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Competition and Entrepreneurship: The Fountainhead of the Contemporary Austrian School

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Competition and Entrepreneurship: The Fountainhead of the Contemporary Austrian School

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  • A Liberty Classic Book Review of Competition and Entrepreneurship by Israel Kirzner.

The start of the 1970s was not the best time for the Austrian school of economics. Ludwig von Mises was past his productive years and would pass away in 1973. F. A. Hayek was still active but had turned much of his attention to his work in political theory, and his Nobel Prize was still a few years away. Murray Rothbard had also turned his attention away from economics and toward libertarian theory and activism. Ludwig Lachmann was still very much an engaged scholar, but he was isolated in South Africa and not yet playing the central role he would take on by the decade’s end. There were only a few graduate students interested in pursuing the school’s ideas. The only real voice for the school in the American economics profession was Mises’s former Ph.D. student Israel Kirzner who continued to contribute after publishing three books during the 1960s: The Economic Point of View, Market Theory and the Price System, and An Essay on Capital. Although those books remain important contributions to the Austrian school, their influence when published was negligible.

In particular, the Austrians faced two problems. First, the school had stagnated intellectually. In 1949 Mises published Human Action, and Hayek’s major essays of the 1930s and 1940s were published together in 1948 as Individualism and Economic Order. Those two books laid out a clear and distinct new direction for the Austrian school, but few people picked it up and continued to advance it in a meaningful way in the 25 years that followed. Second, the Austrians failed to engage with the broader discipline of economics. There were economists who were “fellow travelers” and who were influenced by the Mises and Hayek books of the late 1940s, but there was no contribution that laid out a distinct Austrian view of the market and did so in a way that engaged with the then-contemporary mainstream literature.

“One way of seeing the contribution of Competition and Entrepreneurship, and Kirzner’s work on entrepreneurship more generally, is that he provided a Misesian solution to a Hayekian problem…”

That all changed in 1973 when Kirzner published his Competition and Entrepreneurship. Kirzner’s book managed to fill the two needs Austrian economics had at the time. It advanced the school’s ideas in a meaningful and productive way, and it did so by engaging with the mainstream literature in economics in a style that made the book accessible to non-Austrians. One way of seeing the contribution of Competition and Entrepreneurship, and Kirzner’s work on entrepreneurship more generally, is that he provided a Misesian solution to a Hayekian problem, both of which come out of the late 1940s books mentioned above. The Hayekian problem was how to explain the process of social learning that led to the coordination that characterized equilibrium. What ensured that the tendency toward equilibrium would be effective? The answer Kirzner offered was to take from Mises the idea of the entrepreneurial element of human action- the idea that we are not just maximizers but active agents who do not take our means-ends frameworks as given, and to make entrepreneurship the prime mover of the market process. Kirzner argued that the process of plan coordination is set in motion by entrepreneurial alertness to hitherto unseen opportunities, the exploiting of which constitutes the competitive market process.

The book also provided a fertile foundation for the revival of the Austrian school that would begin during the rest of the 1970s. It is not wrong to say that a great deal of the scholarship that characterized the Austrian economics of the 25 years after Competition and Entrepreneurship owed much to the arguments Kirzner made there.

Kirzner makes clear the core of the book’s argument in the very first paragraph. He notes that he will offer a “theory of the market and the price system that differs in significant respects from the orthodox theory of price” (1). More specifically, he will explain his “dissatisfaction with the usual emphasis on equilibrium analysis, and… attempt to replace this emphasis by a fuller understanding of the operation of the market as a process” (1, emphasis in original). This distinction between viewing the market as a process and focusing on equilibrium states was not original to Kirzner, as it appears in various forms in both Mises and Hayek, especially in Hayek’s 1940s papers on competition and socialism. However, none of those were a systematic exploration of that distinction and why it mattered, nor did either Mises or Hayek contend in depth with the mainstream literature of their day. In the time between the late 1940s and the early 1970s, a clear body of equilibrium-oriented thought had come to define modern microeconomics, including work by many scholars friendly to the Austrians. The task Kirzner set for himself was to engage that literature and to demonstrate that the Austrian contribution was something different and more radical than the neoclassical consensus of the day.

