Capital in Disequilibrium

CHAPTER 2 What Does Equilibrium Mean? A Discussion in the Context of Modern Austrian Ideas

Equilibrium Examined and Defined

A term which has so many meanings that we never know what its users are talking about should be either dropped from the vocabulary of the scholar or “purified” of confusing connotations.

(Machlup 1958:43)

The continuing use of the word “equilibrium” by different people to mean different things justifies yet another brief examination. No pretense, however, is made at completeness.

I can think of at least seven different approaches to equilibrium. These are not mutually exclusive and are, indeed, related in important ways:

1.   equilibrium as a balance of forces

2.   equilibrium as a state of rest (a stationary state)

3.   equilibrium as a state of uniform movement (a steady state—of which 2 is a special case)

4.   equilibrium as a constrained maximum

5.   equilibrium as an optimum

6.   equilibrium as rational action

7.   equilibrium as a situation of consistent plans.

In each case at least two dimensions can be identified. Equilibrium can relate to the entire economy (general equilibrium) or to a subset of the economy (partial equilibrium) or to the individual. Equilibrium can be considered for a single all-encompassing period (static equilibrium), or for a succession of self-contained periods (temporary equilibrium) or for a succession of related sub-periods (intertemporal equilibrium).

Examining this further, we note that equilibrium as a balance of forces (as the word implies)1 in some sense is at the base of all other equilibrium concepts. And if “change” (and its absence) is defined appropriately, definitions 1 and 2 are seen to be equivalent. So, for example, the traditional supply and demand equilibrium is a balance of forces that acts to keep prices stable (at rest). In the case of the price of an asset, we may say that if the price is stable, the bulls balance the bears.2 In the case of a perishable good, those forces (whatever they are: technology, price expectations, etc.) which tend to influence the amounts offered for sale and purchase at various prices in a way that tends to push the price up are balanced by those that tend to push it down. This is one way to think of stable prices. If neither supply nor demand change, price (once in equilibrium) will not change. It is also an optimum (definition 5) of sorts in the well-understood sense that, given the fundamental conditions of supply and demand, buyers and sellers are doing the best they can. From another perspective, it is a constrained maximum (definition 4) in that buyers and sellers maximize the perceived opportunities to buy and sell, and thereby achieve a maximum of “satisfaction” as determined by their preferences in relation to the (perceived) opportunities. It may not be an optimum, however, if there are opportunities of which the economic agents are unaware (see Kirzner 1990), or if their actions affect opportunities in other markets adversely. Also, it is possible to see how momentary equilibrium can be generalized to a situation of uniform change (definition 3)—for example, where demand and supply increase proportionately.

So while, in an appropriate sense, equilibrium as a balance of forces is also a state of rest (or a situation of uniform change) and a constrained maximum, it may not be an optimum. Also, in each case it is possible to conceive of situations that are not in equilibrium. Some theorists have found it helpful, however, to define the constraints so broadly as to conceive of individuals as being always in equilibrium (see Shmanske 1994). So, again using the example of simple supply and demand, a situation of non-price rationing, not allowing the price to rise and clear the market, can be seen as an equilibrium situation if we include in all individual decisions the costs imposed by rationing—like waiting in line. Indeed, using this approach, one may predict that the lines at the checkout counter of a supermarket would tend to an “equilibrium” size that equalizes waiting time. Thus the supply curve becomes vertical at the fixed price below the market-clearing price. In effect, the money price has been reduced, but the real price (including waiting cost) has gone up because of a “shift” in the supply curve to the left (from an upward slope to a vertical one). So demand always equals supply if we are careful to include all relevant factors.3 While it is clear that this approach may prove enlightening in some cases, when extended to the level of all agents for the entire economy it can involve disturbing and paradoxical implications. Thus, considering all possible costs and benefits, the world is at all times in a Pareto optimal equilibrium, a Panglosian “best of all possible worlds” given the relevant constraints. Things are what they are because we understand how individuals had to act the way they acted in order to maximize, given the constraints that existed and were perceived by them (again see Shmanske 1994 for a complete discussion). This approach uses equilibrium to characterize rational action (definition 6) where “rational” is understood to refer to the system as a whole and not just to individuals. For normative (policy) purposes this is obviously not very helpful. The policy-maker is, after all, subject to the same, universally perceived, constraints. We shall see that the difficulty arises because of the lack of a distinction between individual and system equilibrium.

