(Elgar Advanced Introductions Series) Randall G. Holcombe-Advanced Introduction to the Austrian School of Economics-Edward Elgar Pub (2014)

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Advanced Introduction to

The Austrian School of Economics

RANDALL G. HOLCOMBE DeVoe Moore Professor of Economics, Florida State University, USA

Elgar Advanced Introductions

Edward Elgar Cheltenham, UK Northampton, MA, USA

Randall G. Holcombe 2014

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For Ross, Mark and Connor: my children, and students of Austrian economics.

Contents

Preface ix

The market process 1 1.1 Spontaneous order 2 1.2 Knowledge and economic coordination 6 1.3 Equilibrium: the coordination of individual plans 9 1.4 Equilibrium: the absence of unexploited profit

opportunities 11 1.5 The market as a discovery process 12 1.6 The element of time 14 1.7 The subjective nature of value 16 1.8 The subjective nature of cost 17 1.9 Utility and individual action 18 1.10 Competition 19 1.11 Conclusion 21

2 Decentralized knowledge: the role of firms and markets 22 2.1 The entrepreneurial nature of firms 24 2.2 Entrepreneurship as arbitrage 26 2.3 Profit and loss 27 2.4 Profits are not certain 29 2.5 Profit and progress: a caveat 29 2.6 Opportunity cost and profit-seeking 30 2.7 Cost and price 31 2.8 Information, knowledge and wisdom 32 2.9 Research and development 35 2.10 The division of knowledge and the supply chain 37 2.11 Tacit knowledge and agglomeration economies 39 2.12 Firms as repositories of knowledge 40 2.13 Searching for prices: disequilibrium exchanges 42 2.14 Conclusion 44

vii

viii ADVANCED INTRODUCTION TO THE AUSTRIAN SCHOOL OF ECONOMICS

3 Economic calculation 46 3.1 Ludwig von Mises on economic calculation 46 3.2 The socialists answer Mises 48 3.3 The Austrian school's answer so 3.4 Decentralized knowledge 52 3.5 Complex systems 52 3.6 The mixed economy 54 3.7 Economic progress 55 3.8 The evolution of economic activity 58 3.9 Product differentiation and progress 6o 3.10 Profit: indicator of progress 62 3.11 Welfare: process versus outcome 64 3.12 Conclusion 66

4 Money, banking and business cycles 69 4.1 The money supply and fractional reserve banking 70 4.2 The basic business cycle theory 71 4.3 The causes of the business cycle 73 4.4 Why do borrowers and lenders make these errors? 74 4.5 The structure of capital 77 4.6 The structure of production and business cycles 79 4.7 The capital stock 82 4.8 The coordination of economic activity 85 4.9 Schumpeterian and Kirznerian entrepreneurship 87 4.10 Inflation 89 4.11 Free banking 90 4.12 Conclusion 91

5 The resurgence of the Austrian school 95 5.1 The rise of the Austrian school 95 5.2 The dormant Austrian school in the mid-twentieth

century 97 5.3 The resurgence of the Austrian school 99 5.4 Austrian economics and capitalism 102 s.s The role of government in the economy 105 s.6 The ideology of the Austrian school 107 5.7 The methodology of the Austrian school 109 s.8 Conclusion 112

Rtferences 117 Index 121

Preface

The Austrian school of economics, nearly extinct in the middle of the twentieth century, has seen a remarkable resurgence toward the end of the twentieth century and into the twenty-first. In addition to an active academic research program, the financial press often refers to the ideas of the Austrian school. College students also have an interest in the Austrian school, I know from talking with my own students, even those who may not intend to go on to graduate study in economics, or look for work in financial institutions. This interest suggests the value of an advanced introduction to the ideas of the Austrian school, in-depth enough that reading it can provide a good understanding of Austrian economics, but accessible enough that someone with a basic knowl-edge of economics can read it and understand what differentiates the ideas of the Austrian school, and makes those ideas "Austrian" beyond just being economics.

A school of thought is defined by the ideas of its members, and there is not a clear line that identifies its borders. First, there is the question of who belongs to a school of thought, and even if that is clear (which it is not), often members of a school of thought disagree with each other on some issues, even if they find broad agreement on most. Presumably, those areas that have broad agreement would constitute the ideas of the school - but members of a school might even disagree on identifying areas where there is broad agreement. For example, the role of entre-preneurship in an economy is an indispensable component of Austrian economics, but Israel Kirzner and Murray Rothbard, two of the more important members of the school, have some disagreements about what constitutes entrepreneurship. This volume deliberately glosses over any disagreements and controversies in an attempt to present a straightforward explanation of the school's major ideas.

One might even call into question the value of describing a school of thought. In a 1974 conference in South Royalton, Vermont that played an instrumental role in the Austrian school's resurgence in the second

ix

X ADVANCED INTRODUCTION TO THE AUSTRIAN SCHOOL OF ECONOMICS

half of the twentieth century, Milton Friedman gave an after-dinner talk in which he questioned the value of delineating economic ideas by schools of thought. He said, "There is good economics and there is bad economics," and said it was more productive to partition economics that way - and do good economics - than to partition it by schools of thought. Why should it matter whether an idea is more closely associ-ated with the Austrian school, or the Chicago school, or the post-Keynesian school, for example? Friedman offered good advice to those in attendance who wanted to engage in economic research, but these schools of thought do have distinguishable ideas associated with them, so despite Friedman's good advice to the practitioner of economics, there still is value in laying out the ideas of a school for those interested in understanding what gives that school a distinct identity.

In keeping with Friedman's advice, all of the ideas I have included in this volume are good economics, in my view. An introductory volume like this is not the place to concentrate on controversies within the school, or to explain the problems with ideas I think are flawed. But, while the volume is my vision of the most important and distinguish-ing ideas of the Austrian school, I did attempt to write it in such a way that those who consider themselves knowledgeable about the ideas of the Austrian school would agree that this volume does, in fact, give a good introduction to the school's ideas.

My own introduction to the Austrian school came when I was a gradu-ate student, and then because of the interests of several classmates rather than from classroom material or discussion. Even though I was an economics major, I was unaware that there was an Austrian school of economics when I was an undergraduate. The ideas of the Austrian school appealed to me, and I attended a number of confer-ences devoted to the school's ideas, as a graduate student and then as a faculty member, including the 1974 South Royalton conference I mentioned earlier. I was a faculty member at Auburn University when the Ludwig von Mises Institute was established there in 1982. I am an Associated Scholar with the Institute, a member of the Society for the Development of Austrian Economics since its founding in 1996 and served as its president in 2007. I have had a long-standing interest in the Austrian school.

As an introduction to the Austrian school, this book is aimed at those who do not have a deep knowledge of the school, and who want to understand what is distinctive about the Austrian school's methods

PREFACE xi

and ideas. The volume is "advanced" because it assumes that read-ers have some background in economics, but it is an "introduction" because it does not assume any knowledge about the Austrian school. Because of its orientation as an introduction to the Austrian school, the references throughout the text and listed at the end of the book are to the more significant works by Austrian school authors, or by others whose ideas are related to the Austrian school. The book omits refer-ences to ideas that do not have a specific Austrian connection, so the references listed at the end of the book all have some relevance to the Austrian school rather than to economics more generally.

I gratefully acknowledge the comments of those who have read all or part of the manuscript as it was in progress, including Peter Boettke, Samuel Bostaph, William Butos, Rob Bradley, Peter Klein, Peter Lewin, Dave Garthoff, Sanford Ikeda, Steve Kates, Jonathan Mariano and George Reisman. In trying to present an overview of the ideas of the Austrian school, I recognize that everyone may have a different vision, though I hope there are only slight differences in the details rather than differences related to the broad vision of the school. With that in mind, despite some excellent comments I have received on the project, responsibility for any shortcomings in the way I have presented the Austrian school's ideas must remain solely with me.

