Front Page Titles (by Subject) Israel M. Kirzner, Economics and Error - New Directions in Austrian Economics
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Israel M. Kirzner, Economics and Error - Louis M. Spadaro, New Directions in Austrian Economics 
New Directions in Austrian Economics, ed. Louis M. Spadaro (Kansas City: Sheed Andrews and McMeel, 1978).
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Economics and Error
The title of this paper, it may correctly be surmised, owes something to the title of the famous 1937 paper of Professor Hayek, “Economics and Knowledge.”1 There lies, Hayek acknowledged, an intentional ambiguity in the title of that paper: we are in fact to learn in his paper that the knowledge which economic analysis conveys depends crucially upon propositions about the knowledge possessed by the different members of society. The not dissimilar ambiguity in the title of the present paper may, one ventures to hope, suggest that a good deal of erroneous thought in economics has its source in confusion concerning the nature and role of error in the actions of the different members of society. It is the purpose of this paper to dispel at least some portion of this confusion. If, in the course of this attempt, some incidental light can be thrown, as well, on the problems raised by Hayek in his ‘37 paper, this will be seen to reflect (once again not accidentally) the symmetrical ambiguities embedded in the titles of the two papers.
EFFICIENCY, WASTE, AND ERROR
Economists have traditionally been concerned with issues related to efficiency. Inefficient action occurs when one places oneself in a position which one views as less desirable than an equally available alternative state of affairs. Inefficiency can therefore not be thought of except as the result of an error, a mistake, an incorrect and wrong move. Much of the work of the modern economist has, in fact, the declared aim of avoiding errors, of achieving efficiency. At the same time, however, as he directs his energies toward the obviation of error, the contemporary economist is frequently to be found pursuing his analysis on the assumption that men do not, and will not, ever fall into error. “Waste,” declares Stigler in a recent note, “is error within the framework of modern economic analysis, and it will not become a useful concept until we have a theory of error.”2 Modern economic analysis, we are to understand, lacking a theory of error, can and does proceed only by assuming it away: error and waste simply have no place in the world of economic theory. It is this position that we wish to examine critically. Is it really the case, we must ask, that economic theory requires us to abstract completely from the phenomenon of error? As a preliminary step toward the consideration of this question, it is necessary first to review a number of discussions to be found in the economic literature in which the possibility of error has been seriously canvassed.
MISES, MARKSMEN, AND MISTAKES
In a passage in which he is concerned to explain that human action is always rational (in the sense of being designed to attain definite ends), Mises considers the objection that men make mistakes. This does not, Mises points out, constitute irrationality. “To make mistakes in pursuing one’s ends is a widespread human weakness ... Error, inefficiency, and failure must not be confused with irrationality. He who shoots wants, as a rule, to hit the mark. If he misses it, he is not ‘irrational’; he is a poor marksman. The doctor who chooses the wrong method to treat a patient is not irrational; he may be an incompetent physician ...”3 The implication here is that the incompetent physician and the poor marksman may indeed make mistakes and errors. Rational Misesian human actors are human enough to err. But it is clear that these errors are not inconsistent with the position (excluding errors) cited earlier as taken by Stigler. In fact the reason why these are not errors in the sense relevant to the Stigler position, is entirely similar to the reason why these errors do not, for Mises, constitute irrationality. The mistakes made by the ill-trained medic do not represent a failure by him to attain that which it is within his power to attain. His failure simply reflects lack of the necessary quality of input. An error (in the Stigler sense) occurs only when an input is used in a way that fails to produce what that input can produce. When a poor mathematician makes a mistake in arithmetic4 he is not, therefore, making an error; nor is the failure by a poor marksman to hit the mark an error. It is not an error for a physically weak man to be unable to lift a heavy weight. Nor is it an error, in the relevant sense, when one unschooled in medicine fails to prescribe the proper treatment for a patient. (To be sure, it may be that the incompetent physician, indifferent mathematician, and poor marksman ought not to waste their time [and their patients’ lives] by engaging in tasks for which they are so definitely ill-suited. But of course Mises is concerned with the mistake the physician makes in the course of the practice of medicine, not with the possible error of his attempting to practice medicine altogether.)