In a lecture delivered in 1936, Hayek defined equilibrium as a situation in which “the different plans which the individuals composing [a society] have made for action in time are mutually compatible” (Hayek 1937b:41). This is my definition 7. As this is the definition that we shall adopt in the rest of this work, it is worth examining in some detail. An important aspect is the move away from the purely physical dimensions of equilibrium as a state of rest or balance of forces, to one firmly based in the human mind. Equilibrium is here conceived as a situation in which individual knowledge and expectations, and the actions based on these, are compatible with the “data,” where the “data” for one individual include the actions of other individuals. Scratching the surface of any of the definitions offered above indeed reveals that it is impossible to think of equilibrium in economics without bringing in the perceptions of individuals. After all, we are dealing with human actions and these are determined by the perceptions of the actors. So, in the case of the supply and demand of a single well-defined market, for example, the price will not be observed to change when all individuals are fulfilling their mutually related plans to buy and sell; and where such plans are not fulfilled we may expect these plans to be revised.4

The volitional, intentional aspect of equilibrium is likewise obvious in all of the other approaches. This is widely recognized, although in the formal technical treatments of modern economics one is often apt to lose sight of it, as for example in the case of neo-Ricardian capital theory and general equilibrium theory. There is no doubt, however, that Hayek’s insights have been accepted in principle and have been variously endorsed by a number of eminent neoclassical economists. For example:

[Equilibrium refers to] those states in which the intended actions of rational economic agents are mutually consistent and can, therefore, be implemented.

(Hahn 1984:44)

[Equilibrium is a] state where no economic agents have an incentive to change their behavior . . . the equality of demand and supply should not be taken as a definition of equilibrium, but rather as a consequence following from more primitive behavioral postulates.

(Stiglitz 1987:28)

Thus we shall say that an equilibrium situation is one in which individual plans are fully coordinated. Each plan can be successfully executed. Means are exactly matched to ends.

Implications of Equilibrium

It will be immediately apparent that equilibrium thus defined is an extremely unlikely event. It is patently unrealistic. One might wonder at its widespread acceptance as a standard of reference. This raises the important question of the function of equilibrium constructs in economic theory. Obviously, theoretical constructs are, to a greater or lesser extent, unrealistic. They all abstract from reality in order to illuminate it. For example, one common use to which equilibrium constructs are put is the tracing of the (ultimate) consequences of any change while imagining all other possible relevant changes to be absent. In this way a general idea of cause and effect can be built up by isolating the effects of different causes.5 The crucial question is: what are permissible abstractions, and what abstractions render a theoretical construct useless? When is the usefulness of the model compromised so that its results (the cause-effect connections that it suggests) are no longer reliable guides to reality? This is an involved question that we shall not be able to answer here in any detail. I shall contend, however, and hopefully motivate in the course of our discussion, that theoretical constructs that abstract completely from the implications for human action of the passage of time and its implications for changes in knowledge are not likely to be very helpful in understanding economic processes. While it is true that equilibrium “is in the model and not in the world,”6 I want to build a bridge between the “model” and the “world” and maintain that timeless models cannot do this.7 This is most clearly seen in discussing the stability of equilibrium.

Before turning to this, however, we should pause to note some other aspects of equilibrium, understood as the mutual compatibility of individual plans, including the relationship between micro and macro equilibrium, or between individual and system equilibrium.8 Hayek makes an important distinction between these:

I have long felt that the concept of equilibrium itself and the methods which we employ in pure analysis have a clear meaning only when confined to the analysis of the action of a single person and that we are really passing into a different sphere and silently introducing a new element of altogether different character when we apply it to the explanation of the interactions of a number of different individuals.

