University of Economics in Prague

Faculty of Economics
Study program: Economics
THE ANALYIS OF AUSTRIAN BUSINESS
CYCLE THEORY FROM COMPLEXITY
ECONOMICS APPROACH
Bachelors thesis
Author: Alessandra Lanzafame
Supervisor: Ing. Luk Bernat
Year: 2014



I hereby declare on my honor that I have written my bachelors thesis
individually and unaided using the literature referenced in the bibliography.

Alessandra Lanzafame
In Prague, on 18
th
August, 2014


























I would like to thank my thesis supervisor Luk Bernat for his guidance,
support, willingness to help and for giving me the valuable pieces of advice
about the topic. I would like to also thank Brandi Hokama who corrected the
grammar in the thesis.


Abstract
This thesis analyzes the Austrian business cycle theory (ABCT) from the Complexity
Economics approach. Complexity Economics is an approach which comes from the
complexity science. It has started to develop since 1980s in Santa Fe Institute, the leading
institution engaging in the research of complexity. In the thesis I mention the terms which
are bound to Complexity Economics, for example emergence, the bottom-up, self-
organization, bounded rationality etc. The evolution of the markets, networks and
nonlinear dynamics are included in Complexity Economics as well. Complexity
Economics views an economy as a dynamical system which never reaches the equilibrium
unlike the Traditional Economics approach which main focus is on the general equilibrium
of the economy. Another difference would be the way of modelling economies in which
Complexity Economics is leaving the unrealistic assumptions because it utilizes the agent-
based simulations which enable to do that. In the thesis I also focus on the similarities
between Austrian and Complexity Economics, for example the heterogeneity of the agents
or the emergence of the price system. These and others similarities are then applied in the
analysis of ABCT which serves as an example of demonstration that Austrian Economics
could provide the theoretical framework for Complexity Economics which aspires to
become a new paradigm in economics.
Key words: complexity economics, Austrian business cycle theory, traditional economics,
equilibrium
JEL Classification: B41, B53, E32



Abstrakt
Tato bakalsk prce analyzuje rakouskou teorii hospodskho cyklu (ABCT) pohledem
komplexn ekonomie. Komplexn ekonomie je pstup vychzejc z komplexn vdy, je
se zaala rozvjet v 80. letech minulho stolet v Santa Fe Institute, pednm stavu
zabvajcm se tmto pstupem. V prci zmiuji pojmy, kter jsou spjaty s komplexn
ekonomi, jako napklad emergence, pstup zdola-nahoru, samoorganizace, omezen
racionalita apod. Komplexn ekonomie zahrnuje do sv analzy tak evoluci trh, st,
nelinern dynamiku a dv se na ekonomiku jako na dynamick systm, kter nikdy
nedoshne rovnovhy, co ji zcela odliuje od pstupu mainstreamovho, kter se
zamuje na veobecnou rovnovhu ekonomiky. Za dal rozdl meme povaovat pstup
k modelovn ekonomik, v nm komplexn ekonomie opout nereln pedpoklady,
jeliko ke sv analze vyuv multiagentnch simulac, kter toto umouj. Prce se tak
zabv podobnostmi mezi rakouskou a komplexn ekonomi, napklad je kladen draz na
heterogenitu agent, na spontnn emergenci cenovho systmu atd. Tyto a dal
podobnosti jsou pak na zvr aplikovny v analze ABCT, kter slou jako demonstrace
toho, e rakousk kola me poskytnout teoretick rmec pro komplexn ekonomii, kter
aspiruje na to stt se novm paradigmatem v ekonomii.
Klov slova: komplexn ekonomie, rakousk teorie hospodskho cyklu, tradin
ekonomie, rovnovha
JEL klasifikace: B41, B53, E32




Table of contents

Introduction ........................................................................................................................... 1
I. Introduction to Complexity Economics ......................................................................... 3
1. What is complexity? ...................................................................................................... 3
1.1. (Nonlinear) dynamics ............................................................................................. 4
1.1.1. Path dependence .............................................................................................. 5
1.2. Four classes of behavior ......................................................................................... 5
1.3. Emergence .............................................................................................................. 7
1.3.1. From the bottom up ......................................................................................... 7
1.3.2. Landscapes....................................................................................................... 8
1.4. Agents ..................................................................................................................... 8
1.4.1. Bounded rationality ......................................................................................... 9
1.4.2. Inductive reasoning........................................................................................ 10
1.5. Interesting in-between ........................................................................................... 12
2. Review of Complexity Economics .............................................................................. 12
2.1. Self-organization in the economy ......................................................................... 13
2.2. Emergence of the markets ..................................................................................... 14
2.2.1. Market competition ....................................................................................... 15
2.2.2. Evolution in the markets ................................................................................ 15
2.3. Positive and negative feedbacks ........................................................................... 16
2.4. Non-equilibrium .................................................................................................... 17
2.5. Networks ............................................................................................................... 18
3. Summary ...................................................................................................................... 20
II. Comparative analysis of Complexity, Austrian and Traditional Economics .............. 21
1. Principles of Traditional Economics ........................................................................... 21
1.1. Assumptions in economic models ........................................................................ 22
1.1.1. Positivism in economics ................................................................................ 23
1.1.2. Equilibrium approach .................................................................................... 23
1.1.3. Perfect rationality and full information ......................................................... 24
1.1.4. Exogenous shocks ......................................................................................... 25
1.2. Comparative statics ............................................................................................... 26
1.3. Dynamics in Traditional Economics ..................................................................... 27


1.3.1. Neoclassical growth model Solow ............................................................. 27
1.3.2. Real business cycle theory ............................................................................. 27
1.3.3. DSGE dynamic stochastic general equilibrium .......................................... 28
1.4. Summary ............................................................................................................... 28
2. Austrian school of economics ..................................................................................... 28
2.1. Principles of Austrian school of economics ......................................................... 30
2.1.1. Methodological individualism ....................................................................... 30
2.1.2. Methodological subjectivism ......................................................................... 30
2.1.3. A priori deductive reasoning ......................................................................... 31
2.1.4. Time ............................................................................................................... 31
2.1.5. Evenly rotating economy ............................................................................... 32
3. Agreements and possible disagreements of Austrian and Complexity economics ..... 32
3.1. Agreements between Complexity and Austrian Economics ................................. 33
3.1.1. BRICE ........................................................................................................... 33
3.2. (In)solvable differences ........................................................................................ 34
3.2.1. Inductive reasoning versus axiomatic-deductive method .............................. 35
4. Differences between Traditional and Complexity Economics .................................... 36
4.1. Five Big ideas that distinguish Traditional and Complexity economics ........... 38
5. Summary ...................................................................................................................... 38
III. Austrian business cycle theory and Complexity Economics .................................... 39
1. Robinson Crusoe Economy ......................................................................................... 39
1.1. Production and consumption ................................................................................ 40
1.1.1. Savings and investments ................................................................................ 41
1.1.2. Path dependence of Robinson ....................................................................... 41
1.1.3. More savings equals more consumption ....................................................... 42
1.2. Dynamics of the single-agent economy ................................................................ 42
2. Robinson and Fridays economy ................................................................................. 43
2.1. Wealth is an emergent phenomenon ..................................................................... 44
2.1.1. Heterogeneity allows the trade ...................................................................... 44
2.2. Time preference .................................................................................................... 45
2.3. Loans, investments and interest rate ..................................................................... 45
3. Multiple-agent economy .............................................................................................. 46
3.1. Indirect exchange and money ............................................................................... 46
3.1.1. Indirect exchange ........................................................................................... 47
3.1.2. Money ............................................................................................................ 48


3.1.3. The price system and economic calculation .................................................. 48
3.1.4. The market of loanable funds ........................................................................ 50
3.1.5. Natural interest rate ....................................................................................... 50
3.1.6. Banks and fiduciary media ............................................................................ 51
3.2. Complexity as a built-in property ...................................................................... 52
4. Austrian business cycle theory .................................................................................... 53
4.1. Capital structure and roundabout methods ........................................................... 53
4.1.1. Hayekian triangle ........................................................................................... 54
4.1.2. Path dependence of production...................................................................... 56
4.1.3. Production as a set of networks ..................................................................... 56
4.2. Economic growth .................................................................................................. 57
4.2.1. Technological innovations and the growth .................................................... 58
4.3. Business cycles ..................................................................................................... 59
4.3.1. Boom ............................................................................................................. 60
4.3.2. Robustness of the economy ........................................................................... 61
4.3.3. Bust the positive or negative feedbacks? .................................................... 61
4.3.4. Course of the cycle with an intervention of the central bank ........................ 63
Conclusion ........................................................................................................................... 64
List of Graphs and Figures .................................................................................................. 66
Bibliography ........................................................................................................................ 67





1

Introduction
The field of economics is going through the greatest change in over a hundred
years. Complexity Economics offers a new approach to the economics but many ideas
have deep historical roots, for example in Austrian school of economics. However,
Complexity Economics has started to develop since late 1970s when a small number of
economists, physicists and social scientists began to wonder if there might be a
fundamentally new way to look at the economy. (Beinhocker 2006) In my opinion, the
concepts of Complexity Economics have a great chance to provide the foundations of
economic theory in the next decades. The aim of this thesis is to introduce Complexity
Economics and the concepts related to this field and apply them in the analysis of
Austrian business cycle theory. The aim of the first chapter is to introduce these
concepts path dependence, classes of behavior, emergence, nonlinear dynamics and so
on.
Why exactly the analysis of Austrian business cycle theory? While doing the
research about the complexity science, I have noticed that there were a lot of similar
things in both approaches. The heterogeneity, dynamics, self-organization or
emergence, these all made me think about if it was possible to join the ideas of
Complexity and Austrian Economics and create their synthesis. I had in my mind the
idea that if these two approaches had unified, they both could have contributed
something new to each other, especially Austrian Economics could adopt the agent-
based modelling as, at least a complementary, method of research. Contrarily,
Complexity Economics could have adopted some theoretical ideas from Austrian
Economics because the theoretical framework of Complexity Economics is still in
progress.
To even think about this joint of Complexity and Austrian Economics, it is
necessary to compare these heterodox approaches with the mainstream economics
which is generally accepted as a consensus within the field of economics. This is the
aim of the second chapter, in which I am also analyzing the similarities and
discrepancies between Complexity and Austrian Economics. The main difference lies in
the notion of equilibrium. Complexity Economics views an economy as a dynamical
system which never reaches equilibrium. The possibility of making agent-based
simulation also allows to model economies without unrealistic assumptions, for
2

example the assumption of perfect rationality, exogenously created novelty or the
indirect connection of economic agents through the price system. The possible
differences between Austrian and Complexity Economics are also interesting. For
example Austrians use axiomatic-deductive method and it means that all economic
theories are logically deduced from the principal axiom that humans act. Instead,
Complexity Economics uses the inductive method and above mentioned agent-based
models as an experimental and empirical evidence of tested theories.
The last chapter is focused on the analysis of ABCT and application of our
gained knowledge from Complexity Economics. The structure of capital and production
can be viewed as a network of manufacturers, producers and suppliers. How
interconnected is this network determines how frightful the recession is going to be. The
path dependence also determines the structure of an economy and actions of agents
might cause positive or negative feedbacks according to how they are going to react to
the signals of their environment. We will also find out that the natural interest rate is an
emergent phenomenon and the artificial interventions of central bank can be either
absorbed by the system, or can cause self-organized criticality.

3


I. Introduction to Complexity Economics
The real voyage of discovery consists not
of seeking new landscapes,
but in having new eyes.
Marcel Proust
Have you ever thought about how language, organizations, markets and
economies were created? We know they are created by people. But how do these
patterns emerge? How does simple interaction between you and your butcher allow
such a complicated and complex system as an economy to be created? This is a question
which I am going to answer in this whole unit.
1. What is complexity?
Complexity science brings a new approach to science and comes from the study
of complex systems. It is an interdisciplinary field explaining how the interactions
between simple entities at the micro level create something different at the macro level,
how these entities coordinate, self-organize and create interesting patterns without any
central control. In many cases, the complex systems also have an ability to evolve and
those entities are able to learn and process the information gained from the
environment. (Mitchell 2009, p. 13) Some examples of complex systems are ant
colonies, fish schools but also consciousness, intelligence or an economy. Social
sciences utilize more and more knowledge from complexity science; for example, the
study of culture - how does it emerge and coordinate, why some traditions and
institutions survive, how they change and so on. Also, economics has started to head
toward complexity, resulting in the field of complexity economics to emerge relatively
recently.
Complexity science is a cross-disciplinary field because it is composed of many
core disciplines. It utilizes the knowledge from computer science, physics, biology,
cognitive sciences and so forth. That is why the definition of complexity has not been
unified yet and I suppose it never will be. But there are some specific characteristics
common for all complex systems nonlinearity, self-organization, non-equilibrium,
4

simple agents, emergence, dynamics and attractors, evolution and many others. I will
discuss them one by one because the understanding of these characteristics is crucial for
subsequent analysis. I would like to start with the dynamics and attractors which are
important for the comprehension of the difference between simple and complex
systems..
1.1. (Nonlinear) dynamics
Lets now focus more deeply on dynamics and the difference between linear and
nonlinear dynamics. System dynamics are represented by the movement of a system
from one point to another or rather from the one state in time t to another in time t+1.
The system takes place in a space and it is called phase space. This space represents all
possible states of the system and these possible states correspond to one unique point in
the phase space. The states that system reaches create some trajectories called phase
portrait (Goldstein 2011)
Certain phase portraits then display attractors as the long term stable sets of points in
the dynamical system. They are the locations in the phase portrait towards which the
systems dynamics tend to move regardless on the initial conditions (Goldstein 2011,
p. 5)
There are three types of attractors: fixed point, periodic and chaotic. (Mitchell
2009, p. 32) Each system has some pattern and Stephen Wolfram

had studied these
patterns on cellular automata and discovered that these patterns are specific and in some
way always very similar. He discovered that these patterns belonged to four classes of
behavior. According to what the attractor is, the system might be linear or nonlinear.
The linear systems are the ones you can understand by understanding their individual
parts and then putting them together. In this case, the whole is equal to the sum of the
parts. Whereas in nonlinear systems, the whole is different from the sum of its parts.
What occurs at the macro level is not easily comprehensible from the observation of the
micro level interactions. That is why the behavior of the nonlinear systems is rather
unpredictable. An example model of the nonlinear system would be a logistic map.
1


1
For further details see Melanie Mitchell, Complexity: A guided tour, p. 27
5

1.1.1. Path dependence
The initial conditions of the system matter because they determine the path
which the system is going to evolve. This stands also for agents. The agents past
decisions put them into some situation and this has influence on their future decisions.
Their past decision influence the emergent phenomena of the system. One single
decision can change everything. The systems structure acts as the memory of system.
(Page 2014) Page (2009, p. 32) also talks about path dependence. He says that path-
dependent processes are not predictable. The unpredictability is not given by
randomness but it depends on actions along the path. Page refers to the example of
QWERTY keyboard as the example of path dependence.
1.2. Four classes of behavior
Every pattern a system produces can be assigned to one of the class of behavior.
Wolfram (2001, p. 231) has numbered these classes regarding to their increase of
complexity.
Class 1 behavior is uniform behavior, represented by a fixed point attractor. All patterns
evolve over time and are gradually attracted into stable state equilibrium. A System
with this behavior is sensitive to initial conditions and any randomness disappears in
time.

