The Foundations of Modern Austrian Economics
A characteristic feature of the Austrian approach to economic theory is its emphasis on the market as a process, rather than as a configuration of prices, qualities, and quantities that are consistent with each other in that they produce a market equilibrium situation.*1 This feature of Austrian economics is closely bound up with dissatisfaction with the general use made of the concept of perfect competition. It is interesting to note that economists of sharply differing persuasions within the Austrian tradition all display a characteristic dissenchantment with the orthodox emphasis on both equilibrium and perfect competition. Thus Joseph A. Schumpeter's well-known position on these matters is remarkably close to that of Ludwig von Mises.*2 Oskar Morgenstern, in a notable paper on contemporary economic theory, expressed these same Austrian criticisms of modern economic theory.*3
Ludwig M. Lachmann indicated that his own unhappiness with the notion of equilibrium primarily concerns the usefulness of the Walrasian general-equilibrium construction rather than that of the simple Marshallian partial-equilibrium construction.*4 But it is precisely in the context of the simple short-run one-good market that I shall point out some of the shortcomings of the equilibrium approach.
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?
The Marshallian explanation of the equilibrating process—not usually introduced into classroom discussion—is similar to the Walrasian but uses quantity rather than price as the principal decision variable.*5 Instead of drawing horizontal price lines on the demand-supply diagram to show excess supply or unmet demand, the Marshallian procedure uses vertical lines to mark off the demand prices and the supply prices for given quantities. With this procedure the ordinate of a point on the demand curve indicates the maximum price at which a quantity (represented by the abscissa of the point) will be sold. If this price is greater than the corresponding supply price (the minimum price at which the same quantity will be offered for sale), larger quantities will be offered for sale. The reverse takes place when supply price exceeds demand price. In this way a tendency toward equilibrium is allegedly demonstrated to exist.
This procedure also assumes too much. It takes for granted that the market already knows when the demand price of the quantity now available exceeds the supply price. But disequilibrium occurs precisely because market participants do not know what the market-clearing price is. In disequilibrium "the" quantity is not generally known nor is the highest (lowest) price at which this quantity can be sold (coaxed from suppliers). Thus it is not clear how the fact that the quantity on the market is less than the equilibrium quantity assures the decisions of market participants to be so modified as to increase it.
Clearly neither of these explanations for the attainment of equilibrium is satisfactory. From the Austrian perspective, which emphasizes the role of knowledge and expectations, these explanations take too much for granted. What is needed is a theory of the market process that takes explicit notice of the way in which systematic changes in the information and expectations upon which market participants act lead them in the direction of the postulated equilibrium "solution." The Austrian point of view does, in fact, help us arrive at such a theory.
In developing a viable theory of market process it is helpful to call attention to the much-neglected role of entrepreneurship. The neglect of entrepreneurship in modern analysis is a direct consequence of the general preoccupation with final equilibrium positions. In order to understand the distinction between a process-conscious market theory, which makes reference to entrepreneurship, and an equilibrium market theory, which ignores entrepreneurship, it will help to compare the Misesian concept of human action with the Robbinsian concept of economizing, that is, allocative decision making.
It may be recalled that Lord 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.*6 Mises, on the other hand, emphasized the much broader notion of purposeful human action, embracing the deliberate efforts of men to improve their positions.*7 Both concepts, it should be noticed, are consistent with methodological individualism and embody the insight that market phenomena are generated by the interaction of individual decision makers.*8 But the two constructions do differ significantly.
Robbinsian economizing consists in using known available resources in the most efficient manner to achieve given purposes. It entails the implementation of the equimarginal principle, that is, the setting up of an allocative arrangement in which it is impossible to transfer a unit of resource from one use to another and receive a net benefit. 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 difficulty with a theory of the market couched in exclusively Robbinsian terms is that in disequilibrium many of the plans of Robbinsian economizers are bound to be unrealized. Disequilibrium is a situation in which not all plans can be carried out together; it reflects mistakes in the price information on which individual plans were made. Market experience by way of shortages and surplus reveals the incorrectness of the original price expectations. Now the Robbinsian framework suggests that the unsuccessful plans will be discarded or revised, but we are unable to say much more than this. 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. Without some clue as to what new expectations will follow disappointments in the market, we are unable to postulate any sequence of decisions. All we can say is: if all the Robbinsian decisions dovetail, we have equilibrium; if they do not dovetail, we have disequilibrium. 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?
