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Friday, September 1, 2006

The Anatomy of Economic Advice, Part II

Israel Kirzner is professor emeritus of economics at New York University and the author of many books about Austrian economics, among them, Competition and Entrepreneurship; Perception, Opportunity, and Profit; and The Meaning of the Market Process. This is the second in a three-part series.

How can positive science (consisting entirely of “is” statements) be translated into “ought” statements within the framework of economic understanding? In the first part of this series we drew attention to some of the paradoxes surrounding economic advice. In particular we drew puzzled attention to the passionate advocacy by Ludwig von Mises of free-market arrangements—the same Ludwig von Mises who insisted on an attitude of purest, disinterested wertfreiheit (“value-freedom”) on the part of all social scientists. In the present article, as a step toward clarifying these paradoxes and puzzles, we discuss the nature of the strictly positive central propositions of economics. We shall find that a careful appreciation for the manner in which economic science accounts for the existence of chains of economic cause and effect can help us see how knowledge of these chains can sustain very definite ways of providing advice and guidance to economic policymakers. Statements describing chains of cause and effect are “is” statements. But, as we shall see, these statements can, in a carefully defined sense, generate the “ought” statements of which economic advice consists.

Cause and Effect in Economic Affairs

Economic science was established as a branch of knowledge in the eighteenth century, when the classical economists recognized that there exist systematic chains of cause and effect in economic phenomena (just as they exist in regard to physical phenomena). Although subsequent progress in economic theorizing radically altered the way in which economics understands economic cause and effect, it was the classical economists who, by establishing the idea of systematic chains of cause and effect, established the scientific discipline of economics.

The very perception of a scientific discipline of economics (or “political economy,” as it was called by the classical economists of the late eighteenth and early nineteenth centuries) carries revolutionary implications for public policy. As Mises emphasized again and again, the discovery of regularities in economic phenomena means that statesmen concerned with public policy can no longer treat the economy as putty that they are free to mold into whatever shape they believe best for society. Every political act, every legislative constraint over economic activity, and every public subsidy must now be recognized as entailing specific consequences. Before instituting any tariff, before granting any right of monopoly, before printing any money, before imposing any kind of price control, those responsible for state policy must ask themselves whether they have fully taken into account all the consequences that are likely to follow from these actions. There are, the classical economists had shown, “laws” of economics that must be respected and taken into account if economic disaster is to be avoided.

But how can such “laws” possibly exist? Surely an intuitive impossibility blocks any conceivable “laws” from existing. It is one thing to observe and understand regularities and causal or functional relationships in physical phenomena. But to expect such regularities and relationships in economic phenomena (which represent the outcome of the independently made decisions and actions of millions of freely choosing individual agents) seems to be glaringly counterintuitive. There seems to be no way of ensuring that freely choosing agents “obey” the regularities that a science might declare to be determinative.

This intuitive difficulty is the fundamental reason why both economic theorists and philosophers have, during the past two centuries, puzzled and argued over the very possibility of an economic science, and over its epistemological character. The present series of papers (and this one in particular) are informed by the insights and philosophical framework identified with the Austrian School of Economics, and especially with the thought of its leading twentieth-century representatives, Mises and F. A. Hayek.

In this framework the focus of attention is on the purposefulness of human beings, and on the way in which the expectations and knowledge of these human beings are systematically modified by economic experience. Changing economic experience alters the terms on which individual agents in fact find themselves able to choose; that experience also teaches agents where they had over-optimistically or over-pessimistically misjudged the terms on which others were prepared to trade with them; that experience also alerts individual agents to opportunities for the future that had hitherto not existed or that have until now not been noticed. Economic theory is able, in this analytical framework, to provide understanding of how exogenous changes in resource availabilities, technical knowledge, and consumer preferences may systematically change market phenomena, and thus determine the course of production and the patterns of resource allocation. To illustrate this approach to economic reasoning, let us take perhaps the most basic of the “regularities” in the market economy, the “law” of supply and demand.