Figure 1 rolling marble (source: Complex Systems Tutorial)
Rolling marble is often used in Traditional Economics to demonstrate how an economy
behaves. Economy is hit by an external shock and deviated from the equilibrium but it
tends to get back.
6

Class 2 behavior is represented by a periodic/limit-cycle attractor. The initial conditions
influence the structure of the pattern but quickly evolve into repeating cycles oscillating
around the same values.

Figure 2 limit cycle attractor (source: Complex Systems Tutorial)
Class 3 is more complicated behavior. It belongs within the chaotic/strange attractors
and is very sensitive to initial conditions. Even though the system tends to evolve in a
chaotic and random manner, the chaotic systems also have some universal properties.
The stable structures never survive because of the surrounding noise.
Strange attractor

Figure 3 Halvorsens attractor (source: SPROT 2008)
Class 4 represents complex behavior. These patterns evolve into structures that interact
in complicated ways. The structures are formed locally and are able to survive for long
periods. The complexity arises at the edge of the chaos. The eventual outcome of these
systems might be stable or oscillating structures as in the class 2 but would require a lot
of time and many time steps to reach this state. Initial patterns are usually simple but
emerge to complex patterns.
7

The last class the complex behavior is the one we will be interested in, in the
context of economics. For example, how economies work, which complex phenomena
we can observe in the economy, how markets or business cycles emerge and so forth.
Emergence is very important property of the complex system and determines the
essence of this approach.
1.3. Emergence
Complexity itself is a property of the system and we can look at it as an
emergent phenomena. Emergence creates novelty, something that could not be deduced
from the properties of the individual parts. But among their interactions something new
and different is created. And this is exactly what complexity is. Complexity is created
by interactions of simple individual parts at the micro level. They have some properties
but we cannot deduce from them what is going to be created at the macro level. We
cannot explain the property of the macro level on the basis of understanding the micro
level. That is why emergence does not have logical properties because it cannot be
predicted. (Corning 2002, p. 7) One example of emergent phenomena is wetness.
Wetness is created by weak hydrogen bonds holding together water molecules. A single
water molecule does not feel wet, but water does. The wetness is something that was not
built-in. We could not deduce this from observing one single water molecule. (Page
2009, p. 21)
Emergence is a product of a dynamical process where individuals (agents) form
collective behavior. For example, ant colonies: ants as individuals are very simple
creatures that seek to satisfy their needs food, respond to chemical signals of other
ants in the colony, fight intruders and so forth. The individuals perform actions
following simple rules but when they work together, they create complex structures that
are important for survival of the colony as a whole. (Mitchell 2009, p. 177)
1.3.1. From the bottom up
Emergent behavior is produced from the bottom up. It is the spontaneous
creation of order which is created by the interactions of agents without any central
control. The bottom-up approach let us study the system by looking at the individual
parts agents - and their interactions. (Page 2009, p. 21) We will talk about the agents
and their properties in the next sub-unit.
8

It is also important not to confuse the terms complicated and complex.
Complicated does not necessarily mean complex. If a system is complicated, it may
have many diverse parts, but if these parts are not adaptive they cannot be complex.
Moreover, complex systems are robust, creating large events that are dynamic. These
dynamics change the patterns of the system and the agents are forced to adapt to these
changes. They must process the information and act in the way that best fits the current
conditions, resulting in the system improving itself by this process of learning. So the
system evolves and adapts to the environmental changes. (Page 2009, p. 4)
1.3.2. Landscapes
Page (2009, p. 6) also introduced the concept of simple, rugged and dancing
landscape models to demonstrate what complexity is and how it is created. He points
out that in the simple landscape there is a global peak which is also the local peak. We
can understand this as an equilibrium state where once a system reaches it, it is not
going to change because the interactions do not take place. The rugged landscapes
usually have more local peaks and one global peak, which is difficult to find. We can
imagine the ruggedness of the landscapes as the diversity of the system which is created
by the interactions of the agents. However, rugged landscapes are not complex. Sooner
or later, agents reach their respective global and local peaks and the system will become
static. Complexity is created when landscapes dance.
The dancing landscapes contain interacting agents who are interdependent and
must adapt. This means that my choice is somehow dependent on the current and
previous actions of other agents in the system. Agents interact locally and create local
peaks. These local peaks are the best nearby options and the global peak is the best
possible action. As landscapes dance, the local peaks change position, which makes it
hard to find the optimal solution because the agents must adapt to the new conditions of
the system.
1.4. Agents
Since we try to explain the complex patterns, structures, macro behavior and
outcomes, we should also focus on the micro level the agents. Agents form the bottom
of the system and they have some properties and abilities. These determine the
complexity of the system and I will mention a few of them.
9

For agents to interact with each other, they must communicate and perceive
information from their environment. (alamon 2009, p. 68) The communication is an
important prerequisite because it allows agents to cooperate, coordinate and compete
with each other. They are also able to evaluate the outputs from the environment and
react, therefore they are adaptive. Agents change their actions based on ongoing events.
Agents are also goal oriented but they do not accomplish their goals by
themselves, instead they accomplish them with the cooperation with other agents. All
their actions and decisions are evaluated with respect to the agents objectives and
agents perform only those actions that are in accordance with their goals. (alamon
2009, p. 25) It is also called the if-then or condition-action rule when an agent evaluates
the current state of the world with respect to his goals. (Beinhocker 2006, p. 110)
Nonetheless, agents are autonomous because even though they cooperate, every action
is performed by the individual. Agents also have various preferences, they are diverse in
their abilities and skills, and they have different goals they are heterogeneous.
The heterogeneity of the agents is one of the key differences between the
complexity approach and the traditional economics approach which I will discuss later
when comparing these two approaches. Another important property of agents is
bounded rationality. Bounded rationality and heterogeneity is what makes a world
complex and unpredictable. I will focus on bounded rationality in an independent sub-
unit because this assumption often lead to different implications than the perfect
rationality in traditional economics models. We will discuss why the assumption of
perfect rationality can be a limit in explaining real world phenomena.
1.4.1. Bounded rationality
One assumption in Traditional Economics is that people agents are perfectly
rational; they think of every action, optimize, choose the best possible strategies, they
are fully-informed and so forth. The perfect rationality assumption allows economists to
construct models which can be solved analytically with exact results. Later in this work
we will discuss why this approach can limit our understanding. Beinhocker (2006, p.
122) describes some properties of human thinking and bounded rationality. People act
under framing biases, availability biases, decide under conditions of risk and
uncertainty, use mental accounting, superstitious reasoning or representativeness. For
example framing some issues can affect how we think about them. Under perfect
10

rationality condition, it not matter how we frame the situation. Or availability bias
means that people make decisions based on data they have instead of searching for data
they really need, to make a right decision. These all deviate from the assumption of
perfect rationality. And if we add bounded rationality to economic models, we will get
different results than from traditional models.
Agents do not have perfect information at their disposal. They consider just a
few alternatives while deciding their actions. They exploit from their knowledge.
Agents decide under the uncertainty and cognitive limitations.
Traditional Economics with an equilibrium approach look at what action,
strategies and expectations would be consistent with aggregate patterns agent caused,
but complexity economics asks how the agents would react to these patterns. (Arthur
2013, p. 3) While searching for behavior consistent with the equilibrium approach we
see traditional assumptions of perfect rationality, perfect information, and no diversity
among the agents behavior of all the agents can be treated as corresponding to the
average, representative agents. Thoughts, perceptions, mental states, and feelings are
processed in certain ways that vary amongst human beings, resulting in perceiving
reality differently. Because they react in different ways, this heterogeneity creates
complexity.
People are not endowed with perfect rationality and getting information is
costly. People are diverse and this diversity makes them guess the behavior of other
people. They create beliefs about their environment. (Arthur 2013) People are also not
as good in deductive reasoning as Traditional Economics assume. Instead, because of
their cognitive limitations, people have bounded rationality and tend to simplify the
complicated situations they get into by creating temporary internal models, using
heuristics and hypothesis, which they then apply to these complicated situations.
According to feedback people get from their environment, they strengthen their beliefs
or change them. In other words, people (agents) learn. They learn and evolve in their
strategies, beliefs, internal models in order to get better results next time. But what they
do not do is calculate, optimize and so forth. (Beinhocker 2006, p. 126-130)
1.4.2. Inductive reasoning
Induction reasoning is used in the complexity theory. It allows to make
generalizations from specific observations. Sometimes it is called the bottom up
11

approach. We begin with specific observations and measures, start to recognize some
patterns and regularities, formulate some hypotheses to explore, and finally end up
developing some general conclusions. (Crossman 2014) However, even if the premises
are true, the conclusion can be false. For example: Marry is a woman. Marry is 170
centimeters high. Therefore women are 170 centimeters high.
In complexity science the agent-based simulations are used for the research and
study of phenomena. This method permits to obtain particular observations from which
we can conclude something about reality. Axelrod (1997, p. 21-40) points out: Since
scientific explanations are generally defined as the derivation of general laws, which
are able to replicate the phenomena of interests simulations appear to be less scientific
than analytical models.
Induction works together with abduction. Induction is used to obtain knowledge
about some behavior of the model, but in the real world, we refer to the logical process
of abduction. Abduction is a method of reasoning which looks for the hypothesis that
would best explain the observed phenomena in the model. (Encyclopedia of Complexity
and System Science, p. 214)
This way of reasoning is adopted in the complexity theory because of the
bounded rationality of the people. People learn and create a mental model of particular
situations. If they end up in some similar situation, they will try to match their internal
model to this situation and solve the problem accordingly. They might adjust their
internal models as they face more and more similar situations. That means they will
adopt some general knowledge from the concrete cases.
Inductive reasoning is opposite to deductive reasoning which is used in Austrian
economics. Later in the work we will discuss if this is a big barrier in unifying
Complexity and Austrian approaches.

12

1.5. Interesting in-between
If we summarize the properties of agents, we can tell that they are connected
because they cooperate and are dependent on each others actions. These actions change
the current state of the world and since they cooperate or compete, it always affects
them. There is also some diversity among the agents (they are heterogeneous), but
agents are adaptive because they are able to perceive their environment and react to
changes. They also have bounded rationality because they do not have all information at
their disposal and do not optimize every action. These characteristics work to some
degree. What does it mean?
Agents are connected with each other but all agents in the system are not
connected. Usually agents interact locally with their neighbors, therefore all actions
taken in the world do not affect all agents. It also implies that there is not such a strong
interdependence in the system. Although agents are diverse and heterogeneous, they are
not completely diverse to the others. They are very similar, they differ only in specific
things. And what about adaptation and learning? Agents following fixed rules without
any adaptation or learning will remain in equilibrium. On the contrary, if everyone is
changing his decision and optimize in order to adapt to every change which comes,
there will be equilibrium again. Hence, the complex pattern will arise from little
learning and adaption. (Page 2009, p. 10-12)
Hence, complexity is always created in-between. According to the
aforementioned classes we can say that complexity is created between order and chaos
or at the edge of the chaos.
2. Review of Complexity Economics
In this sub-unit I would like to introduce a new approach to economic science
which has been slowly growing over the last 25 years. Later in this work I will discuss
why the rethinking of economics is needed, the crucial problems of a mainstream
approach and the differences between the mainstream and complexity approach.
At the beginning of his book Origin of wealth, Beinhocker (2006) talks about
problems of the current economic science, e.g. economics is not helpful in explaining
the economic crises, economic theories are often based on unrealistic assumptions and
mathematical models are often contradicted by real-world data and do not provide a
sufficient description of the world. But the important question is: What does this
13

different approach offer? And could the Complexity Economics replace the neoclassical
economics? Is the economic science in the middle of the paradigm-shift?
Complexity Economics offers a new way of thinking about economies. The key
change in this approach is seeing economy as a dynamic system without equilibrium.
The equilibrium approach is not necessarily wrong. But the problem is that this
approach places a very strong filter on what we can see in the economy technological
innovations and exploitations of market opportunities which implies constant
uncertainty etc. (Arthur 2013, p. 3-5) Agents (producers, consumers, firms) interact
with each other and these interactions create aggregate patterns in the system then
agents react to these patterns again. For example when new technology is introduced
to the market and it becomes broadly used, it might, for example, help consumers save
money because it allows them to use one device instead of many (e.g. the smartphones)
and they can use their saved money for something else. Or producers of notebooks
might decrease their prices so the consumers will buy more notebooks. When there is
some change in the system we will constantly react to it. But the economy is a
decentralized whole and all patterns are created spontaneously and without any central
control. How?
2.1. Self-organization in the economy
All interactions in the economy take place in the market. The market is a place
where trading occurs but it is not designed and it works in a decentralized way.
Individuals pursuing their own self-interest lead the society as a whole to greater
outcomes.
The merchant intends only his own gain, and he is in this, as in many other cases, led
by an invisible hand to promote an end which was no part of his intention By
pursuing his own interest he frequently promotes that of the society more effectually
than when he really intends to promote it. (Smith 1776, book 4, ch. 2, p. 485)
This famous quote of Adam Smith catches the main idea of self-organization in
the markets. Agents follow simple rules of utility or profit maximization and they
interact with each other. They cooperate, trade or compete and the competitive markets
emerge. These interactions are constrained locally but still all the participants of the
market are interdependent and connected through the price mechanism. Prices are the
14

