is

    always in season or, more generally, taking on multiple positions with negatively

    correlated seasonal fluctuationswages in a seasonal industry will have to reflect the

    inconvenience of seasonal employment in order to compete with non-seasonal

    alternatives. In other words, workers will earn a premium while working in season if

    doing so requires foregoing employment out of season.

    Finally, Mises reminds the reader that monetary wages are not the only concern of

    workers. Undesirable attributes of a position reduce the effective (i.e., monetary plus

    nonmonetary) wage offered. For example, an individual might prefer not to accept a

    position conflicting with his religious, moral, or political convictions. Similarly, a job

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    might reduce ones social prestige (p. 596). Although popular speech often regards

    such concerns as noneconomic, Mises maintains their significance in economic


    In the three cases described above, one might reasonably ask whether laborers are

    actually unemployed . In our view, the first case looks the least like unemployment. As

    described by Alchian (1969), and reviewed briefly in Section 2.1, it seems reasonable to

    think of workers forgoing employment in order to find a better job as being self-

    employed. Their wage, which comes in the form of higher future wages, is deferred.

    Nonetheless, they are employed in a distinct process of economic activitynamely,searching for a better position. Similarly, one might question whether it makes sense to

    refer to seasonal workers as unemployed out of season. It is uncommon to think of a

    banker as being unemployed over the weekend and between the hours of 6PM and 8AM,

    when offices are closed and he is not working. Why then should we think of the seasonal

    workerwhose employment contract (explicitly or implicitly) also denotes periods

    during which she will not be workingas being unemployed? Of the three cases, the

    third perhaps looks the most like unemployment. However, closer inspection reveals that

    the question remains. Just as one can be employed producing safes to protect the physical

    assets of others, one can also be employed producing ones own physical assets.

    Similarly, one can be employed protecting the non-physical assets of others. A therapist

    who helps with self-esteem issues can be said to protect ones view of self from eroding.

    Why, then, would we consider the third case described abovein which individuals

    protect their non-physical assetsas unemployment?

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    The question of what constitutes unemployment follows naturally from the

    subjectivism emphasized in the Austrian tradition. Working with capital to produce

    distinct physical goods to be purchased by others is only one way in which individuals

    might employ their time. Self-production is also production. Nonphysical goods are also

    goods. And time spent producing nonphysical goods for oneself is no less employed.

    However, it is difficult to exclude such instances of self-employment from empirical

    measures of unemployment. Since a component of measured unemployment is, in fact,

    labor devoted toward desirable production, it is useful to distinguish between two types

    of unemployment. Austrians refer to catallactic unemployment , in which labor is actuallyemployed, and institutional unemployment , which denotes genuine unemployment (i.e., a

    surplus of labor) from a subjectivist perspective.

    The proportion of workers experiencing catallactic and institutional

    unemployment at a particular point in time corresponds to the mainstream view of a

    natural rate of unemployment. 21 To be clear, there is nothing natural about institutional

    unemployment. It arises from unnatural interferences with the market economy.

    However, mainstream economists often view legal changes as technology shocks

    affecting the natural rate. From this perspective, the natural rate is in part a product of the

    legal state of affairs and, as such, should include institutional unemployment. In the

    absence of interferences with the market economy, the natural rate of unemployment

    equals the catallactic unemployment rate.

    21 Bellante (2005, p. 203) similarly claims the Austrian view of catallactic and institutional unemploymentcorresponds to the natural rate of unemployment, which mainstream economists commonly divide intostructural and frictional unemployment. Since, from an Austrian perspective, all unemployment has astructural component and since Mises (1949, p. 597-8) believed the term frictional was inappropriate, weavoid using both terms.

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    2.1.2 Cyclical Unemployment

    The business cycle theory pioneered by Mises and Hayek is, in some respects, similar to

    the more familiar New Keynesian models dominating the profession. 22 In its most basic

    form, the Austrian business cycle theory is a monetary misperceptions model (e.g., Lucas

    1972; Mankiw and Reis 2002). The inability to distinguish relative price changes from

    changes in the general price level (or, alternatively, that all information is not

    immediately available but cascades over the economy in time) causes some prices to

    adjust with a significant lag. In the short-run, money is non-neutral: changes in the supply

    of money, ceteris paribus , cause aggregate economic activity to fluctuate.23

    In whatfollows, we build a very simple model of the macro economy, use the model to present

    the Austrian business cycle, and trace the implications for labor markets.

