- This paper presents,
in non-technical terms, an ‘Austrian’ view of
how a market economy works. The theory is ‘Austrian’
in its being derived from insights which matured during
the course of the century and a quarter history of the
Austrian tradition. These insights came to be articulated
with especial clarity and with originality of emphasis
in the mid-20th-century contributions, respectively, of
two great exponents of the Austrian tradition, Ludwig
von Mises and Friedrich Hayek.
Most economists
agree that markets ‘work’ – that, through
voluntary exchange transactions agents in a market economy
are, without central direction or control, able to participate
in an enormously productive system, taking advantage of
specialisation and division of labour. Moreover, economists
generally agree that the overall social pattern of resource
allocation spontaneously so achieved is highly and benignly
sensitive to changes in consumer preferences, resource endowment
availabilities and known technological possibilities.
These shared doctrines
enable economists to understand both the dramatic increase
in the standard of living achieved in market societies during
the past century and the relative failures (and the recent
numerous examples of complete breakdown) of socialist economies,
whether in Eastern Europe or elsewhere. Yet there remains
a fundamental mystery at the heart of these shared doctrines.
Surprisingly, standard economics does not provide a satisfying
explanation of exactly why and how markets
work. Adam Smith’s ‘invisible hand’ turns
out to be an apt metaphor for what remains an analytical
black box in economic theory. Economic theory, at least
in its mainstream version, explains with great sophistication
the operation of a smoothly working market economy in which
each agent has somehow already found his place. But it turns
out to be virtually silent in explaining the course of events
which enables agents, starting from initial absence of coordination,
to find their places in the social jig-saw puzzle.
So the relatively smooth working of real-world markets remains,
after all, a mystery.
When economists,
Austrian or not, talk of markets ‘working’, they
have in mind processes of social adjustment in which market
participants are spontaneously attracted to offer their
fellows exchange opportunities which tend in aggregate to
exhaust all potential gains from trade throughout the economy.
At first glance such a tendency appears counter-intuitive.
For individual activities to become dovetailed in such a
benign fashion one would expect a virtually omniscient,
omnipotent and benevolent economic czar to survey all individual
preferences, endowments and potentialities; he would then
compute and enforce a pattern of decision-making that not
only coordinates all decisions, but also ensures that no
opportunities for mutual gain remain unexploited.
Yet the theory of
the market claims not only that it is possible for
a set of decentralised individual decisions to exist on
the pattern of the fully coordinated state of affairs. It
claims also that there is a powerful tendency for market
events spontaneously to unfold toward such a fully coordinated
pattern without any central direction and control. The absence,
in mainstream economics, of a satisfying explanation for
the validity of such claims, is a troubling hiatus. The
Austrian theory of entrepreneurial discovery outlined here
aims to fill this gap.
The emergence
of neoclassical theory
Beginning with the
1870s, there emerged a body of economic doctrines broadly
shared by the various schools of economic theory in Europe.
Whether under the aegis of the Marshallian school in England,
the Mengerian school in Austria, or the then emerging Walrasian
tradition on the Continent, up to the 1930s economics came
to emphasise the theory of price, held to coordinate the
decisions of suppliers and demanders. These different schools
of thought are often described as making up a single, broadly
understood ‘neoclassical’ approach to economic
theory. This ‘neoclassical’ theory came to dominate
economic thinking to the present day.
A central tenet
of this neoclassical theory was that price tended toward
the market-clearing level in each market. In terms of the
simple supply and demand diagram (still taught today to
all students beginning economics), this came to mean that
prices too high to clear the market tend to fall (due to
the competition of sellers trying to sell their unsold surplus);
prices too low to clear the market tend to rise (due to
the competition of eager, disappointed buyers). These regularities
governing price movements provided economists with an insight
into markets which appeared perfectly general, applying
to all kinds of goods and services and showing how market
phenomena systematically express the preferences of market
participants. All these neoclassical schools shared the
view that it was scientifically fruitful, in examining different
kinds of markets, to abstract from the institutional detail,
and to focus upon their pure ‘economic’ structure
– an analytical structure from which everything but
supply, demand, and price had been stripped away
The focus was placed
upon the conditions of market equilibrium seen as the expression
of the solution to the system of simultaneous equations
constituted by the relevant supply and demand functions.
This diverted analytical attention from the step-by-step
process through which one might imagine initially dis-coordinated
sets of decisions gradually becoming modified towards greater
mutual coordination. Hence the ‘mystery’ to which
we have drawn attention: mainstream theory fails to explain
how markets do in fact come to work.