linking mechanism between consumers and producers and give them necessary
information to adapt to the market changes.
Without any intention of these agents at the micro level, these interactions lead
the society at the macro level to better outcomes. "Every individual is continually
exerting himself to find out the most advantageous employment for whatever capital he
can command. (Smith 1776, p. 482) The well-being of the society and effective
allocation of resources are spontaneously created they are self-organized. Self-
organization is the invisible hand of Adam Smith. Now, I would like to talk more
about the markets - why and how did they emerge.
2.2. Emergence of the markets
The main goal of mankind was always to survive and man was equipped by the
instincts which allowed him to protect himself. But people lived in small tribes because
it was more favorable. Each member of the clan had his or her own role and tasks to
fulfil so that labor division and trading within the tribe could emerge. But for the tribe to
survive it needed to create rules everyone had to respect and follow in order to lower
risk and danger. Hence, the tribes which kept following rules had a greater chance of
survival. The rules had been set according to the current needs of the tribe - they were
constantly evolving. Working rules had survived and began to develop further into
traditions, culture and institutions. None of this was planned or designed, it emerged
spontaneously. These traditions and institutions also allowed not only people to survive,
but also cooperate with each other which was crucial for the further development of
society and economies. (Hayek 1988, p. 11-22)
The cooperation enabled the labor division and specialization. These had been
realized not only within the tribes but also between various tribes which could therefore
trade with each other. In this way market could emerge. Trading allowed labor division
between the tribes because they could specialize and focus on providing specific goods.
Adam Smith mentioned the example of a pin factory. He observed ten men at work,
each of whom specialized in one or two steps of the pin-making process. (Smith 1776,
book 1, ch. 1, p.4) The specialization and cooperation enabled the tribe to make 48,000
pins per day, or 4,800 pins per man. Without this labor division, the pin factory would
have only been able to make approximately twenty pins per man per day, or maybe
none. (Beinhocker 2006, p. 25)
15

2.2.1. Market competition
Competition is an important element in the market activity. It holds importance
for both consumers and producers. Lets focus on producers for now. Producers in the
market will offer opportunities
4
which they consider at least comparably attractive as
the opportunities of other producers. But producers will offer these opportunities only if
they will yield them the greatest outcome. They follow the profit-maximization rule. If
the market considers these opportunities as non-attractive, these producers will be
rejected by the market and their competitors survive. This motivates them to provide
offered opportunities as efficiently as possible. It is the only way to gain profit on the
market. They adjust their business plans, strategies and so forth just as the tribes
adjusted their rules in order to survive. This is the driving force which enables the
development of new technologies and the decrease of costs and therefore increases the
profit which can be invested again. Schumpeter called this creative destruction. He saw
the growth of the economy in the entrepreneurs innovations which were internal,
endogenous factors crucial in the study of wealth creation. Since entrepreneurs must
adjust their business plans and strategies; we can consider this as some kind of
evolution in the market. And it actually is.
2.2.2. Evolution in the markets
I have indicated how the cooperation and competition affect the markets. There
are firms with business strategies being tested on the market. Markets provide fitness
function and a selection process that represent the needs of the population. Hence, this
function determines the conditions for which firm will survive or fail. It includes many
factors such as satisfaction of the demand, quality of the goods and services,
competition in the market and also institutional conditions in which the firm operates.
Markets provide a means of shifting resources toward the firms which make the best use
of them with minimal costs. The evolutionary algorithm of the markets also includes
replication. If there is a monopoly in the market because of introducing new product or
technology and it is successful, it is very likely to be replicated by other firms if there
are few or none barriers for entry to the market. These are the reasons why the markets
work so efficiently. Beinhocker (2006, p. 295) compares the traditional economics

4
Goods and services
16

view of the market-efficiency with the complexity economics view. He states: The
reason that markets are good at allocation has more to do with their computational
efficiency (they get the right signals to the right people), than with their ability to reach
a global equilibrium.
Traditional Economics considers markets as perfectly efficient under
equilibrium conditions but the equilibrium conditions are never met and markets do not
work perfectly. Hence, there is a consensus about efficiency of the markets both in the
traditional view as well as in the complexity view but there is a difference in how they
approach it.
2.3. Positive and negative feedbacks
When I talked about dynamics before, I was describing how the dynamics work
in the system and that we can observe many kinds of dynamics according to the classes
of behavior. But now, I would like to describe with a few examples, how the dynamics
are actually created.
We can notice that economy is a very dynamic and vivid entity and all taken
actions influence another people, their decisions and behavior. Often these actions have
some influence for other actions to take place and it can launch cascades of actions with
positive or negative feedback. Actions where positive feedback occurs produce more of
that action. Beinhocker (2006, p. 100-102) gives an example with a consumers drop in
confidence can lead to decreased spending, which leads to decreased production, which
leads to unemployment, which leads to even lower consumer confidence and thus a
further drop in spending, spiraling right down into a recession.
Positive feedback reinforces, accelerates, or amplifies whatever is happening, whether
it is a virtuous cycle or downward spiral. Systems with positive feedback can thus
exhibit exponential growth, exponential collapse, or oscillations with increasing
amplitude. (Beinhocker 2006, p. 101)
Negative feedback has an opposite effect. They tend to stabilize a system and
push in the opposite direction. They also tend to make a system self-regulating; they
produce stability and reduce the effect of fluctuations. In the traditional economics
approach we can consider the market-clearing price as the negative feedback which
leads the market to equilibrium.
17

Another constituent of the dynamics in the system are time delays. Time delays
are created by the opposite effect of the positive and negative feedback. Beinhocker
(2006, p 102) says: The positive feedbacks drive the system, accelerating it, but at the
same time the negative feedbacks are fighting back to dampen and control it. When time
delays are thrown in, the driving and damping can get out of balance, and out of synch,
causing the system to oscillate in highly elaborate ways.
Are the positive and negative feedbacks and time delays consistent with the
equilibrium approach of Traditional Economics? Or is the notion of non-equilibrium in
the economy more realistic?
2.4. Non-equilibrium
Lets recall the model of landscapes. We already know that if there were only
perfectly rational agents and they were all the same, they could reach only one global
peak, Mount Fuji single equilibrium. There is no space for exploration,
improvements and creation. We reach just this one point and we are done. But the real
world is full of rugged and dancing landscapes, especially in the economies. We do not
know how agents might react to the aggregate patterns they create and as I have stated,
agents do not even know how the other agents will behave.
Hence, this makes the landscapes dance. An agent must adapt to new situations
and this implicitly assumes non-equilibrium because equilibrium is a pattern that does
not change. (Arthur 2013, p. 3) Therefore the equilibrium system cannot endogenously
create novelty. It does not mean that we could not reach the equilibrium. On the
contrary, while climbing the hills we can get stuck at the local optimum, lets say in the
temporary equilibrium. When we go to the store, we want to buy tomatoes and they are
some price. We might think that they are very expensive. But we want them and we buy
them. If we do this, we agree with their price, we get to the equilibrium, to the local
optimum. Why is it temporary? Because it may happen that due to better conditions
next year there will be better harvest, more tomatoes and therefore they will cost less.
Again, conditions will change and it also changes our situation because we are better off
now with the lower price of the tomatoes. The landscape dances, new situations emerge
and we have to react to them.
This all puts the economy in non-equilibrium, it is the natural state of the
economy and it is always open to reaction. There does not exist an optimal solution for
18

each situation and we usually adapt to the upcoming situations. It allows us to explore
our way forward, we create strategies and actions that are tested for survival. For
example, if a firm uses wrong strategies it may lead to its loss and discharge from the
market. Evolution enters to the system but it arises in the natural tendency of strategies
to compete for survival. (Arthur 2013, p. 7) In the next sub-unit, I would like to briefly
introduce the basic concept of networks because their study is crucial for understanding
how economies work.
2.5. Networks
Before the science of networks was developed, the networks had been studied in
certain disciplines, for example in mathematics the networks were called graphs and the
graph theory developed, sociologists studied social networks and so forth. But scientists
had started to wonder if networks had some common properties and if we could
formulate some theory about their structures, evolution and dynamics. But why is so
important to focus on the study of networks? As Mitchell (2009, p. 233) states, network
thinking means focusing on relationships between entities. These relationships give us
the insight to how the complexity and emergent phenomena are created.
The complex systems as a whole are a set of networks which are in addition
composed of the nodes and the edges (or links) between them. We can measure the
degree of a node through the number of edges coming into or out of the node. If some
node has a high degree, it becomes a hub a node with many connections coming in or
out of it. We also measure the distance between the nodes. This allows us to observe for
example the shortest path between two certain nodes. Elimination of the hub in the
network may lead to the failure of the system because many nodes are connected and
dependent on it. The nodes can also form clusters which are fractions of pairs of
neighbors that are connected to one another. (Mitchell 2009, p. 234 238) The cluster is
for example when you have two friends who are also friends with each other. We can
again measure the clustering coefficient which is the average fraction over all the nodes.
The networks are often neither regular, nor completely random. The regular
networks have long average path length between the nodes and high average clustering.
The random networks, instead, have low average path length and low average
clustering.

19


Figure 4 Regular and Random network (source: GILBERT, HAMIL 2009)
But the real world complex networks have different properties. They have low
average distance between nodes and high average clustering. This is called the small
world property. These networks have relatively few long-distance connections but a
small average path-length. (Mitchell 2009, p. 238)

Figure 5 - Small-world network (source: GILBERT, HAMILL 2009)
All complex networks have the small-world property and as you can see in the
picture, there are many hubs and clusters which creates an interesting pattern of the
network. The study of networks allows us to understand how the structures of networks
are created and organized and also the robustness of the network or its cascade failures.
It could help us, for example, to better understand the bank failures during a financial
crises, how fast the crises will spread on the global market or how fast the technological
innovation will catch on. Hence, the study of networks is crucial for Complexity
Economics. Complex networks have also the long-tailed (power law, scale free)
distribution. These kinds of networks have a small amount of hubs, heterogeneity of
degree values, self-similarity and small-world structure. (Barbsi, Albert 1999, p. 2-4)
Every scale-free network has small-world property but it does not necessarily hold
reversely. In economies we can observe many power law phenomena, such as wealth
distribution or prices of assets on the financial markets.
20

Network science is an interesting field which is very important for studying
complex systems. The structures of networks can significantly influence the behavior of
complex systems. Also, including the concept into economic models could have
interesting implications for the economic science.
3. Summary
In this chapter we have introduced Complexity science and Complexity
Economics. We have listed key disciplines which create Complexity science and
explained a few concepts which we will need in our analysis later. Since Complexity
Economics is relatively new discipline with different approach, I would like to now pay
attention to comparison of Complexity, Austrian and Traditional Economics.

21

II. Comparative analysis of Complexity, Austrian and
Traditional Economics
Experience without theory is blind,
but theory without experience
is mere intellectual play.
Immanuel Kant
Complexity science has its foundations in Classical Political Economy based on
Adam Smith and his invisible hand which I talked about in the previous chapter. The
principles of the complex systems theory was later developed by Austrian School of
economics concretely by F. A. Hayek. His theory of spontaneous order and complex
phenomena created the basis of complexity science. Hence, I would say that Austrian
economics and Complexity economics might have much in common and I would like to
examine their similarities in this chapter. But we also need to look at the differences in
these two approaches and see if there is any problem which could cause some difficulty
in our analysis.
It is also important to focus on the Traditional Economics concepts, compare
them with Austrian and Complexity Economics and therefore analyze what these
approaches could possibly offer instead of the mainstream approach. Our gained
knowledge will help us with further analysis of business cycles.
1. Principles of Traditional Economics
By Traditional Economics I mean Mainstream or Neoclassical economics
which is generally accepted as a paradigm in economic science and the consensus
which is taught at universities nowadays. By Traditional Economics I will refer to
Mainstream/Neoclassical Economics.
Unfortunately, the models constructed in the traditional economics approach do
not correspond to empirical evidence (Beihnhocker 2006, p. 48) which is why this
should be sciences main task to explain how the world works, in our case, how the
economies work. In this unit, I would like to describe the main characteristics of
Traditional Economics and discuss its problems. General criticism of Traditional
Economics is about the unrealistic assumptions in models- mainly about the perfect
22

rationality of agents. I will also focus on the equilibrium approach which limits our
understanding of economic phenomena. This should lead to answer why, in my opinion,
complexity economics is a better approach to study economies.
1.1. Assumptions in economic models
As I mentioned above, the main criticism of traditional economics is held for its
assumptions. Milton Friedman advocates the unrealism of assumptions used for
constructing economic theories. He says that until the theories enable us to predict the
future and explain some phenomena according to reality, the significance of the realistic
assumptions is very low and, contrarily, the important hypotheses have assumptions that
inaccurately describe the reality. The assumptions do not have to be realistic since they
offer accurate approximation of reality. (Friedman 1966, p. 15)
Good models, indeed, are an approximation of reality and they should work like
a map show the streets and roads but without unnecessary details which would
encumber the map and lose its function. The problem is not the simplification of
assumptions, it is even desirable, but the contradiction of assumptions and reality.
Traditional Economics faces this problem. But the main task of science should be to
explain phenomena, not to predict it. Economics is often compared with meteorology.
Meteorologists are capable of explaining what and why something is happening in the
atmosphere, they can also offer some predictions about weather, but since the
atmosphere is a highly dynamical system facing thousands of changes over time, long
run predictions often do not work. The economy works similarly. It is a dynamical
system which creates complex phenomena and changes over time. Time also plays a
very important role in a systems dynamics and I will discuss this later. But I would like
to now describe the way economics has arrived to adopt these simplified, even
unrealistic assumptions.
It all began when Lon Walras imported the concept of equilibrium from physics
to economics. It allowed him to solve the problems with mathematical precision but it
required the making of a set of highly restrictive assumptions. (Beinhocker 2006, p. 48)
A lot of criticism came down but it was highly ignored by economists.
8
Milton
Friedmans essay even helped to support this approach.

