Friday, January 24, 2014

Kirzner on the Law of Supply and Demand in Austrian Economics

Israel M. Kirzner’s Austrian analysis of the law of supply and demand and prices can be found in these short articles:
Kirzner, Israel M. 2000. “The Law of Supply and Demand,” The Freeman, January 1

Kirzner, Israel M. 2000. “Entrepreneurial Discovery and the Law of Supply and Demand,” February 1, 2000

Kirzner, Israel M. 2000. “The Irresistible Force of Market Competition,” March 1, 2000

Kirzner, Israel M. 2000. “Toward an Austrian Critique of Governmental Economic Policy,” April 1
First Kirzner notes,
“The basic insight underlying the law of supply and demand is that at any given moment a price that is ‘too high’ will leave disappointed would-be sellers with unsold goods, while a price that is ‘too low’ will leave disappointed would-be buyers without the goods they wish to buy. There exists a ‘right’ price, at which all those who wish to buy can find sellers willing to sell and all those who wish to sell can find buyers willing to buy. This ‘right’ price is therefore often called the ‘market-clearing price.’

Supply-and-demand theory revolves around the proposition that a free, competitive market does in fact successfully generate a powerful tendency toward the market-clearing price.
This proposition is often seen as the most important implication of (and premise for) Adam Smith’s famed invisible hand. Without any conscious managing control, a market spontaneously generates a tendency toward the dovetailing of independently made decisions of buyers and sellers to ensure that each of their decisions fits with the decisions made by the other market participants. Were this tendency to be carried to the limit, no buyer (seller) would be misled so as to waste time attempting to buy (sell) at a price below (above) the market-clearing price. No buyer (seller) would in fact pay (receive) a price higher (lower) than necessary to elicit the agreement of his trading partner. To the extent that this proposition is valid, free competitive markets achieve what F. A. Hayek has justifiably called a ‘marvel.’ But it is in regard to the validity of this proposition (and in particular to our reasons for being convinced that this proposition is both valid and relevant) that Austrians differ sharply with mainstream textbook economics.”

Kirzner, Israel M. 2000. “The Law of Supply and Demand,” The Freeman, January 1
So how does Austrian economics differ from mainstream neoclassical economics on this point?

As Kirzner points out, it differs in the following ways:
(1) Kirzner contends that neoclassical economics holds that market agents have “perfect knowledge,” while Austrians reject this and accept that agents have “imperfections in knowledge”:
“This conclusion is that in any free market, the market-clearing price is instantaneously (or, at least, very rapidly) established. If every market participant knows what every other market participant is prepared to do (including, especially, the quantity he is prepared to buy or sell at any given price), it follows that any price higher than the market-clearing price cannot emerge (since prospective sellers would realize that they would be left with unsold goods). It follows, similarly, that any price lower than the market-clearing price cannot emerge (since prospective buyers would realize that they will be left without the goods they wish to buy and for which they are in fact prepared to pay a higher price if necessary). The proposition that free-market prices are thus inevitably market-clearing prices proceeds inexorably from the belief that market prices are, in effect, instantaneously known to all potential market participants.

The assumption that all market participants are always fully aware of market opportunities in which they might be interested is often presented, in mainstream textbook expositions, as part of the assumption of so-called ‘perfect competition.’ Perfect competition explicitly presumes universal market omniscience. One way of expressing the Austrian unhappiness with the mainstream textbook treatment is to point out that to start supply-and-demand analysis by assuming that competition is ‘perfect’ (in the textbook sense) is not only to be wildly (and therefore unhelpfully) unrealistic.”

Kirzner, Israel M. 2000. “The Law of Supply and Demand,” The Freeman, January 1
So Austrians reject the neoclassical unrealistic vision of “perfect knowledge” and “perfect competition.”

(2) But, for Austrians, while most prices are not market-clearing prices nor equilibrium prices (in the sense of being equal to marginal cost), nevertheless there exists a tendency for prices to move towards market clearing values (as also argued in Kirzner 1985: 205), and these movements towards the market clearing point are what supply and demand curves show:
“The core of the classroom analysis generally consists of discussion showing, first, that any market price higher than that indicated by the intersection of the two curves (that is, a price higher than the market-clearing price) must tend to produce competitive pressure toward a decrease in price (since the high price will generate a surplus of unsold merchandise); and second, that any market price lower than that indicated by the point of intersection must produce competitive pressure toward an increase in price (since the low price will generate a shortage of goods offered for sale, as compared with the quantities prospective buyers wish to buy).