(Hayek 1937b:35)

It is from a careful consideration of the meaning of individual equilibrium that a number of implications for our understanding of system equilibrium emerge. First, Hayek argues that the “tautological propositions of pure equilibrium analysis” are not directly applicable to the explanation of social relations. Examining individual equilibrium shows it to be equivalent to rational action. “What is relevant [however] is not whether a person as such is or is not in equilibrium but which of his actions stand in equilibrium in so far as they can be understood as part of one plan” (ibid.:36). Second, the role of the individuals’ knowledge and, therefore, the knowledge of all individuals, is of crucial importance. “It is important to remember that the so-called ‘data,’ from which we set out in this sort of analysis, are (apart from his tastes) all facts given to the person in question, the things as they are known to (or believed by) him to exist, are not, strictly speaking, objective facts” (ibid.:36). So it is quite conceivable, and likely, that in some respects different individuals’ “knowledge” of the same circumstance will be not only different but inconsistent. And some types of knowledge are likely to be more reliable guides to action than others.

Third:

since equilibrium relations exist between the successive actions of a person only in so far as they are part of the execution of the same plan, any change in the relevant knowledge of the person, that is, any change which leads him to alter his plan, disrupts the equilibrium relations between his actions taken before and those taken after the change in his knowledge. In other words, the equilibrium relationship comprises only his actions during the period in which his anticipations prove correct. [And] since equilibrium is a relationship between actions, and since the actions of one person must necessarily take place successively in time, it is obvious that the passage of time is essential to give the concept of equilibrium any meaning.

(ibid.:36–37, italics added)

So equilibrium is not only a relationship between individuals at a point of time, it is necessarily also a relationship between actions over time. For equilibrium to exist during a period of time it must exist at every point of time within that period. If equilibrium exists at a point of time, then individuals’ plans are consistent with each other and with the technical facts of the world such that each plan can be successfully implemented. This means that in the absence of any change (meaning the arrival of new knowledge) equilibrium will exist at every point of time. This definition of equilibrium thus implies intertemporal equilibrium.9

A Tendency Towards Equilibrium?

Hayek on Equilibrium Tendencies

In the history of the development of the equilibrium concept economists have been concerned with certain basic properties that equilibria may or may not exhibit. The most basic is the question of existence—whether or not an equilibrium can be shown logically to exist. According to our definition this involves showing that a situation exists (logically) such that all plans can be implemented. In the voluminous mathematical literature on general equilibrium such a proof was ultimately discovered, but at the expense of the imposition of a set of heroic restrictions on knowledge, preferences and technology. It was also possible to show that under certain even more restrictive conditions such an equilibrium was unique (Ingrao and Israel 1990). It is clear, however, that the importance that these properties assumed is directly related to the formal, technical, mechanistic nature of the conception of equilibrium that tended to dominate this literature (and still does). For Hayek, equilibrium was never understood as a state that could ever actually be said to exist, although its logical existence is clearly implied. He was more concerned with the question of whether or not it could be shown or argued that a tendency toward equilibrium (“a greater degree of plan coordination”) characterized the actual market process. This is related to the questions of stability and/or convergence that the mathematical economists have been unable to answer satisfactorily.10 But for Hayek (and those who followed his lead) it was not a theoretical matter. As this will be quite important, I will quote at some length from Hayek:

We shall not get much further here unless we ask for the reasons for our concern with the admittedly fictitious state of equilibrium. Whatever may occasionally have been said by overpure economists, there seems to be no possible doubt that the only justification for this is the supposed existence of a tendency toward equilibrium. It is only by this assertion that such a tendency exists that economics ceases to be an exercise in pure logic and becomes an empirical science. . . .

In the light of our analysis of the meaning of a state of equilibrium it should be easy to say what is the real content of the assertion that a tendency toward equilibrium exists. It can hardly mean anything but that, under certain conditions, the knowledge and intentions of the different members of society are supposed to come more and more into agreement or,. . . that the expectations of the people and particularly of the entrepreneurs will become more and more correct. In this form the assertion of the existence of a tendency toward equilibrium is clearly an empirical proposition, that is, an assertion about what happens in the real world. . . . And it gives our somewhat abstract statement a rather plausible common-sense meaning. The only trouble is that we are still pretty much in the dark about (a) the conditions under which this tendency is supposed to exist and (b) the nature of the process by which individual knowledge is changed.

(Hayek 1937b:44–45)

This was a preoccupation of Hayek’s throughout his career even as he moved beyond economics narrowly understood. Whether or not he was able to provide a satisfactory answer to items (a) and (b) in the quotation above is a matter of some debate (see, for example, Rizzo 1990, 1992; Lewin 1994).