8
For further details see Beinhocker (2006, p. 45 48)
23

1.1.1. Positivism in economics
Traditional Economics adopted the positivistic approach to the research.
According to Friedman (1966) the ultimate goal of a positive science is the development
of a theory that yields valid and meaningful (predictions about phenomena not yet
observed). Its function is to give a sense to empirical data and explain them. Theory is
to be judged by its predictive power; only factual evidence can show whether it can be
accepted or rejected. The way of testing the validity of a hypothesis or theory is by
comparing the predictions and experiences. The empirical evidence is obtained from the
statistical data or controlled experiments. The quantitative analysis is then performed by
econometrics which applies mathematics, statistics and computer science to economic
data. It practically allows economic theories to be empirically tested and it is also
utilized for making predictions. (Geweke et al. 2006, p. 2-6)
1.1.2. Equilibrium approach
Walrasian equilibrium or the general equilibrium approach assumes the
existence of two types of agents households and firms firms offer goods and demand
labor force and households offer labor force and demand goods. Firms are a profit
maximizer, meaning that they seek production function which yields to the greatest
returns. On the other hand, the households seek to maximize their utility by choosing a
set of goods that satisfy their needs the best under the budget constraint. Hence, we
consider two types of agents but the agents are homogenous.
Very often we encounter the term representative agent. It means that the agents
have the same properties and they are identical. It is often used in macroeconomics
because it is easier for the aggregation. The sum of their choices are mathematically
equivalent to the decision of one individual. Since we consider households and firms to
be identical, we arrive to perfectly competitive markets. Firms are price takers, price is
set by the demand function and there is practically no space for technological
innovation or change. This is because the economic profit of the firms is zero and there
is nothing left to invest. Both households and firms form the supply and demand sides
and the economics tries to figure out whether these two sides can reach trade agreement
based on single price they are willing to trade for on the market. When the supply and
demand match, market reaches the equilibrium. (Cardenete et al. 2012, p. 5-7)
24

In Walrasian equilibrium, economy is also assumed in that all markets are
interconnected and the change in price of one good affects all the prices of other goods.
Since all the markets are interconnected, we can also calculate the prices by a set of
equations. The interactions are held indirectly through the price mechanism and the
prices, matching the demand and supply, are set by an auctioneer who makes the
process of finding trading opportunities cost free. (Hahn, 2008)
Alfred Marshall developed the concept of partial equilibrium. It focuses only on
the single-product market when other conditions are being held fixed. In other words it
uses the ceteris paribus condition. It examines the effects of some actions in the
equilibrium of that particular market. The dynamical process in these models is the
adjustment of prices to supply and demand or the clearance of the market. This process
is considered in the short run where economy is out of equilibrium, the prices are not
clearing market, there is an excess of demand or supply, preferences of people and costs
of firms are also fixed. In the long run everything adjusts by change in prices, demand
equals supply and market is in equilibrium. Time in neoclassical models is not often
considered and it is being distinguished between the very short run, short run and long
run periods. (Salanti 1991, p. 73-75)
Nevertheless, it is not completely true that traditional models do not include
time. This has bearing on the static models only. Neoclassical economics also deals with
the dynamic models which we will pay attention later.
1.1.3. Perfect rationality and full information
I have already mentioned that adding the equilibrium approach into economics
requires many restrictions and simplifications of models, so that we could obtain nice
analytical solutions. The biggest critics came down on the assumption of perfect
rationality of people. They calculate, optimize and take into account all information that
is available for free. They think of every single action they are going to take.
Furthermore, they live in a simple world with linear relationships. They are also
self-interested in economic matters and there is no space for altruism. Since economics
is so called science of human action, these simplifications, almost unrealistic, do not say
much about human action. Of course, there is psychology which should tell us how
human behavior works and why. However, some pieces of knowledge from psychology
could be useful for economics as well because unrealistic assumptions in models could
25

lead us to unrealistic results. In fact, Herbert Simon, Daniel Khaneman and Amos
Tversky, who contributed to the development of behavioral economics, proved that the
concept of perfect rationality is misleading and it is not necessary for modelling
economic behavior. Instead, they constructed many theories on the basis of bounded
rationality. They used findings from psychology and used them to explain some
economic phenomena. For example the Prospect theory describes how people choose
between probabilistic alternatives that involve risk. People make decisions according to
their subjective evaluation of potential losses and gains based on certain heuristics
rather than the calculation of expected value of final outcome. (Kahneman, Tversky
1979, p. 267-272)
People also do not seek for the best solution and utility maximization but for the
satisfactory solution. During this process they sometimes, on purpose, skip searching
for additional information and are satisfied with the available solution. People neither
optimize nor calculate their actions. Instead, they use heuristics or mental models which
help them to act quickly and without much effort.
1.1.4. Exogenous shocks
If Traditional Economics does not include real time in the models and uses only
short run and long run periods to distinguish between non-equilibrium and equilibrium
state, how does it deal with the changes in economy? The changes in economy are
represented by moving from one equilibrium to another. These changes are embodied in
exogenous shocks. These shocks are exogenous because the effects which cause the
changes are not included in models. Hence, the dynamics are represented as
equilibrium, shock, new equilibrium and so forth. The exogenous shocks are created by
technological innovations, government actions or weather. But the problem here is that
the most interesting things which apparently effect economies are placed outside the
models. This could imply that business cycles in the economy are also exogenous and
random because they are caused by these exogenous shocks. (Beinhocker 2006, p. 54-
56)
It is obvious (and I have talked about it earlier) that good models should be a
simplification of the reality but they should also explain the phenomena. But traditional
economic models take the most interesting issues which fundamentally influence the
26

events in economy away and I ask myself the question, Is this the right way to model
economies and investigate the economic actions?
1.2. Comparative statics
In general equilibrium analysis, the economy itself is represented by a system of
equations. Each equation captures a relationship between the endogenous and
exogenous variables. It is often used as a linear approximation to the system of
equations that defines the equilibrium, under the assumption that the equilibrium is
stable. It permits easier understanding of particular relationships and nice analytical
solutions. (Kehoe 1987)
The number of endogenous variables should be equal to the number of
independent equations. When examining models constructed by others, it is not always
obvious which variables are endogenous and which variables are exogenous but it
should be explicitly stated. A solution to the system of equations is a set of values for
the endogenous variables, such that all of the equations of the system are
simultaneously satisfied. (Nachbar 2008)
Comparative statics is a technique used in Traditional economics which is used
to examine how the solution for the endogenous variables is affected when the
exogenous variables change, in other words, on the relationship between the variables.
It compares two states of the systems before the change and current state. This
analysis focuses on how output is changed rather than the dynamical process of
reaching a new equilibrium. (Nachbar 2008) An example of using this technique is in
the study of markets: the changes in demand and supply and how these changes affect
the equilibrium price and equilibrium quantity. Simply put, how the change of price of
good A, which is the substitute of good B, affects the price of good B.
This approach is different from that of Complexity and Austrian Economics, it
focuses on the outcome and relationship between two variables while others remain
fixed. Nevertheless, in the real world there are many variables and relationships
between them and we cannot simply illustrate it by the system of equations. A system of
equations might capture the state of the system in one single moment but the study of
the process can best explain why things happen in the particular way.
27

1.3. Dynamics in Traditional Economics
Every static equilibrium occurs in a given set of data. A change in the data
results in a new equilibrium position. As we discussed, comparative statics compares
these two points, two states before and after. We distinguish between static analysis of
static economy, static analysis of dynamical economy and so forth. In static analysis
there can be several equilibrium points and the process from moving from one to
another is a subject of the dynamic analysis. (Omay et al. 2004, p. 5) Therefore we can
say that dynamic analysis studies the path how the economic equilibrium is attained.
Economic variables change over time and thus the variables are considered as functions
of time. Time is therefore key factor in dynamic analysis.
Economic dynamics includes changes, time lags and external shocks. In a
dynamic equilibrium the variables may all be changing. Economic dynamics is
concerned with growth, business cycles or stability of equilibrium.
1.3.1. Neoclassical growth model Solow
The main interest of this model is to analyze how an economy reaches the steady
state equilibrium. In the steady state, various variables grow at the constant rate and
economy does not grow. However, at the beginning of the analysis, the state of
economy is unstable and economy converses to its equilibrium point which will not
change during the time. Hence, the dynamics in this model are the convergence to
equilibrium by balancing the growth rate of given variables which are different at the
beginning of analysis. (Mankiw 2010, p. 217)
1.3.2. Real business cycle theory
This theory is based in the Solow growth model and focuses on the causes and
propagation of business cycles in economy. According to this theory, business cycles
are an adequate response of optimizing agents to external technological shocks. These
shocks influence the production function and therefore strike the whole economy. The
dynamics in this theory are represented by external stochastic shocks which change the
potential product of the economy and therefore labor markets, market of loanable funds
and so forth. (Romer 2011, p. 189-237)
28

1.3.3. DSGE dynamic stochastic general equilibrium
Real business cycle model is an example of the DSGE model. DSGE modelling
creates one part of applied macroeconomics and is used in contemporary
macroeconomics for making predictions and understanding the structural changes in the
economy. (Roger, Farmer 2008) They study how the economy evolves over time and
reaches the equilibrium. DSGE models are based on micro-foundations, therefore they
study the aggregate level behavior of the economy by analyzing the interactions
between the agents and how they react to the fluctuations which the economy suffer
from. These fluctuations have random external character and that is why these models
are called also stochastic. (Farmer R., 2008)
1.4. Summary
In this unit we have discussed important characteristics of the Traditional
Economics approach, which is mainly focused on static equilibrium and dynamic
equilibrium achieving analysis. Reaching the equilibrium in the model requires certain
assumptions which also serve to simplify the analysis. We will return to these subjects
later when comparing the differences between Traditional and Complexity economics.
Now, lets focus on the tradition of the Austrian school of economics and its
methodology.
2. Austrian school of economics
Austrian school of economics is the school of economic thought which dates
back to the publication of the book Principles of Economics in 1871 by Carl Menger.
He was one of the three co-founders of marginal utility theory. However, Austrian
school differs from others by its rejection of mathematics; Menger did not use
mathematic tools in his analysis of marginal utility. Austrians are interested in the
individuals perspective of economic action and care that their theories are being
constructed with focus on subjectivism which is called

agent-based reasoning.
(Rosser 2009, p. 394) Austrians also see market as a complex process that produce
order from interactions between the individuals (from bottom up).
Friedrich A. Hayek, another representative of Austrian school, strongly
contributed to the birth of Complexity Science with his works The Sensory Order
(1952) in which he described the central nervous system as a complex adaptive system
29

and Theory of complex phenomena (1964). Hayeks theory of complexity is related to
Santa Fe complexity. (Rosser 2009, p 395) He was openly and actively interested in
complexity ideas, system theory, cybernetics and evolution. The biggest characteristic
of Hayek is his notion of spontaneous order.

30

2.1. Principles of Austrian school of economics
Austrian school began research of economic phenomena through praxeology
science. Praxeology is built on the axiom that humans act. They act in order to satisfy
their need (reach their goals) and this behavior is then conditional. This axiom is
irrefutable. (Elgar 1997, p. 58) The first who came up with praxeology was Ludwig
von Mises in his book Human Action (1996, p. 103). At the beginning of the book
(1996, p. 103) At the beginning of the book he describes human action and sets the
purposefulness as an assumption of a conditional human action which is his main topic
of research. A priori could be deduced from praxeology- the economic theories and
explained economic phenomena. Hence, Austrian economics uses an axiomatic-
deductive method and is not empirical science. Theories cannot be verified or falsified
by empirical data but again by some deductive reasoning.
2.1.1. Methodological individualism
Praxeology is interested in the human action of individual beings. Mises (1996,
p. 41-43) states that all actions are performed by individuals. Collective actions are
always done through the intermediary (one of the members of the group). Social
institutions emerge spontaneously because of the individuals interests which motivate
them to unify. Since the individual is the one who acts, all economic phenomena can be
traced back to this individual. That is why Austrian school refuse macroeconomic
aggregates, such a GDP.
2.1.2. Methodological subjectivism
Methodological subjectivism means that people assign a value to the things. A
good does not contain the value on its own. But we cannot measure the value by some
numbers or units. The value is rather ordinal than cardinal. An individual values the
marginal unit of the good which is the additional unit of that good. The utility from
these additional units is called marginal utility. (Boettke 1998, p. 17-22) This is also an
explanation for the well-known paradox of the diamond which Adam Smith and other
classical economists have wondered about. It is obvious that water is more useful than
diamond. But still the diamond is way more expensive than water. People do not decide
about all diamonds of the world or about all the water but rather about 1 piece of
diamond and a bottle of water. And because people have a lot of water, the marginal
31

utility from water is lower than the marginal utility from the first diamond and thus the
bottle of water is cheaper than this diamond.
Subjectivism is important to explain the development of exchange. For two
people to exchange goods with each other, they must value the good of other partner
higher than their own good. After exchanging, they both have to be better off otherwise
they will not exchange.
2.1.3. A priori deductive reasoning
Austrian economics derives from deductive logic a priori their economic
theories. For Mises, economic phenomena must be deduced from the first axiom that
humans act. If we assume this axiom true, conclusions logically deduced from it are
valid. According to Austrians, the deductive method is the key instrument in
understanding and describing economic patterns.
Austrians argue that the methods used by natural sciences could not work in
social sciences because there are no underlying constants in human behavior that can be
observed in natural sciences. Second, there is no way to conduct a truly controlled
experiment in the social sciences because people are aware of the experiment and their
actions are influenced by the environment and so forth. (Murphy 2003)
2.1.4. Time
The presence of time in human decision making seems to be clear but it is often
ignored in economic analysis. Time is an omnipresent scarce factor that individuals
must take into account in their human action. (Rothbard 2009, p. 13) Individuals prefer
their end to be achieved in the shortest possible time. The sooner it arrives, the better.
Time is a means to be economized and each individual valuates time differently. This is
given by time preferences which we will talk about later. Rothbard (2009, p. 4)
assumes:
All human life must take place in time. Human reason cannot even conceive of an
existence or of action that does not take place through time. At a time when a human
being decides to act in order to attain an end, his goal, or end, can be finally and
completely attained only at some point in the future.

