Market Theory and the Price System. Israel M. Kirzner
he is willing to supply on these terms. That portion of production that is not earned by resource owners is received by entrepreneurs as pure profit. We now consider briefly the factors that determine the size of profits, and especially the coordinating functions that profits fulfill.
THE COORDINATING FUNCTION OF PROFITS IN A MARKET ECONOMY
In the previous sections it was seen that the market process simultaneously solves the three fundamental problems of economic coordination through the price system. The emergence of a price structure reflects a priority system that guides resources to (what this priority system pronounces to be) their most productive uses. But the price system is not “automatic”; it functions only as the expression of human actions. In particular the price system is the expression of entrepreneurial decisions consciously planned and executed. Entrepreneurial decisions are made with the purpose of winning profits.
Profits are to be won whenever something can be sold for a price higher than the price it can be bought at (or higher than the sum of the prices of everything needed for its production). For an entrepreneur to win profits it is necessary, first, that such a price discrepancy exist; and second, that the entrepreneur know that it exists. Now, for a price discrepancy to exist, it is necessary that those willing to sell the commodity (or the factors necessary for its production) for the lower price and those willing to buy the commodity at the higher price be unaware of each other’s attitudes. If these sellers and buyers knew each other’s attitudes, these would soon be altered to eliminate the price discrepancy. The entrepreneur wins profits by becoming aware, earlier than others, of the hitherto unknown discrepancy (reflected in the price differential) between the attitudes of those willing to sell for less and of those willing to buy for more.
It is the characteristic of the real world to which the analysis of market theory may be applied that, at any one time, numerous instances occur of the kind of ignorance that makes it possible for price discrepancies and profits to emerge. Each market participant knows some of the market facts relevant to his own situation, but is ignorant of a great many more. Among the alternatives from which Market Participant A believes he has to choose, some particularly attractive alternative is usually missing (obtainable by dealing with Market Participant B) which might have been included if only A and B would have known of each other’s situation and attitude. From the point of view of an imaginary, disinterested outsider knowing all these facts, both A and B are the losers due to their ignorance of some market facts. From the point of view of the omniscient outsider, the market always has room for a reshuffling of resources or goods according to the pattern that would take place if the market participants themselves were not in ignorance of the opportunities available to them.
It is here that we can see the essential character of the coordinating functions performed by the market process. The market process tends to present market participants with alternatives that approximate those opportunities they would choose if they possessed all the relevant information. The market process achieves this without making it necessary for market participants to learn all this detailed information. Instead, the market reveals any lack of coordination resulting from ignorance by market participants of potentially available opportunities through the emergence of price discrepancies. Ignorance of available opportunities then equates to ignorance of price discrepancies. Where this kind of ignorance persists, the opportunity exists for the first discoverers of the price discrepancy to step in and win profits. In doing this they wipe out the price discrepancy itself, and thus remove the lack of coordination that resulted from the limited market knowledge of market participants.
The quest for profits thus serves as a complete substitute for the search for conditions where ignorance exists on the part of market participants of the opportunities available to them. In the quest for profits the latter search has been replaced by a simple search for price discrepancies. Wherever discrepancies exist between prices paid for identical goods, or between prices paid for goods and those paid for everything required for their production, then the imaginary omniscient economist could point out possibilities for reallocation of goods or resources that would benefit all concerned. The market tends to act to achieve precisely this reallocation by offering prizes (profits) for the detection and removal of price discrepancies. It is thus the activity of the entrepreneur in his search for profits that serves as the driving force of the price system, enabling it to solve the problems of coordination outlined in the previous sections of this chapter.
Chapter 3 examines the operation of a market system, with respect to the way it achieves the goals or functions that its participants may seek to fulfill through this means of social organization.
An “economic problem” consists for an individual in ensuring that the resources at his disposal be utilized in the most effective manner possible, from the point of view of his own cherished goals. With some reservations, it is possible to speak of an economic problem facing society in general, and of the “efficiency” with which a form of social organization fulfills the goals set for it.
For a system of social cooperation, efficiency requires the coordination of separate activities. Social cooperation opens up the way to the improved fulfillment of individual wants through division of labor; but division of labor is beneficial only where carried on in a coordinated fashion. Coordination involves (a) the development of a priority system for the satisfaction of wants, (b) some way of determining the method of production to be employed for each adopted project, and (c) a way of assigning rewards to the individuals cooperating jointly in productive activities.
The market simultaneously solves these coordinating problems through the price system. Prices determine the priority with which the various possible products will be produced on the basis of consumer demand working through the entrepreneurial search for profits. The same process guides entrepreneurs to the employment of definite methods of production (those which can achieve a given result at the lowest money cost). At the same time the pricing process assigns prices to the services of those cooperating in production. The driving force in the process is thus the entrepreneurial search for profits, leading to the production of products commanding the highest prices (for given production costs) and to the employment of the resources involving least cost (for a given productive purpose).
SUGGESTED READINGS
Knight, F. H., The Economic Organization, Kelley and Millman Inc., New York, 1951, pp. 3–30.
Mises, L. v., Human Action, Yale University Press, New Haven, Connecticut, 1949, pp. 694–697, 258–323.
In this and the succeeding chapters we discuss the theory of the demand side of the market. Our task will be to explain the way the alternatives presented to each consumer by the market determine the way he spends his income and the quantities of each good that he decides to purchase.
In the present chapter a framework is set forth within which individual consumer demand theory intuitively “fits.” This is the notion of marginal utility. It must be stressed that utility theory provides no explanation in terms of any external observable criteria. It merely provides a logical means of mental orderliness in bringing coherence into a description of individual behavior. It provides a framework by which an internal consistency can be introduced into the explanation of consumer adjustment to changes in market data. The fact that this framework is intuitively and introspectively valid makes it extremely valuable in explaining the actions of market participants.
This chapter provides the conceptual apparatus