23 May 2011

Kirzner & Lachman on the “market process”

From The Foundations of Modern Austrian Economics edited by Edwin Dolan.

Kirzner, “Equilibrium Versus Market Process”:

In our classrooms we draw the Marshallian cross to depict competitive supply and demand, and then go on to explain how the market is cleared only at the price corresponding to the intersection of the curves. Often the explanation of market price determination proceeds no further—almost implying that the only possible price is the market-clearing price. Sometimes we address the question of how we can be confident that there is any tendency at all for the intersection price to be attained. The discussion is then usually carried on in terms of the Walrasian version of the equilibration process. Suppose, we say, the price happens to be above the intersection level. If so, the amount of the good people are prepared to supply is in the aggregate larger than the total amount people are prepared to buy. There will be unsold inventories, thereby depressing price. On the other hand, if price is below the intersection level, there will be excess demand, “forcing” price up. Thus, we explain, there will be a tendency for price to gravitate toward the equilibrium level at which quantity demanded equals quantity supplied.

Now this explanation has a certain rough-and-ready appeal. However, when price is described as being above or below equilibrium, it is understood that a single price prevails in the market. One uncomfortable question, then, is whether we may assume that a single price emerges before equilibrium is attained. Surely a single price can be postulated only as the result of the process of equilibration itself. At least to this extent, the Walrasian explanation of equilibrium price determination appears to beg the question.

Again, the Walrasian explanation usually assumes perfect competition, where all market participants are price takers. But with only price takers participating, it is not clear how unsold inventories or unmet demand effect price changes. If no one raises or lowers price bids, how do prices rise or fall? (p. 116)

The concept of “economizing” is insufficient for explaining the market process:

Robbins defined economics as dealing with the allocative aspect of human affairs, that is, with the consequences of the circumstance that men economize by engaging in the allocation of limited resources among multiple competing ends. ...

Robbinsian economizing consists in using known available resources in the most efficient manner to achieve given purposes. ... For Robbins, economizing simply means shuffling around available resources in order to secure the most efficient utilization of known inputs in terms of a given hierarchy of ends. It is the interaction in the market of the allocative efforts of numerous economizing individuals that generates all the phenomena that modern economics seeks to explain. ...

The notion of a Robbinsian plan assumes that information is both given and known to the acting individuals. Lacking this information market participants are blocked from Robbinsian activity altogether. ... We lack justification within this framework for stating, for example, that unsold inventories will depress price; we may only say that with excessive price expectations Robbinsian decision makers will generate unsold inventories. As decision makers they do not raise or lower price; they are strictly price takers, allocating against a background of given prices. If all participants are price takers, how then can the market price rise or fall? By what process does this happen, if it happens at all? (p. 118-9)

Entrepreneurship fills the gap:

Mises’s concept of human action embodies an insight about man that is entirely lacking in a world of Robbinsian economizers. This insight recognizes that men are not only calculating agents but are also alert to opportunities. Robbinsian theory only applies after a person is confronted with opportunities; for it does not explain how that person learns about opportunities in the first place. ... [W]hen the prevailing price does not clear the market, market participants realize they should revise their estimates of prices bid or asked in order to avoid repeated disappointment. This alertness is the entrepreneurial element in human action, a concept lacking in analysis carried out in exclusively Robbinsian terms. At the same time that it transforms allocative decision making into a realistic view of human action, entrepreneurship converts the theory of market equilibrium into a theory of market process. ... (p. 119-20)

The producer’s decisions about what product to produce and of what quality are invariably a reflection of what he believes he will be able to sell at a worthwhile price. It is invariably an entrepreneurial choice. The costs he incurs are those that in his estimation he must in order to sell what he produces at the anticipated price. Every improvement in the product is introduced to make it more attractive to consumers, and certainly the product itself is produced for precisely the same reasons. All costs are in the last analysis selling costs. (p. 123)

Robbinsian incentives can be offered in nonmarket contexts. The bureaucrat, employer, or official offers a bonus for greater effort. For entrepreneurial incentives to operate, on the other hand, it is necessary for those who perceive opportunities to gain from noticing them. An outstanding feature of the market system is that it provides these kinds of incentives. ... It would be good to know more about the institutional settings that are most conducive to opportunity discovery. It would be good to apply basic Austrian theory to the theory of speculation and of the formation of expectations with regard to future prices. All this would enrich our understanding of the economics of bureaucracy and of socialism. (p. 124)