32

2.1.5. Evenly rotating economy
Austrian economics focuses on the study of the market process and how to reach
the equilibrium state. Instead of using the term equilibrium, Austrians use Evenly
Rotating Economy (ERE). But economy will never reach this state because the prices of
all products remain the same, all needs are satisfied and there is no space for money
(because there is no exchange) and therefore the human action also does not exist. This
concept is also used to illustrate the function of entrepreneurship and to demonstrate
meaning of profit and loss. (Mises 1996, p. 244-248)
The same market transactions are repeated again and again. The goods of the higher
orders pass in the same quantities through the same stages of processing until
ultimately the produced consumers' goods come into the hands of the consumers and
are consumed. No changes in the market data occur. Today does not differ from
yesterday and tomorrow will not differ from today...Therefore prices--commonly called
static or equilibrium prices--remain constant too. (Mises 1996, p. 247)
3. Agreements and possible disagreements of Austrian and
Complexity economics
We can observe that Austrian and Complexity economics have in common
certain characteristics in their approach and methodology. A deep theme of Austrian
economics has been that of spontaneous order or self-organization of the economy.
The origin of this theme dates to the putative founder of the Austrian School, Carl
Menger, with his theory of the spontaneous emergence of money for transactions
purposes in primitive economies. Menger drew this approach from the Scottish
Enlightenment figures of David Hume, Adam Ferguson, and Adam Smith, with the
latters Wealth of Nations (1776) holding particular importance. The most important
developer of this idea within the tradition after Menger was F.A. Hayek (1948), who
would identify this self-organization phenomenon with emergence, later expanding
upon this in the broader concept of complexity.
I would like to now focus on the substantive links between Austrian and
Complexity Economics and also underline possible differences.
33

3.1. Agreements between Complexity and Austrian Economics
The crucial characteristic which connects Complexity and Austrian Economics
is the view of an economy as a dynamical complex system where subjective preferences
matter because they differentiate agents. Agents are heterogeneous. Austrians also
emphasize the process of learning. They hold onto the concept of rationality of people
but in a subjective way. People act the best they can according to the information and
knowledge they have in order to fulfill their goals. This concept of rationality is not in
contradiction of bounded rationality. Contrarily, Austrians embed the asymmetry of
information in their analysis and are aware of the cognitive limitation of peoples minds
However, what is the most substantial common characteristic of Complexity and
Austrian economics is the concept of emergence and complexity. Hayeks spontaneous
order is an analogy for the complexity. It all comes from the bottom up, from the
interactions among the heterogeneous individuals. From these interactions the
dynamical market emerges without any central planner or human design. Spontaneous
order in society is the result of human action, but not of human design. (Hayek 1967,
p. 11) Hayek sees society and its institutions as a network produced by the decisions of
many individuals, distributed over space and time, each seeking to solve her problem
and spontaneously create a societys structure. (Rosser 2009) Talking about society,
complexity theorists like Austrians emphasize that is it not possible to understand
aggregate behavior without recognizing what is going on at the micro level.
3.1.1. BRICE
In Handbook of research on complexity (2009, p. 397-400) the common
methodological overlaps of Complexity and Austrian Economics are summarized. Their
initial letters create an acronym BRICE.
BOUNDED RATIONALITY: The term bounded rationality was invented by Herbert
Simon. Hayek and Mises derived the impossibility of economic calculation in socialism
from bounded rationality. Hayek explains bounded rationality in The Sensory Order. He
notes that the mind has some cognitive limitations and it would have to be more
complex than itself to fully explain itself to itself. (Hayek 1952, p. 186-190)
RULE FOLLOWING: In complexity economics it is typical to model agents as rule
followers. (Arthur 1994) This is linked to bounded rationality. We have discussed
earlier that people are not so good at deductive logic and they would rather create
34

beliefs and internal models to follow and assign to certain situations and patterns. They
then match the accidental situation to their internal models and act accordingly. Hayek
(1973, p. 11) said: Man is as much a rule-following animal as a purpose-seeking one.
INSTITUTIONS: According to Austrians and complexity economists, economic
performance depends on the institutions. Institutions are important for shaping
microeconomic behavior. (Rosser 2009, p. 399) Austrians recognized that institutions
matter and included the analysis of institutions in their study. Carl Mengers theory of
the evolution of money is one example; without any protection of proprietary rights, the
exchange could not emerge.
COGNITION: Cognition is linked to the bounded rationality as well. Cognitive
psychology also forms as part of complexity science. It is important to understand what
the cognitive limitations of the mind are. Hayek paid attention to the cognition in The
Sensory Order and as I have already mentioned, his complexity theory is rooted in the
complexity of the mind. Among the complexity theorists, Stuart Kauffman was
especially focused on cognition. According to him it is important that entities in the
adaptive system interact and respond to the changes in environment. But their ability to
comprehend the environment is still limited and they have to deal with what they know.
EVOLUTION: Both complexity and Austrian economics focus on the evolution of the
markets. What should agents do to survive market competition? Hayek played a very
important role again because he moved towards an evolutionary perspective on the
economy. He saw a complex evolutionary process in which natural selection operated at
a higher level of the emergent form. Dispersed heterogenous agents in the economy
interact with each other spontaneously creating the institutions and laws, and at this
level evolution occurred because only the best institutions became steady. (Rosser
2009)
3.2. (In)solvable differences
Austrian economists are very critical in using mathematical tools for an
economic analysis. Complexity economics, instead, uses mathematical and
computational tools for its research. But the use of mathematics was different than 100
years ago when Walras adopted the concept of general equilibrium solvable by linear
equations. Complexity Economics uses agent-based simulations which, in my opinion,
are not inconsistent with the Austrian approach.
35

Another discrepancy is the equilibrium approach. Austrians have adopted the
concept of evenly rotating economy which is, in other words, the concept of
equilibrium. On the other hand, complexity economics views an economy as a complex
dynamical system that is always moving out of equilibrium. But, as we have discussed
earlier, the ERE serves as an illustration rather than description of the reality. Austrians
focus on the entrepreneurial process and consider the state of equilibrium as
unreachable. I would not be afraid to note that some kind of temporary equilibrium is
also acceptable beyond the scope of complexity economics.
3.2.1. Inductive reasoning versus axiomatic-deductive method
I would like to pay special attention to this rather methodological issue of how
Austrian and Complexity economics approach the research of economic phenomena.
Mises states that economics is a sub-discipline of praxeology which is an axiomatic-
deductive science of human action. Mises refuses adoption of methods from natural
sciences because we cannot track regularities in human action and make predictions
from their observations. Praxeology logically deduces every economic phenomena from
the axiom of human action which is a priori assumed. But how do you want to assume
something about the reality from logically deduced terms without any empirical
evidence? How is the logical analysis of the term human action related to the real act
of human action or exchange? (pecin 2012, p. 398)
This is an interesting question which arises while deeply analyzing the method
of Austrian economics. It is exactly this reason that we cannot assume human action is
regular; it is not correct to stick with one theory and consider it as the single and
unchangeable truth. But this does not mean that praxeology is not useful. In my opinion,
the inductive method and axiomatic-deductive method of praxeology are not
inconsistent with each other. Contrarily, praxeology could offer solid theoretical basics
for the complexity economics. Agent-based models, which are also the main mean for
testing theories could, in return, provide the experimental evidence of the economic
phenomena for Austrians. The experimental results compared to the empirical evidence
could then yield to the correction of the praxeological basics of human action, if needed.
Human action per se is dynamical and flexible, people learn and adapt all the time, and
thus it is also needed for theories to still develop.
36

4. Differences between Traditional and Complexity Economics
The aim of this chapter is to compare Traditional, Austrian and Complexity
Economics. We are now ready to underline key differences between Traditional and
Complexity Economics. Traditonal economics views an economy as the equilibrium
system. This implies that the economy should be a closed system. Beinhocker (2006,
p. 68) defines closed system as follows:
A closed system is a system having no interaction or communication with any other
systemno energy, matter, or information flowing into or out of it.
He also states that closed systems always have a predictable end state which go
toward equilibrium. Even if the trajectory of the system might seem to be chaotic, the
system always ends up in its equilibrium. Instead, complex adaptive systems are a
subcategory of an open system. There is need for energy to process information and
sustain order. Open systems are complicated and exhibit unpredictable behavior far
from equilibrium. Beinhocker (2006, p. 69) also mentions that as long as an open
system has free energy, it is impossible for the system to ever reach equilibrium.
Economy was misclassified in 19
th
century by Marginalists and considered as a closed
system. But a closed system does not spontaneously self-organize and does not create
complexity and novelty over time.
9
(Beinhocker 2006, p. 70)
Hence, the fundamental difference between Traditional and Complexity
economics is the approach to the economy as an equilibrium and out-of-equilibrium
system. This approach deviated the development of economics toward the generally
accepted mainstream idea which we know today. Another seeming difference could be
the static and dynamical approach to modelling the economy. But as we have discussed,
Traditional economics has also adopted into the models dynamics, concretely into
DSGE models. The difference here is that in Traditional economics, the dynamical
process which include external shocks and interactions between the agents, is still
studied as the way to reach equilibrium. Instead, Complexity economics studies the
emergence of the structure of the economy, how the interacting agents spontaneously
self-organize into networks, how they respond to signals from the environment and how

9
One might ask whether this is the right concept to approach an economy. As Beinhocker further discuss
in his book, this is the physical approach and the economy is rather social phenomena. For deeper
explanation of this issue, please, see Origin of Wealth, chapter 1, part 2
37

these responses affect positive or negative feedback in the economy. Considering
external shocks, this is a very important contrast between Traditional and Complexity
Economics. For example, technological shocks are considered to be the external shocks
in TE. But technological shocks are an endogenous part of the economy and CE
approaches them in this way.
An important part of Traditional Economics is the adoption of assumptions in
models. The most controversial assumption is about the perfect rationality of agents.
Complexity economics adopted a more realistic view of the economic agents and
includes the agents with bounded rationality into the model. Development of Behavioral
economics contributed a lot to this approach. Behavioral economics shows how the
assumption of perfect rationality is violated by psychological biases and so forth. For
example, people are overconfident and make errors in estimating probabilities.
According to Farmer (2012, p. 8), the problem is that the behavioral view is difficult to
integrate into the traditional models because of the rational expectations equilibrium.
On the other hand, agent-based models have the potential to incorporate behavioralism
into the models and behavioral economics can provide the foundations for quantitative
simulation models. (Farmer 2012, p. 12)
If we summarize the key differences between Traditional and Complexity
economics, we can say that Complexity Economics focus on the process and Traditional
Economics on the outcome. The process involves evolution, emergence of patterns,
interacting agents and so forth. In Traditional Economics, agents are rational, optimize
and maximize their utility.

38

4.1. Five Big ideas that distinguish Traditional and Complexity
economics
Beinhocker (2006, p 97) summarizes the key differences between Traditional
and Complexity Economics at the beginning of the chapter Complexity Economics in
his book.
Complexity Economics Traditional Economics
Dynamics Open, dynamic, nonlinear systems, far
from equilibrium.
Closed, static, linear systems in
equilibrium.
Agents Modeled individually; use inductive rules
of thumb to make decisions; have
incomplete information; are subject to
errors and biases; learn and adapt over
time.
Modeled collectively; use complex
deductive calculations to make decisions;
have complete information; make no
errors and have no biases; have no need
for learning or adaptation. (are already
perfect)
Network Explicitly model interactions between
individual agents; networks of
relationships change over time.
Assume agents only interact indirectly
through market mechanisms.
(e.g., auctions)
Emergence No distinction between micro- and
macroeconomics; macro patterns are
emergent result of micro-level behaviors
and interactions.
Micro- and macroeconomics remain
separate disciplines.
Evolution The evolutionary process of
differentiation, selection, and
amplification provides the system with
novelty and is responsible for its growth in
order and complexity.
No mechanism for endogenously creating
novelty, or growth in order and
complexity.

5. Summary
In this chapter we had discovered that Traditional and Complexity Economics
rather differ from each other in many concepts and found the similarities between
Complexity and Austrian Economics. These similarities will serve us as a guideline for
our further analysis of Austrian business cycle theory. We will see that Complexity and
Austrian Economics overlap in many aspects but Complexity Economics introduces
new look at not only the business cycle theory but also the economy at all.

39

III. Austrian business cycle theory and Complexity
Economics
The curious task of economics is to demonstrate to men
how little they really know
about what they imagine they can design.
Friedrich August von Hayek
We will start this chapter by analysis of single-agent economy, two-agent
economy and get to the real-economy concept. We will try to apply the knowledge
from previous chapters and focus on the development of barter exchange, labor
division, emergence of money and then all wrap up with the analysis of business cycle
which is inseparably connected to money and external shocks in Austrian concept.
We will see if we can apply something new or different from complexity approach.
1. Robinson Crusoe Economy
Before we start to analyze the problem, we should first set some assumptions which will
facilitate our analysis.
- Robinson is both consumer and producer
- We assume only one consumer good coconuts
- Robinson decides between consuming coconuts or leisure time
Imagine Robinson has shipwrecked on an island. He is alone and his only worry
is how to survive there. Therefore, his goal is to survive in the island. This means that
he has to optimize his decisions in order to fulfill his goal. For example he will need to
eat some food and find a place to hide before unexpected weather conditions like a
tempest. But he has no experience with living on the island and he first needs to find
something to eat. He has one little coconut tree with just two coconuts at disposal.
Suppose that Robinson needs 10 coconuts per day to maintain his health. That means
two are not enough for him. Now he faces a dilemma should he explore the island and
find additional coconut trees with more coconuts or exploit what he has, get some rest
and continue tomorrow? Lets have a look at his options. If he decides to explore the
island he will find, with high probability, more sources of food. But he could also be
40

surprised by a tempest, get soaked and become ill. It would not be good for him because
he needs all his strength for building a cabin where he could live. On the other hand, if
he stays where he is and eats two coconuts (he exploits), he could become ill as well
because this amount of coconuts does not provide enough nourishment for his health.
Where is the answer then? It lies in between. He can just walk a few miles, find
another coconut tree with enough coconuts for him to survive and continue to explore
the island another day.
As we can see, the economic behavior must also be applied in the case of
survival. The answer of what to do lies, in many cases, in between the extremes. In
this case, it was optimal for Robinson to explore just a little bit in order to get enough
food. But there are other problems Robinson must face.
1.1. Production and consumption
Because we live in the world of limited resources and we are not immortal, time
is precious for us. And what about Robinson? He is in a more complicated situation. He
is alone in the island and if he desires something, he must gain it with his bare hands. In
his case, he must climb the trees and grab the coconuts. We already know that Robinson
needs 10 coconuts for his decent health. The time he spends climbing trees and
knocking down coconuts is 1 coconut per hour on average. Therefore he spends 10
hours per day to obtain 10 coconuts and what is left is his leisure time which also
includes his time for sleep.
He can continue living the way he is but Robinson is not satisfied. He is working
hard every day and it tires him, he feels the lack of energy and hence, he decides to
produce some type of instrument a pole, which would help him to obtain at least the
same amount of coconuts but with less amount of time and endeavor. We will call this
instrument capital good and coconuts are consumer good. Consumer goods are
consumed directly (Robinson eats coconuts) and capital goods are used to produce
consumer and capital goods. Consumer goods satisfy peoples needs directly and capital
goods indirectly.