This criticism of
mainstream price theory applies only to claims that the
theory explains how equilibrium prices and quantities
emerge in the course of the market process. A mainstream
theorist may simply postulate a universal tendency
towards equilibrium, claiming then that the theory provides
a valid understanding of market outcomes. If one believes
that the market price for a given commodity does, at least
roughly, correspond to the price that would prevail under
equilibrium conditions, the theory which explains exactly
what is implied by the phrase ‘under equilibrium conditions’
is certainly neither internally contradictory nor uninformative.
But our criticism
of the theory would still be valid. Instead of charging
incoherence in the use made of mainstream theory, criticism
would focus on the arbitrariness of the postulate needed
to render the theory of any interest in understanding the
real world. A theory which relies, for its relevance, upon
the arbitrary postulate of a universal tendency towards
equilibrium, must be severely circumscribed. By itself
it offers no explanation for the phenomena we
are seeking to explain.
Some mainstream
theorists dismiss this criticism. Granted, they would say,
that the theory does not offer a picture of the equilibrating
process. That does not affect the value of the theory in
the slightest because the function of a theory is not to
offer a picture of reality. It should provide a ‘black-box’
formula capable of generating predictions; the validity
of a theory is to be judged only by the empirical accuracy
of the predictions it generates (Friedman 1953: 3-43). But
this approach does not satisfy the ‘scientific curiosity’
which inspires such questions as ‘what is the secret
of capitalist success?’; ‘why and how do markets
work so well?’
Breaking out
of the neoclassical box: the theory of entrepreneurial discovery
The theory of entrepreneurial
discovery sees the explanation of market phenomena in the
way entrepreneurial decisions, taken under disequilibrium
conditions, bring about changes in prices and quantities.
The market process so initiated consists of continual entrepreneurial
discoveries; it is a process of discovery driven by dynamic
competition, made possible by an institutional framework
which permits unimpeded entrepreneurial entry into both
new and old markets. The success which capitalist market
economies display is the result of a powerful tendency for
less efficient, less imaginative courses of productive action,
to be replaced by newly discovered superior ways of serving
consumers – by producing better goods and/or by taking
advantage of hitherto unknown, but available, sources of
resource supply. The theory focuses on the concept of discovery
in contrast to the notion of the individual decision in
mainstream theory.
The concept of
discovery
In neoclassical
analysis, the decision-maker is unable to exercise genuine
choice. Given arrays of objectives and available resources
automatically mark out the option-to-be-chosen; any other
option is ruled out in advance. It is unthinkable that the
decision-maker might deliberately select a less preferred
option instead of a preferred option (and what is more preferred
and less preferred is known to the agents as defined by
and in the given arrays of objectives and available resources).
So the act of choice
consists in nothing more than computing the solution already
implicit in the data. There is nothing creative in such
an act. And since it is assumed that decisions are inevitably
and inescapably made without error, this mainstream notion
of the decision in effect squeezes the decision-maker out
of the picture; the decision is ‘made’ by the
sets of data which are ‘given’ prior to the decision.
Mainstream theorising adopts this stylised concept to render
the outcome of decisions determinate, unaffected by unsystematic
factors such as impulse, surprise, or fear. But, in order
to escape the limitations of such theory, we have to escape
this narrow notion of the decision. The notion of discovery
points the way.
When a surprising
discovery is made, it cannot be ascribed to any deliberate
act that can be fitted into the neoclassical concept of
the decision. There has been no deliberate search for a
piece of information (the value of which was known in advance,
and the cost of finding of which was known in advance).
Rather the act of discovery consisted in having ‘undeliberately’
noticed what was already costlessly knowable.
Where the neoclassical concept of the decision makes it
unthinkable that an available gainful opportunity has not
been grasped, a more realistic perspective permits us to
recognise that such opportunities may simply not have
been noticed. An opportunity may not be grasped not
because the information needed to grasp it was too costly
to make it worthwhile, but because the costlessly obtainable
opportunity (or the costlessly available information that
would have brought the opportunity within immediate reach)
was simply, ‘inexcusably’, overlooked. An act
of discovery occurs when someone notices what has up to
now been overlooked.
Recognising the
possibility that a gainful opportunity may fail to be grasped
because it has not been noticed permits the appreciation
of dimensions of individual choice and of social interaction
which standard economic theory obscures. Awareness that
opportunities may go unnoticed and therefore ungrasped,
allows us to explore the pure discovery of hitherto unnoticed
opportunities.