    As discussed above in Section 1.2, the unique feature of the Austrian business

    cycle theory is its emphasis on the capital structure. 24 A highly stylized version of the

    capital-based production process is presented in Figure 3. In this depiction, known as the

    Hayekian triangle, a sequence of inputs produces a single point output. The input

    sequence can be broken down into stages of production, with the horizontal axis

    measuring the time of each stage and the total time to completion. The vertical axis

    measures the value of output. Hence, the value of a semi-produced good in a particular

    stage of production can be deduced from the height of the hypotenuse at that stage.

    22 The degree of similarity between the two approaches is admittedly contentious. See, for example, Zijpand Visser (1994), Butos (1997) and the citations contained therein. Although these articles compare andcontrast Austrian and (pre-Real Business Cycle) New Classical approaches, noted dissimilarities with the

    New Classical view are, in virtually all cases, equally applicable to New Keynesian models.23 Many Austrians use the term monetary non-neutrality to denote Cantillion effects. We do not disputethe existence of Cantillion effects. However, the topic is well beyond the scope of this paper and would addunnecessary confusion to our analysis.24 Our presentation of the Austrian business cycle theory draws heavily on Garrison (2001). See also:Horwitz (2000).

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    By allowing for a greater degree of specialization, a longer production process

    enables one to produce more output. 25 However, longer production processes also require

    additional time to completion; one must wait longer before consuming the end product.

    Selecting a capital structure requires entrepreneurs take into account both the potential for

    greater production and the cost of waiting. Whereas the former depends on the production

    function of a firm, industry, or economy, the latter is reflected in the interest rate. Positive

    25 Merely lengthening a production process does not guarantee greater production (e.g., includingunnecessary steps). Nonetheless, the output of those processes actually employed is positively correlatedwith the length of the production process since it is not in the interest of entrepreneurs to employ a lessefficient production process.

    Stages of Production

    F i n


    G o o d s

    Early Stages Late Stages

    Figure 3 The Hayekian Triangle

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    (negative) technology shocks are depicted by a steepening (flattening) of the hypotenuse,

    thereby permitting greater (less) output for the same amount of production time.

    Decreases (increases) in the interest rate cause the hypotenuse to flatten (steepen),

    thereby enabling faster (slower) economic growth. Simply put, interest rates are used to

    discount future values: a lower interest rate, by increasing the present value of future

    output, encourages a more roundabout production processthat is, a process which takes

    more time to complete. In this way, the depth of the capital structure depends, at least in

    part, on the prevailing interest rate.

    The Hayekian triangle is combined with a market for loanable funds and production possibilities frontier to form the three-quadrant Austrian macro model

    presented in Figure 4. Since the capital structure, as depicted by the Hayekian triangle,

    reflects the prevailing interest rate, the model must have some way of generating an

    interest rate. Austrians maintain that interest rates are determined by the intersection of

    supply and demand in the market for loanable funds, which is depicted in the lower right

    quadrant of Figure 4. The supply curve S LF reflects the amount of funds savers desire to

    lend at various interest rates. The demand curve D LF reflects the amount of funds

    borrowers desire to invest at various interest rates. Equilibrium is determined when the

    interest rate i* equalizes savings and investment.

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    Stages of Production

    C o n s u m p

    t i o n



    I n t e r e s

    t R a

    t e


    S = I



    F i n


    G o o d s

    Hayekian Triangle Production Possibilities Frontier

    Market for Loanable Funds

    Figure 4 The Austrian Macro Model

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    The production possibilities frontier for the economy is included in the upper right

    quadrant. Given that the market for loanable funds coordinates saving and investing

    plans, total output over a period must be either (1) consumed or (2) saved and invested.