41

1.1.1. Savings and investments
If Robinson wants to create some capital good, the pole, he must save some
coconuts first because he will spend some time searching for material and producing the
pole and therefore he will not be able to collect coconuts those days. The next day, he
starts to save 2 coconuts and eat only 8. He has been saving for 20 days and has
collected 40 coconuts. Robinson can now take 4 days off from collecting coconuts and
set himself to produce the desired tool. The first day he spends wandering the island and
searching for suitable branches, he finds some of these and the second day he modifies
them by sharpening them a bit. On the third day Robinson is supposed to finish the pole
but he fails because he does not know exactly how to make the pole.
Consider two opposite situations in the first case, Robinson is smart and
realizes that he is not sure about the procedure of production of the pole so he saved
coconuts for 4 days instead of 3 which should be sufficient for time of production. If he
fails, he will be fine because he has enough savings and he can afford to make mistakes.
In the second case, Robinson is optimistic and trusts himself that he will manage to
produce the pole on the first attempt. If he fails, on the fourth day he will find himself
without sufficient savings and he will not be able to continue in production of the pole.
He will have to collect and save the coconuts again and it will lengthen the process.
Robinson would be disappointed and he would remember his error and learn from it.
Next time he would be careful and save more coconuts.
1.1.2. Path dependence of Robinson
Complexity Economics takes into account that path dependence very much
affects peoples decision making. The same stands for Robinson. His path is affected by
his intelligence, luck and randomness. His decisions affect his path and his path affects
his decisions back. For example, Robinson could just be unlucky and go the wrong
direction when wandering the island. He might encounter some wild animal or another
unexpected thing could happen which would prevent him to produce the stole. But he
could not know this. In fact, in the real world people never know all information
needed.
Path-dependence is related with evolution. Evolution enable the improvement of
things because only the best strategies can survive. Robinson would not be successful
without good strategy, exactly because of random circumstances.
42

1.1.3. More savings equals more consumption
Suppose Robinson overcame all obstacles and managed to produce the pole.
With the pole he is now able to knock down 5 coconuts per hour instead of climbing
trees and grabbing the coconuts. It means that for his nutritional needs he must work
only 2 hours per day instead of 10. But Robinson is smart and he knows that an
unexpected situation can take place so he decides to save coconuts and keep a stable
level of savings in case he would become ill and would not be able to work. Hence, he
will work 3 hours per day, consume 10 coconuts and save 5 coconuts. But the use of the
pole could depreciate and Robinson must also invest for maintenance of it so that he can
use it without problems every day. It takes another hour per day of maintenance. In total
he spends 4 hours per day working and the rest of his 20 hours remain as leisure time.
Robinson utilizes this time for further exploration of the island, improving his cabin and
transforming it into regular house. He is also relaxing more and enjoying better health.
Robinson is both consumer and producer and he produces consumer and capital
goods. Capital goods postpone direct consumption but allow him to consume more in
the future. For this is necessary to save and invest the savings into production of capital
goods. In Robinsons case, he has to consume less coconuts while saved coconuts are
consumed during days he is creating the pole (capital good). The pole then allows him
to have more coconuts in less time and therefore he can consume more coconuts or save
them and invest again. In the next example we will see how Robinsons economy
changes when Friday arrives to the island.
1.2. Dynamics of the single-agent economy
We can observe dynamics in Robinsons economy. Dynamics do not depend on
the amount of agents but on the actions Robinson does and decisions he has to make
every day. Imagine Robinson is now satisfied with his situation he gathers coconuts,
maintains the pole, enjoy his free time and go to sleep. He repeats this process every
single day and he does not want to improve his situation anymore. According to
Complexity Economics, this situation might resemble the limit-cycle attractor. The
initial conditions influenced Robinsons situations but soon he evolved into the
situation he is satisfied with and repeat it over and over again. Even if we assume
Robinson producing new capital goods which allow him to obtain more coconuts and
therefore more free time, soon he would get into this attractor anyway.
43

In fact, each individuals economic actions remind, more or less, the periodic
attractor. But the interactions of these individuals make the outcome of the system
complex. Robinson works for his own purpose and does not interact with anyone else.
Therefore the outcome of his economy is simple as well. But the simplicity does not
implies non-dynamics, as we discussed. In the next example we will see how
Robinsons economy changes when Friday arrives to the island.
2. Robinson and Fridays economy
As in the first model, we have some set of assumptions:
- There are 2 consumer goods fish and coconuts
- Both Robinson and Friday are able to produce both of these goods
- Robinson has absolute advantage in producing both of the goods
Suppose there is now Robinson and Friday on the island. They are both able to
produce coconuts and fish. Robinson, with his pole, is able to produce 5 coconuts per
hour and catch 3 fish per hour. Friday is able to produce 2 coconuts per hour and catch 2
fish per hour. That means Robinson has absolute advantage in producing both goods.
That does not mean Friday is unnecessary. As Robinson has absolute advantage, he also
has higher opportunity costs than Friday. If he produces coconuts as usual (3 hours per
day = 15 coconuts), he must give up 9 fish. But in the same situation, Friday will give
up only 6 fish. In relative units, 1 coconut costs 3/5 of fish for Robinson and 1 fish for
Friday, which is more. Contrarily, 1 fish costs 5/3 of coconuts for Robinson and again
for Friday is 1 coconut, which is less. According to this, it is more favorable that
Robinson focuses on production of coconuts and Friday on production of fish.
By arrival of Friday the situation of the islands economy has changed.
Robinson needs coconuts for his good nutrition but with an additional unit of coconut
consumed, the marginal utility of Robinson decreases and he desires to eat some more
fish. But if he spends time fishing and gathering coconuts, he will have just 6 hours of
leisure time which he does not want to give up. Friday would like to also divide his
consumption between coconuts, fish and leisure time as well as Robinson. In this
moment barter exchange may emerge. But there is an important condition - they must
cooperate with each other.
44

2.1. Wealth is an emergent phenomenon
Suppose that Robinson and Friday become friends and therefore cooperate with
each other. In first days together on the island they both produce coconuts. They also
desire to consume fish, but producing fish would cost either coconuts or leisure time.
Hence, they decide to specialize in production. According to previous calculation, even
if Friday is absolutely worse in production of both coconuts and fish, he will focus on
production of fish because the opportunity costs of Robinson to give up production of
coconuts are higher than for Friday. If they specialize in production, they can exchange
what they have produced.
The simple goal of increasing the utility from consumption lead to cooperation
and created the emergence of barter exchange. Robinson will be willing to pay no more
than 5/3 coconuts for 1 fish and Friday will be willing to accept no less than 1 coconut
therefore the price will establish between these two figures. Lets assume that the price
will be 4/3 of coconuts for 1 fish. Robinson and Friday decide to exchange 4 coconuts
for 3 fish every day. Robinson now has 11 coconuts and 3 fish and Friday has and 4
coconuts 3 fish. Before trade, the whole economy produces 7 coconuts per hour and
no fish, now the economy produces 5 coconuts per hour and 3 fish per hour. Because
the price of 3 fish is 4 coconuts, we can say that the economy now produces 9 coconuts
which is more than before and Robinson and Friday are now better off.
2.1.1. Heterogeneity allows the trade
The trade is possible only if participants of the trade have different preferences
and both hold something (goods or services) the other desire. Complexity Economics
assumes agents to be heterogeneous. This assumption correspond to the reality because
if agents were completely identical, they would not have anything to trade with each
other. Heterogeneity of the agents and among their preferences allows the system to
become dynamical and create interesting patterns. Traditional Economics works with
the term representative agent. It means that all agents in the economy are assumed to
be identical and we can analyze the utility function, preferences and so forth of just this
one agent. The preferences of all agents in the economy are then sum up to obtain the
aggregate level result. But this assumption contradicts even the possibility of the trade
and as we discussed before, the outcome of the complex system (which an economy
indisputably is) does not correspond to sum of the individual parts. Therefore, the
45

aggregation in the traditional way is irrelevant and it is incompatible with the individual
level.
Hence, the possibility of the trade results in the production of more goods,
services and therefore creation of more wealth. This is not something planned and set,
this is an emergent property of the economy.
2.2. Time preference
Robinson consumes 7 coconuts and 2 fish and saves 4 coconuts and 1 fish for
his stockpile. He has already saved a ton of coconuts for worse times. Unfortunately, all
of what Friday produces and trades with Robinson must be consumed in order to
maintain his health. But he also wants to improve his situation and catch more fish with
some equipment because he is fishing with his bare hands. He has 2 options: He can
save as Robinson did and invest his savings into production of a fishing rod. Or he can
borrow from Robinsons savings and transform it into investment immediately. Time
preference is what determines how Friday will decide.
Time plays an important role in economic decision-making because we do not
have an infinite time at our disposal. Robinsons willingness to save implies that his
time preference is low. It means that he does not feel an urgent necessity to consume
right now and he is willing to postpone his consumption in the future. Lets say that
Friday has a higher time preference than Robinson, he is impatient and does not want to
wait for the production of his fishing rod. Therefore he would like to borrow from
Robinson. But Robinson must also be willing to lend Friday his savings. And he will do
so only if he receives some recompense interest - for postponing his consumption.
Even though his time preference is low, he still appreciates more current consumption
before future consumption. The interest is actually payment for opportunity costs, while
the opportunity cost is the possibility of using Robinsons savings in another way other
than lending it to Friday.
2.3. Loans, investments and interest rate
Robinsons willingness to save is dependent on his time preference. The lower
his time preference will be, the smaller interest he will require. Interest is the difference
between the price of future goods and equivalent current goods. Friday, instead, has a
higher time preference which is why he wants to borrow from Robinson. He is willing
46

to pay the interest that is the price of increasing current consumption but will be
compensated by decreasing future consumption. So, he will reduce his future
consumption in order to increase his current consumption. Friday wants to use the loan
for his investment. And he will only invest if the revenue from the investment will at
least cover the amount of the loan and the interest.
Robinsons economy and Robinson and Fridays economy models showed us
that seemingly simple situation can result into the dynamical process. Adding second
participant to the economic process made the things even more interesting. We could
observe the emergence of the barter exchange and the development of the loanable
funds market. But the real complexity emerges at the level where lots of agents interact
with each other.
3. Multiple-agent economy
We have slowly proceeded from one agent economy to real world economy
where many agents appear. We will stress all assumptions and we will handle our
analysis with abstractions which indeed will converge to real observations. We will also
leave concrete numerical examples and assume an infinite number of agents as well as
goods.
3.1. Indirect exchange and money
In the Robinson and Fridays economy we could observe the emergence of
barter exchange between them. Robinson was gathering coconuts, Friday was catching
fish and they set up a price to exchange these two goods. The barter exchange is not
possible in the multi-agent economy because of the problem of double coincidence of
wants. Anyone who wants to sell some good, must find not only one who wants to
purchase it, but also one who has a commodity for sale that he wants to acquire. The
market is therefore very limited and the division of labor as well.
In the real economy there is also a lot of goods and services. The chance we will
meet exactly the right person who wants to buy our good and give up the good we
desire is infinitely small. In this situation there is an emergent demand for the good
which would solve these market discrepancies. In the beginning there can emerge many
of these goods which would serve to mediate exchange. By the time people proceed to
one single good because of transactional costs, problems arise in negotiation between
traders from different cities (e.g. everyone would like to pay with the local medium of
47

exchange). When this single good medium of exchange exists, we do not talk about
direct exchange anymore but rather about indirect exchange.
3.1.1. Indirect exchange
Mises (1996, p. 398) describes the indirect exchange as follows:
Interpersonal exchange is called indirect exchange if, between the commodities and
services the reciprocal exchange of which is the ultimate end of exchanging, one or
several media of exchange are interposed.
Lets define the indirect exchange as the act where an individual buys a
commodity not for direct satisfaction but in order to exchange that commodity again for
another which he desires for consumption or production.A medium of exchange is a
good which people acquire neither for their own consumption nor for employment in
their own production activities, but with the intention of exchanging it at a later date
against those goods which they want to use either for consumption or for production.
Mises (1996, p. 401)
How do people decide whether to use some commodity as a medium of
exchange? It is obvious that the medium of exchange comes from an easily tradable
good which most people will be willing to accept (e.g. because of its exploitability).
And this commodity should have many other properties to become a stable medium of
exchange. Rothbard (2009, p. 190) defines it as: demand for use by more people, its
divisibility into small units without loss of value, its durability, and its transportability
over large distances.
The division of labor and specialization among agents requires some generally
accepted medium of exchange because new professions arise, as well as heterogeneity,
and thus coincidence between the actors of trade is almost impossible. As for the trade,
the medium of exchange enables and simplifies the provision of loans. In the case of
Robinson and Friday, it was simple. There were only two goods in the economy
coconuts and fish therefore Friday redeemed the arranged interest in the form of
coconuts and fish. But in the real economy with many agents and goods this would not
be possible. Imagine, for example, a professor of biology. He would borrow 5 coconuts
and arrange the interest of 2 coconuts. Therefore he would repay 7 coconuts. But he
would have to find someone who will exchange 7 coconuts for his lecture of biology in
48

order to repay this debt. This is a very complicated process which would prevent loans
from being provided and therefore hinder the development of the economy through the
lack of accumulation of the capital.
3.1.2. Money
The generally accepted medium of exchange is money. With money, problems
of double coincidence of wants is nearly eliminated. It not eliminated completely
because we must find the counterparty who will accept the money. This implies that
money increases the scope for specialization and division of labor. It also widens the
market opportunities because various professions can develop. Lets go back to the
professor of biology. Imagine he wants to buy a loaf of bread. Without money, the
baker would have to first listen to the lecture of biology in order to sell the bread to the
professor. Maybe nobody or too few people would like to listen these lectures and the
professor would have to change his job in the beginning and do something else. The
specialization requires the emergence of money, but money deepens the specialization
and labor division further.
Money also allows economic calculation because one function of money is the
unit of account. We can express the prices in money units. Also, as I have indicated
above, money allows monetary representation of loans and interests which is important
for the development of the market of loanable funds. Money thus serves to give
information about the situation on the market, about the value of goods and services and
better orientation in loans and interests. Money becomes a component of almost all
trades. Mises (1953, p. 35) states: Money still functions to-day as a means for
transporting value through space. This is very important for entrepreneurs who are the
driving force of an economy. Money gives them necessary information which they can
utilize in their economic decisions.
3.1.3. The price system and economic calculation
The price system is created as a dynamical process in which there are two sides
of participants buyers and suppliers. These participants enter to the market with
certain knowledge according to which they decide about their actions. They do not have
perfect knowledge about the market. Nor sellers, neither buyers. And this interestingly
affects the pricing. Everyone does not have the same information about the situation in
the market.
49