In order for unsold inventories to depress price, market participants with unsold goods need to realize that the previously prevailing price was too high. Participants must modify their expectations concerning the eagerness of other participants to buy. But in order to make these assertions we must transcend the narrow confines of the Robbinsian framework. We need a concept of decision making wide enough to encompass the element of entrepreneurship to account for the way in which market participants change their plans. It is here that the Misesian notion of human action comes to our assistance.
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. Misesian theory of human action conceives of the individual as having his eyes and ears open to opportunities that are "just around the corner." He is alert, waiting, continually receptive to something that may turn up. And when 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.
There have, it is true, been other definitions of the entrepreneurial role. The principal views on the question have been those of Schumpeter, Frank H. Knight, and Mises. I have argued, however, that these alternative definitions upon analysis all have in common the element of alertness to opportunities.*9 Alertness should be carefully distinguished from the mere possession of knowledge. And it is the distinction between being alert and possessing knowledge that helps us understand how the entrepreneurial market process systematically detects and helps eliminate error.
A person who possesses knowledge is not by that criterion alone an entrepreneur. Even though an employer hires an expert for his knowledge, it is the employer rather than the employee who is the entrepreneur. The employer may not have all the information the hired expert possesses, yet the employer is better "informed" than anyone else—he knows where knowledge is to be obtained and how it can be usefully employed. The hired expert does not, apparently, see how his knowledge can be usefully employed, since he is not prepared to act as his own employer. The hired expert does not perceive the opportunity presented by the possession of his information. The employer does perceive it. Entrepreneurial knowledge is a rarefied, abstract type of knowledge—the knowledge of where to obtain information (or other resources) and how to deploy it.
This entrepreneurial alertness is crucial to the market process. Disequilibrium represents a situation of widespread market ignorance. This ignorance is responsible for the emergence of profitable opportunities. Entrepreneurial alertness exploits these opportunities when others pass them by. G. L. S. Shackle and Lachmann emphasized the unpredictability of human knowledge, and indeed we do not clearly understand how entrepreneurs get their flashes of superior foresight. We cannot explain how some men discover what is around the corner before others do. We may certainly explain—on entirely Robbinsian lines—how men explore for oil by carefully weighing alternative ways of spending a limited amount of search resources, but we cannot explain how a prescient entrepreneur realizes before others do that a search for oil may be rewarding. As an empirical matter, however, opportunities do tend to be perceived and exploited. And it is on this observed tendency that our belief in a determinate market process is founded.
Characterization of the market process as one involving entrepreneurial discovery clarifies a number of ambiguities about the market and dispels several misunderstandings about how it functions. Advertising provides an excellent example on which to base our discussion.
Advertising, a pervasive feature of the market economy, is widely misunderstood and often condemned as wasteful, inefficient, inimical to competition, and generally destructive of consumer sovereignty. In recent years there has been somewhat of a rehabilitation of advertising in economic literature, along the lines of the economics of information. According to this view advertising messages beamed at prospective consumers are quantities of needed knowledge, for which they are prepared to pay a price. The right quantity of information is produced and delivered by the advertising industry in response to consumer desires. For reasons having to do with cost economy, it is most efficient for this information to be produced by those for whom such production is easiest, namely, by the producers of the products about which information is needed. There is much of value in this approach to an understanding of the economics of advertising, but it does not explain everything. The economics-of-information approach tries to account for the phenomena of advertising entirely in terms of the demand for and supply of nonentrepreneurial knowledge, information that can be bought and sold and even packaged. But such an approach does not go beyond a world of Robbinsian maximizers and fails to comprehend the true role of advertising in the market process.
Let us consider the producer of the advertised product. In his entrepreneurial role, the producer anticipates the wishes of consumers and notes the availability of the resources needed for a product to satisfy consumer desires. This function might appear to be fulfilled when the producer produces the product and makes it available for purchase. In other words, it might seem that the entrepreneur's function is fulfilled when he transforms an opportunity to produce a potential product into an opportunity for the consumer to buy the finished product. Consumers themselves were not aware of the opportunities this production process represents; it is the superior alertness of the entrepreneur that has enabled him to fulfill his task. It is not sufficient, however, to make the product available; consumers must be aware of its availability. If the opportunity to buy is not perceived by the consumer, it is as if the opportunity to produce has not been perceived by the entrepreneur. It is not enough to grow food consumers do not know how to obtain; consumers must know that the food has in fact been grown! Providing consumers with information is not enough. It is essential that the opportunities available to the consumer attract his attention, whatever the degree of his alertness may be. Not only must the entrepreneur-producer marshal resources to cater to consumer desires, but also he must insure that the consumer does not miss what has been wrought. For this purpose advertising is clearly an indispensable instrument.