CROCE, TECHNICAL ERROR, AND ECONOMIC ERROR
In the course of his famous correspondence with Pareto at the turn of the century (in the Giornale degli Economisti), Benedetto Croce did find a definite place for “economic error.” Such an error, Croce explained, must be sharply distinguished from “technical error.” Technical error, for Croce, consists in an error of knowledge; it occurs when one is ignorant of the properties of the materials with which one deals (such as when one places a heavy iron girder on a delicate wall too weak to support it). Economic error, on the other hand, occurs for example when, yielding to the temptation of the moment, one pursues a transient fancy which is not one’s true goal; it is, Croce explains, an error of will, “the failure to aim directly at one’s own object: to wish this and that, i.e. not really to wish either this or that.”5 Avoidance of economic error requires that one aim at one’s goal; failure to aim at one’s goal constitutes, therefore, a special category of error. This error arises out of the incorrectness not of the pattern of acts taken in pursuing one’s immediate aim, since these are, from the point of view of that aim, entirely appropriate, but of one’s immediate aim itself. To pursue this aim is—from the perspective of one’s “true” goals—an aberration. One places oneself into contradiction with oneself, one aims at that which one does not, in fact, seek to attain.
Croce’s concept of economic error has not found favor among economists. The writer has elsewhere6 reviewed the careful analysis which Tagliacozzo many years ago made of Croce’s position.7 Briefly the reason why economists have no place for Croce’s “economic error” is that it seems impossible, from the point of view of pure science, to distinguish between “true” goals and erroneous, transient ones. Once we have accepted the possibility that man can discard yesterday’s goals and adopt new ones towards which he will direct today’s purposeful actions—we have surrendered the possibility of labelling the pursuit of any end (no matter how fleeting the “temptation” toward it may be, and no matter how permanent remorse over having “yielded” to it may turn out to become) as, on scientific grounds, an erroneous one.Croce’s economic error, it then turns out, emerges only as a result of invoking (unspecified) judgments of value in terms of which to classify, from a man’s own point of view, those goals of his which it is “correct” to pursue and those the pursuit of which he must consider an error.
It seems worthwhile to digress briefly to note that Mises—in whose writings one finds no room at all for the type of “economic error” identified by Croce—seems to have consistent scientific grounds for his unwillingness to recognize such error. It is well known that Mises denied the independent existence of a scale of values (actuating human choices) apart from the acts of choice themselves (“the scale of values ... manifests itself only in the reality of action”).8 The notion of a given scale of values, Mises is at pains to explain, can therefore not be used to pronounce a real action (at variance with that scale) as “irrational.” The logical consistency which human action necessarily displays, by no means entails constancy in the ranking of ends.9 Mises’ insistence on the possibility of changes in adopted preference rankings is closely related to his understanding of choice as undetermined. Man does not choose as a reaction to given circumstances—on the basis of a previously adopted scale of values; he chooses freely at the time he acts, between different ends and different ways of reaching these ends. It follows that the notion of economic error as perceived by Croce has no place in economic science.
ERRONEOUS ACTION AND IMPERFECT KNOWLEDGE
That men frequently act on the basis of imperfect knowledge is of course not disputed by writers for whom error in economic theory is excluded. In the passage (cited above) where Mises defends the “rationality” of erroneous actions, he mentions an example which we have not yet cited. “The farmer who in earlier ages tried to increase his crop by resorting to magic rites acted no less rationally than the modern farmer who applies more fertilizer.”10 Men certainly engage in actions which they may regret when they discover the true facts of the situation. Croce, we have seen, termed this kind of mistake a technical error. Erroneous action arising from ignorance is not, however, generally seen as a serious threat to an economics which excludes error. With respect to the perceived framework of ends and means, error-free decision making can still be postulated. The very notion of an ends-means framework, of preferences and constraints, of indifference curves and budget lines, enables the economist to confine his analysis to choice within the given framework. The source of error in such choices, being outside that framework, is thus, by the very scope of the analysis, in effect excluded from consideration.