1 The market process

Economic analysis, as it has developed through the twentieth century and into the twenty-first, is built on the foundation of equilibrium analysis. The supply and demand framework within which economists explain the operation of markets is familiar to all students of econom-ics. Prices adjust in markets so that the forces of supply and demand balance each other, and the quantity supplied equals the quantity demanded. The equilibrium framework implies that when an economy is not in equilibrium, market forces pull it toward equilibrium, but the supply and demand model itself depicts the equilibrium outcome, not the market forces that produce it. One of the distinguishing features of the Austrian school is that it focuses on the ongoing market process that tends to lead an economy toward equilibrium more than on the equilibrium outcome itself.

The Austrian approach to economic analysis recognizes that there are market forces in an economy that create a tendency for it to move toward an equilibrium, but also that an economy will never actually arrive at an equilibrium. Partly this is because the market environment is always changing. People's preferences may change, and as knowledge advances, bringing with it new insights and technologies, new products and production processes are always being developed. Another reason an economy will never reach equilibrium is because the information necessary to arrive at an equilibrium is disbursed among all of the participants in an economy, and the nature of this decentralized infor-mation means that it can never be aggregated in such a way as to pro-duce an equilibrium. The information available to market participants is constantly changing, so individuals are constantly updating their knowledge base with information that may be incomplete, uncertain and even contradictory. A market economy is organized to coordinate the plans of everyone in an economy, but the information required to do so is such that this coordination problem can never be completely and finally solved.

2 ADVANCED INTRODUCTION TO THE AUSTRIAN SCHOOL OF ECONOMICS

Conceivably, if the knowledge base of all market participants remained unchanged, the economy could eventually approach an equilibrium, but as an economy moves toward equilibrium, the underlying market conditions are continually changing, and individuals are continually updating their information and expectations to adjust to those changes. Some factors that disrupt the coordination of economic activity may be temporary, but many introduce permanent changes in the economy, and economic adjustment leads to a structure of economic activity different from what has existed in the past. Within the framework of equilibrium economics one might say that the underlying equilibrium has changed, but in fact it is always changing, and equilibrium may not be the most appropriate description of the outcome toward which an economy is tending at any point in time. Equilibrium suggests that if an economy is disturbed from its equilibrium state, forces will pull it back to that state, but when the existing state is disrupted by the introduc-tion of new products and new production methods, the economy will never return to where it was previously.

Austrian school economists do refer to equilibrium concepts, but in the context of a continually evolving economy, equilibrium is a continually moving target. The market economy is a coordination mechanism that enables individuals to make use of the information they possess to plan their economic activities in such a way that they are consistent with everyone else's plans. This coordination does not always work perfectly, and one goal of economic analysis is to under-stand why it can sometimes break down. Despite some problems, however, the market mechanism works amazingly well to coordinate everyone's plans and to make effective use of all of the decentral-ized knowledge that is possessed by everyone in the economy. The economic forces that lead markets to clear, so that the quantity sup-plied equals the quantity demanded in all markets, are so strong that people typically take for granted that they can readily acquire any good or service by paying the market price. The Austrian school focuses on the process by which economic coordination takes place, leaving the outcome toward which it is tending as a matter of second-ary importance.

1.1 Spontaneous order

Perhaps the most important lesson economics has to teach is that the activities of individuals can be effectively coordinated into an orderly

THE MARKET PROCESS 3

and efficient outcome without anyone planning it out, or even being able to foresee the outcome. The market economy is a spontaneous order. It is a result of human action, but not of human design.1 Richard Wagner (2007) uses an analogy of people marching in a parade versus people moving from store to store in a shopping mall. In both cases there is an orderly flow of people, but in the first case each individual's movements are planned out and coordinated by a centralized top-down plan, whereas in the second case all individuals make their own plans and the overall outcome is orderly and efficient, even though the outcome cannot be forecast ahead of time. No central authority could predict who would be in which store at any particular time, yet each individual's decentralized planning leads to a spontaneous order that allows everyone's individual plans to be coordinated.

Spontaneous order emerges in many social activities, both within and outside of economic phenomena. To see how spontaneous order can emerge through social interaction, consider an example outside economics: the development of language. Who invented language? Nobody. Language is the result of human action but not of human design. Language began with primitive people making sounds that came to be understood by others as having meanings. Some sounds referred to people, places, things or ideas: nouns. Other sounds denoted activities, which we now call verbs. Sometimes additional nuances might convey valuable meaning, so nouns and verbs can be modified by adjectives and adverbs. What a great idea! Who invented adverbs? Nobody. They are the result of human action but not of human design.

Money is another result of human action but not of human design. In primitive times as people were recognizing the benefits of specializa-tion in their economic activities, people found that rather than pro-ducing everything for themselves, they could specialize in activities in which they were more productive and trade their output to get more than if they produced everything they consumed themselves. For example, a person might see that he could produce farm tools and trade them to farmers, and end up with more food to consume than if he farmed himself. In such a system some goods would be better to accept in exchange than others. If people were offering a seller goods that seller did not want to consume, it would be better to accept brooms in exchange than milk, for example. If the individual did not consume the milk, it would spoil, whereas the brooms, being more durable, could be kept and traded to someone else later.


Some goods are naturally more acceptable in exchange than others because those goods can be more easily traded away at a later date. Therefore, people are more willing to accept those goods in exchange even when they have no desire to consume them. Carl Menger (1871 [1976]), founder of the Austrian school, called money the most trad-able of commodities. Over time people come to understand which goods are readily tradable and which are more difficult to trade away, and one or a small set of goods becomes accepted as a medium of exchange. Nobody invented money. It evolved as the result of human action but not of human design.

The market economy is itself a spontaneous order: the result of human action but not of human design. Nobody invented or designed the market economy. Rather, individuals saw the advantages of specializa-tion and gains from trade, and began trading with each other. As they did, market institutions, such as money, emerged without anyone plan-ning them out. Individuals saw economic problems and challenges, but each problem also presents an opportunity to overcome it, and market institutions developed from the bottom up, with no central planner and no central plan.

One example is the development of stock markets to facilitate financ-ing economic activity. In the 15oos Europeans began undertaking com-mercial activities all over the world. Individuals with sufficient wealth could purchase and outfit a ship to engage in trade, with the hope that it would come back with goods from far-away lands that could profit-ably be sold at home. Most of the time these voyages were successful, but not always, and when the ship an investor had financed failed to return, that investor suffered heavy losses. Thus, the origin of the common phrase "when my ship comes in" to signify a fortunate event. This financing of trading ships was profitable, but risky.

To deal with the risk, a group of individuals in Amsterdam got together and agreed to pool their resources to finance several ships. All would share in the profits when the ships returned. Some would likely not return, but by pooling their risks this way they could reduce their individual risk and maintain the same expected return on their invest-ments. This enterprise was the Dutch East India Company, which was established in 1602. The enterprise proved profitable, and when the ships started coming in the owners decided to reinvest the proceeds to send out more ships, rather than just take the profits. But some owners wanted to get their money out, so they sold their shares to others


who wanted to participate. Soon the shares of the Dutch East India Company were regularly traded, to the extent that some individuals undertook the specialized activity of helping to match buyers and sell-ers for a fee. The successful marketing of shares of the Dutch East India Company encouraged other businesses to market shares in their companies, and so starting from a few individuals who saw a profit opportunity in helping to match buyers and sellers of shares, stock markets emerged as an institution that undertook this activity. Stock markets emerged as a result of human action but not of human design.

Innovations that facilitate market exchange continually happen that way. Some stores were willing to allow trusted customers to buy on credit when they were short on money, and be paid back later. This was institutionalized as the stores offered credit cards to buyers. In the 1950s almost all credit cards were specific to one retailer. Department stores had their own credit cards and gas stations had theirs. People who wanted to buy something using a credit card had to have a card issued by that particular seller. Once credit cards were established, entrepreneurs recognized the value of having one card that was widely accepted, so that by the twenty-first century store-specific credit cards have nearly gone extinct and given way to cards like Visa and MasterCard that are nearly as widely accepted as cash. The credit cards people take for granted today are the result of human action but not of human design. They evolved into their current form as entrepreneurs found continually better ways of managing transactions.