Lachmann versus Kirzner

The revival of the Austrian research program, in its market process variety, since the 1970s, has seen a return to this issue of equilibrating tendencies in a more energetic fashion. In particular, it has emerged as a defining issue within the Austrian School of economics in a way that was clearly foreshadowed during some historical moments in June 1974 in South Royalton, Vermont, at a conference marking the start of this revival (Dolan 1976). At that conference two papers in particular outlined the two key perspectives that have appeared to be in conflict ever since—by Ludwig Lachmann and Israel Kirzner (Lachmann 1976a; Kirzner 1976). In these two papers (and some others by the same authors in the conference volume) we find a clear, concise articulation of the issues.11 Both Kirzner and Lachmann regard the market as a process in time, out of equilibrium. Both regard the question of equilibrating tendencies to be problematic. But for Kirzner the problem is resolved by the actions of the entrepreneur in noticing disequilibrium situations and profiting by their removal, thus providing a reason to believe in, and an explanation of, a tendency in markets towards equilibrium.

The problem is most simply seen once again in the supply and demand analysis of an isolated market. As Kirzner remarks, often our explanations proceed no further than an identification of the market-clearing price at the intersection point—“almost implying that the only possible price is the market clearing price.” Our common-sense explanations proceed in terms of familiar Walrasian equilibrating processes. At prices below market clearing, there is an excess supply in the aggregate (unsold stocks) and this will tend to force prices down; while the opposite is true for a situation of excess demand (unsatisfied buyers). “Thus, we explain there will be a tendency for price to gravitate toward the equilibrium level.” We should note that it is implicitly assumed that there is always only one price in the market. “One uncomfortable question, then, is whether we may assume that a single price emerges before equilibrium is attained. Surely a single price can be postulated only as a result of the process of equilibration itself.” Various explanations have been offered and devices suggested for dealing with this problem, including Marshallian adjustment processes and perfect competition, none successfully. The problem remains because “disequilibrium occurs precisely because market participants do not know what the market-clearing price is” (Kirzner 1976:116–117).

This approach can be generalized to equilibrium in contexts other than the isolated market. The problem of explaining convergence to equilibrium is a problem of explaining how individuals out of equilibrium obtain the information necessary for them to have knowledge of, and incentives to make, the appropriate adjustments. In the process of developing the solution Kirzner reaffirms the Hayekian definition of (dis)equilibrium. “Disequilibrium is a situation in which not all plans can be carried out together; it reflects mistakes in the price information on which individual plans were made” (ibid.:118). It is the Kirznerian entrepreneur who notices these mistakes and is able to take advantage of them. Kirzner’s well-known, and justly admired, theory of entrepreneurial action in the removal of all manner of price discrepancies will not be summarized here.12 Suffice it to say that the entrepreneur is “an all-purpose arbitrageur” (my term) who is alert to profit opportunities that exist as a result of price differences at a point of time, price differences between two points in time (after accounting for interest and holding costs), or price and cost differences (that is the price of a finished product and the cost of all the resources, including interest, necessary to produce it). By exploiting these generalized price discrepancies the entrepreneur tends to remove them, thus providing the answer to the original uncomfortable question. The tendency to equilibrium is supplied by entrepreneurial action. Kirzner then states clearly the issue that we are investigating:

Disequilibrium represents a situation of widespread market ignorance. This ignorance is responsible for the emergence of profitable opportunities. Entrepreneurial alertness exploits these opportunities when others pass them by. G. L. S. Shackle and Lachmann emphasized the unpredictability of human knowledge, and indeed we do not clearly understand how entrepreneurs get their flashes of superior foresight. We cannot explain how some men discover what is around the corner before others do so. . . . As an empirical matter, however, opportunities do tend to be perceived and exploited. And it is on this observed tendency that our belief in a determinate market process is founded.

