Liberty Matters

On Frameworks, Theories, and Models: Reply to Peter Boettke

This is a very interesting and useful discussion not only of Israel Kirzner’s ideas on entrepreneurship and market process, but also of Austrian economics more generally. The latter is really more important than the former because we Austrians are more and more pursuing new insights and paths in the development of modern Austrian economics. As I said in the late 1990s, I do not expect economics as an entire discipline or Austrian economics in particular to look the same in the next few decades as it did in the mid-20th century. Already we see a big difference between the Austrian work prior to the mid-80s and today. Much of this is thanks to Peter Boettke’s efforts and to those of his students. But we also see the enormous revolution that is taking place in our discipline due to the development of behavioral economics. A major, but as of yet incomplete, transformation in the economic conception of rationality is underway. This is highly relevant to Austrian economics and to any theory of the market process based on Hayek’s insight that the crux of the matter is learning and the social transmission of information.
I do not want this discussion to come down to a quibble over the words “framework,” “theory,” and “model.” But if I imagine myself saying to a non-Austrian economist that Kirzner has a theory of the market process, I will find myself misunderstood. He or she will expect me to say a lot more than what Kirzner has developed in his work. He or she will deny that Kirzner’s has such a theory. Why?
Let’s examine just what Kirzner has argued. First, the market process is driven by entrepreneurship. Second, entrepreneurship is best conceived of as arbitrage (“costless”buying low and selling high). Third, before arbitrage can take place, the entrepreneur must be “alert to” or “notice” price inconsistencies (also called “errors”). Fourth, this activity “tends” to correct these errors in the direction of the fundamental underlying variables.
After the demise of the efficient markets hypothesis in its strong form, very few economists will deny that there is arbitrage. Whether all entrepreneurial activity is best characterized as arbitrage is another question. For example, Kirzner’s scenarios cleverly interpret the adoption of a new technological innovation as arbitrage – resources were being used in an inferior way until the entrepreneur noticed that if they were combined in a different way (the innovation) they could yield greater value. But note that this scenario and as well as his others are essentially static pictures of the world. All the knowledge is there somewhere, but it is just not combined properly. In any event, how does the entrepreneur notice these things? Well, he just does. How he sees through the cloud of uncertainty is remarkably not part of economics. It is psychology. Kirzner’s begins with the fact of entrepreneurial alertness and draws out implications. But if we do not understand the how, then what can we really say about the tendency to notice errors and to move toward equilibrium?
I think Kirzner confuses the noticing of prices inconsistencies with a movement toward an equilibrium relative to underlying data. This is fundamental. This is also where psychology of one sort or another must come into the picture. Behavioral economists as well as standard economists have been discussing bubbles and herding behavior. There have been claims that agents may suffer from all sorts of systematic biases. If, for example, most agents expect that a certain asset will appreciate in value (but they are wrong), the agent who knows that they are wrong can go broke by selling or shorting the asset as long as the over-optimism prevails. Furthermore, those who are less optimistic will sell to those who are more optimistic. They will have bought low and sold high. But they worsen the situation relative to the putative underlying data. Where is the tendency toward equilibrium?
This brings us directly to the word “tendency.” I have discussed the various meanings of “tendency” in Hayek’s work in my “Hayek’s Four Tendencies Toward Equilibrium” (in the bibliography). There I discussed John Stuart Mill’s distinction between “tendency” and “disturbing causes.” In effect he said that we call a “tendency” a force that we believe is dominant and a “disturbing cause” a force that we think is weaker or less conspicuous. I think this is at root an empirical matter. If we believe that there is a tendency toward equilibrium and that everything else is to be classified as “disturbances,” we are really saying that the first force is empirically dominant. How can we say this without some concrete ideas about learning: not only learning about price inconsistencies (perhaps the simpler part) but also learning about the knowledge of other agents in the market?  What they believe will affect the entrepreneur’s behavior and thus can affect whether all that noticing produces a move toward equilibrium or not.
Kirzner indeed set up a framework that, in conjunction with Hayek’s, focuses on the issue of alertness in markets. Good. But Kirzner’s avoidance of the how of social learning leads him into substantive claims he cannot legitimately make. There is no escaping the empirical element in any theory of the market process. Without an elaboration of that empirical element we do not have a “theory” as most economists use the word. We have a framework but, I fear, a framework that does not easily direct us to the key issues. In summary, we cannot leap from the willingness or desire of agents to learn – purposefulness – to a tendency toward equilibrium.