In the first section, I sketch Kirzner’s argument. In the second I provide a critique.
I. Kirzner on Hayek on Prices
Hayek’s view of the role of prices as communicating economic knowledge is well known.
In a market for any particular commodity, an equilibrium market price equates demand with supply and ensures that there is no excess demand or excess supply (Kirzner 1985: 197). Equilibrium market prices communicate the necessary information to buyers and sellers to achieve economic coordination (Kirzner 1985: 198). In this economic sense, an equilibrium (or market clearing) price is the “right” price. In a general equilibrium, there is perfect communication signalling and economic coordination.
But prices in the real world are virtually always disequilibrium prices, and the general system can never be in a general equilibrium state. Kirzner – like Hayek – conceives the price system as providing a mechanism to progressively improve information and coordination in relation to the past. Disequilibrium prices may communicate incorrect information and result in waste, but their movement towards equilibrium values permits a “discovery” process by market participants to generate greater economic coordination (Kirzner 1985: 205).
That is, in an uncoordinated or relatively uncoordinated economy, a flexible price system in which market buyers and sellers move prices in trades towards their market-clearing values will
“generate systemic changes in market decisions about price offers and bids, in a way that, by responding to the regrettable results of initially uncoordinated sets of decisions, tends to replace them by less uncoordinated sets” (Kirzner 1985: 198).Thus even when prices are in disequilibrium they will achieve this higher degree of coordination as long as in exchanges they are flexible and moved towards their equilibrium (or market clearing) value.
For example, excess supply in a particular market indicates that prices are too high, so that sellers will eventually move their price downwards (Kirzner 1985: 199).
Disequilibrium prices in the sense of prices not at costs of production also provide profit and loss (Kirzner 1985: 205), and higher profits signal that entrepreneurs should move into these markets, while losses signal that they should move out into other lines of production.
Kirzner contends that Hayek sometimes failed to communicate properly this point about the coordinating role of flexible disequilibrium prices in his earlier work (Kirzner 1985: 203), but that it is brought out most clearly in Hayek’s papers “Competition as a Discovery Procedure” (Hayek 1978) and “The Meaning of Competition” (Hayek 1948).
But what are the problems with this Austrian model of economic coordination? Kirzner complains that “governmentally imposed obstacles to price flexibility” thwart the process of economic coordination (Kirzner 1985: 203).
But with widespread fixprice markets where administered prices dominate, the private sector itself already overwhelmingly shuns the flexible price system required in the ideal and almost utopian vision of Austrian economics. Disequilibrium prices are deliberately created and maintained by fixprice enterprises in a vast swathe of the economy, simply because they prefer it that way. Such businesses are not generally in the habit of using flexible prices as their normal method of clearing supply, or equating demand with supply. In other words, the whole Austrian view that flexible movement of prices towards market-clearing levels provides continuing, coordinating adjustment of supply and demand and permits a “discovery” process for capitalists is simply wrong in the fixprice markets. And these fixprice markets dominate advanced capitalist economies.
Even the existence of “clearance” and “liquidation” sales do not change this fact, for clearance sales are very much the exception, not the rule. In the retail trade, for example, what are called “clearance sales” are often a matter of some discounts, but with deceptive psychological tricks with advertising. Very often producers with excess supply will merely add this to inventory.
Supply is mostly equated with demand by direct output and employment changes, and changes in the quantity of stock. This is how a real economy generally achieves economy coordination. Prices are relatively inflexible, and so much so that fixprice firms only rarely change their prices, perhaps on average once a year (Melmiès 2010: 450), and even then the price adjustments are mostly caused by changes in the costs of factor inputs and wages.
Another consequence of these fixprice markets is that profits too tend to be relatively stable. A business wants its profit markup to be relatively stable (at least in terms of avoiding large falls in it), and so there is some degree of stability of profits that results from price administration (Gu and Lee 2012: 461). Stable profits in turn allow stable margins for internal financing of investment (Melmiès 2012).
Stable fixprices mean a rise in money supply or credit does not necessarily or even generally cause the price “distortions” imagined in Austrian theory, for fixprices are generally inflexible with respect to demand changes (though matters are different in flexprice markets).
There is no doubt that profit and loss has a major role to play in market economies in driving investment, but the particular importance given to profit and loss signals in the Austrian view of flexible prices is exaggerated, for fixprice firms generally shun the losses that they would suffer by sharply reducing the prices of their goods below costs of production to clear their product markets (Gu and Lee 2012: 461).
As noted above, fixprices are generally not adjusted in response to changes in demand, and instead output or inventory will be adjusted. Therefore when demand has changed in response to changes in credit, it does not follow that, say, consumer prices will rise and then the profits in those consumer industries as well, which will (according to Austrian theory) drive overinvestment in these lines of production. Instead, direct output and employment changes are more likely. Profits will increase but not because prices have increased: it is because extra demand has led to extra sales with increased production. When demand falls, changes in inventory and production will follow.
Another assumption underlying the Austrian vision of economics is the belief in a strong tendency for profits to be equalized across the economy. But that idea is unconvincing. It assumes an unrealistic degree of competition across markets, whereas in the real world very different degrees of competition between industries, market power, barriers to new entry, patents, labour issues and other factors will thwart the process.
Jonathan Finegold Catalán, “Conceptualizing Price Distortions,” Economic Thought, 21 May, 2013.
Gu, G. C. and F. S. Lee. 2012. “Prices and Pricing,” in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics (2nd edn.). Edward Elgar, Cheltenham. 456–463.
Hayek, F. A. von. 1948. “The Meaning of Competition,” in F. A. von Hayek, Individualism and Economic Order. University of Chicago Press, Chicago. 92–106.
Hayek, F. A. von. 1978. “Competition as a Discovery Procedure,” in New Studies in Philosophy, Politics, Economics, and the History of Ideas. University of Chicago Press, Chicago.
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.
Melmiès, J. 2012. “Price Rigidity,” in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics (2nd edn.). Edward Elgar, Cheltenham. 452–456.