(ibid.:121)

Lachmann makes it clear that he does not believe in a “determinate market process.” While he is readily prepared to endorse the notion of individual equilibrium, he has no use for general equilibrium (and, as is clear from the context, any equilibrium other than that of the individual) or tendencies toward it. “The notion of general equilibrium is to be abandoned, but that of individual equilibrium is to be retained at all costs, It is simply tantamount to rational action. Without it we should lose our ‘sense of direction’” (Lachmann 1976a:131). The reason for his rejection of market equilibrium is his understanding of the implications for action of the passage of time. Once again, as with Kirzner, I shall not stop to summarize in any detail Lachmann’s well-known views in this regard. I merely note some implications. He considers it axiomatic that the passage of time cannot occur without the arrival of new knowledge. Each moment in time is unique and time is irreversible. “As soon as we permit time to elapse, we must permit knowledge to change” (ibid.: 127–128, italics removed). I have referred to this as Lachmann’s axiom.13

Although old knowledge is continually being superseded by new knowledge, though nobody knows which piece will be obsolete tomorrow, men have to act with regard to the future and make plans based on expectations. Experience teaches us that in an uncertain world different men hold different expectations about the same future event . . . divergent expectations entail incoherent plans . . . what keeps this process in continuous motion is the occurrence of unexpected change as well as the inconsistency of human plans. . . . Are we entitled, then, to be confident that the market process will in the end eliminate incoherence of plans. . . ? To say that the market gradually produces a consistency among plans is to say that the divergence of expectations, on which the initial incoherence of plans rests, will gradually be turned into convergence. But to reach this conclusion we must deny the autonomous character of expectations. . . . Expectations are autonomous. We cannot predict their mode of change as prompted by failure or success.

(ibid.:128–129)

There is thus no way to know which of the “opportunities” perceived by the Kirznerian entrepreneurs are “real” and which are (perhaps inconsistent) figments of their disparate expectations. In this way Lachmann departed company from Kirzner and Hayek and was not prepared to assert the existence of any tendency toward equilibrium. “What emerges from our reflections is an image of the market as a particular kind of process, a continuous process without beginning or end, propelled by the interaction between the forces of equilibrium and the forces of change” (Lachmann 1976b:61).14

The issue of convergence, of a tendency toward equilibrium,15 thus remains a contentious issue in which a lot is perceived to be at stake. From Lachmann’s lead, further investigations of the meaning and implications of Lachmann’s axiom have followed, the most elaborate of which is the in-depth examination by O’Driscoll and Rizzo (1996). The varying reactions to this book bear testimony to the depth of the rift within the subjectivist Austrian family. This is well captured in the two reviews by Kirzner (1994a) and Lachmann (1994).16 Although intrafamily disputes are often the most vociferous, where there is so much agreement on everything else of significance it is perhaps surprising. Yet it appears to be fundamental.

Hayekian equilibrium is a state of complete coordination of plans (and the expectations on which they depend). An equilibrating tendency is thus a tendency of markets to coordinate human affairs. By denying the existence of equilibrating tendencies, Kirzner worries, one may be led to deny the “plausibility of possible systematic processes of market coordination” and in the extreme “render economic science non-existent” (Kirzner 1994a:40–41). On the other hand, Lachmann worries that by affirming the existence of persistent equilibrating tendencies “we are playing right into the hands of our opponents who merely have to point to obvious instances of malcoordination to win debating points” (Lachmann and White 1979:7). Further, “the root of our difficulty lies in this: in a market . . . all coordinating activity must engender some discoordination of existing relations” (Lachmann 1986:11) hence endogenous change. Those who take Lachmann’s axiom seriously see no way to avoid the conclusion that change is endogenous and continuous, thus making any statement about equilibrating tendencies inherently suspect. At the heart of the problem is the “autonomy of individual expectations” and the choices to which they lead. Lachmann’s axiom follows from the inability to deny its implication that individual behavior cannot be predicted because future knowledge cannot be predicted (O’Driscoll and Rizzo 1996). Expectations relating to the choices of other individuals must be diverse and, therefore, are bound to be falsified. But if expectations are bound to be falsified, implying that prediction is impossible, how do we do economics? Indeed how do we act at all? Is life possible without equilibrium?