Austrians do not have serious disagreement with such discussions in themselves; they simply point out that those discussions are utterly inconsistent with the assumption of perfect competition (which textbook analysis takes as its operative assumption). A little careful analysis of the perfect-competition assumption (which analysis can, however, unfortunately not be fitted into this space) suffices to show that under perfect competition there cannot in fact exist two curves (the demand curve intersecting with the supply curve). Under perfect competition the supply-and-demand diagram shrivels instantly to a single point—the point where the two curves would have intersected (had the curves themselves existed!). This is so because any point on a market supply curve or on a market demand curve that is not that intersection point can have analytical existence only by suspending some or all of the conditions that define the state of perfect competition. The diagram (valuable though it certainly is!) is simply not consistent with the assumed conditions under which it is supposed to be operating.”
Kirzner, Israel M. 2000. “The Law of Supply and Demand,” The Freeman, January 1
So Austrians reject the Walrasian “perfect competition” model. This is confirmed by Kirzner in his other writings:
“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. The real world pattern of resource allocation at any given moment can be described as optimal only relative to existing information in fact possessed by entrepreneurial market participants. The tension in Mises is quite imaginary; it is perceived—quite understandably and reasonably perceived—only as a result of reading Mises through the spectacles acquired in studying mainstream economics.” (Kirzner 2000: 168).
(3) Human beings as economic agents have imperfect knowledge and are imperfect themselves, given that they face uncertainty:
“For Mises, each human being is, in a very important sense, an entrepreneur. … And it is the entrepreneurial element in those decisions that is responsible, in the Austrian view, for that crucially important tendency toward market-clearing that (for Austrians as well as for non-Austrians) constitutes the heart of the law of supply and demand.

The Misesian notion of human action is significantly richer than the mainstream-economics notion of the economizing decision. An economizing decision is seen as the selection of the most desirable option out of an array of given alternatives with a given ranking of what is more desirable and less desirable. Since both the alternatives available and the ranking are already identified prior to the act of decision, such decision-making consists essentially of the solution to a mathematical maximization exercise; the outcome is predetermined: it is implicit in the given context within which the decision is to be made.

For Misesian human action, on the other hand, the action is, most importantly, seen as including the determination of both what the available alternatives are and what ranking of relative desirability is to be adopted. Determining these elements inevitably exposes the agent to the uncertainties of an open-ended future (in a sense absent in the context of the standard ‘economizing decision’): action is the present choice between future alternatives that must, in the face of the foggy uncertainty of the future, now be identified in the very act of choice.
It is this aspect of human action that renders it, for Mises, essentially entrepreneurial. Mathematical expertise in solving maximization problems is of very limited help in choosing among courses of action when the very alternatives must be ‘created,’ as it were, by the agent’s entrepreneurial imagination and creativity, by his daring and boldness.”
Kirzner, Israel M. 2000. “Entrepreneurial Discovery and the Law of Supply and Demand,” February 1, 2000
(4) For Austrians, arbitrage and alert entrepreneurs and their desire for profit create a tendency towards market clearing prices, even though real world prices will mostly be non-market clearing prices:
“For Austrians, the law of supply and demand is simply an insight into one particular (but central) element in this more comprehensive, dynamic, entrepreneur-driven market process. For any particular commodity, the market forces acting on the prices at which it will be bought and sold (and thus the market forces acting on the decisions made to produce and to buy it) tend to identify and exploit the opportunities (structured by the technology and the economics of its production on the one hand, and by the urgency with which potential consumers wish to consume it, on the other hand) and thus to ensure that the quantities which are simultaneously worthwhile for producers to produce and for consumers to buy will in fact tend to be produced, offered for sale, and purchased.