To be sure it is precisely this aspect of modern economics against which Professors Lachmann and Shackle have, among other matters, so vigorously rebelled. Since all action is future-oriented, necessarily involving an unknown and unknowable future, men’s actions are inevitably attended by what Knight called error in the exercise of judgment.11 Such error may, if one chooses, be subsumed under Croce’s technical error, but the all-pervasive and inescapable character of such errors in judgment does, in the view of these distinguished critics, seriously compromise the usefulness of abstractions depending on given, known, ends-means frameworks. In this paper, we will not pursue further the profound consequences with respect to modern economics which the Lachmann-Shackle critiques imply. Our discussion proceeds, instead, in the context of modes of discourse which do perceive continued relevance in theories of choice dependent on supposedly given, known frameworks of preferences and constraints.
It should be pointed out that a good deal of modern theorizing proceeds along a path on which actions based on mistaken knowledge appear not to be errors, in a sense deeper than that so far discussed in this paper. It is not merely that an action is seen as “correct” within the framework of the perceived—but in fact the quite wrongly perceived—ends-means framework. The action is frequently seen as correct also in that the ignorance, on which the mistaken perceptions are to be blamed, may itself be viewed as having been deliberately (and quite correctly) cultivated. Economists have long recognized that men must deliberately choose what information they wish to acquire at given prices. One who on a deliberate gamble refrains from acquiring a certain piece of costly knowledge, and who then, in consequence of his ignorance, makes a “mistake,” may indeed regret his lack of good fortune in having lost as a result of his gamble, but may nonetheless quite possibly still feel that the chances which he originally confronted (when deliberating on whether or not to acquire the costly information) rendered his original decision the correct one. The relevant ends-means framework, within which actions have been pronounced consistently errorless, has now been broadened to embrace the situation within which the choice was made not to buy improved information. If Mises’ “incompetent” physician had taken a calculated risk in deliberately not studying with sufficient care the treatment of a rare disease, his subsequent errors may indeed be seen as “technical errors”; (they may also, as we have seen earlier, be seen simply as the entirely-to-be-expected shortcoming in output quality consequent on the less-than-perfect quality of medical input). But the ignorance responsible for the technical error in medical treatment (or, if one prefers, for the less-than-perfect quality of medical expertise available for deployment) may itself be the consistent result of a correct, deliberate, choice. This way of seeing imperfect knowledge—as the correctly planned limitation on input quality—permits one to subsume errors arising out of imperfect knowledge under the general class of errors treated above in the section “Mises, Marksmen, and Mistakes,” that is, as not constituting errors at all (in the sense of somehow failing to achieve an available preferred state of affairs). This way of looking at things has gained plausibility as a result of the development during the last 15 years by Stigler and others, of the Economics of Information (in which detailed analysis is undertaken of decisions concerning the optimum degree of ignorance to be preserved under different conditions, and of the market consequences of such decisions).
LEIBENSTEIN AND THE LACK OF MOTIVATION
Harvey Leibenstein has written an extensive series of papers developing the concept of X-inefficiency and exploring the extent to which this type of inefficiency has yet to be incorporated into standard economic theory.12 In this paper we consider only those aspects of his work that bear directly on the possibility of error within the scope of economic analysis. In the present section we briefly take note of some of the objections raised recently by Stigler against certain aspects of Leibenstein’s contribution.
For Leibenstein, X-inefficiency (as contrasted with the more conventional allocative inefficiency) is equivalent to what for others is called technical efficiency,13 the failure of producers to achieve, with the inputs they use, the highest technically possible level of output. Among the sources of this kind of inefficiency, in Leibenstein’s view, is inadequacy of motivation and of effort. “The simple fact is that neither individuals nor firms work as hard, nor do they search for information as effectively, as they could.”14 Stigler has severely criticized Leibenstein on his use of language.15 For the purposes of our discussion of the possibility of error in economics, Stigler’s objections can be stated as follows. It is certainly true that greater output could frequently be achieved by greater effort and stronger motivation. But this does not indicate error, in the sense of failing to achieve an available state of affairs more desirable than that actually achieved. If individuals are not sufficiently motivated to work harder, this presumably reflects, deliberately and “correctly,” their preference for leisure. If, again, firms have not succeeded in organizing production so as to enhance worker motivation, this constitutes the firm’s choice of one “technology” of production, as against the possibility of alternative (more productivity-conscious) technologies. Choice of one technology, yielding lower physical output per week than another available technology, does not, without our knowing all the relevant costs, warrant our asserting the presence of error in the choice of technologies. Stigler’s objections are completely convincing. Leibenstein has not, in his exploration of motivational inefficiency, discovered cases of genuine error, in the sense relevant to our discussion. (We will return later in this paper to consider other aspects of Leibenstein’s X-inefficiency as more promising in this respect.)