Imagine a bakery which is a monopoly in certain village. It looks like it is a
great opportunity to set prices really high. But quite nearby there is a neighboring
village where there is also a bakery. Not every buyer knows this and the owner of
bakery 1 is also unaware who knows. How will the prices will be set then? Since the
price system is a dynamical process, it is possible that in the beginning, prices will be
set a little higher because the baker will take advantage of his monopoly situation in the
market. It is possible that many people will be too lazy to go to the neighboring village
to buy some bread and will be willing to pay more to the local baker. But after some
time people might discover the other bakery and the monopoly baker will have to adapt
the price closer to what the price marginal buyer
10
will be willing to pay. There are also
another issues which affect price-setting such as change of preferences, the lowering of
transactional costs, more information available and so forth. The price set is some kind
of equilibrium price because the price must be such where both sides agreed upon it.
But that is only the temporal equilibrium price which can be easily changed by the
circumstances mentioned above. The ideal equilibrium price, the global peak might
never be achieved.
We can express the prices in money units. The prices tell us about the
preciousness of all the goods in the market. The increasing price of some commodity
means that commodity is becoming more precious (e.g. because of its scarcity, the
increased demand of that good and so forth). But the price also gives information to
entrepreneurs about the market opportunity. Through prices, coordination in the market
occurs because people are motivated to adapt to change in price. These changes give
them necessary information because if the price of some commodity starts to increase,
the products made from this commodity also become more expensive and people reduce
their using. The price systems allows the allocation of resources to the best
opportunities and if nothing steps in to this system, it works as efficiently as possible.
Entrepreneurial activities are subject to economic/monetary calculation. Mises (1996, p.
230) claims:
Monetary calculation reaches its full perfection in capital accounting. It establishes
the money prices of the available means and confronts this total with the changes

10
Buyer who will buy the good only at some maximum price. Even there are another buyers who are
willing to pay higher price, the competitive process will ensure the price will set according to this
marginal buyer.
50

brought about by action and by the operation of other factors. This confrontation shows
what changes occurred in the state of the acting mens affairs and the magnitude of
those changes; it makes success and failure, profit and loss ascertainable.
Mises (1996, p. 229) also mentions that the system of economic calculation
operates only in the institutional setting of private ownership of the means of
production.
3.1.4. The market of loanable funds
You can notice the development of the loanable-funds market in the example of
Robinson and Friday. Robinson gave his savings (at his own disposal) and created the
supply side of the market. It was Friday who demanded the savings from Robinson for
his own investments. They created the loanable funds market although they were the
only participants in this market. The loanable funds market is fundamental in economic
growth analysis. Garrison (2002, p. 37) states: the demand for loanable funds
represents the borrowers intentions to participate in the economys production
process. Planning investments requires time, risk and uncertainty. They buy input for a
price with the expectation to sell the output for higher price.
However, the future is unsure and their intention might not turn out well. The
supply side savers do not save for no reason. Instead, their savings in this moment
means the higher consumption in the future. Garrison (2002, p. 40) calls it save-up-for-
something (SUFS). This denotes increased profitability for resources acquired now by
investors in the future. But this future demand is uncertain and therefore economic
development is uncertain as well. We do not know how the preferences will change or if
some technological change will occur. This all affects economy and pushes away from
possible equilibrium.
3.1.5. Natural interest rate
The natural interest rate originates from the loanable funds market. The supply
for loanable funds is influenced by time preferences and the willingness to save. The
demand for loanable funds then reflects the willingness and investment opportunities of
entrepreneurs. These entrepreneurs wish to utilize these savings in the production
process and pay input prices now in order to sell the output for a higher (expected)
price. The market for loanable funds then coordinates the production plans with
consumer preferences while the mechanism which balances these two sides of the
51

market is the natural interest rate. The term natural comes from the supposition that
the interest rate is determined by real phenomena. We can observe the emergence of the
natural interest rate in the example of Robinson and Fridays economy. Natural interest
rate determines the price of the future consumption. But since the transactions in the
economy are depicted in money units, the change in monetary base can unfavorably
effect the interest rate in the economy. We will discuss this later.
3.1.6. Banks and fiduciary media
As the trade developed monetary transaction arose. Depending on what the
money was like, it was sometimes difficult for a transaction to take place physically,
from hand to hand. Moreover, if the trade was not local, there were high transaction
costs to transport the money to another town or city. People again were searching for
some way to facilitate this process. They wanted to save the physical money in a safe
place where it could be preserved and withdrawn at any time. And because of this is a
great market opportunity, the first banks occurred.
11
They were not like todays banks.
They were rather like depositories. Clients paid the fee and the bank saved the money
under the condition that the client could come whenever he liked and withdraw it. He
received a certificate which confirmed the client had his savings at this bank and after
its presentation he could withdraw his money. In the course of time, people started to
use these certificates for their transactions and this is how money substitutes emerged.
These money substitutes are fully covered by the commodity which serves as
money. For example, assume that the money commodity is gold and 1 ounce of gold is
issued 1 certificate, thus this certificate has the same value as the 1 ounce of the gold.
This all depends on the trust of the banks clients because they still have to be willing to
accept this substitute as the medium of exchange.
In the course of the time, the owners of banks realized that people would never
withdraw all their assets and started to lend their money for the interest. Banks then
transformed into providers of loans and practically into intermediary between supply
side and demand side of loanable funds market.

11
The real historical origin of banks is not the main essence of this example. Important is the function of
first banks and that they emerged by circumstances and preferences of people without any intention.
52

Imagine the few who are willing to offer their savings and the others who would
like to borrow. It would be impossible for all these people to meet and negotiate with
each other. The bank can provide the loan from the savings of its clients. Suppose there
are two types of bank accounts saving and deposit accounts. Lets assume these
savings are put into a saving account (fixed-term account) and become unavailable for
some period. These savings are then provided as a loan for interest. After the expiration
date the banks pay the saver the interest which is financed from the interest obtained by
the debtor. The amount of money in the economy did not change because the
unavailable money of savers became available for debtors. But there is another option
for how to provide the loans. There are also deposit (regular) accounts to which their
owners have access any time. These are not savings but deposits. But as I have
mentioned, banks know people would most likely not withdraw all their money, so the
bank starts to provide the loans but they are not covered by savings. Nobody postponed
his consumption to the future. In the economy there is now more money because
depositors have their money still at their disposal. The money which is not covered by
the commodity is called fiduciary media. Fiduciary media is a money substitute which
is not covered by the real money. This practically means that two different people have
the certificates for the same money commodity and this creates problems in the overall
economy.
3.2. Complexity as a built-in property
Complexity is created between an order and the chaos. Every open system has a
property of increasing entropy (disorder). This means that an open system
12
tends to go
toward the chaos and an economy is not an exception. With many agents in the
economy, the things get complicated and more disordered because of the problem of
double-coincidence of wants and other issues we discussed before. But people tends to
facilitate the things in order to live easier and improve their situation. Therefore money,
price system and markets emerge because they return the system back toward the order.
But the system (economy) never comes back to complete order because of the
interactions between the agents and the dynamics created by these interactions. This
means that the system is moving between the order and chaos over time and the
complexity arises. The complexity is a built-in property of the economy because

12
Open system in the physical sense, there is a flow of the energy in and out.
53

without the interactions of the agents, there is an absolute order and nothing happens.
With the increasing interactions, the disorder increases but in the absolute chaos
(without prices, money and so forth), the market transactions are not possible as well.
Thus, we need a little of the order and the disorder for the economy to be created.
4. Austrian business cycle theory
We have gradually studied all the elements related to an economy which are
crucial for the Austrian theory of business cycles. Now we can start the analysis
including the knowledge from Complexity Economics and we will proceed step by step
from the outline of Austrian theory of capital to business cycle theory.
4.1. Capital structure and roundabout methods
Time plays an important role in both Austrian and Complexity Economics.
Production process takes some time and the time determines the structure of production
because of the time preferences. People choose to produce consumer goods (by
employing the labor and natural resources) or capital goods which are afterwards
utilized for production of consumer goods according to their time preference. The time
preferences of people are heterogeneous. Every person prefers and will attempt to
achieve the satisfaction of a given end in the present to the satisfaction of that end in the
future. This is the law of time preference. (Rothbard 2009, p. 320)
People give up current consumer goods and the resources are now free for
production of capital goods. But the capital is heterogeneous as well, regarding what is
the capital used for. Traditional Economics considers capital to be homogeneous. But
this approach is not completely correct. If the capital were homogeneous, the whole
production would not have much sense. The capital would only maintain itself
because there would not be a space for innovations and novelty. The homogenous
capital also denies the peoples possibility of having different time preferences. The
heterogeneous structure of capital and production reflects that some people have lower
time preferences and they are willing to postpone their consumption and some of them
have higher time preferences and they rather consume.
The structure of production according to Austrian theory is divided into
production stages which are determined by the degree of roundaboutness. The stages
which are more far away from consumption are called roundabout methods of
54

production. (Bhm-Bawerk 1891, p. 20) The roundabout methods are more productive
but they also ask for more time.
Huerta de Soto (2009, p. 277) talks about the complexity of production. He says
that production processes are very complex and lengthy, the stages are interrelated and
divided into many processes which require innumerable actions of humans. The time is
really important in human action and thus also in the production. Austrian economists
accent the intertemporal structure of production. (Rothbard 2009, p. 319-320)
4.1.1. Hayekian triangle
Austrians use the Hayekian triangle as a graphical representation of the
roundaboutness of production. Figure 2 below illustrates the structure of production.
The length of the triangle represents the length of the production process and the height
represents the value of the consumer good. At the beginning of the triangle there are
original factors of production employed.
13
They create intermediate output which is
transformed to another intermediate product but with higher value. The process
continues until consumer goods are produced. The triangle represents the flow of time
from the beginning of the production until the finalization of the consumer product.

Figure 6: Hayekian triangle the structure of production

13
Labor and land.
55

The incline of the Hayekian triangle equals the natural interest rate. As you can
see below in Figure 3, as the incline gets smaller, the stages of production increase and
production lengthens. And vice versa, as the incline gets bigger, the stages reduce and
production shortens. The natural interest rate reflects the different values among the
stages. (Potuk 2012, p. 2)
Garrison (2002, p. 50) explains that The slope of hypotenuse of the Hayekian triangle
reflects the market-clearing rate of interest in the market for loanable funds.
And then: the slope of the hypotenuse and the market-clearing rate of interest
will move in the same direction. That is, a lower (higher) rate of interest will imply a
shallower (steeper) slope. (p. 50)

Figure 7 the change in the slope of hypotenuse of the Hayekian triangle
A higher interest rate implies less roundabout methods used, thus less capital
invested and lower productivity of given technology and vice versa. Lower interest rate
implies more roundabout methods used, more capital invested and higher productivity.
You can see the real effect of roundaboutness below in Figure 9.

