Market Process

The Theory of Market Process

As an alternative to equilibrium, Austrians offer the model of market process. Individuals, within the institutions of a market economy, trade and otherwise cooperate to achieve their own chosen goals. Through trading, individuals learn new information, causing them to revise their plans. The market process is this "series of systematic changes in the interconnected network of market decisions" (Kirzner, p. 10).

The theory of the market process makes assumptions that, in the Austrian view, delineate the situations in which the theory is valid. The underlying assumption of all Austrian theories is that humans choose. Market theory also assumes the existence of markets, that is, an institutional framework of private property and contracts where force and fraud are absent. Market theory assumes that knowledge is imperfect. Specific areas of market theory may use other assumptions, such as the existence of money or of production.

The assumption of human choice allows for many economic concepts to be defined. For example, choice always involves alternatives; one alternative is defined as having greater value than another if the individual would choose that alternative over the other. Value is thus always relative, never objective. An end is the result sought by an action; a means is anything used to achieve an end; a good is anything desired by an individual. Many other useful definitions and laws can be derived solely from the assumption of choice.

Market process theory assumes that there is no force and fraud. Force includes force by individuals in the form of theft and so forth, and force by the government in the form of taxation, regulation, and so forth. Austrians recognize that force by both individuals and governments exists, and that market theory does not completely explain reality. Instead, market theory allow economists to understand the processes at work in a market society and to isolate the effects of force. Attempts to analyze real-world markets must account for government and individual force. Austrian analysis of government policies thus includes not only the direct effects of the policies, but also the effect of the policy on the functioning of the market process.

Austrian market theory assumes imperfect knowledge. Individual market participants have limited knowledge of resources, products, technology, prices and other participants' actions. A related assumption is that individuals can learn, that they are alert to the possibility of new information.

Specific aspects of market theory may require other assumptions. Theories dealing with production, for instance, assume that resources can be combined into products. The assumption of production allows other definitions to be used, for example, those of consumer, producer and resource owner. As another example, many theories deal with prices and so assume the use of money.

The objective of market process theory must be to help economists understand market processes that actually exist. Market theory must explain how widely diffuse knowledge is coordinated and put to use, how market participation helps individuals achieve their own goals, how prices are determined, and how resources are allocated.

The problem that cooperation (including markets) is intended to solve is how to best achieve goals. The knowledge necessary for the solution of this problem includes scientific knowledge of production processes and so forth, but also includes local knowledge, "knowledge of the particular circumstances of time and place" (Hayek, p. 80). This knowledge is not concentrated in one mind, and truly cannot be, because such local knowledge changes faster than any one human mind can gather it. Instead, this knowledge is spread out among many individuals. Part of the problem is how to communicate the necessary knowledge to different people, and how to encourage those that have the knowledge to use it.

Prices convey information about resources to market participants. Buyers and sellers each have knowledge of affairs within their limited horizons, but to make the best use of their resources they must also have information from other areas. Prices convey the minimum information they need: how scarce each resource is relative to other resources, and changes in this relative scarcity. "Prices can act to co-ordinate the separate actions of different people in the same way as subjective values help the individual to co-ordinate the parts of his own plan" (Hayek, p. 85).

With imperfect knowledge, opportunities for beneficial exchange will go unexploited. A good (or bundle of inputs) can be bought at a lower price than at which it (or its product) can be sold. These opportunities exist because sellers are unaware that they can receive a higher price and because buyers are unaware that there are sellers who will accept a lower price. Such price differences are opportunities for arbitrage profit.

Entrepreneurship in the Austrian model is alertness to such opportunities. When a resource becomes more scarce in one area, it is the entrepreneur who notices and responds to the price differences between that area and other areas, in the process affecting prices so that they convey the correct information. It is the entrepreneur who utilizes knowledge of new products and new production methods.

Profits provide the incentive for people to use the knowledge they have. If an individual has knowledge of how to produce a new good, or of a less costly way to produce an existing good, he can achieve benefits for himself by utilizing this knowledge. A person will use his knowledge if he believes it will make him better off (allow him to achieve more of his goals).

Profits greater than 'normal,' then, can serve to improve the quality or quantity of goods. This conclusion is the opposite of that of equilibrium models, that profits are a sign of inefficiency. The difference in conclusions results from equilibrium models' assumption of perfect knowledge, whereas in the Austrian model (as in reality) knowledge is spread among many individuals, who must be convinced to use it.

Entrepreneurial profit is the difference between the price the entrepreneur pays for the good (or input bundle) and the price he receives for it (or its product). Entrepreneurship is not a factor of production; the input bundle contains everything needed for production. What the entrepreneur does is decide to commit those inputs to the production of one good rather than another.

There is a fundamental difference between the entrepreneur and the resource owner. A resource owner who sells or rents his resource receives profit as the difference between what he gives up and what he receives, but the entrepreneur gives up nothing. A resource owner has sole control over the supply of the resource, but the opportunities noticed by the entrepreneur can be noticed (and exploited) by anyone with similar alertness.

Offers to buy and sell are available in the market. Each market participant (buyer or seller) accepts the offer he feels is the best available to him, and at the same time recognizes that others will accept his offer only if they believe it is the best available to them. Each participant therefore must try to make his offer the best available.

Competition in the Austrian model is this attempt to make an offer the best available. Competition is inherently entrepreneurial because it requires that competitors be alert to other offers available. Entrepreneurship is inherently competitive because no resources are needed to notice profit opportunities.

Entrepreneurs, through competition with each other, eliminate profit opportunities. When an opportunity is noticed, an entrepreneur makes an offer just enough to outdo current offers. Competing entrepreneurs strive to outdo each other until there is no more opportunity for profit.

The entrepreneur, then, is the driving force of the market process, allocating resources to the production of goods most desired by consumers. When consumer values change, or resources become more or less scarce, entrepreneurs notice and eliminate the resulting profit opportunity.

The market process, the co-ordinated adjustment of economic plans, is inherently competitive. Any restriction of competition restricts the adjustment process. However, many actions that neoclassical economists consider to be restrictions of competition Austrians consider to be competition. Cutting prices, building excess capacity, improving quality, and advertising are all ways to make one seller's offer better than others' offers. Such actions could have equally been taken by the seller's competitors, who either did not notice the opportunity or felt it was not worthwhile.

The only possible restrictions on competition in the Austrian view are monopolized access to some resource or the use of force to prevent others from making better offers available. If a resource necessary for production is not available to potential competitors, a producer limits the ability of others to make better offers to consumers.

Monopoly in the Austrian view is monopoly over the use of a resource, not over the production of a good. Production can not be monopolized except by the use of force. If force is absent and resources are equally available to all, a producer who happens to be the only seller of a particular product is still under competitive pressure to make the best offer available to buyers. If the single seller raises prices such that profit opportunities are created, entrepreneurs will notice and exploit the opportunities.

Monopoly can have several sources. Monopoly can result from economic institutions; for example, property rights convey a monopoly over the property. Monopoly can also result from entrepreneurial effort; an entrepreneur may competitively buy the complete stock of a resource. The profits and disadvantages are attributed to the institutions in the first case, and to entrepreneurship in the second case.

Austrians analyze markets using these basic concepts of competition, entrepreneurship, market process and prices. Different institutional arrangements and government policies are compared by examining their effects on the market process.