ECONOMICS WITHOUT ERROR?
Let us stand back and observe the position to which we have been led. This position might appear to coincide completely with that in which no place for error exists in economic analysis—if by error one means deliberately placing oneself in a situation which one prefers less than another equally available situation of which one is aware. We have refused to accept Croce’s terminology (in which economic error can occur when one has been temporarily seduced to aim deliberately at a goal which one in fact prefers less than another “true” goal). We have, with Stigler, refused to accept Leibenstein’s apparent perception of inadequately motivated persons, persons not trying as hard as they really could, as ones who are infact placing themselves in less preferred situations. We have pointed out that errors made by agents whose lack of competence or skill renders such mistakes inevitable, clearly do not involve failure to achieve any attainable preferred position (since the inadequate quality of available inputs places such preferred positions out of reach). And where, as a result of imperfect knowledge, an agent achieves a position less preferred than an equally available alternative position, we have seen that he too cannot, within the framework of the information he believed to be relevant, be convicted of error. Moreover we have seen that insofar as this agent deliberately refrained from acquiring more complete or more accurate knowledge, he cannot even be described as having placed himself in a less preferred situation at all (since in his view the cost of acquiring the more accurate knowledge made ignorance the preferred risk).
It should be observed that our apparent conclusion that error has no place in economics does not depend on any artificial assumption, as does, for example, appear to be implied in Stigler. For Stigler, it appears, error is deliberately (and artificially) excluded by the economist from his purview, on the grounds that we lack a theory of error.16 But for us as Austrians, it should be clear, our conclusions follow strictly from the insight that men are purposeful (or “rational,” as Mises uses the word). If men pursue purposes, it follows that of course they do not consciously act to place themselves in situations that are any but the most preferred of those equally available alternatives of which they are aware. If men turn out to have failed to achieve the most preferred situations it must be either that those situations were in fact not available, or that (possibly as a result of deliberate, purposeful earlier decisions) these agents were not aware of the full range of alternatives. Not only, that is, have we apparently been led to Stigler’s conclusion that there is no place for error in economics, we have been led to this conclusion as implied directly in the very assumption of purposefulness from which we take our point of departure.17
Economics, it thus seems to turn out, is peopled by beings whose purposefulness ensures that they can never, in retrospect, reproach themselves for having acted in error. They may, in retrospect, indeed wish that they had been more skillful, or had commanded more inputs, or had been better informed. But they can never upbraid themselves for having acted erroneously in failing to command those superior skills or to acquire more accurate information. They must, at every stage concede that they had, in the past, acted with flawless precision (insofar as they were able). Any reproaches which they may validly wish to direct at themselves—for example for not having tried hard enough or for having succumbed to temptation—arise out of later judgments of value (concerning the significance of leisure or of the goal represented by the fleeting temptation) with which they had, at earlier dates, disagreed. Such self-reproach, we now understand, is not for having acted in error, in the sense relevant to the present discussion.18
Indeed the reader might reasonably claim cause for irritation at the triviality of our conclusion. Given the paramountcy accorded to purposefulness, and given a definition of error which excludes “wrong” judgments of value as well as failures ascribable to ignorance or inadequacy (whether due to causes beyond the control of the agent or to his past purposeful choices)—surely the conclusion that error is excluded is so obviously implicit in our definitions as to be completely uninteresting.