The market economy that has produced such a profound increase in people's material wellbeing since the beginning of the Industrial Revolution is a spontaneous order that has evolved as a result of human action but not of human design. Perhaps the most important lesson economics has to teach is that an orderly and efficient outcome can emerge without anyone planning it out. Looking back to the 1950s, 196os, 1970s and even the 198os, many reputable economists believed that central planning was a more efficient way to organize an economy than to leave things to the uncertainties of the market. After the col-lapse of the Berlin Wall in 1989, followed by the break-up of the Soviet Union in 1991, that view fell from favor and capitalism was viewed as a more effective economic system than socialism. To understand why capitalism works so well, one must understand the process by which markets allocate resources. The Austrian school's emphasis on the spontaneous order generated by the market process has led scholars in the school to look favorably on the market allocation of resources, and


to be more critical of resource allocation through government plan-ning than the economics profession in general.

The most significant lesson economics has to offer is that people's activities can be coordinated through the market mechanism to pro-duce a spontaneous order, without anybody planning or designing the outcome. Everybody makes their own individual plans, and the institu-tions of the market coordinate these individual plans so that, in gen-eral, people's plans can be realized, and people can make the best use of the information they possess to produce an outcome that works best for the prosperity of everyone. This insight goes back at least to Adam Smith (1776 [1937]), who noted that individuals pursuing their own interests are led by an invisible hand to do what provides the greatest benefit for everyone.

A comparison of the outcomes of the centrally planned socialist econ-omies of the twentieth century with capitalist economies shows that no central plan is necessary for a desirable outcome, and that, more typically, the outcome of a spontaneous order is more desirable than the outcome of a top-down plan. Individuals make their own plans, based on their own individual knowledge, and these decentralized plans are coordinated through the market mechanism to produce an orderly outcome that is the result of human action but not of human design.

1.2 Knowledge and economic coordination

The main function of a market economy is to coordinate the economic activities of all of its participants. Partly, this means that market forces work to equate the quantity supplied to the quantity demanded in all markets. This is what economists often mean when they refer to market equilibrium, but in light of the critical analysis of the concept of equilibrium given earlier, it is probably more descriptive to refer to the equating of the quantity supplied with the quantity demanded as "market-clearing" rather than "equilibrium." As already noted, it is often the case that events that disturb the current state of affairs are permanent changes that have a permanent effect on the allocation of economic resources. Regardless of the terminology, all economists have a good understanding of the market-clearing forces in an econ-omy and the way they coordinate people's activities by bringing the quantity supplied to equal the quantity demanded.


Taking a longer view of the economic process, economic conditions are always changing, and information about those changes is widely disbursed and often subject to interpretation. People have incomplete information. Nobody knows everything everyone else knows, so the knowledge one person has will be different from, and perhaps con-tradictory to, the knowledge of other people. Even more, individuals themselves may have information from different sources that is con-flicting and contradictory. In what is surely the single most influen-tial academic article written by an Austrian school economist, Hayek (1945) notes that every individual has some specific knowledge of time and place. Individuals possess knowledge that not only does nobody else have but nobody else could have. A market economy coordinates all of the decentralized knowledge held by individuals throughout the economy.

Much of the knowledge people have is tacit knowledge, which means knowledge that they are able to use but which they are not able to effectively communicate to others. Tacit knowledge can be used only by the people who have it. Hayek notes that while people often think of knowledge in the sense of scientific knowledge, a great deal of knowl-edge consists of past experiences and observations that provide a basis for action and decision-making, but that the holder of the knowledge would be unable to summarize by writing it down or explaining it to someone else. Much as one cannot learn how to ride a bicycle or hit a baseball only by listening to someone else explain how to do it, or watching someone else do it - those activities must be learned through experience - many economic activities are also undertaken with tacit knowledge. Corporate chief executive officers (CEOs) and others in management positions get paid high salaries because they have acquired tacit knowledge that is not easily communicated to others. If this were not the case, corporations would hire people with new Masters of Business Administration (MBA) degrees to run their companies - who do have the latest scientific knowledge about busi-ness management - rather than the more experienced people they actually hire. If this were not the case, the mentoring that employers deliberately provide to their junior employees would be unnecessary.

Tacit knowledge is possessed by everyone in the economy, not just those at the top of the corporate hierarchy. Hayek (1937 [1949]) emphasizes that as people gain experience in a job they learn to do it better and more productively, and as people gain experience in a particular line of business they are better able to judge what would be


successful in that line of business. Often, what would make a desir-able business location, what would be a desirable change in a product design or what could improve the efficiency of a production process is something people are better able to determine with experience. While these examples are from the top of the business hierarchy, even those who have entry level jobs pick up tacit knowledge through experience and become more productive as a result.

Not only is knowledge often decentralized and tacit, people with incomplete knowledge and with different knowledge bases frequently will arrive at conflicting conclusions. Some people perceive that action A will be a profitable course of action while others believe that in the same situation action B will be profitable. Both may be right, both may be wrong or one course of action may be better than the other. To offer but one example, when Apple introduced its iPhone in 2007 many observers believed it would meet with limited success because the phones prior to the iPhone had mechanical keys that observ-ers thought users would prefer to the touch screen interface on the iPhone. Within a few years of the iPhone's introduction, however, the touch screen interfaces were the clear market favorite.

In the face of this type of uncertainty, and with decentralized and tacit knowledge, the market is a discovery process. One cannot know whether A or B will be more profitable, because the answer depends on people's subjective preferences, and those preferences will only be revealed through market transactions. The information does not exist in the absence of the market. People can make use of their knowl-edge to direct economic resources in ways that they believe will be profitable. The market rewards the effective use of knowledge with profits and penalizes the ineffective use of knowledge with losses, so the market provides a mechanism for directing resources toward those goods and services consumers value most. In many cases profitable decisions will be the result of superior knowledge, but other times they may be the result of luck. Regardless, the information is a product of the market and does not exist in the absence of the market. Once the market reveals the profitable course of action, that information has been revealed to all market participants, and market forces lead toward the production of goods and services that provide additional value to the economy.

In an economy where underlying conditions are unchanging -obviously, a hypothetical economy- solving the problem of effectively


allocating resources would be almost trivial. Prices of goods for which the quantity supplied exceeded the quantity demanded would fall, and prices of goods for which the quantity demanded exceeded the quantity supplied would rise, until the economy came to rest with an equilibrium configuration of prices. The real economic problem is that underlying conditions are always changing, and in ways that are dif-ficult to foresee and potentially difficult to understand even when they are seen. When knowledge is decentralized and tacit, there is no way even in theory that a central planner could gather up all the relevant information and allocate resources efficiently. The market is a mecha-nism for coordinating the knowledge possessed by all individuals in an economy so that it can be used most effectively.

1.3 Equilibrium: the coordination of individual plans

Hayek (1937 [1949]) depicts economic equilibrium as the coordination of individual plans. In the short run this means that markets clear, so that the quantity supplied equals the quantity demanded in all markets. Everyone who wants to buy at the market price can, and everyone who wants to sell at the market price can, so everyone's plans are coordi-nated. Over the longer run additional complications come into play. An entrepreneur who begins building a factory or an apartment building now can only estimate the demand for the factory's output, or for rental apartments, when their projects are completed. If their estimates were overly optimistic, their plans will not be able to be realized. Some fac-tories may lay idle, and some apartments will remain unrented. If their estimates were overly pessimistic, consumers may not be able to realize their plans. Consumers might set aside money to buy a house, or to take a family vacation, in a year or two, only to find that when the time comes prices have risen such that their plans cannot be realized. For an economy to be in equilibrium, the plans everyone makes today must be able to be realized in the future. O'Driscoll and Rizzo (1985) use this notion of equilibrium as the coordination of individual plans, and Lewin (1997) offers a good explanation of Hayek's ideas on equilibrium.