The “Law” of Supply and Demand

This basic understanding of the behavior of market prices identifies the nature and the direction of the forces operating in the market for each product and for each resource. This understanding sees the market for any given item, be it a product for human consumption (such as milk or the services of an opera singer), or a resource (such as farmland for growing crops or the services of an engineering instructor for the training of engineers), as being continually modified by market experience in systematic fashion. At any given time “too much” or “too little” of the given item may be offered for sale (or sought to be bought). (“Too much” being offered for sale means that, at current prices, more of an item is being offered for sale than is being bought. “Too little” being offered for sale means that, at current prices, more of the item is being sought to be bought than sellers wish to sell.) The “law” of supply and demand focuses attention on the existence of spontaneous market forces tending to “correct” these imbalances.

Where “too much” has been offered for sale, falling prices (for the relevant item) tend to encourage some (“marginal”) sellers to cut back on its production and to encourage potential buyers to seek additional quantities for purchase. Where “too little” has been offered for sale, rising prices for the relevant item tend to encourage potential sellers to increase production (and thus the quantities they will offer for sale) and to discourage some (“marginal”) buyers from continuing to buy. Were this process of adjustment in a given market to be permitted to continue indefinitely (that is, were the costs and techniques of production for the relevant item, on the one hand, and the preferences of the consumers, on the other, to remain indefinitely unchanged while market adjustments continued), the market for that item might be imagined to attain “equilibrium.” Market equilibrium corresponds to the imaginary state of affairs in which neither “too much” nor “too little” of an item is being offered for sale. In such an imagined state of equilibrium there would be no scope for market forces to be set into motion. Prices and quantities offered for sale and sought to be bought are, in such an imagined state of equilibrium, such that no tendencies are set in motion for any of them to change.

Contrary to what many students of economics have been taught to believe, the “law” of supply and demand does not (when it is properly understood) declare that each market is at or near equilibrium at each moment. Nor does it declare (the less-objectionable form of the above) that markets tend rapidly to achieve equilibrium. Rather the “law” declares that, to the extent that a market, at any given moment, is not at equilibrium, this will itself set into motion forces predominantly pushing the market in the direction of equilibrium.

However, it should be understood and emphasized, the continual changes in the relevant exogenous variables (for example, the costs of production, the availability of resources, and the patterns of consumer preferences) will almost inevitably ensure that the equilibrium position for a market at any given moment is different from what that position was at any earlier moment. So the market forces unleashed by the disequilibrium conditions at one moment will almost certainly not ensure the attainment of equilibrium at any subsequent moment.

Nonetheless, it is reasonable to point out, the more gross imbalances present in the market at any given moment will, according to the “law” of supply and demand, tend to be corrected. An “oversupply” places pressure on prices to fall, discouraging marginal sellers from some production and encouraging additional purchases, and thus tending to eliminate the imbalance. A “shortage” operates in the reverse, but equally benign, direction. Let us examine why the elimination of these “imbalances” can legitimately be described as “benign.” In the final article of this series, this will help us to understand the sense in which economic theory can, in scientifically objective fashion, promote sound economic-policy advice.

Market Imbalance—Why Is It Regrettable?

Let us consider the case of “overproduction” in a particular market (a market seen as isolated and insulated from other markets). Due to miscalculation or other error, the decisions of producers in this market have overestimated the eagerness of buyers to buy. The amounts offered for sale, and the prices expected and asked by potential sellers, are not matched by the decisions of potential buyers (and thus by the prices at which potential buyers expect to be able to buy, and at which they are willing to buy). This imbalance corresponds to decisions that have turned out to have been disappointing, and to decisions that turn out to have been regrettable. Some potential sellers (who might otherwise have offered to sell for lower prices, but who mistakenly held out for higher prices) are disappointed in that their plans to sell at higher prices cannot be successfully carried out. Those sellers may also regret their refusal to offer to sell at lower prices, or they may regret their decisions to produce in the first place. The failure of the decisions of some of the potential sellers to dovetail with corresponding decisions of potential buyers reveals the “error” of all of those decisions and is the source of both disappointment and regret.

A different, more accurate pattern of decisions, by both potential buyers and potential sellers, might have permitted them to achieve more successful fulfillment of plans than has in fact occurred. When a pair of market participants might have engaged in voluntary exchange to mutual advantage (for example, at a lower price), their failure to have done so (due to “error”) seems, at least at first glance, to have been unambiguously unfortunate—for everybody. Nobody, it seems at first glance, has gained anything by the fact that potential steps to mutual advantage were not taken.