But, as the remaining pages of this paper will attempt to show, the conclusions to which we have apparently been led by our discussion thus far, are not trivial at all—in fact they are not even true. Not only is there nothing, as we shall see, in the assumptions and definitions on which economic analysis is built, which rules out error—it can be shown that economic analysis can hardly proceed at all without making very important use of the concept of error (as well as of the discovery and correction of error). Let us see how all this can possibly be maintained.
IGNORANCE AND ERROR
Much weight was placed, in earlier pages, on our recognition that mistakes made as a result of ignorance do not qualify as errors (in the sense relevant to our discussion). A man who acted with complete precision, given the knowledge he thought he possessed, could not, we maintained, be reproached with having acted in error. (And where the limits to his stock of knowledge had been deliberately selected, we certainly understood him to have acted, at all times, beyond reproach.) That is, the man at no time refrained from exploiting any known opportunity for achieving the most desirable situation possible. Yet surely we must recognize that, valid though these statements are, within their own framework, they may not fully exhaust our interpretation of the situations to which they refer.
A man walks along a street, sees a store with signs offering to sell apples for $1 but, perhaps thinking of other things, enters a second store where he pays $2 for identical apples. He may have “seen” the signs in the first store, but his perception of them was so weak as to mean that, when he paid $2 in the second store he did not, in fact, “know” that he was rejecting a preferred opportunity for one less preferred. Within the framework of his “knowledge,” the $2 apples were indeed his best opportunity; he made no error. Yet, surely, in an important sense he will (when he realizes his mistake) reproach himself for having been so absentminded as to pass by the bargain which he saw, for the more expensive purchase. In this sense he did commit an error, the error of not acting on the information available to him, of not perceiving fully the opportunity before his very nose. He did (without the excuse of not having the necessary information available to him) consciously place himself in a less preferred position than that available to him. It is true that he was not “aware” of the superior alternative. But, because the necessary information was available to him, it was surely an error on his part to have failed to act upon it (i.e., to have remained unaware of the superior opportunity). His “unawareness” cannot be “excused” (from conviction of error) on the grounds of inadequacy of inputs (since the information inputs were at hand). It cannot be excused on the grounds of an earlier decision to refrain from acquiring information (since no such decision was made). This unawareness cannot be flatly excluded as impossible (because of inconsistency with purposeful action) because there is nothing in purposeful action which by itself guarantees that every available opportunity must be instantaneously perceived.19
In the discussion in the first portion of this paper knowledge was treated as something like an input, a “tool.” Someone lacking this needed input could not be reproached with error for not succeeding in achieving that for which this input was needed. (And where this input had deliberately and correctly not been acquired because of its cost, this exemption from reproach became even more justified.) But we now see that ignorance may mean something other than lack of command over a needed tool—it may be sheer failure to utilize a resource available and ready at hand. Such failure, moreover, is not inconsistent with purposefulness, since an available resource ready at hand may not be noticed; purposefulness is not necessarily inconsistent with tunnel-vision. (Of course one might insist that an agent not blessed with the alertness needed to notice resources available at hand, simply lacks, through no “fault” of his own, another “resource” [i.e., “alertness”] necessary to take advantage of the other resources with which he has been blessed. We cannot set down such a use of terms as wrong. We simply point out that while decisions can in principle be made by a person to acquire a resource which he lacks, we can not conceive of one lacking “alertness,” making a decision to acquire it. This is so because, among other reasons,20 before a decision to acquire anything can be considered, one must already assume the alertness necessary for the perception that such an acquisition is needed and possible at all. Or, to put it somewhat differently, alertness cannot be treated as a resource with respect to which decisions are made on how to use it, since, in order to make such a decision with respect to a resource, one must already have been alert to its availability. “Alertness” thus appears to possess a primordial role in decision making which makes it unhelpful for it to be treated, in the analysis of decisions, “as any other resource.” We claim, therefore, justification for a terminology which maintains that where ignorance consists, not in lack of available information, but in inexplicably failing to see facts staring one in the face, it represents genuine error, and genuine inefficiency.)21