If, for example, current production of this commodity is ‘too low,’ this means that opportunities exist for additional units to be produced at an outlay below the highest price potential consumers would be prepared to pay; it is ‘worthwhile’ to produce these additional units. Entrepreneurial producers will tend to discover and act on such opportunities. If, on the other hand, current production is ‘too high,’ this means that the production outlay for at least some units exceeds the highest price potential consumers are prepared to pay for them; these units were produced as a result of entrepreneurial error. Entrepreneurial producers will tend to discover these (marginal) losses and cut back on production.

The entrepreneurial forces acting on the market for any one commodity are thus continually pushing that market toward the market-clearing point—that is, to where (a) the quantity produced is such that (only) all units ‘worth producing’ are indeed produced, and (b) the market price for this commodity is just high enough to make it, as a practical matter, worthwhile for producers to produce this quantity, and is just low enough to make it worthwhile for consumers to buy it.

Clearly, these forces would, were all other dynamic changes in market conditions to be suspended, tend to achieve exactly those outcomes identified, in more conventional mainstream formulations of the law of supply and demand, by the intersection of the supply curve and the demand curve. It is for this reason that we have described Austrian economics as basically in agreement with mainstream economics in its emphasis on the centrality of the law of supply and demand.
It is worthwhile, however, briefly to ponder the sense in which the Austrian version of the ‘law’ avoids reliance on any presumption of universal perfect market knowledge (a presumption that, as seen in the preceding article, pervades much standard economics).”
Kirzner, Israel M. 2000. “Entrepreneurial Discovery and the Law of Supply and Demand,” February 1, 2000
(5) Kirzner takes up Hayek’s theories and sees the movement towards supply and demand equilibrium via flexible prices as a “learning” process:
“As Austrian economist F. A. Hayek emphasized, the market process we have been describing in entrepreneurial terms can also usefully be understood in terms of learning. The process through which the market tends to generate the ‘right’ quantity of a commodity, and the ‘right’ price for it, can be seen as a series of steps during which market participants gradually tend to discover the gaps or errors in the information on which they had previously been basing their erroneous production and/or buying decisions. Buyers who had overestimated the willingness of producers to produce and sell the commodity had been ‘incorrectly’ refusing to offer higher prices (that they would indeed have been prepared to pay); those who had underestimated that willingness were ‘incorrectly’ offering higher prices than were in fact needed to inspire sellers to produce. Sellers who had overestimated the willingness of buyers to buy were ‘incorrectly’ asking higher prices (and were producing more units of the commodity than it was ‘really worthwhile’ to produce), and so on. The market process is one in which, driven by the entrepreneurial sense for grasping at pure profit opportunities (and for avoiding entrepreneurial losses), market participants, learning more accurate assessments of the attitudes of other market participants, tend toward the market-clearing price-quantity combination.”
Kirzner, Israel M. 2000. “Entrepreneurial Discovery and the Law of Supply and Demand,” February 1, 2000
(6) And Austrians also have a different understanding of “competition”:
“Following a long tradition in economics going back at least to Adam Smith, Austrians define a competitive market not as a situation where no participant or potential participant has the power to make any difference, but as a market where no potential participant faces nonmarket obstacles to entry. (The adjective ‘nonmarket’ refers, primarily, to government obstacles to entry; it is used to differentiate such obstacles from, for example, high production costs that might discourage entry. These latter do not constitute noncompetitive elements in a market; to be able to enter means to be able to enter a market if one judges such entry to be economically promising-it does not mean to be able to enter without having to bear the relevant costs of production.) That is, a situation is competitive if no incumbent participant possesses privileges that protect him against the possible entry of new competitors.

The achievements that free markets are able to attain depend, in the Austrian view, on freedom of entry, that is, on the absence of privilege. It is because the law of supply and demand (as understood by Austrians) depends crucially on freedom of entry that this meaning of the term ‘competition’ is so important.”
Kirzner, Israel M. 2000. “The Irresistible Force of Market Competition,” March 1, 2000
So what is the problem with this Austrian theory?

First, the simple and plain fact – despite the claims of Austrians that their price theory and view of supply and demand is more realistic than neoclassical economics – is that the Austrian vision is still grossly unrealistic. It assumes most firms are price takers and really do adjust prices in response to demand and supply dynamics.