Appendix: Equilibrium, Time and Expectations

The problem of convergence to equilibrium revolves essentially around the prior problem of how economic agents in a disequilibrium situation acquire information that would motivate them to take actions that would result in the economy moving toward equilibrium. They cannot be presumed to know what the equilibrium price is, since this would assume away the entire problem. Kirzner’s answer, as we have seen, is that the entrepreneur, the important economic agent in this context, acts on the basis of price discrepancies—“buying low and selling high”—thus moving prices toward the establishment of one price. But how do we know that this will be the equilibrium price? The problem may be seen most simply if we once again use the simple supply and demand case of an isolated market.

The simplest case is the one where we assume that the positions of the supply and demand curves are unaffected by the actions of individuals in the market. That is to say, the effects of trading at “false prices” must be assumed to be negligible—small enough to be ignored. We thus ignore any possible income effects that might give rise to path dependence. We rule out changes in the “data” as a result of the actions of the market participants themselves—we rule out endogenous change; and we rule out changes that emanate from outside of this market, like changes in technology—we rule out exogenous change. In this case the equilibrium price is a fixed target, an unmoving attractor. Should the market arrive at it, it will stay there in the absence of any exogenous change. The question is: if the price is not at the equilibrium price, will it move towards it?

Traditionally, and predictably, this problem has been answered by attempting to investigate how individuals might react to the information they receive in disequilibrium. So for example, when the price is above the equilibrium price, there will be more available for sale than is demanded. The existence of excess supply will tend plausibly to suggest to economic agents (or an entrepreneur will suggest to them) that they reduce the price that they offer or ask, and in this way the price will tend to fall. But to what level will the price fall; how do agents form their expectation of what the price should be? These “reaction functions” can be of greater or lesser complexity, and depending on their properties the problem will exhibit a “smooth” transition toward the equilibrium price in each successive “period,” an oscillating approach, a perpetual circling around it, or an explosive divergence away from it.

This is the familiar corn–hog cycle. It suffers from pretending to know how individuals will react in any given disequilibrium situation. It is not plausible to suggest that individual reaction functions that depend on each other’s reaction to ever increasing higher levels can be mathematically modeled in a satisfactory way. However, it may be argued that another route is available. Whatever the precise way in which individuals react, as long as there is enough variation in reactions, and as long as we allow enough time to elapse in the absence of fundamental change, we may argue that as a result of sheer “trial and error,” propelled by varying reactions to disequilibrium prices, the market will eventually, if not sooner then later, “hit” on the equilibrium price. It is hard to believe that an unmoving equilibrium price will not eventually be discovered and established. It is, after all, a “preferred” price in the sense that it results in the mutual fulfillment of all buy and sell plans and we reasonably expect it to emerge out of individual free trades.

Now of course the problem is that it is not at all plausible to assume that the supply and demand curves are fixed for the duration. The above exercise may establish a convergence in principle (not a “rigorous” proof, but a suggestive argument), and this may suggest further that, as an empirical matter, reactions are such in the real world that a “tendency” toward the equilibrium price will prevail even though it is continually being thwarted by shifts in supply and demand. The argument is that the tendency in the market is toward equilibrium. To the extent that this is disturbed it is as a result of exogenous changes in supply and demand forces, like a new technology, new products, etc. Thus, it is the presence or absence of endogenous change that has emerged as a critical issue.

The simple supply–demand case is suggestive in two ways. First, where the world is such that the “underlying realities” (in this case the positions of the supply and demand curves or, more accurately, the contingent trades that they represent) are constant, it seems natural to argue that convergence will occur. So even if, for centuries, most people believe erroneously that the world is flat, and for some time there is a variation of beliefs, since the world remains round no matter what we believe or how we act messages from our experience will eventually convince us (all of us?!) that it is round. There is a notable convergence of expectations as a result of experience. No one now expects to fall off the edge. Generally a stable (constant) decision environment is conducive to convergence, exhibiting the required feedback. Second, the simple supply–demand case can be generalized to situations of multiple markets as long as we continue to ignore income or wealth effects and rule out exogenous changes. Then the entrepreneur becomes key. Price discrepancies in geographically separated markets or for inputs versus outputs will then tend to be eradicated even as each market is “groping” its way to isolated equilibrium. And in this case it is easy to see how prices are powerful transmitters of information. Once again, the result is ideal, depending as it does on the assumption of unvarying underlying realities and sufficient variation in individual reaction.