    Hence, there is a tradeoff at the macroeconomic level between consumption and

    investment. Combinations of consumption and investment inside the production

    possibilities frontier would indicate that the economy is underperforming, whereas those

    outside represent an overheating economy. Both are suboptimal. Individuals in an

    underperforming economy would prefer to produce (i.e., consume and/or invest) more;

    those in an overheating economy would prefer to produce less. Since the economy canmove beyond the production possibilities frontier, Austrians often refer to it as a

    sustainable production possibilities frontier. Production beyond the frontier is

    unsustainable in the sense that it can only be achieved while market participants are

    fooled into thinking their actions are consistent with their preferences given the available

    resources in the economy. In this way, the production possibilities frontier depicted in

    Figure 4 is analogous to the vertical aggregate supply curve employed by mainstream

    economists: both denote the natural level of output.

    The three-quandrant Austrian macro model, in its simplest form, can be

    summarized in the following way. Individuals choose either to consume or save. Savings

    are transformed into investments through the market for loanable funds. The interest rate

    emerging from the market for loanable funds sends a signal to entrepreneurs regarding

    the optimal structure of production. Entrepreneurs coordinate capital and labor to produce

    output in a manner consistent with the optimal structure of production. Since the new

    output must also be consumed or saved, the process repeats.

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    According to Austrians, macroeconomic coordination breaks down when the

    prevailing interest rate deviates from the natural (market clearing) rate. Consider, for

    example, the case where the central bank increases the money supply unexpectedly. In

    the market for loanable funds, a net increase in bond purchases by the central bank looks

    a lot like an increase in real savings. The perceived increase in savings is shown

    graphically in the lower right quadrant of Figure 5 by a rightward shift in the supply of

    loanable funds from S LF to S LF + m . Since it does not constitute a genuine increase in

    savings, but rather an increase in money, the new supply curve S LF + m is depicted with a

    dashed line . Market participants respond to the perceived increase in savings by biddingdown the interest rate from i* to i. Saving decisions are determined by the intersection of

    the prevailing interest rate i and the original supply curve, S LF ; on the horizontal axis, we

    denote the quantity saved S. Borrowing decisions are determined by the prevailing

    interest rate i and the new supply curve S LF + m ; on the horizontal axis, we denote the

    quantity borrowed I . In other words, when the prevailing interest rate falls below the

    natural rate, savers save less and borrowers borrow more. The shortage of loanable funds

    goes unseen, at least in the short run, as it is papered over by the credit expansion.

    We can trace the results of disequilibrium in the loanable funds market to the

    other two quadrants of the Austrian macro model. As savers save less (i.e., consume

    more) and borrowers borrow more, the economy begins to overheat. The overheating

    economy is depicted in the upper right quadrant of Figure 5 by the consumption-

    investment bundle beyond the production possibilities frontier. At the same time, the

    structure of production is distorted. The low interest rate encourages (and enables) some

    entrepreneurs to take on longer production processes. However, consumption has also

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    increased, leading some entrepreneurs to direct more resources toward final goods. The

    combined result, depicted in the upper left quadrant of Figure 5, is a distortion of the

    Hayekian triangle. Hence, the unsustainability of output is depicted in two ways: the

    economy is operating beyond the production possibilities frontier and the structure of

    production suffers from discoordination.

    The distorted Hayekian triangle from Figure 5 is depicted again in Figure 6 so that

    we might more clearly articulate the prevailing discoordination. For simplicity, we divide

    the stages of production into three distinct periods: early, intermediate, and late stages.

    Garrison (2005) describes two distinct signals sent by the prevailing interest rate and theirrespective effects on these stages of production. First, the lower interest rate has a time

    discount effect that is, it lowers the cost of lengthier production processes. As a result,

    some resources are diverted to early stages of production. Second, the increase in

    consumption produces a derived demand effect . Entrepreneurs respond by diverting some

    resources to late stages of production in order to satisfy the demands of consumers more

    quickly. If the lower interest rate were backed by real savings, the Hayekian triangle

    would pivot, lengthening the structure of production in a sustainable way. However, since

    the lower interest rate results from unexpected monetary expansion, there is a real

    resource constraint. Increases in early and late stagesshaded light grey in Figure 6

    come, in part, at the expense of output in intermediate stagesshaded dark grey. 26 Once

    26 As discussed below, there is also a net increase in output and employment so some resources are being pulled out of non-employment uses (e.g., leisure, search, etc.).

