Austrians and the Market’s Tendency to Equilibrium

Austrian economists have four different concepts of equilibrium and it is my intention to analyse them in this post:

“Despite frequent assertions that Austrian economics is defined as ‘market process economics’ or ‘disequilibrium economics,’ the concept of equilibrium features prominently in causal-realist economics (Hülsmann, 2000; MacKenzie, 2008) At least four distinct equilibrium constructs appear in Austrian analysis. Following Mises’s terminology, as amended by Salerno (1994a), we can call them the plain state of rest (PSR), the fully arbitraged state of rest or Wicksteedian state of rest (WSR), the final state of rest (FSR), and the evenly rotating economy (ERE). Two of these, the PSR and WSR, describe real-world outcomes, while the FSR and ERE are what Mises called ‘imaginary constructions,’ hypothetical scenarios that do not obtain in reality, but are useful in economic reasoning, allowing the theorist to isolate the effects of particular actions or circumstances, holding all else constant.” (Klein 2010: 135).

In summary, the four concepts of equilibrium are as follows:

(1) the “plain state of rest”;

(2) the “Wicksteedian state of rest” or “fully arbitraged state of rest”;

(3) the “final state of rest,” and

(4) the “evenly rotating economy” (ERE).

(1), (3), and (4) were defined by Mises, and (2) developed subsequently by other Austrian economists.

These are examined below.

(1) The Plain State of Rest
First, the “plain state of rest”:

“People keep on exchanging on the market until no further exchange is possible because no party expects any further improvement of its own conditions from a new act of exchange. The potential buyers consider the prices asked by the potential sellers unsatisfactory, and vice versa. No more transactions take place. A state of rest emerges. This state of rest, which we may call the plain state of rest, is not an imaginary construction. It comes to pass again and again. When the stock market closes, the brokers have carried out all orders which could be executed at the market price. Only those potential sellers and buyers who consider the market price too low or too high respectively have not sold or bought.” (Mises 2008: 245).

This “state of rest” is further described by Murphy and Gabriel:

“The plain state of rest is not an imaginary construction; it happens whenever there are no transactions, because no buyer wishes to acquire more units of the good or service at the price necessary to induce a seller to surrender more units. The plain state of rest is only transitory; it will be disrupted whenever preferences change and mutually advantageous exchanges once again exist.” (Murphy and Gabriel 2008: 107).

“Mises’s illustration … of the plain state of rest—namely, the daily close of a stock market—is rather unfortunate, for the market closes at a preordained time, and in principle there could be frustrated buyers and sellers who don’t exchange simply because of the closing bell. To make matters worse, Mises justifies his choice by pointing out (in footnote 9) that he is disregarding the fluctuations in stock prices over the course of the trading day. A better choice would have been a market in which prices remain fairly stable; then a period in which no sales took place (even though the market is ‘open’) would constitute a plain state of rest.” (Murphy and Gabriel 2008: 107).

Kirzner notes that the “plain state of rest” equilibrium is not a Marshallian partial equilibrium:

“The ‘supply and demand’ which are continually in equilibrium in Mises’s world, do not refer to the supply and demand schedules so basic to mainstream microeconomic theory. They refer simply to the circumstance that, in any situation, those potential transactors who have been aware of available mutually beneficial trade possibilities, will all certainly have moved to take advantage of these opportunities; once these opportunities have been grasped, market activity of course ceases, the plain state of rest has been attained.

To describe the price emerging from these exchange transactions as a ‘market-clearing price’ (Salerno, 1993, p. 121), is therefore misleading. Certainly the price permits all those who stand to gain by exchanging at this price and who are aware of this—to exchange to the point where no known remaining mutually gainful opportunities exist. But the term ‘market-clearing price’ (a term not used by Mises) is used in standard economics to refer to the exhaustion of all mutually gainful exchange opportunities under the hypothetical conditions of (relevant) omniscience. Standard economics indeed notoriously proceeds, in applying supply and demand theory to the real world, to operate as if conditions of relevant omniscience can be taken as given. Mises is certainly not making any such assumption of omniscience. His market prices are certainly not ‘market clearing prices’ (in the usual sense of that term). There is, one is able to reassure the puzzled reader, therefore no contradiction in his exposition. Real world market prices are not the equilibrium prices of standard economic theory. (Real world prices relate to equilibrium only in a very narrow sense, a sense to which no attention at all is given in standard theory.) Real world prices are indeed likely to be ‘false’ prices, setting off entrepreneurial-competitive activity modifying the pattern of resource allocation.” (Kirzner 2000: 167–168).