Figure 8 lengthening the stages of production
56

The shape of the Hayekian triangle also implies the amount of consumption.
When there are more stages of production, it also implies lower present consumption.
The vertical axis represents the amount of consumer goods. If people would rather save
than consume in the economy, there is less consumer goods for a current period.
We can look at the Hayekian triangle also from the complexity perspective. The
Hayekian triangle is a representation of the dynamical process. We can imagine the
triangle as a phase space and each stage of production as a possible state of production.
The phase portrait is therefore the structure of production which determines what
attractor the system tends to evolve. But the attractor is the stable state of the system
and the real economy is buffeted by certain disturbances, decisions of agents (for
example change in preferences, technological changes) and so on, thus the system
usually moves away from the attractor. Therefore, we can understand the Hayekian
triangle as the dynamical model of production process.
4.1.2. Path dependence of production
Lets analyze the production process from the complexity view. The production
process is a dynamical process and all the stages of production are interconnected. How
the next stage of production will develop depends on the previous stage, thus we can
observe certain path dependence. This is very important regarding to technologies
which really affect the capital structures and production. Cars based on gasoline/diesel
is an example. These fuels are made from petroleum and the petroleum must be
extracted. This is preceded by many production processes, machines for extraction must
be produced and so forth. A lot of various industries emerge, many people devote to
study and focus on these problems. But what if another resource for cars had been
chosen? Possibly electricity or hydrogen? The whole development of the capital
structure would have been different and therefore the economies would be different as
well
4.1.3. Production as a set of networks
It is important to understand the production process as the network of
manufacturers, producers, suppliers and so forth. This will help us to better understand
why some business cycles become frightful and some we do not even notice in the
economy. The important role play the companies which production steps in many
industries. They create hubs to which a lot of other smaller companies are dependent on.
57

There are just a few of these big companies and there are a lot of small ones. Moreover,
the larger is production process, the higher are the degrees of nodes in the production
network. This means that more companies are connected to others and the
interconnectedness increases. So, the intensity with which the business cycle strikes the
economy depends on the particular structure (network) of production of the economy. It
is evident that less roundabout processes will have a smaller chance for terrific failures
since they have incorporated less stages of production and the connections are not so
numerous. Indeed, it is not secure for this kind of process either because it highly
depends on the presence of hub in the production network.
4.2. Economic growth
The capital in the each stage of production needs to be maintained otherwise the
particular stage of production could collapse as would the whole production process. It
is because the capital depreciates and it is not maintained on its own. The natural
interest rate secures that there is capital created which serves to maintain the given stage
of production. This ensures the smoothness and stability of production. (Potuk 2012,
p. 5) When the investments exceed the depreciation rate of the capital, Garrison (2002,
p. 35) calls it secular growth in the economy. Indeed, the investments must be fully
covered by a sufficient amount of savings otherwise the economic growth becomes
unsustainable. Secular growth occurs without having been caused by change in policy,
technological advance or change in preferences.
Garrison says that savers will supply bigger amounts of loanable funds because
of an increase in their incomes and entrepreneurs will demand bigger amounts of
loanable funds to maintain a growing capital structure and to also accommodate to
future demands for consumer goods. Because of shifts in the supply and demand for
loanable funds, the natural interest rate remains the same. The area of Hayekian triangle
gets bigger but there is no change in slope of hypotenuse which means more roundabout
methods of production and a higher output at the same level of interest rate.
58


Figure 9 the expansion of the Hayekian triangle
4.2.1. Technological innovations and the growth
Technological innovations are assumed to have a positive influence on the
production process; they increase productivity, decrease costs of the production and
therefore increase the profit. But there is an underlying process which occurs while the
technological innovation is taking place in the production.
A response to the new technology highly depends on the adaptability of the
system. If the new technology is introduced but the economy or the particular industry
is resistant, it will not have positive effects on the production. But it is not industry or
system which is resistant but the individuals who are behind all economic decisions and
actions. Thus, the individuals are those who affect the adaptability and resilience of the
system. According to Folke (2006, p. 262) the adaptability is the function of the social
componentthe individuals and groups act to manage the system intentionally or
unintentionally. If the new technology creates market opportunity, and because the goal
of entrepreneurs is to maximize their profit, we can almost certainly assume that they
will utilize this opportunity. If they do and they are successful, they will launch the
cascade of positive feedbacks.
59

Higher profits of entrepreneurs allow them to reinvest these profits to the new
capital. Thus, there is an increase of demand for the loanable funds and the natural
interest rate raises. New technology does not affect the whole production process all at
once but rather gradually and unevenly because of time lags. However, we can also
observe the negative feedback effect. An increased interest rate causes the reallocation
of resources toward the later stages of production (where technological change did not
occur) which allows an increase in consumption. (Garrison 2002, p. 58) The Hayekian
Triangle expands but the slope of hypotenuse gets bigger as well.
14
Due to an increase
in investments, there is an increase of income as well as savings. Then the supply for
loanable funds also increases and the natural interest rate adjusts to its previous value.
15

Technological shock is an example that shows the increase of productivity without
causing the boom and bust of the economy. In Austrian theory, booms and busts have
monetary origin.
4.3. Business cycles
According to Austrian theory of business cycle (ABCT) the changes of money
supply causes fluctuations in the economy. The central bank and commercial banks (the
banking system) play key roles in the spread of new money within the economy. Either
the central bank increases the money in the economy directly or the commercial banks
start to issue fiduciary media through the loans which, as we already know, are not
granted by the increase in savings of the people. But the only way to introduce new
money into the economy is by decreasing the interest rate on the loanable funds market.
The increased supply for loans which results from bank credit expansion will
initially exert the same effect which is produced by the flow of new loans from the
increased savings (for example due to the changes in intertemporal preferences of the
people). It will tend to cause a widening and lengthening of the stages in the productive
structure. (de Soto 2009, p. 348) The credit expansion triggers the series of positive and
negative feedbacks which will harmfully affect the economy.

14
See Figure 10
15
This assumption is used to facilitate the example of the influence of technological shock to the
production process. There are more alternatives how the resources might be allocated. For example, the
technological innovation is so demanding for the resources that the allocation of them prevails in the
earlier stages of production and the interest rate remains higher. For further explanation see Garrison
(2001) p. 60.
60

4.3.1. Boom
The decrease of the interest rate lengthens the production process and
entrepreneurs begin to undertake the projects which require more roundabout methods
of production. They seem now profitable because it seems that people changed their
time preferences and want to consume more in the future. This triggers a process of
maladjustment and dis-coordination. The interest rate is artificially lowered by banks
through a process of credit expansion (de Soto 2009, p. 351) and it launches the set of
positive feedbacks new projects require original means of production (labor and
natural resources) for the stages furthest from consumption. But these means of
production are concentrated in the stages closer to consumption hence the entrepreneurs
must attract the labor force by offering higher wages. They are also willing to pay
higher prices for natural resources the price of inputs start to gradually increase.
Market forces reflecting the preferences of income-earners are pulled in the direction of
more consumption. Market forces stemming from the effect of the artificially cheap
credit are pulled in the direction of more investment. (Garrison 2002, p. 70)
Huerta de Soto (2009, p. 364) describes three reasons for the increase of consumer
goods prices and I will underline two of them.
a) Time preferences of economic agents remain stable and therefore they continue
to save the same proportion of their income. The monetary demand for
consumer goods increases with the increase in monetary income.
b) The greater demand for original means of production in the stages further from
final consumption causes a slowdown in the production of new consumer goods
in the short and medium-term because they are withdrawn from the stages
closest to consumption. It is also clear that until new investment processes are
finished, they will not allow a larger quantity of consumer goods to reach the
final stage. The growth of income and reduced supply for consumer goods and
services causes their prices to increase.
The price level will rise in the overall economy because it is an interdependent
and interconnected system. But it is not a proportional process because only a few
subjects will get new credit. They will not get new funds proportionally to their amount
of wealth but new funds will flow to the sub-marginal investors (the firms which
projects were not profitable at the original interest rate level) and sub-marginal
61

consumers (which will lower their savings at new interest rate level). (Kvasnika 2007,
p. 28) This process changes the structure of production, the structure of wealth of
participants of the market and the economy.
4.3.2. Robustness of the economy
When the system experiences some changes which do not emerge spontaneously
but are rather some external (artificial) shocks, it does not mean the system cannot
handle it. Contrarily, complex systems in general (including the economy) have the
property of robustness or resilience which is the capacity of a system to absorb
disturbance in order to preserve the same function and structure. We need to take into
account the resistance of the system which is a crucial aspect of resilience. As we see,
entrepreneurs utilize the decrease of the interest rate for the new projects while the
structure of production and prices of outputs and inputs change. The great problem
arises when the system starts to suffer from too many shocks.
4.3.3. Bust the positive or negative feedbacks?
Austrian theory assumes the bust as an adjusting process of the disturbed
economy. There is an increase of income which creates an increased demand for
consumer goods and it increases the prices of the goods and so on. This pushes the
stages near to consumption and to higher production stage and the Hayekian triangle
begins to straighten up which means the increase of the interest rate.
Lets have a look at Figure 11 where the whole process is graphically displayed
on Hayekian triangle.

Figure 10 the process of the boom and the bust in the economy
62

By adjusting the interest rate back to the higher level, the economy experiences
the negative feedback which gets the system back on the track of less roundabout
methods of production. But Complexity Economics considers also the time delays in the
analysis. The process of adjustment it not so quick and smooth. The missing resources
in the earlier stages of production of production launches some positive feedbacks
again. The labor force is now freed because it is not needed anymore for the production.
It can be gradually absorbed by the later stages of production. Because of time delays
and long-term contracts, the wages are not flexible and do not decrease so fast. Thus,
the unemployment starts to increase even more. Later, during the bust, the economy
experiences the lack of consumer goods because the production in earlier stages
remained incomplete. Economy must now adapt to the real time preferences of people
and arrange the production stages according to these preferences.
You might ask why the economy is not able to absorb these shocks. The answer
lies in the term self-organized criticality. Page (2009, p. 36) talks about the self-
organization of the system where the aggregation of individual actions produces an
emergent pattern at the macro level. A system is critical if a small event triggers large
cascades of events. Therefore, self-organized criticality implies that the systems self-
organize into the emergent state which is critical, and produce big events.
Hence, the adjustment of the interest rate helps to clarify that the investments
from the earlier stages of production should not (and they even cannot) be finished but
the single act of the adjustment of the interest rate is not the key for a reversion back to
the economic growth. The recession is a complex process and so the bust. It is the
combination of time delays, peoples ability to adapt to the new conditions in the
environment, the connectedness within the economy and so forth.
The critical point in this case was the moment when the later stages of
production could not be financed anymore because of the lack of sufficient savings in
the banking sector.

63

4.3.4. Course of the cycle with an intervention of the central bank
Lets get back to the point where later stages of production ran out of the
resources needed for the finalization of the projects. In this moment, the bust should
occur and economy would slowly rehabilitate. But the central bank decides to help and
influence the supply side of the loanable funds market. There are 3 options of how to do
that: a) minimum required of reserves, b) discount rate, or c) open market operations.
(Garrison 2002, p. 68) For our analysis it does not matter which instrument central
banks decide to use. Commercial banks get another injection of credit and credit
expansion can continue. By lowering the interest rate and the need of investors to finish
the running projects, the process of boom and bust will repeat but at the higher price
level. Rothbard (2009, p. 1002) describes the process as follows:
The only way to avert the onset of the depression-adjustment process is to continue
inflating money and credit. For only continual doses of new money on the credit market
will keep the boom going and the new stages profitable. Furthermore, only ever
increasing doses can step up the boom, can lower interest rates further, and expand the
production structure, for as the prices rise, more and more money will be needed to
perform the same amount of work.
This procedure may postpone the bust phase but it requires accelerating the
inflation rate which, if the banks do not stop this process, would lead to the collapse of
the economy and absolute disruption of the price system because of hyperinflation. The
central bank and banking system at all is powerful and it can significantly affects the
structure of the economy. Even if the actions of the central bank are considered
artificial, it is a part of the economy and it should be taken into account endogenously
while analyzing the business cycles because the central bank creates an important part
of the economy.

64

Conclusion
In this thesis I have introduced Complexity Economics and analyzed the
differences between Complexity and Traditional Economics. I have also tried to
underline the similarities and differences between Complexity and Austrian Economics.
We have found out that the key difference between the traditional and complexity
approach is in their view of an economy. Complexity Economics considers the economy
as an open system, which is complicated and exhibits unpredictable behavior, thus it is
impossible for the economy to reach equilibrium. Also, the approach to dynamics in the
economy is different. Traditional Economics works with the external shocks which get
the economy out of equilibrium. Instead, Complexity Economics sees the dynamics in
the process where agents interact with each other and respond, adapt and learn from the
environment. An important issue in TE is also the adoption of unrealistic assumptions in
models. The most controversial assumption is about the perfect rationality of agents.
I have also focus on the difference between methodologies of Austrian and
Complexity Economics. Seemingly opposite methodologies resulted in that they were
not inconsistent with each other. Praxeology could give theoretical basics for
Complexity Economics and agent-based models could, in return, provide the
experimental evidence of the economic phenomena. This could popularize Austrian
economics again because its main critics lies in the lack of empirical testing of its
theories.
After the comparison of Complexity, Traditional and Austrian Economics, we
started to construct the model of an economy by initially analyzing a single-agent
economy of Robinson Crusoe, than we added Friday into the analysis and then we
focused on the real economy with many agents. We have found out that even when
Robinson is alone on the island, his decisions and actions make his economy
dynamical. Indeed, it is not complex, because complexity emerges when things get a
little complicated. The analysis becomes even more interesting with Friday in the
economy. We have seen that the labor division, specialization, barter exchange and even
the loanable funds market emerged only with two participants in the economy.
In the multiple-agent economy we have observed the increasing entropy that is
reversed by emergence of money, price system and market. They return the system back
65

toward an order but economy is never completely ordered or disordered and that is why
it is a complex system. Because complexity is created at the edge of chaos.
The last chapter was devoted to the ABCT. I have talked about the structure of
production, that in fact is a set of networks created by the manufacturers, producers and
suppliers and that the interconnectedness of the economy determines the course and
intensity of the business cycles. I have also emphasized the importance of the path
dependence which determines the structure of the economy and the robustness of the
economy. The robustness is a property of the system to absorb the external shocks and
do not change its structure. I have also discussed how the business cycle is created
according to Austrians and that the positive feedbacks play an important role in
spreading the business cycle and the negative feedbacks, contrarily, are necessary to
stop the bust in the economy. When the economy is not able anymore to absorb the
shocks, system has reached the self-organized criticality. The aggregation of individual
actions, the incorrect decisions to invest (in our case) produces an emergent pattern at
the macro level the business cycle the critical state of the system which is triggered
by some small event.
The last topic I have focused on was a role of the central bank and its
interventions during the business cycle. I have concluded that the central bank lengthens
the adjusting process of mal-investments and incorrect decisions and its interventions
are considered as the artificial shocks. But, in my opinion, the central bank is still the
part of the economy and therefore we should consider it as an endogenous part of the
analysis.
Complexity and Austrian Economics have much in common and this thesis
proved that many ideas of these two approaches can complete each other and many of
them are very similar. I suppose that if Austrians and complexity theorists start to work
together, they can achieve a lot of success in the economic field and their synthesis may
become a new paradigm in the economy.

66

List of Graphs and Figures
Figure 1: A rolling marble
Figure 2: A limit cycle attractor
Figure 3: Halvorsens (strange) attractor
Figure 4: The regular and random network
Figure 5: Small world network
Figure 6: The Hayekian triangle the structure of production
Figure 7: The change in the slope of hypotenuse of the Hayekian triangle
Figure 8: Lengthening the structure of production
Figure 9: The expansion of the Hayekian triangle
Figure 10: The process of the boom and the bust in the economy

67

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