Discovery and
entrepreneurship
Every individual
act constitutes, necessarily, an act of discovery. In acting,
the individual is not simply (as in neoclassical theory)
acting out his preference ranking given at the outset; he
is, at the moment of action, alertly establishing
those preference rankings (with all their implications),
in the face of the radical uncertainty he confronts. When
he acts to seize an opportunity, he is not seizing a ‘given’
opportunity; he is, at that moment, declaring that opportunity
to exist. He is, as it were, discovering that opportunity’s
existence.
The most careful
prior deliberation could not define the framework established
at the moment of action. Establishing the existence of an
opportunity framework calls for alertness to a set
of circumstances hitherto not yet noticed. A ‘framework’
involves not only assumed given arrays of goals and of resources;
it involves expectations of relevant goals and of relevantly
available resources in the future. The uncertainty
enveloping the future means that the establishment of such
an expectational framework of ends and means constitutes,
necessarily, a creative act of discovery.
Such an act of discovery
involves more, however, than finding something that happens
to attract attention. The discovery of an opportunity
means the discovery of anomaly. Discovering an attractive
opportunity always represents something of a pleasant surprise.
If the gain embodied in the opportunity had been fully anticipated,
grasping it would hardly represent a creative act of discovery.
The gain would be nothing but the realisation of something
fully expected
An act of discovery
in which resources are deployed to achieve an objective
represents the realisation that, before the discovery, the
relevant resources had been undervalued. The full
potential of these resources had not been up to now understood.
Thus the act of discovery, and thus indeed every human action,
represents the discovery of hitherto unsuspected value
in hitherto undervalued resources.
The pure entrepreneurial
function consists in buying cheap and selling dear –
that is, in the discovery that the market has undervalued
something so that its true market value has up to now not
been generally realised. This permits the pure entrepreneur
to buy something for less than he will be able to sell it
for. His act of entrepreneurship consists in realising the
existence of market value that has hitherto been overlooked.
By contrast, in
the neoclassical theory of the firm the owner of the firm
maximises the difference between revenues and costs. Both
the revenues and costs associated with alternative levels
of output are given. The ‘profits’ the firm so
maximises are thus fully expected and known to be available
before the firm’s output decision is made. There
is no surprise whatsoever in the ‘profits’ grasped
through the firm’s decision. Winning them constitutes,
in effect, nothing more than mechanically carrying through
a plan firmly settled on in advance.
But in reality,
the entrepreneur who ‘sees’ (discovers) a profit
opportunity, is discovering the existence of a gain which
had (before his discovery) not been seen by himself or by
anyone else. Had it been seen previously, it would have
been grasped or, at any rate, it would have been fully expected
and would no longer then be a fresh discovery made now.
Whenever an entrepreneur
senses the possibility of pure profit by moving into a new
line of production, or by innovating a new method of production,
he is taking advantage of what he believes to be a case
where the market is erroneously assigning two different
values to what is, in economic reality, the same item. The
powerful driving force of entrepreneurial alertness is always
and everywhere at work, noticing such errors through the
attraction provided by the pure profit which such errors
create. Entrepreneurial profit-making is occurring, not
only through bringing the prices of a given physical good
towards equality throughout the market. The same entrepreneurial
profit-making operates towards bringing resource prices
into relevant equality with future product prices.
What is important
is that, in operating along this dimension, entrepreneurial
alertness is not only pushing prices towards relevant ‘equality’,
it is also moving resources from one line of production
to another. The tendency, in a market economy, for resources
to become reallocated from less productive uses (as judged
by consumers) towards more productive uses, operates through
the same entrepreneurial discovery procedure which creates
a tendency for the prices of a given commodity to move towards
equality.
Entrepreneurial
discovery and imperfect information
Mainstream theory
has developed the important theory of search, significantly
enriching the realism of the theory. Recognising the ubiquity
of imperfect information, search theory ingeniously incorporates
into the mainstream paradigm the possibility of imperfect
information. It assumes that those whose information is
incomplete know how much information they lack, that they
know the value to them of the missing information, and that
they know precisely how (and at what cost) it is possible
to obtain the missing information. Mainstream theory is
then able to ‘explain’ exactly how much additional
information will be obtained, through deliberate, cost-benefit-calculative
search. Obtaining information in this mainstream approach
is a special kind of production activity, an activity which
can and is, therefore, incorporated into the enriched equilibrium
picture which search theory makes possible. The discovery
central to the Austrian approach is entirely different.