So, if we are correct in this judgment, the market process, which according to our “law” of supply and demand initiates continual market tendencies toward the correction of such imbalances, would appear to be benign. It tends to discover and to correct “erroneous” market decisions—that is, decisions which operate to frustrate the exploitation of potentially mutually gainful exchanges.

Although we have been careful to express this approving judgment (for the outcome of the “law” of supply and demand) strictly in tentative terms, we shall find that it in fact holds more robustly than we have suggested. As we shall see in the final article of this series, it tends to hold even when we drop the special assumptions made in this section. There is a definite sense in which the “positive” theory of supply and demand leads ineluctably to an understanding of its socially benign character (that is, of its “normative” implications). We have in fact glimpsed here the basis for scientifically based economic advice. But the present article has not yet completed its exposition of the “positive” operation of the “law” of supply and demand. Before proceeding further we must explore more carefully exactly how this “law” achieves its magic—its tendency to correct market imbalance. We shall find that the “normative” discussion of this section can help us understand the “positive” operation of the competitive market process.

How the Market Works*

As we have seen, market imbalance reflects and expresses decisions that have been made in error. Market participants have been disappointingly left with unsold goods. Had they known this previously, they might have produced fewer units of these goods; they might even have gone into entirely different lines of production; or they might have been happy to have sold for lower prices (the only reason for their having failed to do so being their erroneous conviction that they could obtain higher prices).

Notice that this understanding of market imbalance refers, in effect, to two distinct kinds of error. One kind of error made by participants in the market we have considered is that mutually gainful exchange opportunities have simply not been taken advantage of. (Thus when market prices have been “too high,” generating offers to sell that have been rejected, this is likely to mean that mutually gainful sales could, in principle, have occurred at lower prices.) A second kind of error has meant that some market participants have been led to believe (quite erroneously) that (nonexistent) opportunities for mutually gainful exchange really did exist. The first of these two kinds of error is thus to fail to recognize existing opportunities. The second kind of error is to “see” opportunities which in fact do not exist. One might describe the first kind of error as one of undue pessimism (failure to see opportunities really staring one in the face); the second kind of error might be described as one of undue and unjustified over-optimism. This insight can help us understand the process of market adjustment, the operation of the “law” of supply and demand.

Let us consider the errors of over-optimism. Whenever such an error occurs, it is discovered (and thus presumably corrected) almost inevitably. One’s market experience reveals where one has been over-optimistic; the opportunities that one had over-optimistically expected to encounter simply do not happen. Such chastening experience tends, almost inevitably, to rein in over-optimistic market anticipations. Such experience “teaches” where and how more realistic expectations are in order. Where over-optimistic would-be sellers had, for example, refused to sell for lower prices (confidently, but erroneously, expecting to sell at higher prices), their disappointing experience in the market tends to teach them to lower their asking prices.

But the other kind of error (that expressing undue pessimism) does not seem capable of “automatic” correction in any similar way. An opportunity (for mutually beneficial exchange) that was not seen today by the relevant parties (and therefore not taken advantage of) may not be seen tomorrow either (even if it still exists tomorrow). Let us take an example. If different prices for “the same” item have been prevailing in different parts of “the same” market, this is a scenario in which potentially mutually advantageous trading opportunities have existed, but have been missed. After all, in any market in which buyers have been buying at higher prices while some sellers have been selling at lower prices, we have a situation where these buyers and these sellers could obviously have benefited by trading with each other at some price lower than those higher prices at which the buyers have been buying, but higher than those lower prices at which the sellers have been selling. Clearly these market participants were simply unaware of what was going on elsewhere in this same market. But there seems no obvious manner in which such unawareness might be spontaneously replaced by superior market information. There seems no obvious way through which the market might tend to replace widely divergent market prices with less divergent prices.

It is here that the spontaneous market process depends on entrepreneurial alertness for one of the most fundamental (and widely recognized) tendencies in free, competitive markets: that prices for the same item do move toward a single price throughout the market.