Knowledge and expectations as the driving forces of the market process:

Ludwig M. Lachmann, “On the Central Concept of Austrian Economics: Market Process”:

The market process is the outward manifestation of an unending stream of knowledge. ... The pattern of knowledge is continuously changing in society, a process hard to describe.(p. 127)

The stream of knowledge produces ever new disequilibrium situations, and entrepreneurs continually manage to find new price-cost differences to exploit. When one is eliminated by strenuous competition, the stream of knowledge throws up another. Profit is a permanent income from ever-changing sources.

In the first place, how do we determine the true origin of any particular bit of knowledge? When and how do ill-founded surmises and half-baked ideas acquire the status of respectable knowledge? ... Two things we may assert with reasonable confidence. ... we cannot have future knowledge in the present. Also, men sometimes act on the basis of what cannot really be called knowledge. Here we encounter the problem of expectations.

Although old knowledge is continually being superseded by new knowledge, though nobody knows which piece will be obsolete tomorrow, men have to act with regard to the future and make plans based on expectations. Experience teaches us that in an uncertain world different men hold different expectations about the same future event. ... divergent expectations entail incoherent plans (p. 128)

Expectations must be regarded as autonomous, as autonomous as human preferences are. To be sure, they are modified by experience, but we are unable to postulate any particular mode of change. To say that the market gradually produces a consistency among plans is to say that the divergence of expectations, on which the initial incoherence of plans rests, will gradually be turned into convergence. But to reach this conclusion we must deny the autonomous character of expectations. ... If the stream of knowledge is not a function of anything, how can the degree of divergence of expectations, which are but rudimentary forms of incomplete knowledge, be made a function of time?

Unsuccessful plans have to be revised. No doubt planners learn from experience. But what they learn is not known; also different men learn different lessons. (p. 129)

All useful knowledge probably tends to be diffused, but in being applied for various purposes it also may change character, hence the difficulty of identifying it. (p. 127)

Two possible views of the market process:

For one view the market process is propelled by a mechanism of given and known forces of demand and supply. The outcome of the interaction of these forces, namely, equilibrium, is in principle predictable. But outside forces in the form of autonomous changes in demand and supply continually impinge on the system and prevent equilibrium from being reached. The system is ever moving in the direction of an equilibrium, but it never gets there. The competitive action of entrepreneurs tending to wipe out price-cost differences is regarded as “equilibrating”; for in equilibrium no such differences could exist.

The other view, which I happen to hold, regards the distinction between external forces and the internal market mechanism as essentially misleading. Successive stages in the flow of knowledge must be manifest in both. Market action is not independent of expectations, and every expectation is an attempt “to catch a glimpse of future knowledge now.” (p. 129-30)

It might be held, however, that every process must have a direction, and unless we are able to show that every stage of the market process “points” in the direction of equilibrium, no satisfactory theory of the market process is possible. But this is not a convincing view. (p. 130)

The notion of general equilibrium is to be abandoned, but that of individual equilibrium is to be retained at all costs. It is simply tantamount to rational action. Without it we should lose our “sense of direction.” The market process consists of a sequence of individual interactions, each denoting the encounter (and sometimes collision) of a number of plans, which, while coherent individually and reflecting the individual equilibrium of the actor, are incoherent as a group. The process would not go on otherwise. (p. 131)

[T]he divergence of expectations, apart from being an obstacle to equilibrium, has an important positive function in a market economy. It is an anticipatory device. The more extended the range of expectations, the greater the likelihood that somebody will catch a glimpse of things to come and be “right.” Those who take their orientation from the future rather than the present, the “speculators,” permit the future to make its impact on the market process earlier than otherwise. They contrive to inject a glimpse of future knowledge into the emergent market pattern. Of course they may make mistakes for which they will pay. Without divergent expectations and incoherent plans, however, it could not happen at all. (131-2)

The consequences for capital theory:

Kirzner, “The Theory of Capital”:

A man’s future plans depend not only on the aggregate size of his capital stock but also very crucially upon the particular properties of the various goods making up the stock. Goods that can be used in a complementary relationship permit certain plans that a purely physical measure necessarily suppresses. ...