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    Stages of Production

    C o n s u m p

    t i o n



    I n t e r e s

    t R a

    t e



    S I


    S + mLF


    F i n


    G o o d s

    Figure 5 Austrian Business Cycle

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    the real resource constraint is realized, the boom turns to bust. And since resources have

    been malinvested redirected to the wrong stages of productiona reallocation period

    takes place wherein output falls to a point inside the original production possibilities


    Macroeconomic discoordination of the type envisioned by Austrians distorts labor

    markets in two dimensions. The vertical change in employment is virtually identical to

    the view held by most mainstream economists: aggregate employment (and total hours

    worked) goes up during the boom and down following the bust. However, Austrians also

    point to horizontal changes in employment wherein labor is misallocated during the

    boomthat is, directed to unsustainable projectsand must be reallocated following the

    Stages of Production

    F i n


    G o o d s




    Figure 6 The Distorted Hayekian Triangle

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    bust. We describe both in greater detail in order to highlight the subtle distinction

    between the two.

    When monetary expansion initiates a boom, individual sellers clearly observe the

    demand for their goods increasing. However, the decentralized nature of knowledge in

    the economy precludes these sellers from observing the increase in aggregate nominal

    spending. Sellers respond by raising prices and increasing inventories, thereby

    encouraging producers to increase the supply of available goods. In order to increase

    output, producers must employ more laborthat is, producers must hire new workers

    and/or persuade existing workers to work more hours. In both cases, producers bid upwages to convince workers to forego alternative uses of their time (i.e., leisure or

    employment elsewhere). Workers agree, in part, because they (like sellers) cannot easily

    observe the increase in aggregate nominal spending. Hence, employment and wages rise

    above their natural levels during the boom.

    Although Austrians recognize the vertical change (i.e., overemployment) during

    the boom, they are more apt to stress horizontal changes since mainstream economists

    often disregard them. Accepting that aggregate employment increases does not require

    accepting that employment increases evenly across all occupations. Since Austrians

    maintain that the increase in output during the boom is primarily concentrated in early

    and late stages, they similarly expect employment in early and late stages of the

    production process to grow more rapidly than those in intermediate stages. The time

    discount and derived demand effects discussed above encourage entrepreneurs in early

    and late stage industries to bid some workers out of intermediate stage industries (and

    non-employment) in order to increase output in those stages. Workers agree, in part,

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    because they cannot easily observe that the production processes they are joining are

    ultimately unsustainable. Recall that the vertical change referred to increases in wages

    and employment on average during the boom. Horizontal changes, in contrast, denote

    increases in wages and employment on average in early and late stages relative to wages

    and employment in intermediate stages. Hence, Austrians maintain that wages and

    employment increase on average during the boombut these increases are more

    pronounced in early and late stages of production.

    Vertical and horizontal changes in employment are similarly present following the

    bust. Alchian (1969, p. 121) describes the vertical change in detail:A decrease in general demand causes an increase in unemployment because more

    people will accept unemployment to engage in search, and unemployed personwill look longer. Wage earning opportunities will diminish in the sense that lowerwages are available elsewhere. People use time to learn that the failure to findother equally good job options as quickly as they thought they would, reflectsdiminished alternatives in general, not unlucky search. The discerned maximumoffers will be lower than if the structure of alternatives had not decreased. Thelower level and slower rate of rise of best observed options is at first taken as anunlucky string of searches, and so unemployment is extended in the expectation

    of shortly finding that elusive best option. And with each person looking longerthe total number of unemployed at any one time will be larger. (Incomes fall andfeedback effect occurs.) Each now has the added task of revising his whole

    pattern of expectations. Whereas he was formerly searching for a higher clearlyformulated expected wage, now he must learn that the best has deteriorated.