There is a sense in which an individual “plain state of rest” per se is a trivial notion of equilibrium as described here by Kirzner, which is different from and opposed to the alternative idea of equilibrium as one of supply and demand in a product market. But, despite Kirzner, Mises does have a clear belief in the tendency of free markets to produce supply and demand equilibrium via flexible prices (as we will see below).

Moreover, in the context of an economy with a flexible price system in the way Mises imagines, “plain states of rest” could be construed as specific steps in a sequence over time towards market-clearing prices, and this is how Salerno seems to understand the concept:

“prices ... are generated by the market process and serve as the data for economic calculation. These are realized prices; or, in other words, they are the actual outcome of the historical market process at each moment in time and are determined by the value scales of the marginal pairs in each market. They are, therefore, also market-clearing prices the establishment of which coincides with a momentary situation, what Mises calls the ‘plain state of rest’ (PSR), in which no market participant, given his existing marginal-utility rankings of goods and money and knowledge of prevailing prices, can enhance his welfare by participating in further exchange. However, despite their character as market-clearing prices, these are also disequilibrium prices. Thus as a consequence of the unavoidable errors of entrepreneurial forecasting and price appraisement under uncertainty, most goods are sold at prices that do not conform to their monetary costs of production, thereby generating realized profits and losses for producers.” (Salerno 1990: 121; cf. Salerno 2010: 141).

So prices are “disequilibrium prices” in the sense that they are not equal to marginal costs of production, but allow profit and loss. Kirzner criticises Salerno’s use of the term “market-clearing price” in the context of an individual “plain state of rest” since this is unlikely to be a true market-clearing price in the sense of a supply and demand equilibrium in a product market. But if “plain state of rest” prices are construed as “market-clearing prices” over time in a sequence as prices are adjusted toward the price at which there is supply and demand equilibrium, then Salerno’s use of the term “market-clearing price” is justifiable.

This appears to me how Salerno does conceive supply and demand equilibrium in product markets as a tendency to market-clearing prices over time:

“Mises conceives the market process as coordinative, ‘the essence of coordination of all elements of supply and demand.’ This means that the structure of realized (disequilibrium) prices, which continually emerges in the course of the market process and whose elements are employed for monetary calculation, performs the indispensable function of clearing all markets and, in the process, coordinating the productive employments and combinations of all resources with one another and with the anticipated preferences of consumers.” (Salerno 1993: 124).

(2) The “Wicksteedian State of Rest” or “Fully Arbitraged State of Rest”
This concept is explained by Klein:

“Lying between the … [sc. plain state of rest] and the … [sc. final state of rest] is the WSR [sc. Wicksteedian state of rest], a realistic concept in which trading takes place while preferences remain constant, with market participants revising their beliefs about other participants’ reservation prices until all feasible gains from trade are exhausted. Wicksteed’s (1910, pp. 219–28) fruit market provides the canonical example. By the end of each market day, a specified period in which preferences, stocks of goods, and the set of traders remains fixed, what Wicksteed calls ‘the equilibrating price’ has been achieved. In this situation, ‘the marginal position of the commodity in question is identical upon the relative scales of all who have secured a supply, and higher on them all than it is on the scales of any of those who have secured no supply’ (Wicksteed, 1910, p. 216). The market day is a hypothetical construct, in that it holds only as long as preferences, technical knowledge, stocks of goods available for exchange, and so on are held constant. And yet, the WSR is not a purely imaginary construction, as this process of equilibration takes place in real markets, at least over short periods of calendar time.” (Klein 2010: 138).

The “Wicksteedian state of rest” thus appears to be a supply and demand equilibrium in an individual product market.

(3) The Final State of Rest
Thirdly, we have the “final state of rest”:

“But now we go a step further. We pay attention to factors which are bound to bring about a tendency toward price changes. We try to find out to what goal this tendency must lead before all its driving force is exhausted and a new state of rest emerges. The price corresponding to this future state of rest was called the natural price by older economists; nowadays the term static price is often used. In order to avoid misleading associations it is more expedient to call it the final price and accordingly to speak of the final state of rest. This final state of rest is an imaginary construction, not a description of reality. For the final state of rest will never be attained. New disturbing factors will emerge before it will be realized. What makes it necessary to take recourse to this imaginary construction is the fact that the market at every instant is moving toward a final state of rest. Every later new instant can create new facts altering this final state of rest. But the market is always disquieted by a striving after a definite final state of rest.” (Mises 2008: 246).

A “final state of rest” price is a market clearing price and (apparently) a price equal to marginal cost.

For Mises, the real world exhibits a tendency towards this ideal state of equilibrium, or, as Mises says, the market “at every instant is moving toward a final state of rest.”

But there is some ambiguity here: is the “final state of rest” a situation where all prices in all product markets have reached their market-clearing and equilibrium values? Or it is only meant to refer to an individual product market?

