Liberty Matters

Kirzner’s Theory of the Market Process


I am very pleased to join this discussion of Israel’s Kirzner’s work. I was his colleague at New York University from 1976 (initially as a postdoctoral fellow) until his retirement in 2000. I have had many, many discussions with him about economics and, most revealingly, seen his interactions with his Austrian critic, Ludwig Lachmann. Out of all this, I have enormous respect but important disagreement with certain aspects of his market theory. Beginning with The Economics of Time and Ignorance and extending into several articles, I have elaborated my criticisms and alternative views.
Professor Kirzner addressed the right questions – many of which had been ignored or paid lip service to by mainstream neoclassical theory. He mapped out a promising approach, but he never did show, as a matter of pure theory, that the alert entrepreneur could be relied upon to move the economic system toward an “equilibrium.”
Remember that Kirzner’s attempt (at least for a long time) was to derive a market equilibration tendency from the category of purposiveness – defined broadly so as to include the alertness and creativity of entrepreneurial action.  While the purposiveness of human conduct is an extraordinarily important idea and is necessary for a satisfactory theory of the market process, it is not sufficient. As F.A. Hayek showed, this requires empirical propositions about learning and the transmission of knowledge. Where are these in Professor Kirzner’s work? We know that he resisted the introduction of psychology into economics both with regard to tastes but also with regard to learning. While the former resistance could be justified in a static subjectivist theory of choice, a theory of processes must rely on some substantive ideas about learning. Actual processes are empirical.
Pure theory, in the sense meant by Kirzner, sets up a framework for analyzing market processes but does not fully provide the tools for doing so. We can make statements about arbitrageurs seeking to exploit price inconsistencies for profit (true enough), but demonstrating the social consequences of this behavior is something else. Simplified examples of buying low and selling high are woefully insufficient. We need to take the empirical element seriously.
The framework that Kirzner gives us for analyzing the market correctly moves us away from concentration on equilibrium states. He also rejects the idea that the market is “inefficient” insofar as it deviates from optimal equilibrium outcomes. Kirzner says correctly that the test of market efficiency is the speed, degree, and extent to which errors are corrected. The agents that correct market errors are not mechanical pre-programmed agents. They are capable of reconceiving a problem situation in creative and unpredictable ways. Thus interpretation is a vital component of entrepreneurial behavior.
This is a framework for a theory and not a theory itself. A framework (perhaps a “research program”) is very important; it can provide direction for further research to prove its mettle.
Ludwig Lachmann criticized Kirzner’s approach in a number of respects. First, purposiveness in the broad sense does imply alertness and learning. But this does not mean that people learn what is appropriate to move the system toward “equilibrium.” Second, entrepreneurs seek to make profits by exploiting price inconsistencies. However, this is not the same thing as moving the system toward equilibrium with respect to the underlying data. Consider that an entrepreneur can make money by exploiting the incorrect beliefs of others that a certain resource is undervalued. He will sell the resource to the party who overvalues it – thus making money but not correcting the error. Economists know that there can be bubbles and herd behavior. These are empirical issues.
All of this should not be confused with a different issue – whether the price system is better than comprehensive socialist planning. The either/or comparison is relatively easy. It does not require showing in any detail how markets equilibrate or not under specified circumstances. Here we can be satisfied with some broad generalizations about market processes. But when the subject turns to the role of equilibrium analysis in market economies we must dig deeper.
The rise of behavioral economics has introduced economists to a wide variety of psychological ideas. Unfortunately, the dominant behavioral approach seems to seek out only those areas in which the learning process fails in some important way. But some economists have introduced ideas about attention (=alertness?) and framing of choice situations. These could be very helpful empirical ideas in a theory of the market process.
Austrians of an aprioristic bent often will say that all of the complications I have raised belong to applied economics and not to theory. I do not wish to enter into a fruitless discussion of where theory ends and applications begin. To derive from the category purposiveness a “tendency” toward equilibrium is problematic. (Clearly, it means little to argue that the tendency claim requires us to remove from consideration any disturbing forces that would falsify the statement.) What we can “derive” is the idea people will be alert in a myriad of ways to opportunities to profit. However, seizing these opportunities does not always lead to equilibrating moves. It may lead to disequilibrating moves.
The fundamental question that Kirzner’s valuable contributions should lead us to is an inquiry into what kinds of social order increase the accuracy of knowledge possessed by agents and improve the mechanisms by which this knowledge is transmitted. I have argued for concepts of institutional efficiency and pattern coordination as the foci of a useful approach to market process theory. In his later years, Hayek himself thought that the concentration on arguments about tendency toward traditional equilibria should be superseded. The economic system is more like a stream of water which overflows it confines here and there and yet exhibits some recognizable pattern.
In sum, Kirzner made extremely valuable framework contributions toward building a theory of market processes. It is for the rest of us to come up with a theory of the market process.