Everyone recognizes that the future is uncertain, so they make plans with contingencies as much as they are able. The family in Atlanta plans their Hawaiian vacation two years hence, with the proviso that if they have insufficient funds they will go to Orlando instead. O'Driscoll and Rizzo (1985), recognizing that people may have to adjust their plans to


unforeseen changes in circumstances, prefer to call the coordination produced by the market pattern coordination. People make plans that are flexible enough that they can adjust them to meet various contin-gencies. Sometimes contingency plans are not sufficient, and people's plans cannot be realized. The economy falls out of equilibrium. Factors that can cause people's plans to fail to be coordinated will be discussed later; at this point note that one way to view equilibrium, following Hayek, is that people's plans are coordinated so that people are able to realize their plans.

When the passage of time is considered in this way, equilibrium becomes a slippery concept. People are always updating their plans in light of new information they acquire, so in that sense nobody's plans they have today are going to be completely realized into the indefinite future. O'Driscoll and Rizzo (1985, pp. 8o-81) discuss this under the heading of exact coordination. The economy will never be in equilib-rium in the sense that all the plans everyone has made will all be real-ized. However, that coordination of plans is closer to reality when one realizes that people are able to incorporate contingencies into their plans. People make plans for tomorrow, but they update those plans as new information presents itself so that when tomorrow arrives, they are able to realize their updated plans.

Equilibrium seems to imply a determinate outcome toward which the economy tends, but changing conditions would also seem to imply that the equilibrium toward which the economy tends is itself always changing. A market process approach suggests that the economy is continually evolving, and people's plans are continually adapting to new conditions. The market generates information that allows indi-viduals to adapt, so that as the future unfolds, people are able to realize their updated plans.

Considering the fact that people make plans well into the future - it may take years from the initial planning and design of a product for the product to come to market - the fact that in most markets the quantity supplied equals the quantity demanded most of the time is a remarkable achievement of the market mechanism. It works so well that people typically take it for granted. Not only do consumers often take for granted that they can go to the store and buy any one of a multi-tude of products at a moment's notice, economic models often take it for granted as well. Models often assume markets are in equilibrium without analysing the forces that get them there.


1.4 Equilibrium: the absence of unexploited profit opportunities

Kirzner (1973) depicts equilibrium as the absence of unexploited profit opportunities. It is difficult to envision a real-world economy where there are no unexploited profit opportunities, so an economy would never arrive at equilibrium. Entrepreneurs notice and act on these profit opportunities, pulling an economy closer to equilibrium, and Kirzner emphasizes the equilibrating role of entrepreneurship. Meanwhile, new profit opportunities constantly arise, keeping the economy from ever arriving at equilibrium.

Hayek and Kirzner are both prominent Austrian school economists, so it is interesting to see the differences in the way they define equi-librium. An economy could be in equilibrium as Hayek defines it, with everyone's plans coordinated, while an unnoticed profit opportunity continues to lie unnoticed, so the economy would not be in equilib-rium as Kirzner defines it. An economy can be in equilibrium follow-ing Hayek's definition, but not according to Kirzner's. However, if an economy is in equilibrium according to Kirzner's definition, it must also be in equilibrium according to Hayek's. If there are no unexploited profit opportunities (Kirzner), everyone's plans must be coordinated (Hayek), for if they were not, an entrepreneur could profit from facili-tating the coordination of people's plans. In a neoclassical competi-tive equilibrium, with perfect information and where all markets clear, both Hayek's and Kirzner's definitions of equilibrium are satisfied, so there is no way to differentiate these two views of equilibrium in that framework.

Hayek's idea of equilibrium as the coordination of individual plans is generally accepted and will be the equilibrium concept most used here, but with the caveat that the Austrian school's process-oriented approach to economic analysis emphasizes the ongoing evolution of economic activity, making equilibrium a hypothetical concept rather than a description of the real-world economy. Markets tend to clear, so the Austrian school accepts the concept of equilibrium in that sense, but when an existing configuration of prices and quantities is disturbed, the disturbance often changes the underlying economic conditions so that the economy will not return to its previous state.


1.5 The market as a discovery process

People interact with each other in markets by exchanging goods and services under terms that are mutually beneficial. People agree to exchanges only if all parties to those exchanges believe they will ben-efit. While economists often talk about equilibrium prices, and many models are built around the notion that market forces produce equi-librium prices, the notion of an equilibrium price is an abstraction. Buyers can see (some of) the prices at which some sellers are willing to sell, and sellers can see (some of) the prices at which buyers are willing to buy, but there is no information available to anyone about an equilibrium price. In many cases, before making a purchase, buyers will look at offers from many sellers, both to find a favorable price and to consider quality differences that might come with different prices. If some sellers' prices are higher than others, information will spread and the seller will lose customers, which puts a check on how much a seller can charge. If sellers find that they consistently are unable to produce enough to meet demand at their current prices, they will raise them. These are all individual adjustments that buyers and sellers make when they look for the most favorable transactions they can find. Nobody tells buyers and sellers what equilibrium prices are; prices tend toward market-clearing prices as the result of the interaction of buyers and sellers in markets.

The market value of any good or service is completely determined by the interaction of suppliers and demanders in that market. The market process reveals the value of goods and services in an economy. The market price of each individual transaction provides information that aids buyers and sellers in determining what prices they would be will-ing to accept in the future. Prices may rise and fall over the course of a day or week, but one would be hard-pressed to say that one price is an equilibrium price and another is a disequilbrium price. Prices change depending on economic conditions, which may be very local condi-tions at times.

Conversely, prices may remain the same as economic conditions change. Often, suppliers are reluctant to raise or lower prices based on changes in daily or weekly conditions, so will absorb changes in underlying conditions by adjusting their inventories. Sellers of umbrel-las may find it to be better business practice to maintain constant prices, which provide information to their customers, rather than raise umbrella prices on rainy days, for example. Could we then say that the


heavier sales of umbrellas made on rainy days were made at disequi-librium prices? Prices represent terms that are mutually agreeable to buyers and sellers, and price changes are an ongoing part of the market process. The idea of disequilibrium prices has limited usefulness to the Austrian school's view of the market process.

This process by which the market reveals the value of goods and services is essential to the coordinating function the market plays. Because knowledge is decentralized, and because much knowledge is tacit, people would have a very limited ability to coordinate their eco-nomic activities without market prices. In his famous essay, "I, pencil," Leonard Read (1958) noted that nobody knows how to make a pencil. Read notes that the graphite "lead" is mined in Ceylon (now Sri Lanka) and mixed with clay from Mississippi and several other products - he mentions candelila wax from Mexico as one- in a complex production process. The cedar wood for the pencil undergoes a separate com-plex process before being mated with the graphite. The brass ferrule that holds the eraser has to be mined and refined, and the eraser is made from rape-seed oil that originated in the Dutch East Indies (now Indonesia) and pumice from Italy, combined with other ingredients. Read's story is powerful because he shows how something as simple as a pencil requires the coordination of the economic activities of people from all over the world. These people cooperate even though they will never meet, and speak different languages so they would have trouble communicating with each other if they did meet; yet their economic activities are coordinated so that they all cooperate to produce a pencil that is inexpensively available to consumers throughout the world.