Entrepreneurial Alertness

One of the less obvious, but nonetheless most powerful elements acting in markets is entrepreneurial alertness—the propensity of human beings to notice that which it is in their interest to notice. Sooner or later buyers paying unnecessarily high prices do tend to discover where they can obtain comparable goods at significantly lower prices. Sellers selling for unnecessarily low prices do tend to discover where they can find buyers willing to pay higher prices. Moreover, sooner or later entrepreneurs will discover that they can grasp pure profit simply by buying at the lower prices and selling at the higher prices. We do feel convinced that widely diverging prices in the same market for a given product or resource will give way in this fashion to competitive forces tending to push these diverging prices toward each other. Errors of undue pessimism do tend to be corrected in this way—as a result of entrepreneurial alertness.

So the “law” of supply and demand explains chains of economic causation along each of two distinct dimensions. First, as we have seen earlier, it operates toward the correction of market imbalances for given items. Second, it operates to correct such imbalances at the same time as it corrects the phenomenon of divergent prices for each such item. The forces of supply and demand operate to correct “wrong” decisions that are unduly optimistic, at the same time as it operates to correct “wrong” decisions that are over-pessimistic.

The Broad Scope of Our Analysis

Our discussion thus far has been extremely simple both in its assumptions and its substance. We have talked of the market for a “given item” while assuming this market to be isolated and insulated from all other markets. When one broadens one’s analytical perspective to include the markets for innumerable products and resources that may be bought and sold, and to include not only simple buying and selling decisions but also decisions on what to produce and how to produce, it might appear that we are now in a world of mind-boggling complexity, for which our simple analysis has little relevance. But this is not the case. The insights of the previous sections do have immediate relevance even for the most complicated of interlocking markets.

Consider, for example, a market in which a particular item C is produced by combining input A with input B, in accordance with some production recipe. Imagine that such production is highly profitable. The combined costs of inputs A and B are, at a given level of output, significantly lower than the revenue obtainable from selling C in the consumer-goods market. This scenario may seem fairly complicated (in comparison with the scenarios discussed earlier). But we should notice that this scenario is one in which buyers are paying higher prices than necessary, and sellers are selling at lower prices than necessary—exactly as in the single-item market discussed in the preceding section. Thus those selling A and B at prices summing to less than the price being paid for C could, in principle, have produced C and sold it for the higher price (since only A and B are needed to produce C). The profitability of this line of production results from a (disguised) divergence of prices “for the same item” in the same market (that is, it results from the circumstances that everything needed to produce C can be bought for less than the market price for C). Thus this profitability can be expected (unless we postulate monopolistic control of access to resources A and B) to tend to attract competitive entrepreneurial attention. This will tend to eliminate the profitability of this line of production (by pushing the price of C and the sum of the prices of A and B closer together).

Although this is not the place to do so, similar analysis can demonstrate the broad relevance of our earlier discussion of the “law” of supply and demand to key aspects, at the very least, of complex market scenarios.

Cause and Effect in Economic Affairs

Our discussion has illustrated the way in which simple economic theory accounts for the existence of definite and systematic chains of cause and effect in economic affairs. There do exist definite ways in which economic decisions made in any one period tend to take systematic account of the other decisions being made in the same markets. In this way decisions do mold each other in systematic fashion. And we have seen how the manner in which such “molding” tends to occur appears, at least at first glance, to deserve being called “benign.” This simple analysis will help us understand, in principle, how economic theory can lead toward making judgments on the “goodness” of specific policy initiatives through an understanding of the likely consequences of such initiatives.

We are now ready to tackle, in the final article in this series, the question posed at the beginning of the first article: Can positive economic understanding be translated into scientifically objective and valid economic advice?

*Much of the material in this article, and especially the material in this section, is covered in greater detail in my monograph How Markets Work: Disequilibrium, Entrepreneurship and Discovery (London:  Institute of Economic Affairs, 1997).

  • Israel Kirzner is Emeritus Professor of Economics at New York University. He is widely published (some of his books include: The Economic Point of View, Market Theory and the Price System, An Essay on Capital, Competition and Entrepreneurship, Perception, Opportunity and Profit Studies in the Theory of Entrepreneurship, Discovery, Capitalism and Distributive Justice). Also, he has published many articles and edited both books and journals. He resides in New York. He is a member of the FEE Faculty Network.