The Austrian school of economics is appreciated by many free market advocates, but it’s really an approach to economics rather than a set of conclusions. Many of the insights from Austrian economics pervade my thinking and my work with businesses. However, I’m not totally Austrian. This series of articles will explain some concepts from the Austrian school that are particularly useful in business decisions, followed by a couple of issues where I differ from my Austrian economics friends.

Mises Institute via Blue Wallpapers (Ludwig von Mises)

I was captivated by the subject in high school when I read Economics in One Lesson, so I scrimped and saved to buy a copy of Human Action. In college I did an independent study project reading more by Ludwig von Mises, Murray Rothbard and Friedrich Hayek. In graduate school I read more Hayek and attended a seminar in Austrian economics. I was also immersed in mainstream economics, the Keynesian model, and econometric analysis, which thorough-going Austrian economists would disapprove of.

Subjective value is the first topic in this series. Later articles will address the Austrian view of competition, individuals versus groups, how knowledge may be spread throughout an organization, plus other topics.

The value of a good or service comes from what the buyer thinks it’s worth. That seems basic, but contradicts centuries of belief that value is derived from the cost of production.

Subjective value was developed by the Austrian school’s founder Carl Menger (and developed independently and simultaneously by William Stanley Jevons and Leon Walras). Menger wrote in his Principles of Economics: “Value is therefore nothing inherent in goods, no property of them, but merely the importance that we first attribute to the satisfaction of our needs….” Note that he focuses on our perception of how a product will increase our satisfaction. Value is thus subjective.

The value of a product is not based on its cost of production, but on what prospective owners think it’s worth to them. You cannot force me to value something highly by saying that it cost a lot to produce. As a prospective buyer, I don’t care what something cost to produce; I just care how much the product will benefit me.

The business implication is critical. Ask not how much it costs to make it; ask how much it is worth to the customer. There are certainly limits due to competition, which I’ll discuss in a later article, but begin your pricing decision by considering value to the user.

Markup pricing, in which price is set at some percentage over cost, can be optimal, but only if the markup reflects the business’s pricing power. And pricing power is based on the buyer’s subjective evaluation of your product.