Vaughn understands the “final state of rest” in the former sense:

“The second equilibrium notion Mises employs is the ‘final state of rest,’ the state toward which the market tends if there is no change in the data. This apparently is Mises’ analogue to general equilibrium. Whereas the plan state of rest is a phenomenon that is routinely found in markets, the final state of rest is an ‘imaginary construction’ in that it can never be achieved in reality, although it is a necessary analytic tool for understanding the direction of price changes.” (Vaughn 1994: 81–82).

However, Murphy and Gabriel seem unclear on whether Mises thinks of the “final state of rest” as a general state of equilibrium:

“the final state of rest is indeed an imaginary construction. It refers to the situation in which all of the effects of a particular disturbance have run their course, and the price in question has reached its final price. If a new report causes half of the smokers to quit cold turkey, a plain state of rest in the cigarette market will soon emerge at a much lower price. However, as cigarette manufacturers scale back their operations and the glut of inventory is reduced to the new level (appropriate for the cut in customers), a new final price will emerge (that may be higher or lower than the previous final price, depending on the specifics). (Murphy and Gabriel 2008: 107–108).

Despite this, the “final state of rest” involves market clearing prices in the sense of supply and demand equilibrium.

(4) The Evenly Rotating Economy (ERE)
This is described by Mises in these terms:

“The imaginary construction of the final state of rest is marked by paying full regard to change in the temporal succession of events. In this respect it differs from the imaginary construction of the evenly rotating economy which is characterized by the elimination of change in the data and of the time element. (It is inexpedient and misleading to call this imaginary construction, as is usual, the static economy or the static equilibrium, and it is a bad mistake to confuse it with the imaginary construction of a stationary economy.) The evenly rotating economy is a fictitious system in which the market prices of all goods and services coincide with the final prices. There are in its frame no price changes whatever; there is perfect price stability. The same market transactions are repeated again and again. The goods of the higher orders pass in the same quantities through the same stages of processing until ultimately the produced consumers' goods come into the hands of the consumers and are consumed. No changes in the market data occur. Today does not differ from yesterday and tomorrow will not differ from today. The system is in perpetual flux, but it remains always at the same spot. It revolves evenly round a fixed center, it rotates evenly. The plain state of rest is disarranged again and again, but it is instantly reestablished at the previous level. All factors, including those bringing about the recurring disarrangement of the plain state of rest, are constant. Therefore prices—commonly called static or equilibrium prices—remain constant too.” (Mises 2008: 247–248).

We further read that it is a state where there is no profit and loss (Mises 2008: 249) and where there is no uncertainty whatsoever about the future, and nobody holds cash for precautionary motives (Mises 2008: 250).

The evenly rotating economy, then, is a purely “imaginary construction” (Mises 2008: 247) and real world market economies do not have a tendency towards it. So it need not detain us.

(5) Analysis
Despite constant changes in the data and disequilibrating phenomena, nevertheless for Mises the market economy is constantly tending towards new “final states of rest” (in which values have changed owing to changes in current market data).

But this seems like a rather weak notion of equilibrium. If an economy does not ever attain a long-run convergence to a particular “final state of rest,” but consists of multiple short-period convergences to one “final state of rest” quickly thwarted as the economy must adjust to a new convergence to yet another new “final state of rest,” then it is difficult to see why Mises can declare that markets have any strong or effective long-run self-equilibration.

What, then, is Mises left with, if he wants to argue that market economies have a strong tendency to equilibration?

Mises has two fundamental processes as follows that cause an economy to have a tendency to coordination, which may run deeper than his short period convergences to shifting “final states of rest”:

(1) a flexible price and wage system, in which prices and wages have a tendency to move towards market clearing values in the sense of demand and supply equilibrium, even if the overall economy never reaches a “final state of rest.”

That is to say, prices and wages are flexible and determined by supply and demand in trades between buyers and sellers. Increased demand drives prices upwards, and decreased demand drives prices downwards. Demand curves are well behaved and each product market has a market-clearing price that would equate quantity demanded by buyers with quantity supplied by sellers to eliminate surplus or shortages of goods.

This demand and supply equilibrium tendency is also held to include the market for loanable funds, so that saving and investment are supposed to be coordinated by a market clearing interest rate.

(2) the entrepreneurial pursuit of profit, which has a tendency to drive profits towards zero as firms and businesses compete against each other by noticing profit differences, and by moving in and out of markets to exploit high profits.

Factor (1) above is fundamentally important.

