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Book Review: How Markets Work

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How Markets Work: Disequilibrium, Entrepreneurship and Discovery
by Israel M. Kirzner (London: Institute of Economic Affairs, 1997); 78 pages; £8.00.

The revival of Austrian economics during the last 20 years is largely due to the original and numerous contributions of Israel M. Kirzner. Kirzner studied with Ludwig von Mises at New York University starting in the mid 1950s. He recounts in a recent issue of the Review of Austrian Economics (vol. 9, no. 2, 1996), in honor of the memory of Murray N. Rothbard, that what intrigued him was that at the first session he attended of Mises’s NYU seminar in economic theory, Mises began by stating, “The market is a process.”

He recalls that because he had a “rather spotty undergraduate training in economics (and mainly along Keynesian lines), Mises’s statement … left me completely puzzled. I could not fathom what on earth could be meant by the observation that the market is a process. I now, in retrospect, consider that all my subsequent training and research in economics, both before and after obtaining my doctorate under Mises, has consisted in learning to appreciate what it was that Mises meant by this assertion.”

In his latest contribution, How Markets Work: Disequilibrium, Entrepreneurship and Discovery, Kirzner summarizes his Austrian theory of the market process and contrasts it with the premises and conclusions of mainstream, neoclassical microeconomics. This book provides a concise and extremely readable exposition of the two frameworks for understanding the market order and how it works.

Kirzner explains that both the neoclassical and Austrian traditions had their beginnings in the discovery of the concepts of subjective value and marginal utility in the last three decades of the 19th century. He shows that through the 1920s, it appeared that the two traditions were merely slight variations on the same theme, with no fundamental differences between them. By the early 1930s, they seemed to be converging into one version of modern economics.

The Austrians ultimately realized that they were pursuing a type of economic analysis different from the economics being formalized in England and the United States. The reason for their realization was the debate over the possibility of economic calculation under socialist central planning that became especially heated in the 1930s and 1940s.

In 1920, Mises had argued that a fully centrally planned economy could not rationally allocate resources under the planners’ control. The reason was that planners would not know the value of resources, capital, and other factors of production in alternative uses. In the market economy, such rationality was possible because entrepreneurs could openly and freely compete in the purchase or hire of resources, labor, or capital to employ them in different lines of production. And the entrepreneurs’ bids for those purchases or hires in the form of market prices would reflect their respective estimates of the consumers’ demands for the final goods that the factors of production could manufacture.

In the late 1930s, socialist economist Oskar Lange responded by saying that yes, Mises was right — a functioning economy needs prices to estimate the cost of using scarce resources in alternative uses. But, Lange said, they could easily be provided in a socialist economy.

A central planning board would be responsible for setting prices for factors of production and finished goods. The managers of the state-owned factories and enterprises would be required to make their choices as to the combinations of resources to use in their respective production activities. They would do that by using the artificially set prices to estimate the least-cost way of manufacturing their goods. If the prices set by the central planning agency resulted in shortages or surpluses, the central planners would merely adjust the prices until the respective supplies and demands were in balance.

Kirzner argues that this socialist response to Mises’s challenge made both Mises and his Austrian colleague Friedrich Hayek realize that their concept of the market economy and its workings was in some fundamental sense different from the neoclassical model upon which Oskar Lange had attempted to defend the possibility of a functioning socialist economy.

Mainstream, textbook, neoclassical economics is grounded on the theory of perfect competition. Perfect competition is a situation in which there are so many buyers and sellers in the market that no one buyer or seller can influence the market price through his own actions. Instead, he takes the market price as “given” and just adjusts the quantity to what he considers most advantageous to purchase or sell at that price. Also, each seller sells a product exactly like the ones his rivals are offering to consumers in the same market. And each agent is presumed to have either “perfect” or “sufficient” knowledge so that he never makes a mistake on the market; that is, no buyer ever pays a price higher and no seller ever sells for a lower price than those that the “objective” conditions of the market dictate. This state of perfectly adjusted market equilibrium, in which errors and mistakes are excluded and product innovation and differentiation are prohibited, then becomes the benchmark by which the “real market” is evaluated and judged.

Kirzner argues that in contrast to this conception of the market economy, the Austrians, especially Mises and Hayek, developed an alternative theory of the market process. In their framework, individuals have less than perfect knowledge. Uncertainty hangs like a cloud over the possibilities of the future. Entrepreneurs are creative innovators and discoverers alert to market opportunities overlooked or not seen by others. Competition acts as a discovery procedure in which the entrepreneurs confront and try to outdo each other in anticipating and satisfying future consumer demand.

By ignoring and abstracting away these real and realistic aspects of the world in which actors and entrepreneurs choose and act, the neoclassical perfect-competition model leaves itself unable to explain the process by which suppliers and demanders, consumers and entrepreneurs coordinate their actions for mutual benefit and gain.

Thus, Lange’s model of a “market socialism” seemed plausible only because it assumed away all the problems of imperfect and dispersed knowledge, changing circumstances, and the need to constantly discover opportunities in the changing circumstances of a dynamic market — one that services the wants and desires of its many participants.

In the final section, Kirzner applies the Austrian theory of the market process to the issues of advertising, antitrust, and welfare, as well as to the justice of entrepreneurial profit. Under this last topic, he explains what he had earlier called his “finders-keepers” theory of the justness of profits. (See the review of Kirzner’s Discovery, Capitalism and Distributive Justice, in Freedom Daily, February 1990.)

Dr. Kirzner has presented an exceptionally clear exposition of the Austrian and neoclassical approaches to economics. If only this book could find its way as assigned reading in economics classes across America!

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    Richard M. Ebeling is a professor of economics at Northwood University. He was formerly president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003).