Nobody in the world has sufficient knowledge to build a pencil, yet markets coordinate the economic activities of individuals through-out the world to manufacture them. Much of the information people need to know about the economic activities of others is summarized in market prices. Through the process of market exchange, markets discover the prices of graphite, cedar, brass and the other ingredients that go into making a pencil, so firms that produce them can decide on how much of what combination of materials to use in the manufactur-ing process. Perhaps different types of wood or different types of metal could be substituted. If materials become too expensive, people may substitute mechanical pencils, or pens, for wood pencils. The market discovers the value of goods and services as people engage in exchange, and those market prices convey a substantial amount of information about the knowledge others in the economy have. The manufacturer


of a pencil does not have to know how to mine graphite to make use of the knowledge of people who do. The knowledge remains decentral-ized even as people's economic activities are coordinated.

The information about the value of the various components that go into making a pencil, and the value of the pencil itself, is generated by the market process. The information would not exist if the market pro-cess did not produce it. The market is a discovery process that reveals these values, but information about the values of these goods would not exist if the market process did not produce it. The market process both produces the information and makes it available to market par-ticipants. Without the market, there would be no information to be discovered about the value of these goods.

1.6 The element of time

Economic processes occur over time. An equilibrium framework for analysing economic phenomena tends to obscure the significance of time, because in that framework it appears that the conditions that define an equilibrium remain given and unchanging, and the role of the market process is to pull the economy toward that equilibrium. In fact, economic conditions are constantly changing, partly as a result of the decisions continually being made by other economic actors who are deciding their courses of action based on necessarily imperfect information. Future conditions depend on decisions people are in the process of making in the present. Their choices determine the future trajectory of the economy. Thus, people do incorporate various con-tingencies into their plans, and the discovery process is only partly discovering facts about the physical world, and is largely discovering how others are reacting to both the physical world and to the antici-pated plans of others in the economy. In the first category, people will be alert to how the weather might affect their plans -for example, how it will affect a farmer's crops, or a tourist's vacation plans- or how the discovery of a new manufacturing process or a new type of product might affect the market for an existing product. In the second category, producers must be alert to changes in people's consumption prefer-ences, and consumers must be alert to changes in the types of goods and services, and their prices.

Because people base their current decisions on information that is necessarily incomplete and sometimes contradictory, their judgments


do not produce a determinate outcome, and the future trajectory of the economy depends on the choices people make in the present. The economic notion of an economy being pulled toward an equilibrium suggests that the equilibrium outcome is implied in the initial condi-tions. Even in equilibrium models that build in time, the equilibrium trajectory of the economy is implied in the initial conditions.

Time is important in economics because the future is uncertain. Individuals gather information to help them make judgments about future events, but even that information is continually evolving. The information available tomorrow will be different from the informa-tion available today, and may even contradict the information available today. Within the market process, people are continually obtaining and updating information about future conditions that are always uncer-tain, and their decisions under uncertainty are factors that affect those future conditions. Incorporating time into economic analysis is more than just having a model that depicts economic processes that occur over time. It is incorporating the uncertainty that always comes with economic decisions, and incorporating the way that people acquire knowledge about the choices and economic opportunities they will have in the future.

The open-ended nature of the future precludes planning for it by, for example, considering all the possible states of the future world, assign-ing probabilities to them and then taking the best course of action given those expected states of the world. One reason is that in the real world some possible outcomes cannot be foreseen because of the limits of people's knowledge. Similarly, even if one could know every possible future state of the world, it would not be possible to assign probabilities to them. The real world is characterized by uncertainty, which makes the future indeterminate and unpredictable.

Economic analysis helps people to make judgments about the future, so people can have some expectations about future income (both theirs and aggregate income), prices and availability of goods. The future is not completely unknowable. Because of their accumulated knowl-edge, people's expectations about the future tend to be roughly cor-rect most of the time. An important part of understanding how the economy works is understanding how people obtain that knowledge, and how the knowledge of everyone in the economy is coordinated to produce an orderly outcome that is the result of human action but not of human design. But the element of time in economic analysis means


more than just recognizing that time passes. It means understanding how individuals can make plans today that they hope to fulfill in the future, and how the economic system coordinates those plans.

1.7 The subjective nature of value The value of goods and services is determined by the subjective evalu-ation of people who purchase them. That subjective value may vary from person to person, and may vary for the same person at differ-ent points in time. A person who lives in a dry climate may place little value on umbrellas, and may not even own one. A person who lives in a rainy climate may own several (I do, and always keep one in my car and one in my office because unexpected showers can pop up where I live). Someone caught in the rain while traveling may be will-ing to pay substantially more for an umbrella than if the person was shopping around for a new one in good weather. Similarly, the value people place on goods and services can vary due to fads, fashions and information that becomes available. Music, clothing, reading material and even foods are valued differently by people, and in the aggregate as indicated by market prices, over time. For example, eggs were once viewed as an ideal food for their nutritional value, until people became more concerned with their cholesterol content. The subjective value people placed on eggs fell, reducing the demand for them. Value is not an objective quality attached to goods and services; it is determined by the subjective evaluation that consumers place on the utility they get from consuming them.

One of the observations that Carl Menger (1871 [1976]) made in his Principles of Economics is that if people increase the quantity they consume of a good or service, the additional units they consume will be used to satisfy less urgent desires, and those less urgent uses will have a lower subjective value to the consumer. Water provides a good example. The first few cups of water an individual consumes every day are very valuable, and indeed, life-sustaining. People who live in places where water is costly to obtain, such as in the desert, or astronauts in space, pay a lot to get it and have an incentive to conserve it. If water is scarce, people might take sponge baths to conserve it; where it is more plentiful, they might take leisurely showers. If water is very inexpen-sive, they might use it to water houseplants, or to wash their dog or their car. These uses that have a lower subjective value do not reduce the value of the water they drink to sustain their lives, however. The


first few units of water consumed will have a high subjective value, and if more is available, consumers will use them for uses that have increas-ingly less subjective value.

If the price of water goes up, people will reduce their consumption by reducing the water used for activities that have less value; perhaps such as washing their cars. But this is a conjecture and may vary from person to person. We cannot know the subjective values other people place on goods and services except by observing their behavior in the marketplace. Some people who are very fond of their cars might take fewer showers so they can continue to keep their cars spotless. Because value is subjective, the value of goods is only revealed when people engage in market transactions. The transactions indicate that all par-ties to them believe they are gaining value, and the market price is the value of the utility gained from the marginal unit.

The value individuals place on goods and services varies from person to person, and over time. By revealing how much individuals are will-ing to pay for goods and services, the market reveals this informa-tion about the value of goods and services. Information on value does not exist in the abstract, waiting to be discovered. That information is generated through the market process.

1.8 The subjective nature of cost The demand side of the subjective nature of value is not an idea that is unique to the Austrian school but on the supply side, economists often present costs as objective facts, not explicitly, but implicitly and without any analysis. Economic costs are market values just as are the prices of final goods, and they are determined the same way, subjec-tively. The value of inputs into the production process is determined by the value of the output those inputs produce, so the subjective value people place on final goods and services is what determines the value of the inputs that produce those goods and services.

Menger (1871 [1976]) called consumer goods "goods of the first order," and the intermediate goods that are inputs into the production process "higher-order goods." The price of higher-order goods is determined by the value consumers place on goods of the first order. If the value of a final good or service rises, that will make the inputs that produce the good or service more valuable.


Two centuries ago if a piece of land had oil on it, the value of the land was reduced because seepage of the gooey stuff interfered with the ability to farm the land. The use of oil products for fuel, lubricants and other purposes now makes land with oil on it more valuable. The value of the input is determined by the value of the final goods it can produce. Similarly, professional basketball players get paid more than the top track and field athletes not because it takes more skill to play basketball but because people are willing to pay more - they subjec-tively value watching basketball more - than they are willing to pay to watch track meets. The value of inputs into the production process is determined by the subjective value people place on the value of the output they produce.

Professional basketball players were paid much more in the 2ooos than in the 1950s, both absolutely and relative to other professions. Why? Because in the 1950s it was rare for games to be televised and audi-ences were mostly limited to those who paid for a ticket to watch games in person. Half a century later, people could watch televised games and advertisers placed a high value on being able to reach those audiences, so the subjective value of the output increased, in this case because of advances in technology. The higher subjective value of the output meant that the subjective value of the inputs - the labor ser-vices of the basketball players - increased.