IGNORANCE, ERROR, AND ENTREPRENEURIAL OPPORTUNITIES
We have shown that genuine error is not inconsistent with the fundamental postulates of economics. It remains to show that economic analysis depends on the presence of this kind of error for its most elementary and far-reaching theorems. Let us consider the theorem which Jevons correctly called “a general law of the utmost importance in economics,” which asserts that “in the same open market, at any one moment, there cannot be two prices for the same kind of article.”22 Now Jevons presented this Law of Indifference as valid only where no imperfection of knowledge exists. Yet surely economists ever since Jevons have understood the law as asserting a tendency at all times for divergent prices of identical goods to converge, ceteris paribus, toward a single price. That is, the law asserts a tendency for imperfect knowledge to be replaced by more perfect knowledge.23 Now the existence of such a tendency requires some explanation. If the imperfection of knowledge (responsible for the initial multiplicity of prices) reflected the lack of some “resource” (as where means of communication are absent between different parts of a market), then it is difficult, without additional justification, to see how we can postulate universally a process of spontaneous discovery. If, say, imperfection in knowledge resulted from deliberate unwillingness to incur the costs of search, it is not clear how we can be confident that, in the course of the market process such unwillingness will invariably dissipate, or that the necessary costs of search will invariably fall. (Of course one can construct models in which these costs may be supposed to fall. One type of theorizing concerning the nature of the market process has, following on the line of the economics of information, in effect taken this approach.)
Surely our justification for asserting the existence of a tendency for the prices of identical articles to converge rests on our understanding that the imperfection of knowledge (on which one must rely in order to account for the initial multiplicity of prices) reflected, at least in part, sheer error. We understand, that is, that the initial imperfection in knowledge is to be attributed, not to lack of some needed resource, but to failure to notice opportunities ready at hand. The multiplicity of prices represented opportunities for pure entrepreneurial profit; that such multiplicity existed, means that many market participants (those who sold at the lower prices and those who bought at the higher prices) simply overlooked these opportunities. Since these opportunities were left unexploited, not because of unavailable needed resources, but because they were simply not noticed, we understand that, as time passes, the lure of available pure profits can be counted upon to alert at least some market participants to the existence of these opportunities. The law of indifference follows from our recognition that error exists, that it consists in available opportunities being overlooked, and that the market process is a process of the systematic discovery and correction of true error. The hypothetical state of equilibrium, it emerges, consists not so much in the perfection of knowledge (since costs of acquiring knowledge may well justify an equilibrium state of ignorance) as in the hypothetical absence of error.
All this permits us to concur (in general terms, if not in matters of detail) with that aspect of Leibenstein’s concept of X-inefficiency which he identifies with the scope for entrepreneurship.24 Scope for entrepreneurship, we have discovered, is present whenever error occurs. Pure profit opportunities exist whenever error occurs. Whenever error occurs in the context of production, inputs are being used to achieve less than the optimum quantity and quality of outputs; the producer is operating inside the “outer-bound production possibility surface consistent with [his] resources.”25 X-inefficiency is possible, it reflects error, and is necessarily reflected in the availability of entrepreneurial profit opportunities and scope for entrepreneurial discovery and improvement. That our conclusion with respect to this aspect of Leibenstein’s contribution apparently differs from that of Stigler (who rejects the notion of X-inefficiency entirely) is fully consistent with our refusal to accompany Stigler in his insistence on excluding error from economics.
MARSHALL, ROBBINS, AND THE REPRESENTATIVE FIRM
In the course of his critique of Leibenstein, Stigler has valuably recalled our attention to an old issue in the economic literature, the rationale underlying Marshall’s concept of the representative firm. It was Lionel (now Lord) Robbins who in 192826 explained Marshall’s motive in introducing the rather trouble-some notion of the representative firm, and who showed, with the most effective logic, that there is in fact no need for this awkward construct at all. Our discussion thus far enables us to make several comments on the issue.