The Austrian theory is utterly refuted by the widespread existence of administered prices/mark-up prices in most capitalist economies: prices that are set on total average cost of production plus a profit mark-up, and that are generally and normally left unchanged when demand changes. The empirical evidence suggests that such mark-up prices account for somewhere between 54% to 70% of prices in modern market economies (see Appendix 1 below). That is the majority of prices and the percentages found in many surveys are so high that the Austrian story about prices can be taken seriously.

Secondly, the glaring problem with the Austrian view of competition – with its emphasis on opposing alleged government obstacles to competition – is that mark-up pricing industries themselves, not only through the mark-up price but also through effective use of excess capacity and inventories, create severe market barriers to entry, a state of affairs which destroys the Austrian view of market “freedom of entry” in most product markets. For, if a mark-up price remains generally fixed in relation to demand changes, and does not even rise when demand rises, how can there even exist any effective market signals to businesses to enter a new market with high prices when those high prices do not even appear in the first place?

The answer is obviously that these “market signals” do not appear, and that the Austrian theory has already collapsed because most markets (which are mark-up/administered pricing markets) do not set prices in the way required by the theory.

Furthermore, even though the Austrians want to argue that “non-market” barriers to entry refer mostly or wholly to government intervention and that “market” barriers present no problem, they have failed to consider very serious real world “market” barriers that originate from the private sector itself.

Many modern markets are dominated by corporate enterprises, which have long been concerned with creating barriers to entry and which are not motivated by the idea of long-period maximisation of profits (in the neoclassical or Austrian sense). Instead, many corporations are more concerned with not inducing new entries into their markets (Lee 1998: 54–55).

As noted above, many modern firms have excess capacity available to deal with unexpected increases in demand, along with inventories (Lavoie 1992: 124). The effective use of excess capacity is a powerful method by which modern firms deter other firms from entering a market, and such a practice functions as a strong barrier to entry (Lavoie 1992: 124, citing Sylos Labini 1971: 247).

But Austrians like Kirzner remain mired in an economic theory divorced from reality, and are blissfully unaware of the empirical evidence that refutes their theories.

Appendix 1: Empirical Evidence on Administered Prices
“Downward’s Pricing Theory in Post-Keynesian Economics: Chapter 8,” January 23, 2014.

“Mark-up Pricing in South Africa,” January 20, 2014.

“Mark-up Pricing in Sweden,” January 9, 2014.

“Mark-up Pricing in Canada,” January 7, 2014.

“Some More Empirical Evidence on Full Cost Pricing,” December 10, 2013.

“Mark-up Pricing in New Zealand,” November 30, 2013.

“Mark-up Pricing in Australia,” November 30, 2013.

“Mark-up Pricing in Japan,” November 29, 2013.

“Mark-up Prices in Iceland,” November 25, 2013.

“Mark-up Pricing in Norway,” November 23, 2013.

“Mark-up Pricing in Ireland,” November 22, 2013.

“Two Marketing Studies on US Administered Prices,” November 16, 2013.

“Hall and Hitch on Marginal Cost and Price,” November 4, 2013.

“Administered Pricing in the United Kingdom,” October 19, 2013.

“Administered Prices in the Eurozone: Some Empirical Data,” October 16, 2013.

“Gardiner Means on Administered Prices,” June 20, 2013.

“Early Literature on Administered Pricing,” May 8, 2013.

Kirzner, Israel M. 1985. “Prices, the Communication of Knowledge, and the Discovery Process,” in Kurt R. Leube and Albert H. Zlabinger (eds.), The Political Economy of Freedom: Essays in Honor of F. A. Hayek. Philosophia Verlag, Munich. 193–206.

Kirzner, Israel M. 2000. The Driving Force of the Market: Essays in Austrian Economics. Routledge, London and New York.

Kirzner, Israel M. 2000a. “The Law of Supply and Demand,” The Freeman, January 1

Kirzner, Israel M. 2000b. “Entrepreneurial Discovery and the Law of Supply and Demand,” February 1, 2000

Kirzner, Israel M. 2000c. “The Irresistible Force of Market Competition,” March 1, 2000

Kirzner, Israel M. 2000d. “Toward an Austrian Critique of Governmental Economic Policy,” April 1

Lavoie, Marc. 1992. Foundations of Post-Keynesian Economic Analysis. Edward Elgar Publishing, Aldershot, UK.