By viewing advertising as an entrepreneurial device, we are able to understand why Chamberlin's distinction between fabrication costs and selling costs is invalid.*10 Fabrication (or production) costs are supposedly incurred for producing a product, as distinguished from selling costs incurred to get buyers to buy the product. Selling costs allegedly shift the demand curve for the product, while the costs of fabrication (production) affect the supply curve only. The distinction has been criticized on the grounds that most selling costs turn out to be disguised fabrication costs of one type or another.*11 Our perspective permits us to view the issue from a more general framework, which embodies the insight that all fabrication costs are at once selling costs as well. If the producer had a guaranteed market in which he could sell all he wanted of his product at a certain price, then his fabrication costs might be only fabrication costs and include no sum for coaxing consumers to buy it. But there never is a guaranteed market. 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.
The Austrian concept of the entrepreneurial role emphasizes profit as being the prime objective of the market process. As such it has important implications for the analysis of entrepreneurship in nonmarket contexts (such as within firms or under socialism or in bureaucracies in general). I have already remarked that we do not know precisely how entrepreneurs experience superior foresight, but we do know, at least in a general way, that entrepreneurial alertness is stimulated by the lure of profits. Alertness to an opportunity rests on the attractiveness of that opportunity and on its ability to be grasped once it has been perceived. This incentive is different from the incentives present in a Robbinsian world. In the nonentrepreneurial context, the incentive is constituted by the satisfactions obtainable at the expense of the relevant sacrifices. Robbinsian incentives are communicated to others by simply arranging that the satisfactions offered to them are more significant (from their point of view) than the sacrifices demanded from them. Incentive is thereby provided by the comparison of known alternatives. In the entrepreneurial context, however, the incentive to be alert to a future opportunity is quite different from the incentive to trade off already known opportunities; in fact it has nothing to do with the comparison of alternatives. No prior choice is involved in perceiving an opportunity waiting to be noticed. The incentive is to try to get something for nothing, if only one can see what it is that can be done.
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. Only by analysis of the market process does this very important entrepreneurial aspect of the market economy come into view. The real economic problems in any society arise from the phenomenon of unperceived opportunities. The manner in which a market society grapples with this phenomenon cannot be understood within an exclusively equilibrium theory of the market. The Austrian approach to the theory of the market therefore holds considerable promise. Much work still needs to be done. 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. It can be convincingly argued that Mises's famous proposition concerning economic calculation under socialism flows naturally from his "Austrianism." Here, too, there is room for further elucidation. In all this agenda, the Austrian emphasis on process analysis should stand up very well.
Notes for this chapter
For an elaboration of a number of issues raised in this paper, see Israel M. Kirzner, Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973).
Joseph A. Schumpeter, Capitalism, Socialism, and Democracy (New York: Harper & Row, 1942), pp. 81-106.
Oscar Morgenstern, "Thirteen Critical Points in Contemporary Economic Theory: An Interpretation," Journal of Economic Literature 10(December 1972):1163-89.
Ludwig M. Lachmann, "Methodological Individualism and the Market Economy," in Roads to Freedom: Essays in Honour of Friedrich A. von Hayek, ed. Erich Streissler et al. (London: Routledge & Kegan Paul, 1969), p. 89.
Alfred Marshall, Principles of Economics, ed. C. W. Guillebaud, 2 vols. (London: Macmillan & Co., 1961), 1:345-48; Marshall sometimes used the Walrasian approach (ibid., pp. 333-36).
Lionel Robbins, An Essay on the Nature and Significance of Economic Science (London: Macmillan & Co., 1962), pp. 1-23.
Ludwig von Mises, Human Action: A Treatise on Economics (New Haven: Yale University Press, 1949), pp. 11-142; on the comparison of Misesian and Robbinsian notions, see Israel M. Kirzner, The Economic Point of View (Princeton: D. Van Nostrand, 1960), pp. 108-85.
In the preface to the first edition of his book, Robbins acknowledged his debt to Mises (On the Nature, pp. xv-xvi).
Kirzner, Competition, pp. 75-87.
Edward Hastings Chamberlin, The Theory of Monopolistic Competition, 7th ed. (Cambridge: Harvard University Press, 1962), pp. 123-29.
See the literature cited in Kirzner, Competition, pp. 141-69.
Part 3, Essay 2, On the Central Concept of Austrian Economics: Market Process
End of Notes
Return to top