    To put it succinctly, falling nominal spending leads to decreasing wages and employment

    on average. The horizontal change results because, having been bid out of sustainable

    projects during the boom, misallocated labor must now relocated to desirable production

    processes. Indeed, Austrians maintain that the degree of misallocation (of both labor and

    capital) can explain, at least in part, the length and severity of the recession. 27

    27 Austrians also stress the uncertainty produced by discretionary government policy.

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    Briefly answering two questions often aimed at Austrians when horizontal

    changes in employment are emphasized helps clarify the Austrian view. First, why dont

    workers just return to their pre-boom occupations (or leisure activities) where, according

    to the Austrian account, the economy was operating at a sustainable level? There are

    actually two layers to this answer. For starters, the framework employed to describe the

    business cycle simplifies the complexity of the real world. Recall that Austrians see the

    economy as tending toward rather than being in equilibrium at any given point in time;

    but the business cycle theory starts by assuming the economy is in equilibrium. This

    simplification gives a clear point to which the economy might returnan idea Austriansgenerally reject. Moreover, changes in underlying fundamentals over the period have

    surely unseated the pre-boom equilibrium. Workers accepting positions in booming

    sectors are, in some cases, replaced by new workers. These new workers will have

    acquired job-specific skillssome of which were known to old workers but some of

    which are entirely new. For example, old workers will not necessarily know how to

    navigate new internal processes or how to communicate and work effectively with

    coworkers hired after their departure. Similarly, old workers will have gained new habits

    and modes of operation that might not fit well in their old environments and, at the same

    time, might not be easy to dispense with. Since some things cannot be undone or

    unlearned, the post-boom economy will be fundamentally different in some respects than

    the pre-boom economy. Hence, even if the pre-boom equilibrium could be achieved, that

    pattern of economic activity would no longer be consistent with overall plan


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    The second question that might be answered to shed light on the Austrian

    perspective goes as follows: if unemployment increases as resources are reallocated

    during the recession, why doesnt unemployment increase as resources are reallocated

    during the boom? 28 Implicit in the question is the mistaken view that Austrians reject the

    vertical change described above. As we have attempted to show, emphasizing horizontal

    changesas Austrians are apt to dodoes not preclude the existence of a vertical

    change. To clarify, we state the matter using Alchians (1969) view of search. Although

    the return to specializing in searching (i.e., searching while unemployed) increases

    temporarily during the boom, workers do not initially recognize the change in theunderlying distribution of offers and therefore do not engage in as much search as they

    would if the change were obvious. Employers, by contrast, see the demand for their

    products increase and search for workers. Hence, in a boom, much of the reallocation

    takes place while many workers are employed and some workers are moving from long-

    term non-employment (e.g., leisure) to long-term employment. Contrast this with the

    period following the bust. Again, workers do not initially recognize the change in the

    underlying distribution of offers. However, they now observe their own offers falling and

    begin specializing in search for better offers. Hence, in a recession, many workers are

    unemployed and some workers are moving from long-term employment to long-term

    non-employment (e.g., leisure). Whereas workers would have engaged in more

    specialization in search (i.e., unemployment) during the boom if they had recognized the

    change in the underlying distribution of offers and believed the distribution to be

    sustainable, they would have engaged in less search during the recession if they had

    28 Krugman (2010) asks this very question.

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    recognized the change in the underlying distribution of offers and believed the

    distribution to be sustainable.

    But the Austrian viewsome will replystates that unemployment results during

    the recession because workers have the wrong skills. In other words, Austrians point to

    frictions associated with horizontal changes to explain the period of adjustment. Arent

    workers similarly ill-suited to change jobs during the boom? Of course, to some extent,

    frictions are present in the boom as well. But during the boom, Austrians argue, the

    perceived profit opportunities increase in early and late stage production processes such

    that some entrepreneurs might prefer taking on a less than ideal candidateperhapsopting for more on the job trainingin order to capture some of the available profits.

    After all, capturing some profits with a less-than-ideal employee is better than waiting for

    the ideal employee if, by the time she is likely located, the profits have been