Basing his interpretation on the authoritative opinion of Dennis Robertson, Robbins explains that Marshall devised the representative firm “to meet the difficulties occurring in the analysis of supply when there is a disparity of efficiency as between different producers.”27 This disparity means that part of the total supply of each product (the magnitude of which helps determine price) is produced by producers making zero or negative profits. Consequently it would appear that “the magnitude of net profits is irrelevant to the determination of ... price.” For this reason Marshall explained that price is to be understood in terms of the normal costs (including gross earnings of management) associated with the representative firm.28
Robbins went to great pains to show that, insofar as concerns these disparities of efficiency between firms that would not disappear in equilibrium, there is no need at all to invoke, the notion of a representative firm. Such disparities in efficiency are to be traced to the presence of entrepreneurs of varying ability. “Just as units of a given supply may be produced on lands of varying efficiency, so their production may be supervised by business men of varying ability. What is normal profit for one will not be normal profit for another, that is all.”29 As Stigler put it, it is inappropriate to use variations in entrepreneurial ability to account for variations in costs among firms: “... differences in the quality of an input do not lead to differences in outputs from given inputs ... [When] costs of firms differed because of quality of entrepreneurs (or other inputs), the differences in productivity would be reflected in differences in profits (or other input prices).”30
In other words, differences in costs of production arising from differences in entrepreneurial ability mean that the equilibrium prices for the various entrepreneurial inputs will be correspondingly different. When account is taken of the costs of these entrepreneurial inputs it will be seen that, in equilibrium, there exist no cost variations between entrepreneurs. Stigler appears to conclude that Robbins’s discussion justifies the neoclassical practice of viewing each producer as always at a production frontier. If as a result of varying quality of entrepreneurial inputs, there occurs output variation, this is simply because, as a result of the variance in entrepreneurial quality, each producer may have a production frontier above or below that of others.31 There is no room, in this scheme of things, for Leibenstein’s X-inefficiency (which implies the possibility that differences in output are a result of genuine differences in sheer efficiency, not attributable to differences in input quality).
For our purposes it is useful to point out that the portion of Robbins’s critique of Marshall upon which Stigler draws, is confined explicitly to the state of equilibrium.32 Under conditions of equilibrium we must indeed reject the possibility of genuine disparities in efficiency among firms that cannot be traced to differences in input qualities. In equilibrium such disparities cannot be traced to sheer error. But under conditions of disequilibrium, when scope exists for entrepreneurial activity, there is no reason why genuine disparities may not exist among different producers, traceable (not to differences in input qualities—since we do not view alertness as an input—but) to differences in the degree to which producers have succumbed to error. Robbins’s critique of Marshall does not, therefore, imply any need to reject Leibenstein’s X-inefficiency (insofar, as we have seen, such inefficiency coincides with the existence of a scope for entrepreneurship).
ERROR IN ECONOMICS: SOME NORMATIVE APPLICATIONS
Our concern in this paper to defend the possibility of genuine error in economics is based on more than our wish to show how positive economic theory cannot proceed without such possibility. Our concern rests, in addition, upon important normative grounds. Allocative inefficiency in a society of errorless individual maximizers must, it appears on reflection, be accounted for only by the existence of prohibitive transaction costs.33 Improvement in social well-being must, in such a world, appear to be possible only as a result of unexplained technological break-throughs.
Surely such a picture of the world, a picture in which no genuine opportunities for improvement are permitted to exist, is wholly unsatisfying. Surely we are convinced that enormous scope exists at all times for genuine economic improvement and that the world is chock-full of inefficiencies. It is most embarrassing to have to grapple with the grossly inefficient world we know, with economic tools which assume away the essence of the problem with which we wish to deal.
On the other hand, as soon as we admit genuine error into our purview, our embarrassment fades away. Our world is a grossly inefficient world. What is inefficient about the world is surely that, at each instant, enormous scope for improvements exists, is in one way or another ready at hand, and is yet simply not noticed. At each instant, because the market is in a state of disequilibrium, genuine allocative inefficiencies remain yet to be removed simply because entrepreneurs have not yet noticed the profit opportunities represented by these inefficiencies. At each instant available technological improvements (in some sense already ready at hand) remain to be exploited; they remain untapped because entrepreneurs have not yet noticed the profit opportunities embedded in these possibilities. It is genuine error to which we can ascribe much of the world’s ills, and we need an economics that can recognize this.
