Liberty Matters

Can a Theory of the Market Process Deal with Outliers? Or, Why We Should Understand Equilibrium Tendencies as a Constantly High Degree of Social Coordination


The question of equilibration, which has invaded many discussions of market-process theory in the last 40 years, is still alive and well. But we shouldn’t lose sight of the fundamental issue at stake: the existence of social order. Why, in the absence of a system of central command, is there social order rather than social chaos in a free-market economy? Others have asked the same question in a different way: how does Paris get fed? It boils down to explaining the complex chains of causes and effects. Thanks to Hayek’s insistence (and others, such as Hans Mayer), we know that equilibrium analysis only provides an instrumental-causal explanation (what prices and quantities secure equilibrium?). Instead, we are looking for a genetic-causal explanation (how prices, quantities, and diversity of goods come to exist?).[34] I assume we all agree on this.
Mario contends that entrepreneurs seizing gains from trade locally doesn’t imply that the entire economy is moving towards some equilibrium. The reason is because this activity may actually be pushing the entire social order away from a state of coordination rather than closer. That may be true, but I don’t think this phenomenon invalidates a pure Logic of Choice theory of the market process.
One may use John Stuart Mill’s distinction that Mario introduced into the discussion. Question: assuming they are not induced by faulty government policies, are the phenomena (housing bubbles, herd behavior, etc.) under discussion mere disturbances or tendencies? One reasonable case can be made that they qualify as disturbances, not tendencies. Indeed, in the free market, clusters of errors of that nature do not last for all time. They can be damaging to many agents in the economy for some time, but the mechanism of profit and loss eventually reasserts itself in the right direction.
Take the stock market as an example. Value investors such as Graham, Buffett, and Munger know well that one may lose more than 50 percent of one’s investment before making money. I remember Munger explaining, many years ago, that anyone who is not able to withstand (psychologically) such potential losses should not be in the business of investing. A consequence is that holding an asset for less than five years makes it impossible to assess correctly its quality -- a major rule of value investing à la Graham. In many cases the “optimal” holding period is forever. Any particular stock may see its value vary widely over long periods, but eventually the quality of the investment will drive the stock price. Value investors know this, and they consistently find gains from trade over time: Buffett, Munger and many others have done it.
Hence one element has been missing from our conversation. As Gerald O’Driscoll and Mario explained well, we must think of the market process as taking place in real time.[35] Once one incorporates time into the analysis, Mario’s distinction between local and broader equilibrium becomes spurious. Indeed, the concrete pattern of events taking place (in real time) may include outliers and other errors that reinforce themselves for a long while, but not forever. Value investors eventually are vindicated (if indeed it was a faulty bubble), as other investors realize their past erroneous assessments. My point is that there is no standard of time to judge the extent to which learning has taken place. Over the long run (whatever that may mean), local disturbances, such as price bubbles, fade into history. This pattern is seen over and over again in the stock market (and in other markets). What always remains are tendencies for potential gains from trade and innovation to be seized, for prices to gravitate closer to marginal and average costs, etc.
If there is some discussion to have about equilibration, it is not with regard to a situation in which all possible gains from trade and innovation would be exhausted and perfect coordination would be effected. (This situation serves as a foil in some, but not in all, cases.) The discussion to have is with regard to the existence of social order, defined as the constant (or continuous) emergence of a high degree of social (or plan) coordination (or a high degree of exhaustion of potential gains from trade and innovation). I think this is exactly what Kirzner talks about (and also Gerald, Mario, Pete, and many others). The market process does not generate perfect coordination, but constantly produces a dynamic movement, which maintains a high -- but not perfect -- degree of social coordination.
This process is possible because the market consists in the simultaneous elimination of innumerable local price discrepancies over time. Some entrepreneurial errors -- which Mario mentions -- may be exacerbated and will only disappear over time, but other opportunities may be seized rapidly and will bring prices down to the level of costs within a shorter time.[36] I don’t see how -- short of faulty government policies -- the existence of disturbances (however strong they may be) that create discoordination over some period of time can invalidate the fundamental insight Kirzner unearthed (but which had been the insight of mainline economics since the classical period and before), i.e., the tendency for induced variables to gravitate towards the values of underlying variables, over time, thereby creating a constantly high degree of social coordination.
[34.] See Cowan and Rizzo’s (1996) excellent article on the topic.
[35.] Gerald P. O’Driscoll Jr. and Mario Rizzo, The Economics of Time and Ignorance, 2d ed, (London: Routledge 1996).
[36.] And this is without mentioning other issues such as the difficulty of replicating certain specific assets, which makes it harder for others to pursue some opportunities for profit, etc.