Value is subjective, and because the value of inputs is determined by the value of the output they produce, cost is subjective. The subjective nature of cost is a straightforward implication of the subjective nature of value.

1.9 Utility and individual action

People act because they expect to be better off taking those actions than if they did not act. They expect to receive utility from the results of their actions. Taking a market process approach to the analysis of individual action, people engage in economic activity because they believe they will be better off because of their actions. The essential relationship between utility and individual action is that people act because they think it will increase their wellbeing, or utility.

To develop complex models of general economic equilibrium, main-stream economics ascribes utility functions to individuals that require


some assumptions about their individual preferences. Economists often assume that preferences are transitive, which means that if A is preferred to B and B is preferred to C, then A is preferred to C. Goods are assumed to have diminishing marginal rates of substitution. For models to hold up, utility functions are assumed to be continuous and differentiable. Without these restrictive assumptions, there is no guar-antee that the model will have a unique stable solution.

The market process perspective focuses on the ongoing exchanges that take place and the continually evolving types of output that an economy produces. By focusing on the economic process rather than an equilibrium outcome, most of the assumptions about utility that the equilibrium approach demands are not necessary. As long as individu-als engage in economic activity because they believe the result of their action will be an increase in utility, that is a sufficient description of the individual preferences. There is no reason to specify equilibrium conditions because people are always acting, or planning to act in the future. Conditions are always changing, so Austrian school economists do not place the same importance on the idea of a unique stable equi-librium as other economists do. The assumptions economists must make about individual behavior are much less restrictive when taking a market process approach to economic analysis than when taking an equilibrium approach. The market process approach to human behavior does not describe people as maximizing utility but rather as engaged in mutually beneficial exchange.2

1.10 Competition

Economic models often view competitive markets from an equilib-rium perspective. In this perspective, the market mechanism generates competitive prices, and both buyers and sellers in competitive markets are "price takers," which means they accept the market price as given and adjust their behavior to it, deciding how much to buy or sell at the market price. In a similar manner, the model of competitive markets makes the assumptions that output in the market is homogeneous, and that buyers and sellers in the market have complete information. Taking a market process view of competition, "markets" do not set prices, buyers and sellers set prices, even in very competitive mar-kets. Sellers decide what they will charge for their products, and even though they must take prices others charge into account, they do not take those prices as given. For prices to change in markets, which they


often do, some sellers have to decide to change what they charge for their products.

This is true even in very competitive markets, like stock markets. While traders can enter a market order to buy at the "market" price, that price is the lowest price at which someone has entered an offer to sell; similarly, putting in a market order to sell means the price is set by the person who has entered the lowest offer to buy. Prices are set by buyers' and sellers' offers to buy and sell at a particular price, not by "the market." Buyers and sellers either set their own prices or agree to buy or sell at a price that has been set by someone on the other side of the market.

The same is true with product characteristics. Despite the frequent assumption of homogeneous products, this is a simplifying assumption economists often make so their models are more tractable, not a con-clusion derived from the competitive model, or an actual characteristic of competitive markets. In fact, differentiating products to make them more attractive to purchasers is a competitive strategy.3 Similarly, "production functions" are not given to producers. Individual produc-ers decide what production technologies to use, and what character-istics the products they sell will have, even in markets that are very competitive.

Information is not perfect, and is costly to obtain. Different people have different sets of information, and some of it will be, in hind-sight, incorrect. Some sellers may sense that they could charge more for their products, and raise their prices. If they are correct, others will follow and the "market" price will adjust upward. In this case, other sellers who have not adjusted their prices are selling at "dis-equilibrium" prices, below the level that would clear the market. If they are incorrect, the sellers who raised their prices are selling at "disequilibrium" prices. Either way, some exchanges are occurring at "disequilibrium" prices. Prices are always changing, but "the market" never sets or changes prices. Individual buyers and sellers do that, and when they do, prices will vary from seller to seller. Similarly, buyers often shop around for the best combination of price and qual-ity, which will vary from seller to seller. The process by which markets tend to equilibrate is ongoing, and generates information that helps to guide buyers and sellers to utilize resources at their disposal to increase value.


Competition is an ongoing process that brings with it continual changes in prices, production processes and product characteristics. These con-tinual changes, which Joseph Schumpeter (1934, 1947) referred to as creative destruction, replace old products and production processes with new ones and generate economic progress. The concept of com-petitive equilibrium, often used in economic analysis, is not descriptive of the way an actual economy functions. It ignores many of the choices that continually face market participants, and assumes away much of the economic activity that people continually engage in as they adjust their economic activity to changing economic conditions and newly revealed information.

1.11 Conclusion

The market process approach to economic analysis depicts an economy that is continually evolving as people design new products and produc-tion processes, and gain information about their economic activities and the activities of others. Producers not only discover better pro-duction methods, they learn about consumer preferences, and about developments by their competitors and suppliers. Knowledge in a market economy is decentralized, always changing, and information can sometimes be contradictory. Each individual faces the challenge of making best use of available knowledge, and the role of the market economy is to coordinate all of this decentralized knowledge so that people's activities are mutually consistent and their economic plans can be realized. Without this coordination, people would be unable to rely on the economic activity of others, so the division of labor would break down. Economic conditions are continually changing, and the market mechanism provides the means by which people can adjust their own activities to the continually changing plans and circum-stances of others. This market process approach to economic analysis provides the foundation for the ideas of the Austrian school.

NOTES 1 This is one of the key ideas Hayek (1949) emphasizes. The very descriptive phrase "the result of

human action but not of human design" was coined by eighteenth-century Scottish philosopher Adam Ferguson, and was popularized by Hayek in the twentieth century.

2 Buchanan (1964) emphasizes economics as the study of exchange rather than the study of individual choice and utility maximization.

3 Kohn (2004) makes this point Also see Holcombe (2013, chapters) on this point.

2 Decentralized knowledge: the role of firms and markets

Taking a very static - or equilibrium - view of the economic role of a firm, the firm purchases inputs that fall into the broad categories of land, labor and capital, and combines them into outputs. The way that firms transform inputs into outputs is given in the firm's production function. The firm's production function gives the combinations of various inputs that are used to produce outputs, much like a baker has a recipe for combining ingredients to bake an apple pie. Typically, economists assume that the formula - the production function - is given to the firm, so the firm must use this formula to transform inputs into outputs. Typically, the inputs and outputs are also assumed as given. Extending the baking analogy, the baker can use flour, apples, sugar and other specified ingredients as inputs to follow the recipe to produce the output of an apple pie.

In this framework, the baker's sole task is to choose the appropriate combination of inputs and use the recipe given in the production function to produce apple pies as profitably as possible. For the anal-ogy to hold, there will be some flexibility in the recipe. The mix of inputs can vary, and can be chosen so that the amount of sugar rela-tive to apples varies to make the pies sweeter or more tart. The mix of flour to apples can be chosen so that the pie crust is thicker or thinner. The baker also must choose the appropriate number of pies to pro-duce to maximize profit. And the baker must be careful to use inputs efficiently; for example, to not waste apples or other ingredients so that the pies use the minimum amount of inputs for the output that is produced.

Economists often present this production function depiction of the firm in mathematical terms, saying Q = fi.K, L), where Q is the output produced, f is the production function, or recipe used to produce the output, and K and L are the inputs of capital and labor. This formula-tion leaves out the land that was mentioned above, and depicts capital and labor as homogeneous. Combine certain amounts of capital and

22

DECENTRALIZED KNOWLEDGE: THE ROLE OF FIRMS AND MARKETS 23

labor, and the result is output. In this production function approach the firm is assumed to have no alternative to the production function f, can only use those given inputs K and L and must produce output Q. The standard theory of competitive markets often assumes that all firms in an industry produce a homogeneous output, so the type of Q produced is the same for all of them. In this formulation, the only things the people who manage a firm can choose are the quantities of K and L, which are then transformed by the production function they are given into a certain amount of Q.