Lee, Frederic S. 1998. Post Keynesian Price Theory. Cambridge University Press, Cambridge and New York.

Sylos Labini, P. 1971. “La théorie des prix en régime d’oligopole et la théorie du développement,” Revue d’Economie Politique 81.2: 244–272.


  1. First of all: Thanks for posting those great Kirzner quotes !

    On: "The answer is obviously that these “market signals” do not appear, and that the Austrian theory has already collapsed because most markets (which are mark-up/administered pricing markets) do not set prices in the way required by the theory."

    Take a closed economy where all end product prices are set by cost+markup. Assume full employment of resources (perhaps the govt used AD management to achieve this).

    Demand for good A increases and sales at the existing cost+markup,price increase. This causes inventories to run down and producers of goodA need to increase production. But where are the resources for this increase in production to come from given that we are at full employment ? Producers of goodA are in competition with each other (and other industries) for resources and ultimately it must be prices (driven by consumer demand) that allows efficient allocation of resources.

    Even if 70% of prices are set administratively I do not think it a stretch to assume that it is the remaining 30% (that do make use of pricing signals) that allow the prices reflected in price+markup to allocate resources efficiently in an economy.

    Further: Its is probably the fact that the market has accurately led most prices to reflect cost of production that allows cost+markup to be an optimizing strategy.

    1. Your thought experiment is a pointless exercise:

      (1) what economy is closed in the way you imagine? North Korea perhaps?

      What relevance does a closed economy model have to any modern advanced capitalist economy?

      (2) Even at what Keynesians call "full employment", you still have inventories and excess capacity and some idle resources, and above all access to goods via international trade.

      So there is no necessary reason why mark-up prices must rise at full employment in a real world capitalist economy at all.

  2. "(1) what economy is closed in the way you imagine? North Korea perhaps?"

    Well, I just read Godley and Lovoie's "Monetary Economics" and their most sophisticated model (Chapter 11 - A Growth Model) is based on a closed economy. Are you saying their book is also a "pointless thought experiment" ?

    BTW: The global economy is a "closed" model !

    1. (1) First, Godley and Lavoie's model is considerably more realistic than yours is.

      Secondly, Godley and Lavoie (2007: 420) in Chapter 11 are quite clear:

      "We are far from being able at this stage to draw conclusions about the conduct of fiscal and monetary policy in the real world, in particular because the model under discussion describes a closed economy which is not being buffeted by external, or other, shocks"

      So at least they admit their model needs to incorporate real world factors before being relevant to the real world.

      You, on the other hand, seem blissfully unaware of any such need.

      And finally: yes, your thought experiment in a closed economy with no idle resources suggests that prices should rise when demand rises.

      However, it is irrelevant to the real world.

      (2) "The global economy is a "closed" model !"

      Irrelevant. Why? Because (1) most economic analysis concerns nation states or regions of nations and (2) even as a global entity the world economy never reaches a state of no idle resources.

    2. You might want to move onto chapter 12 there Rob. Thats the one titled 'A More Advanced Open Economy Model'. It follows chapter 11.

  3. Yes LK, when I said "Take a closed economy where all end product prices are set by cost+markup. Assume full employment of resources (perhaps the govt used AD management to achieve this)."

    I really thought I was describing the real world rather than just inventing a simple model to make a simple point about prices and resource allocation (that might still have some relevance to a more complex model.)

  4. So, agents do not have perfect information... but markets tend toward a "perfect information price" regardless? Ah... the eternal mysticism at the heart of Austrian economics.

    Of course, if you press them on this they will say, "Oh no, you've misunderstood..." (no I haven't, that's what your theory SAYS!) "...what we really mean is that the market outcomes will always be more efficient than non-market outcomes..." (that's funny because your theory doesn't say that at all).

    This, of course, is a complete matter of Faith. It rests on the assumption that people engage in market activity have better knowledge of the economy than experts. So, a room full of plumbers know more about the macroeconomy than me. It's very quaint really. All ideology and nonsense, of course, but quaint all the same.