The difference is
between the unawareness which is corrected in the course
of entrepreneurial discovery, and the imperfect information
which is completed in the course of deliberate search. The
latter kind of ignorance is an ignorance deliberately chosen,
as it were; the agent knows exactly how much information
it is worth acquiring. The information which he deliberately
refrains from acquiring is simply not worth the cost of
acquisition. The ignorance with which he remains is, from
this neoclassical perspective, optimal ignorance.
But the unawareness corrected in the course of the entrepreneurial
discovery process is an unawareness of which the agent is
himself utterly ignorant. This ignorance is not ‘justified’
by the high cost of deliberate learning; it is not justified
at all. It is simply the expression of one having unaccountably
failed to notice what is, in effect, staring one in the
face.
Entrepreneurial
discovery represents the alert becoming aware of what has
been overlooked. The essence of entrepreneurship consists
in seeing through the fog created by the uncertainty of
the future. When the entrepreneur acts, he is inspired by
the prospective pure-profitability of seeing that future
more correctly than others do. These superior visions of
the future inform entrepreneurial productive and exchange
activity.
In so acting, the
entrepreneur drives the market process which reflects the
flow of new discoveries these entrepreneurial visions have
uncovered. If all exogenous change (in consumer preferences,
resource availability, and technological possibilities)
could be suspended, this dynamic, entrepreneur-driven market
process would proceed until all uncertainties, arising out
of unawareness of what others are able and willing to do,
would gradually become resolved.
Conclusion
The purpose of a
theoretical framework is to foster understanding of phenomena
encountered in the real world. Any such framework necessarily
abstracts from details of the real world in order to develop
an explanatory model able to provide insight into the complexities
of that world. Different explanatory models are designed
to help us understand different facets of the world.
There is no doubt
that important aspects of the market economy can be helpfully
illuminated by mainstream neoclassical economics. But there
are even more important aspects of the economy which remain
obscure when the mainstream framework is applied. Among
the important questions which that framework is, by its
very construction, unable to answer, are: How do markets
work? How are the individual decisions of millions of market
participants able to become as coordinated as they are in
the market economies we know?
The theory of entrepreneurial
discovery, derived from the Austrian tradition, offers a
framework within which satisfying, coherent answers to these
fundamental questions can be found. This theory enables
us, at the same time, to ‘see’ important features
of market economies in a different light from that provided
by the mainstream approach. Deploying the Austrian insights
provided by this approach can help avoid policy pitfalls,
as well as satisfying our purely scientific curiosity about
the way in which the world works.
References
Fisher, Franklin
M. 1983, Disequilibrium Foundations of Equilibrium Economics,
Cambridge University Press, Cambridge and New York.
Friedman, Milton
1953, ‘The Methodology of Positive Economics’
in M. Friedman, Essays on Positive Economics, University
of Chicago Press, Chicago.
Hayek, Friedrich
A. 1945, ‘The Use of Knowledge in Society,’
reprinted in his Individualism and Economic Order,
1949, Routledge and Kegan Paul, London.
Hayek, Friedrich
A. 1978, ‘Competition as a Discovery Procedure,’
in F. Hayek, New Studies in Philosophy, Politics, Economics
and the History of Ideas, University of Chicago Press,
Chicago.
Kirzner, Israel
M. 1973, Competition and Entrepreneurship, University
of Chicago Press, Chicago.
Kirzner, Israel
M. 1997, ‘Entrepreneurial Discovery and the Competitive
Market Process: An Austrian Approach,’ Journal of
Economic Literature, March.
Knight, Frank H.
1921, Risk, Uncertainty and Profit, Houghton Mifflin,
Boston and New York.
Mises, Ludwig von
1949, Human Action, Yale University Press, New Haven.
Thomsen, E.F. 1992,
Prices and Knowledge: A Market Process Perspective,
Routledge, London and New York.
About the Author:
Israel
M. Kirzner has
been Professor of Economics at New York University since
1968. His published works include The Economic Point
of View (1960), Competition and Entrepreneurship
(1973), and The Meaning of the Market Process (1992).
This Schools’ Brief is an edited extract from his How
Markets Work, published by the Institute of Economic
Affairs and reprinted earlier this year as Occasional Paper
No. 64 by the Centre for Independent Studies.
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