Firstly, no, Austrian Economics is not the study of the economy of Austria…

The so-called Austrian School of Economics first coalesced around the thoughts of an economist in Austria, Carl Menger, whose first major book, Principles of Economics, was initially published in Vienna in 1871. Menger wrote this foundational book after having worked as a journalist for the Viennese newspaper Wiener Zeitung as a financial market analyst. He noticed many discrepancies between the well-known theories of the classical economists, such as Adam Smith and David Ricardo, and how real life market practitioners, such as investors and market traders, actually behaved in practice.

In his book, Menger independently formulated the idea of marginal utility, which explained previous economic puzzles such as why a bottle of water could quickly become more valuable than a bag full of diamonds in a hot, dry desert.  It might seem strange to us now why this was a puzzle, but prior to the marginalist revolution, this situation had completely bamboozled all the respected economists.

However, the great insight of Menger’s work was that of subjective value, in other words, that all human action springs from the subjective opinion of each individual about what different things are subjectively worth to that individual. For instance, the previous classical economic position had been that a pair of shoes will get a certain price in the market because of its cost of production. Menger argued that the complete opposite is the case.

It is worthwhile for a shoemaker to spend time, effort, and cash producing a particular pair of shoes, says Menger, because he or she thinks that there is a potential consumer in the marketplace who will value those shoes so much that they will pay more for the shoes than the shoes will cost to produce. And herein lies the real behaviour of real people in the real marketplace. The objective mathematics of the classical economists is thus squashed beneath the subjective opinions of entrepreneurial producers and fickle consumers.

In Austrian Economics, the equality symbol of classical economics disappears. For instance, I might buy a pair of shoes for a hundred pounds, because to me they represent a hundred and fifty pounds of value, for whatever stylistic, whimsical reason I have in my head at the moment I hand the money over. At the same time, the shoemaker is happy to sell me the shoes for a hundred pounds because they have cost him or her fifty pounds to produce.

So I as the consumer have gained a fifty pounds of style value in the shoe market, and the producer gains fifty pounds of cash value. We are both happy. I am rewarded by looking superbly attired in my brand new shoes and the shoe maker is rewarded for taking all those risks and all that work in producing these shoes, and gaining those fifty pounds in cash. In this situation, both sides of the transaction have gained, and thus both sides have acquired wealth from the transaction. Society as a whole is thus better off than it was before the transaction.

Furthermore, none of this has anything to do with the initial cost of production of the shoe. For, so long as the shoemaker can successfully anticipate what will become a desired good, and then produce and sell that good for less than its free market level of desirability, while spending less on production than what will hopefully become a market discovered price, then a market will develop in that particular desirable good. Entrepreneurs who can successfully adapt to the constantly changing markets will ‘dominate’ goods and services production, and those who get it wrong will get weeded out by the forces of creative destruction.

Everything in economics is thus driven by the desires of the consumer rather than the desires of the producer.  Everything else, including the much more famous Austrian Business Cycle Theory, in Austrian Economics flows ultimately from that reversal of cost-of-production economics to subjective value economics. What also flows from this direction-reversal insight is that, to work efficiently and to form effective prices, all markets should be as free from interference as possible, so that producers can produce desired goods for less than consumers are willing to pay, so that voluntary transactions will take place and everyone in society will thus become wealthier as a result.