In Competition and Entrepreneurship, he characterizes that difference as a question of what a theory of the market should attempt to explain. Where mainstream microeconomics is concerned with identifying the combinations of prices and quantities that will produce equilibrium outcomes, the Austrian approach focuses on the interaction of the decisions of market participants and how they “generate the market forces that compel changes in prices, in outputs, and in methods of production and the allocation of resources” (5, emphasis in original). A market process approach is interested in these changes themselves and not the way in which all of these variables might be related to each other in a hypothetical equilibrium.

Further, Kirzner points out that there is a normative element to this difference. For equilibrium-oriented approaches, the desirability of the market as a set of institutions is seen in terms of its ability to produce optimal allocations of resources in equilibrium. Markets are good if and when they generate equilibria because those equilibria have certain optimality properties. From the Austrian perspective, this is misguided. First, markets do not actually ever reach the equilibria described by standard price theory, so why are they useful in making judgments about the desirability of real-world institutions? Second, and more important, because we live in a world of change, an Austrian theory of the market process should judge the desirability of market institutions not by the optimality properties of equilibria but by how well “market forces can be relied upon to generate spontaneous corrections in the allocation patterns prevailing at times of disequilibrium” (5). There is a lot going on in that statement. The keys, however, are its emphasis on “corrections” and “disequilibrium.”

For Kirzner, understanding the market process means understanding the ways in which market institutions enable actors to be aware of their (inevitable) mistakes and provide guidance as to how to correct those errors. Of course, as that correction process takes place, new errors will appear, and those will also require correction. The market, for Kirzner and the Austrians, is an unceasing process of social learning, as people exercise entrepreneurial alertness to discover and attempt to correct the inevitable errors that characterize fallible humans and produce worlds of constant disequilibrium. That is, markets are processes of social learning. Our normative judgment of their social value needs to consider their ability to enable that learning as compared to the learning enabled by alternative sets of institutions. It is the very errors that are banished in a world of equilibrium that are the reason for a variety of real-world market institutions. Equilibrium theory cannot help us understand the importance of those institutions.

Kirzner also expanded upon a point made by Hayek years earlier with respect to the role of knowledge in mainstream models of competition. The model of perfect competition, which still dominates the textbooks today, assumes that everyone has perfect relevant knowledge. The model also assumes that all the participants take the price of their product as given, that is, as dictated by the market as a whole. No one actor can change the price. Furthermore, all the products being sold in each market are identical, as with perfect knowledge the desired characteristics of each good have already been figured out. In his 1937 “Economics and Knowledge,” Hayek defined equilibrium as that situation in which the plans of all actors perfectly dovetail. Each of us has accurate expectations not only about the material world but also about the plans of other actors. In equilibrium, there is no scope for learning because everything is already known.

In a world of disequilibrium and imperfect knowledge, however, there are opportunities to learn and to improve the coordination of plans. The key feature of Kirzner’s entrepreneur is that he is alert to just these sorts of opportunities. The person walking down the street who sees that apples cost $4/pound at one store and then notices them for $2/pound a block away has noticed a situation of discoordinated plans. The buyers at $4 don’t know they can spend less a block away and the sellers at $2 don’t know that they might increase revenue by selling closer to $4. That moment of recognition is, for Kirzner, the essence of entrepreneurship. Seeing what others have enables the entrepreneur not only to profit by arbitraging the difference, but, in so doing, to bring the plans of apple buyers and sellers into greater coordination. Similarly, the person who realizes that a pile of wood, a box of nails, and a hammer can be transformed into ladders that people will value more highly than the sum of the inputs is also engaged in an act of entrepreneurial alertness that brings plans into greater coordination. Production is a kind of arbitrage through time rather than just across space. In the world of perfectly competitive equilibrium, there is no scope for entrepreneurial alertness, as everything that is needed to be known is already known. There is no scope for genuine discovery of what we did not know we did not know. Rather than the textbook world of producers who mechanically maximize profits on the basis of known revenue and cost curves, we are in the world where the challenge is for the entrepreneur to discover “what revenue functions and what cost functions…[he] believe[s] to be relevant for him in general” (38).