It is misleading to talk of a particular resource as being unambiguously associated with a definite stream of forthcoming output, in the sense that such an output stream flows automatically from the resource itself. Decisions must be made as to how a resource is to be deployed before one can talk of its future contribution to output. Because there are alternative uses for a resource and alternative clusters of complementary inputs with which a resource may be used, it is confusing to see a resource as representing a definite future output flow before the necessary decisions on its behalf have been made. (p. 139)

Lachmann, “On Austrian Capital Theory”:

The capital structure of society is never completely integrated. The competitive nature of the market process entails incoherence of plans and limits the coherence of the resulting order. A tendency toward the integration of the structure does exist. Capital goods that do not fit into any existing combination are useless to their owners, are “not really capital,” and will soon be scrapped. “Holes” in the existing complementarity pattern, on the other hand, must cause price-cost differences and thus call for their elimination. But expectations of early change in the present situation may impede the process of adjustment, and even when this does not happen, the forces of adjustment themselves may be overtaken by other forces. ...

As long as all capital is regarded as homogeneous, managers may respond to a marginal fall in the rate of interest by a marginal act of substitution of capital for labor. But heterogeneity of capital entails a regrouping of the existing capital combination; some capital goods may have to be discarded, others acquired. It is no longer a marginal adjustment that is called for but entrepreneurial choice and decision. ...

In a world of disequilibrium, entrepreneurs continually have to regroup their capital combinations in response to changes of all kinds, present and expected, on the cost side as well as on the market side. A change in the mode of income distribution is merely one special case of a very large class of cases to which the entrepreneur has to give constant attention. No matter whether switching or reswitching is to be undertaken, or any other response to market change, expectations play a part, and the individuality of each firm finds its expression in its own way. (149-50)

The subjectivity of capital value and the inevitability of fluctuations in the rate of overall economic growth:

Lachmann, “Toward a Critique of Macroeconomics”:

[E]very time [the interest rate] changes, so does capital value. True as this may be, the real reason for our inability to measure capital lies in the subjective nature of expectations concerning future income streams. (p. 153)

To opt for the market process against general equilibrium means to accept the implication that a fully coherent price system providing a basis for consistent aggregation can never exist.

We find here another reason why steady growth—uniform motion of that supermacroaggregate, the economic system—has to be regarded as absurd. Equilibrating forces in different markets, even if none is affected by unexpected change, require different time periods to do their work. This is obvious if we contrast agricultural produce markets with those for industrial goods. Steady growth, however, requires all equilibrating forces to operate within the same time period.

But the main argument against steady growth is a necessary consequence of the divergence of expectations. Equilibrium in a production economy requires an equilibrium composition of the capital stock. ... A growing economy is a changing economy. It exists in an uncertain world in which men have to formulate expectations on which to base their plans. Different men will characteristically have different expectations about the same future event, and they cannot all be right. Some expectations will be disappointed, and the plans based upon them will have to be revised. The capital invested will turn out to have been malinvested. But the existence of malinvested capital is incompatible with the equilibrium composition of the capital stock. Hence steady growth is impossible. (p. 155-6)

The role of the stock market:

In a market economy, on the other hand, we have in the stock exchange a center for the consistent daily evaluation of all the more important capital combinations. This, to be sure, is not objective measurement. The measurement of capital is forever beyond our reach. But it is something more than mere subjective evaluation. Stock exchange prices of capital assets reflect a balance of expectations. ... Stock exchange equilibrium is market-day equilibrium. Tomorrow’s set of equilibrium prices will be different from today’s. (154-5)

[T]the stock exchange, a fundamental institution of the market economy, imparts an element of social objectivity to individual stock valuations. This is by no means its only, or even its only significant, function. It facilitates the take-over bid by means of which capital resources get into the hands of those who can promise their owners a higher return. (p. 156)

Perhaps the most important economic function of the stock exchange is the redistribution of wealth by means of the capital gains and losses it engenders in accordance with the market view about the probable success or failure of present multiperiod plans. (p. 157)