Now consider the baker, who surely does have a recipe for apple pie. But the baker does not have to stick to that recipe. How about adding raisins to the pie? Substituting brown sugar for refined white sugar? Perhaps corn sweetener would be less expensive, but just as acceptable to those who buy the pies. The baker might even change the type of output and produce cherry pies instead of, or in addi-tion to, apple. When one looks at the baker's production function, so often assumed given to the producer, all of its components are subject to change by the producer. The producer can use different types of inputs, combine them in different ways and can vary the characteristics of the output.

In the real world of competitive markets, characterized by continual economic progress, firms have to continually modify everything that they do so that they can keep up with their competitors. Bakeries, like other retailers, are continually changing their product mixes to adjust to customer demands, coming up with new offerings and looking for ways to cut the cost of producing their current offerings. Economic progress in some areas of the economy, like electronics, is visible enough that it is barely worth mentioning, but this same economic progress is present throughout the economy, even though it is often not so visible. New farming methods and new strains of seeds increase crop yields and make crops more resistant to disease and drought. Farm machinery is continually improving. Methods in manufacturing and even retailing continue to lower costs, even though those advances may barely be visible to people outside those businesses.

The improved products and production methods that lower costs and raise people's material wellbeing present a continual challenge to the people who run firms. Because their competitors are continually improving what they do, each firm must also improve, or fall further behind others in the market. The most important challenge that those


who run firms face is to look for better production methods and better product characteristics so that they can keep up with the continual economic progress in the market.

2.1 The entrepreneurial nature of firms

The role of people who run firms can be broken down into two com-ponents: management and entrepreneurship, as Boudreaux and Holcombe (1989) describe. In the discussion of the previous section, finding the optimal mix of inputs to combine using the production function to produce output is the management function of the firm. Good management means operating the firm's processes as efficiently as possible. The role of the firm's management is to select the right combination of inputs to produce the output at lowest cost, which is determined by the production function, and to try to minimize any waste in the production process. If labor shirks, then management will have to spend more on wages than the cost-minimizing amount. Similarly, any waste of other inputs raises the firm's cost. Managers maximize profit by minimizing the cost of their inputs, and producing at the optimal scale using the optimal mix of inputs.

Entrepreneurship is the spotting and acting on a profit opportunity that has previously gone unnoticed. This could mean looking for a dif-ferent production function, or recipe for production, using different inputs, producing a different output or selling to a different market. The management function of the firm takes the parameters of the pro-duction function as given. The firm produces a given Q using inputs K and Land combining them according to production functionf The entrepreneurial firm recognizes that all of those parameters can be changed. The firm may be able to profit from changing the type of output it is producing, the inputs it is using or the production process itself. Henry Ford's adoption of the assembly line to produce automo-biles is the prototypical example of a change in the production process. Assembly lines had been used before Ford used them, but not for pro-ducing automobiles. Ford spotted the profit opportunity in using this new production method to produce automobiles. Apple Computer offers an obvious example of an entrepreneurial firm changing the type of output it produces as they have introduced the iPod, iPhone, iPad and other innovative products.


Kirzner (1973) emphasizes the pure observation of the profit opportu-nity as the entrepreneurial act, and notes that it takes no resources to notice a profit opportunity; just alertness. The alert entrepreneur sees that there is a previously untapped market, an improved method of production, some innovation in the characteristics of an existing prod-uct that will improve its profitability or even a whole new product that has not been marketed. While it takes no resources to be alert to profit opportunities, an entrepreneurial firm must act on the observation of the profit opportunity for entrepreneurship to take place.

While much can be made of the entrepreneur's observing and acting on a profit opportunity, there is always some uncertainty about whether what appears to be a profit opportunity will actually turn out to be profitable. As Foss and Klein (2012) emphasize, there is always a sub-stantial amount of judgment that goes into determining whether any given entrepreneurial action will in fact be profitable. Any discussion of entrepreneurship tends to focus more on the entrepreneurial suc-cesses than the entrepreneurial attempts that failed, so it is important to recognize the uncertainty inherent in entrepreneurship, and the judgment that is required to successfully transform what appears to be a profit opportunity into an actual profit.

Because some firms are entrepreneurial, all firms must be. A firm could not simply find a profit-maximizing formula using its produc-tion function and survive by continuing to follow that formula for any length of time. Other firms will be innovating by finding less costly methods of production, and more desirable product characteristics, so the firm that just follows the same formula year after year will fall continually behind others in the market. Profits will dwindle and turn into losses. Because of the nature of economic progress, all firms must be entrepreneurial to remain viable. All firms must always be looking for previously unnoticed profit opportunities.

Schumpeter (1947, p. 82) notes, "The essential point to grasp is that in dealing with capitalism we are dealing with an evolutionary process. . . . Capitalism, then, is by nature a form or method of economic change and not only never is but never actually can be stationary." Schum peter's statement supports undertaking economic analysis using a market process approach rather than an equilibrium approach, and also indicates the challenge that entrepreneurs are up against. They cannot discover a successful formula and stick with it because condi-tions are always changing, so firms must change in response, or find


themselves left behind by changing market conditions. Foss and Klein (2012) emphasize that entrepreneurship is not simply being observant enough to notice profit opportunities; it relies heavily on the judgment of the entrepreneur. Nobody can foresee the future, so entrepreneurs must use their best judgment to determine how they should adapt today to the future conditions of the market that can only be imper-fectly anticipated.

Good management is important to the firm, but entrepreneurship is absolutely essential. Firms may be able to get by and even prosper over the long run despite some inefficiencies, but without entrepre-neurship the firm with a successful formula today will fall increasingly behind others in the market as economic progress occurs. Firms must be entrepreneurial to keep up with their rivals. A major distinguish-ing feature of the Austrian school of economics is its emphasis on the entrepreneurial aspects of the firm rather than the management aspects.

2.2 Entrepreneurship as arbitrage

Following Kirzner's idea of entrepreneurship as the observation of an unexploited profit opportunity, entrepreneurship can be thought of as arbitrage: buying at one price and selling at a higher one. For example, someone might notice that apples sell for $0.75 in one city and $1 in a nearby one. A profit opportunity exists because apples can be pur-chased for $0.75 and sold for $1. To actually engage in the entrepre-neurial act, however, will take production and time. The entrepreneur will have to buy or rent a truck to transport the apples, which will result in some expense, and there may be spoilage as the apples are shipped, further reducing the entrepreneur's profit. Taking production into account, there is no profit opportunity if it costs $0.25 or more to ship the apples from one city to the other.

Time is also a factor. By the time the entrepreneur actually gets the apples to the second city, it may be that the price of apples has fallen there, so the apples can only be sold for $0.85. If the shipping cost is $o.1o or more per apple, what at first appeared to be a profit oppor-tunity will have turned out to result in a loss. Because an economy is always evolving, economic conditions will necessarily be different by the time the innovation is acted upon.


Consider a more complicated case of manufacturing a new automo-bile. In principle, this example is little different from the example of shipping apples. The entrepreneur envisions that the firm can hire labor, buy steel and glass and other auto parts, and sell the automobile for more than the cost of the inputs. As with the example of the apples, all that stands in the way of earning the profit is production and time. One can see that in the years between conception and the production of the finished automobile, conditions may have changed, so a new automobile that appeared to be a profit opportunity at one point in time may result in losses. Delorian and Fisker provide two examples of automobile companies that started up with innovative ideas that ultimately proved unprofitable.