In this way, entrepreneurship is central to the error-correcting process of the competitive market. Hayek observed in the aforementioned 1937 essay that really understanding the market process involves explaining how markets facilitate some sort of process of social learning that brings the plans of producers and consumers into greater coordination. If equilibrium is understood in terms of complete knowledge, then any tendency that markets have to move toward equilibrium must be explained in terms of people acquiring knowledge that allows them to correct their mistakes. Hayek offers no explicit answer to how that might happen, but Kirzner’s theory of entrepreneurship fills that gap. If the tendency toward equilibrium (which Hayek also describes as the empirical proposition that prices correspond to costs) is a core piece of what makes economics anything close to scientific, then an explanation for how that happens is crucial. When the Kirznerian entrepreneur notices that differential in apple prices and acts on it he corrects errors on both sides of the market and, what amounts to the same thing, sets in motion the tendency toward market-clearing. That moment of discovery, of realizing that what you thought was the relevant means-ends framework for action is no longer the case, is the moment of entrepreneurial insight that generates the process of social learning that leads to plan coordination. As Kirzner (57) puts it: “[I]t is necessary to build formally into our theory the insight that such a learning process can be relied upon. For this, the recognition of the entrepreneurial element in individual action is completely adequate.”

Kirzner’s use of the phrase “entrepreneurial element” is important too. This is where his “Misesian solution” to the Hayekian problem of learning comes in. For Mises, the alertness that characterizes entrepreneurship is a feature of all human action in a world of uncertainty. Human actors are always speculating about the future when we act in any capacity and are alert to opportunities to substitute a better state of affairs for the status quo. As Mises (1966: 290) puts it in Human Action, “Like every acting man, the entrepreneur is always a speculator. He deals with the uncertain conditions of the future.” Recognizing that the entrepreneurial element in all human action could be deployed to explain how entrepreneurs in the market make possible the social learning process of market discovery is Kirzner’s Misesian solution to the Hayekian problem.

This entrepreneurial process, Kirzner notes, is also inherently competitive. Being alert to previously unseen opportunities is an act of competition in that it aims to create more value than the status quo. Seeing that the wood, nails, and hammer can make a ladder is an attempt to out-do those who are making inferior ladders or close substitutes, or who are using those inputs for alternative uses. Unlike the then-dominant conception of competition, which required price-taking and a large number of small firms producing a homogeneous product, Kirzner’s theory of entrepreneurship focused on the question of freedom of entry and exit. As long as people are free to exercise their entrepreneurial alertness, markets are competitive, regardless of the number or size of firms. And, in this view, product differentiation is seen not as a monopolistic element, but as the very essence of competition. Alert entrepreneurs are continually adjusting their products in attempts to out-do their competition by discovering new ways of creating value and coordinating plans in the face of imperfect knowledge of their costs and consumer demand.

Starting from a world of disequilibrium and viewing entrepreneurship as, to use the title of another Kirzner book, “the driving force of the market,” provides Kirzner and the contemporary Austrian school a unique perspective on questions of competition and monopoly than that of mainstream economics. The approach to these fundamental microeconomic questions that Kirzner provided in Competition and Entrepreneurship became the starting point for what is now almost 50 years of progressive research by the Austrian school. The careful, patient, scholarly engagement with the mainstream that is reflected in Kirzner’s book, and in so much of the rest of his professional work, served not only as a fountainhead of ideas, but a model for young Austrian economists to emulate. No single factor is solely responsible for the revival of Austrian economics, but Competition and Entrepreneurship probably tops the list of books that helped put the Austrian school back in the scholarly conversation in economics.

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