Fortunately, Austrian economics, with its emphasis on disequilibrium and on the entrepreneurial role, is richly suited to fill our need in this respect. Only an economics which recognizes how the profit motive (by which we mean the lure of pure entrepreneurial profits) can harness entrepreneurial activity toward the systematic elimination of error can be of service in pointing the way to those institutional structures necessary for the steady improvement of the lot of mankind.
F. A. Hayek, “Economics and Knowledge,” Economica, N.S. Vol. IV, No. 13 (February 1937).
G. J. Stigler, “The Xistence of X-Efficiency,” American Economic Review, March 1976, p. 216.
L. Mises, Theory and History (New Haven: Yale University Press, 1957), p. 268.
See Stigler, op. cit. p. 215.
B. Croce, “On the Economic Principle,” translated in International Economic Papers, No. 3, p. 177.
I. M. Kirzner, The Economic Point of View (Princeton: Van Nostrand, 1960), pp. 169–72.
G. Tagliacozzo, “Croce and the Nature of Economic Science,” Quarterly Journal of Economics, Vol. LIX, No. 3 (May 1945).
L. Mises, Human Action (New Haven: Yale University Press, 1949), p. 95.
Ibid. pp. 102f.
F. H. Knight, Risk, Uncertainty and Profit, (1921), pp. 225–26.
H. Leibenstein, “Allocative Efficiency vs. ‘X-Efficiency’,” American Economic Review, Vol. 56 (June 1966);” Entrepreneurship and Development,” American Economic Review, Vol. 58 (May 1968); “Competition and X-Efficiency: Reply,” Journal of Political Economy, Vol. 81, No. 3 (May/June 1973); “Aspects of the X-Efficiency Theory of the Firm,” Bell Journal of Economics, Vol. 6 (Autumn 1975).
H. Leibenstein, “Competition and X-Efficiency: Reply,” p. 766.
H. Leibenstein, “Allocative Efficiency vs. ‘X-Efficiency’,” p. 407.
G. J. Stigler, op. cit.
Ibid. p. 216.
Put differently, our perception of the impossibility of error does not depend on any “arbitrary” assumption of utility- or profit-maximizing behavior. Error is impossible because it is inconsistent with the postulate of purposeful action.
The possibility for social “inefficiency” of any kind, in such an errorless world, would, it must appear, then rest either on the possibility that high transaction costs make the “correction” in fact uneconomic, or, on the highly dubious notion of an omniscient observer from whose perspective the errorless (but imperfectly omniscient) members of society are overlooking valuable opportunities for improving their positions. On all this see further, I. M. Kirzner, Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973), Ch. 6. See also the final section of the present paper.
Although, as argued by the writer elsewhere, the extent to which available opportunities are perceived is not at all unrelated to the concept of purposeful action.
The other reasons include the circumstance that, were one to discover someone whose superior alertness to profitable opportunities one wishes to hire, we would expect that other (“alert one”) to have already taken advantage of those opportunities (or at least that he will anyway do so very shortly) on his own account.
For further discussion of some of the issues raised in this and the following sections, see the writer’s Competition and Entrepreneurship, Chapters 2, 3.
W. S. Jevons, The Theory of Political Economy, 4th Edition, 1911 (Pelican Books, 1970), p. 137.
On all this see Hayek’s pioneering contribution in his 1937 paper (see footnote 1). See also the writer’s unpublished paper, “Hayek, Knowledge, and Market Processes.”
H. Leibenstein, “Entrepreneurship and Development”; and Kirzner, Competition and Entrepreneurship, p. 46n.
H. Leibenstein, “Allocative Efficiency vs. ‘X-Efficiency’,” p. 413.
L. Robbins, “The Representative Firm,” Economic Journal, Volume 38 (September 1928).
Robbins, op. cit. p. 391.
See A. Marshall, Principles of Economics (8th Edition, 1920), pp. 342f.
Robbins, p. 393.
Stigler, “The Xistence of X-Efficiency”, pp. 214f.
Stigler, p. 215.
Robbins, pp. 392–396.
See e.g. G. Calbresi, “Transaction Costs, Resource Allocation and Liability Rules: A Comment,” Journal of Law and Economics, Vol. 11 (April 1968), p. 68.