Even in an arbitrage activity with a very short time horizon, such as arbitrage trading on international exchange markets, in which the time between spotting a profit opportunity and acting on it by trading takes only milliseconds, production and time still stand in the way of actually receiving a profit. Traders require fast computers and good algorithms for spotting profit opportunities. Computers and the wages of program-mers and traders are a cost of engaging in such arbitrage, and condi-tions still change fast enough that profit opportunities often only last for milliseconds before they are competed away. Traders are always looking for faster computers and faster algorithms to make their trades.

Entrepreneurship can be thought of as arbitrage because profit oppor-tunities involve buying inputs and selling the resulting output for more than the cost of the inputs. Production and time stand between the entrepreneurial insight and the realization of profit. This is true whether one is selling apples, building automobiles or engaging in arbitrage trading in international exchange markets.1

2.3 Profit and loss

Firms purchase and combine inputs to produce and sell output. If the value of the output the firm produces is greater than the cost of pur-chasing the inputs, then the firm adds value to the economy by taking less valuable inputs and combining them into more valuable output. The difference between the cost of the inputs and the revenue from selling the output is profit, so firms receive profit when they add value to the economy. Conversely, if a firm sells its output for less than the cost of the inputs it uses to produce that output, the firm destroys some


value in the economy, and the firm suffers losses. Value is destroyed when more valuable inputs are transformed into less valuable output. Profitable firms add value to the economy; unprofitable firms subtract value from the economy.

Profit and loss serve the important role of providing an incentive for firms to add value to the economy. Firms that successfully add value to the economy are able to grow and increase their economic activity. Firms that subtract value from the economy eventually shrink until they disappear.

Entrepreneurs try to discover and act on profit opportunities, as Harper (1996) notes, by developing conjectures on what would be profitable innovations, and testing them out in the market. When entrepreneurs are successful they add value to the economy. The motives of entre-preneurs are nearly irrelevant to their actions that add value to the economy. Whether they are looking out for the good of the economy as a whole, or selfishly seeking profit for their own benefit, their entre-preneurial actions benefit everyone. As Adam Smith (1776 [1937]) noted, in a market economy individuals pursuing their own interests are led by an invisible hand to promote the general welfare. Successful entrepreneurship means making profits because profitable firms sur-vive and grow while unprofitable firms eventually run out of assets and go out of business.

Profits and losses are indicators of whether entrepreneurs are success-ful at creating value. Entrepreneurs use their judgment to determine whether certain actions - new product characteristics, new production methods - will be profitable. They can never be sure that an innovation will be profitable because that innovation will be something new. A new method of production, even if it has been tried by other industries or other firms in the same industry, may run into unforeseen problems. Nobody can know for sure whether a new product, or an innovation in the characteristics of an existing product, will sell enough at a high enough price to be profitable because it is new and has never before been tried. Entrepreneurs use their best judgment, and profit when they are correct, but lose when they are incorrect. Thus, profit is an indicator of successful entrepreneurship and loss is an indicator of unsuccessful entrepreneurship.

Because the survival of a firm is dependent on its ability to remain prof-itable, there is a selection process that eliminates unprofitable firms


and allows profitable firms to grow. It is not much of a leap to conclude that the entrepreneurs who oversee firms want them to be as profitable as possible, but regardless of their motivation, the selection process reinforces profitable activity.

2.4 Profits are not certain

The heading of this section almost goes without saying. Profits are never a sure thing for a firm. When entrepreneurs act on a profit opportunity, the profit they anticipate is the result of actions they take at one point in time that will lead to a profit later. The entrepreneur may underestimate the difficulty and expense of acting on that profit opportunity, the entrepreneur may be overly optimistic about the value consumers place on the innovation and there is always the risk that other entrepreneurs may introduce innovations that crowd out the entrepreneur's innovation.

Because profits are never certain, entrepreneurs will engage in innova-tive activity only if they anticipate that the reward in terms of antici-pated profit outweighs the potential for loss. For this reason, profits are necessary for economic progress. If profits were immediately com-peted away, there would be no reward for entrepreneurial innovation. Any innovation would run the risk of incurring a loss, so innovation and progress only occur because the innovator anticipates profiting from the innovation. Profits are necessary for economic progress.

2.5 Profit and progress: a caveat

The link between profit and economic progress applies when the activ-ity of the firm is undertaken through voluntary exchange. It applies when firms buy their inputs and sell their outputs in markets where all transactions are the result of mutual agreement among the par-ticipants. Sometimes, government interference with markets results in transfers of resources that are not wholly voluntary. For example, firms that receive government subsidies may produce output that costs more to produce than its value to consumers. The subsidy, which is a forced transfer from taxpayers to the firm, and ultimately to the consumers of the firm's products, breaks the link between profit and progress. Similarly, if government is the purchaser, there is no assur-ance that output purchased with tax dollars is worth more than it


costs because taxpayers are forced to pay the cost regardless of their preferences. Government mandates have a similar effect. For example, many governments mandate that ethanol be added to motor fuels. The purchase of the fuel by consumers adds value to the economy because they can be observed to voluntarily purchase it, but the requirement that the fuel contain ethanol may reduce value if the cost of producing the ethanol in the fuel is greater than the value consumers perceive it adds to the fuel.

When resources are allocated outside the market - outside the system in which transactions are voluntary - firms can profit from coerced transfers that do not add value to the economy. The role of government in the economy will be discussed further in Chapter 3.

2.6 Opportunity cost and profit-seeking

Equilibrium models often depict firms as profit max1m1zers, but regardless of whether firms try to maximize profit, there is no way to tell whether they actually are. When a firm chooses one course of action, it does so in lieu of making a different choice, and there is no way to know what would have happened had the firm made the differ-ent choice. Firms can tell whether their current activities are profitable, but they cannot tell whether some alternative would have been more profitable, so they cannot know whether they are, in fact, maximizing their profits.

Someone opening a bakery would have to decide whether to rent what appears to be a more desirable location on Oak Street, and pay more rent, or take what appears to be a less desirable location on Elm Street for a lower rent. Should the bakery choose the Oak Street location and make a profit, that decision would turn out to be profitable, but because the bakery did not open on Elm Street, there is no way for the firm to know whether the Elm Street location would have been more profitable. Similarly, the bakery chooses a price for its pies. If it turns out to be profitable, there is still no evidence that it has chosen the profit-maximizing price. Perhaps a lower price would sell enough pies to more than make up the difference and a lower price would increase profits. Perhaps most people would be willing to pay a higher price, so a higher price would be more profitable. The firm could experiment by trying different prices, but that could cost it some business if custom-ers found the bakery's pricing to be unpredictable and started shop-


ping elsewhere. And perhaps a lower price for pies at the Elm Street location would be more profitable than a higher price on Oak Street.

By choosing one option, the firm foregoes other options, so the firm can never know whether the option it has chosen is the profit-maximizing one. Buchanan (1969) emphasizes this as an implication of the subjec-tive nature of cost. Firms can tell if they are profitable, but they have no way to tell whether they are maximizing profits.

Firms can gather information by doing market research, perhaps as simply as offering customers alternatives. Would it be more profitable to sell apple pies or cherry pies? The firm can offer both and adjust its output to the demand it perceives. Entrepreneurs are always looking for profit opportunities, and profit and loss gives them the guidelines to indicate whether their innovations add value to the economy. Whether they are maximizing profit can never be known, and in an economy characterized by economic progress is of peripheral relevance anyway. Firms must always be adjusting their activities and looking for new profit opportunities to keep up with the innovations made by others in the market.

2.7 Cost and price

Economists since Adam Smith have concluded that in competitive markets the price of a good tends to be just sufficient to cover the cost of production, with the implication that the cost of inputs is given, and the price of the good gravitates toward the cost of production. Smith (1776 [1937], p. ss) says, "When the price of any commodity is neither more nor less than what is sufficient to pay the rent of land, the wages of labour, and the profits of stock employed in

Documents

(Elgar Advanced Introductions Series) Randall G. Holcombe-Advanced Introduction to the Austrian School of Economics-Edward Elgar Pub (2014)