Market Theory and the Price System. Israel M. Kirzner
Economic theory abstracts the element of preference—bare and colorless—that emerges in each of these situations. In geometry a proposition may throw light on properties of rectangular objects, including restaurant tables, milk cartons, and billboards. Geometry, however, has nothing essentially to do with eating in restaurants, drinking milk, or advertising. Economic theory is in similar case: it abstracts from actual situations those elements to which it is relevant.
Economic theory is, as a consequence, general, in that its conclusions have validity for sets of data that may be widely different from each other in every particular aspect other than the economic. (To relieve the abstractness of the reasoning, numerous concrete examples are given of situations that may be quite general; these examples will serve only as illustrations of general propositions.) In the theory of the market economy, our propositions will relate to such entities as “goods that consumers desire more urgently,” or “resources that are in relatively short supply,” or “production processes that are relatively more efficient.” Any such proposition may apply to many different situations.
Our “ice block” illustration demonstrates, in addition, the possibility of deducing economic propositions whose validity does not depend upon the accuracy or completeness of any empirical observations. Since our theory of ice prices did not depend on any particular physical properties of ice, nor upon any particular psychological attitudes toward ice (except that it be considered an economic good), our theory required no laboratory experiments upon ice nor any psychological observations of behavior. Our theory depended only on the logic of choice; that is, it required only that we understand what human beings will do when they find that the use that can be made today of a block of ice is more important than the use that could have been made of it yesterday. We are able to develop propositions of this kind because we are acting human beings. We know, without empirical observations, how a change in the attractiveness of the terms on which a human being is free to choose will tend to affect the choice of any being whose behavior is guided by reason similar to our own. Economic theory is founded on this kind of knowledge that we possess. We can analyze the effects of changes upon human action, in the abstract, because we are immediately aware of the logic that governs all human action. The logic that governs human action is the same logic that the economic theorist applies in analyzing this action. If molecules had preferences and acted purposefully to achieve them, then the physicist would have a source of knowledge concerning the behavior of physical matter quite independent of any empirical findings that he might make. This source would be his own immediate understanding of how purposeful beings tend to behave under changing patterns of alternatives. The economic theorist finds himself in precisely such a favored position.
Now, the logical validity of a proposition of economic theory does not mean that the real world presents any instances of the truth of the proposition. In mathematics, for example, it does not follow from the geometrical proposition that states that the base angles of an isosceles triangle are equal, that we will ever be able to find such a triangle. Similarly a proposition linking a restriction in the supply of ice or of any economic good (other things being unchanged) to a subsequent rise in its price does not, in itself, mean that in the real world there has been or will ever be such a restriction in supply (and it certainly does not mean that with any such a restriction in supply, the “other things” will remain unchanged). All that a proposition can assert is that, if given changes occurred under given conditions, then certain consequences would follow.
It is clear, then, that if the economic theorist is to be of any assistance in understanding the real world, he must develop theorems concerning situations that do occur. The economist who analyzes concrete economic problems applies propositions of far-reaching generality to particular situations in which he recognizes the dominance of conditions similar to those governing the relevant propositions. The application of economic theory in this way certainly cannot be done without careful, accurate, and complete factual and statistical descriptions of the real world situations in which it is proposed to detect the operation of the economic laws that are expounded by theory.
Therefore, the work of the “practical” economist, who aims at explaining what has happened in the real world or at predicting the likely consequences in the future of some proposed or adopted policy, must of necessity include close attention to “facts.” Important and indeed indispensable as the examination of the “facts” of economic history—remote or current—may be for these purposes, this task is clearly distinguished from that of constructing theories. The theorist makes assumptions and uses his reasoning to develop the consequences implied in his assumptions. He may take his assumptions from wherever he pleases, including the real world. Economic theory refers to the reasoning out of consequences from assumptions, not to the task of selecting assumptions.
Economic theory emerges then as a tool that can be used in understanding the external world. The tool itself is “abstract,” to be judged for its truth not for its realism. A proposition of economic theory is, to repeat, very much like a theorem in geometry: we prove its truth, and then we may be able to discover in the real world a situation that illustrates its truth. The economist applying theory to real world situations will clothe the abstract propositions of theory with “actual” data. His final pronouncements will “explain” one set of historical events by relating them to other historical events. These pronouncements on the chains of causation, which he claims to have detected in the real market, may certainly be properly judged for their realism. If a decrease in the supply of one good was found to have been followed by a rise in the price of a second good, the economist, applying theory, may perhaps explain the chain of events by saying that the second good is a close substitute of the first. The theory on which he bases his explanation is unquestionably true: the restriction of the supply of one good, other things being unchanged, leads to a rise in the price of substitutes. But whether the economist’s explanation is realistic and relevant depends on whether the second good is or is not a substitute for the first; whether other things were unchanged; and so on.
In carrying out his task of explaining what has happened in the real world, or in predicting the likely consequences in the real world of a particular event, the economist thus combines theory with empirical fact. For these purposes it is frequently quite unnecessary to analyze his final report into its theoretical component on the one hand, and its factual component on the other hand. The skillful economic commentator will combine keen observation of events with statements revealing the theoretical interdependency of these events. A particular case of local unemployment may be linked to a shift in consumer tastes or to the emergence of new, cheaper resource markets elsewhere; an outflow of gold may be linked to particular governmental monetary policies; a particular pattern of industrial organization may be traced back to the tax structure, and so on. It would not be necessary, nor even helpful, in these cases, to separate economic theory from economic fact.
In studying a book such as this one, however, it is imperative that the distinction between theory and fact be kept clear. This book deals essentially with theory. It presents the kinds of logical procedures that must be used to understand the operation of a market economy. It presents the basic tools that the trained economist will use repeatedly in interpreting events in the real world. If these tools are to be used with success, they must first of all be forged as ends in their own right. Economic theory must first be recognized for what it is in and of itself: a body of abstract propositions deduced from hypothetical assumptions.
MARKET THEORY, ECONOMIC THEORY, AND ECONOMICS
We are now in a position to state how the subject matter of this book relates to economic theory as a whole and, even more generally, to the entire discipline of economics.
The theory that we study in this book makes up the core of economic theory, but by no means exhausts it. We investigate here the structure and operation of a market economy in its broadest theoretical outline; and it is within this general body of theory that most other branches of economic theory find their place. We are provisionally able to refrain from paying attention to these other branches of theory only by drastically simplifying the hypothetical market economy we deal with. Once the theory of the simplified