Supply and demand equilibrium is a crucial concept in Mises’s thought and theory, as can be seen from a few selected passages:

(1) “The price structure of the market decides what will be produced, how, and in what quantity. Through the structure of prices, wages, and interest rates the market brings supply and demand into balance and sees to it that each branch of production will be as fully occupied as corresponds to the volume and intensity of the effective demand. Thus capitalist production derives its meaning from the market. Of course, a temporary imbalance between production and demand can occur, but the structure of market prices makes sure that the balance is reestablished in a short time. Only when the mechanism of the market is disturbed by external interventions is the effect of market prices on the regulation of production prevented; they are disturbances that no longer can be remedied by the automatic reactions of the market, disturbance that are not temporary but prolonged.” (Mises 2002a [1931]: 170).

(2) “Entrepreneurs try to supply those goods whose sale promises them the highest possible profit. But it is the market that decides where profits are earned and losses suffered. If consumers demand more of a product, then its price rises; if they demand less, then the price falls. If entrepreneurs produce only those goods whose sale promises to bring them profits, then that means they are following the wishes of the consumers. It is the market, therefore, that directs a capitalist economy, based on the private ownership of the means of production. The changing prices of the market bring supply and demand into equilibrium. The market price—called the ‘natural price’ by the Classical economists and the ‘static price’ by modern economists—finds its level at a point at which no prospective buyer who is ready to pay the market price leaves the market unsatisfied, and no prospective seller who is willing to accept the market price leaves the market with unsold goods.” (Mises 2002b [1933]: 209).

(3) “Price control measures paralyze the working of the market. They destroy the market. They deprive the market economy of its steering power and render it unworkable.

The price structure of the market is characterized by its tendency to bring supply and demand into balance. If the authority attempts to fix a price different from the market price, this situation cannot prevail. In the case of maximum prices, there are potential buyers who cannot buy although they are ready to pay the price fixed by the authority, or even to pay a higher price. Or there are—in the case of minimum prices—potential sellers who cannot find buyers even though they are willing to sell at the price established by the authority, or even to sell at a lower price. The price is no longer the means of segregating those potential buyers and sellers who may buy or sell from those who may not. A different principle of selection has to come into operation. It may be that only those who come first or those who occupy a privileged position due to particular circumstances (personal connections, for instance) will actually buy or sell. But it may also be that the authority itself takes over the regulation of distribution. At any rate the market is no longer able to provide for the distribution of the available supply to the consumers. If chaotic conditions are to be avoided, and if neither chance nor force is to be relied upon to determine distribution, the authority has to undertake this task by some system of rationing.” (Mises 1998 [1940]: 26).

(4) “The aim of price control is to decree prices, wages, and interest rates different from those fixed by the market. Let us first consider the case of maximum prices, where the government tries to enforce prices lower than the market prices.

The prices set on the unhampered market correspond to an equilibrium of demand and supply. Everybody who is ready to pay the market price can buy as much as he wants to buy. Everybody who is ready to sell at the market price can sell as much as he wants to sell. If the government, without a corresponding increase in the quantity of goods available for sale, decrees that buying and selling must be done at a lower price, and thus makes it illegal either to ask or to pay the potential market price, then this equilibrium can no longer prevail. With unchanged supply there are now more potential buyers on the market, namely, those who could not afford the higher market price but are prepared to buy at the lower official rate. There are now potential buyers who cannot buy, although they are ready to pay the price fixed by the government or even a higher price.” (Mises 2010 [1944]: 61).

(5) “The crisis from which the world is suffering today is the crisis of interventionism and of national and municipal socialism; in short, it is the crisis of anticapitalist policies. Capitalist society—there is no difference of opinion about this—is governed by the workings of the market process. Market prices bring supply and demand into balance and determine the direction and extent of production. The capitalist economy gets its meaning from the market. If the function of the market as regulator of production is permanently undermined by an economic policy that attempts to set prices, wages, and interest rates other than in the way the market forms them, then a crisis will surely occur.” (Mises 2002c [1932]: 191).

(6) “The characteristic feature of the market price is that it equalizes supply and demand. The size of the demand coincides with the size of supply not only in the imaginary construction of the evenly rotating economy. The notion of the plain state of rest as developed by the elementary theory of prices is a faithful description of what comes to pass in the market at every instant. Any deviation of a market price from the height at which supply and demand are equal is – in the unhampered market – self-liquidating.” (Mises 2008: 756–757).

So, in the view of Mises, the tendency of either the unhampered market or a real world market towards any “final state of rest” depends fundamentally on a flexible price and wage system that coordinates quantity demanded with quantity supplied in product markets and the labour market.

The action of entrepreneurs who pursue profits is the second most important coordinating mechanism, which (allegedly) causes a tendency for profits to be driven towards zero.

Since neither element is in fact a strong characteristic of modern real world market economies, it follows that the Austrian view of market equilibration is false.


BIBLIOGRAPHY
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