_________________

17Interestingly The New Shorter Oxford English Dictionary offers a number of definitions:

1. A well balanced state of mind or feeling. . . . 2. A condition of balance between opposing physical forces. . . . 3. A state in which the influences or processes to which a thing is subject cancel one another and produce no overall change or variation. . . . Econ. A situation in which supply and demand are matched and prices stable.

Although 2 and 3 are probably the most intuitive colloquially, 1 comes closest to our usage, as we shall see.

18 [The market] cannot make bulls and bears change their expectations but it nevertheless can coordinate these. To coordinate bullish and bearish expectations is, . . . the economic function of the Stock Exchange and of asset markets in general. This is achieved because in such markets the price will move until the whole market is divided into equal halves of bulls and bears. In this way divergent expectations are cast into a coherent pattern and a measure of coordination is accomplished . . . asset markets are inherently ‘restless,’ and equilibrium prices established in them reflect nothing but the daily balance of expectations. (Lachmann 1976b:237–238, italics added)

Clearly Lachmann is here using the term “coordination” in a rather limited sense and in no way to suggest a rendering of expectations compatible.

19Becker (and others using the ‘Chicago approach’) have used this type of reasoning to explain regulation-busting behavior (bribes, black markets, etc.) where individuals are seen as weighing all of the costs and benefits involved in violating regulations, etc. (Becker 1971:106ff.)

20It is possible to conceive of a situation of “statistical” equilibrium where mutually offsetting individual errors are such as to leave the price unchanged. In such a situation, although individual plans are not mutually compatible, we have equilibrium as a kind of balance of forces. Individuals are right “on average.” Hayek discusses this case in passing (Hayek 1937b:43n.) In a way this anticipates aspects of the rational expectations literature developed since the 1970s. As we shall be concerned with equilibrium in terms of its implications for individual perceptions, we shall not consider this case in any more detail. A sufficient, though not necessary, condition for price stability in the partial equilibrium static (non-growth) case, is the compatibility of plans to buy and sell.

21Machlup identifies four basic steps in equilibrium analysis:

1. Initial position—everything could go on as it is.

2. A disequilibrating change.

3. Adjusting changes.

4. Final position—new equilibrium.

Comparing 4 with 1 establishes cause-effect (see the discussion in Machlup 1958:47ff).

22This phrase is from O’Driscoll and Rizzo (1996:24). See generally Machlup (1958).

23See also the discussions in Rizzo (1990, 1992).

24I will use this designation to distinguish in general a higher level than individual equilibrium, whether it be the entire economic system or a subsystem of it (for example, an isolated market). As will become clear from the text, the crucial distinction is between equilibrium as it applies to an individual mind and as it applies to the interaction between two or more minds.

25See also (Hicks 1965:24).

26Once in equilibrium, will the system remain there (stability); and starting from any arbitrary point, will it converge to equilibrium?

27In particular, Lachmann’s analysis of equilibrium appears in its most uncompromising version. It is probably from here, more than from any other time and place, that Lachmann’s reputation as a “radical subjectivist” gained momentum and has since tended to dominate in evaluations of his work.

28For a recent statement see Kirzner (1992). Since the first edition of this book was published in 1999, Kirzner has continued to explain and refine his ideas as they have gained in exposure and popularity especially in the field of management studies. See Kirzner (2009).

29Lewin (1994:236). “According to a well-known Austrian axiom, ‘Time cannot elapse without the state of knowledge changing’ ” (Lachmann 1986:95).

30For an in-depth examination of this debate, see Karen Vaughn (1992; 1994:ch. 7). The debate continues, though in muted terms since Lachmann’s death in 1990. Kirzner has attempted to restate and refine his position (1992) and Mario Rizzo has provided a further critique (Rizzo 1996). For a summary of Kirzner’s position, see Kirzner (1997). For a more recent summary, see Kirzner (2009).

31See the appendix to this chapter.

32Originally published soon after O’Driscoll and Rizzo (1996, first edition 1985) in the Market Process Newsletter. For references to some of the contributions to this debate see Boettke, Prychitko, and Horwitz (1994).

• 1A shorter version of some of the material in this part appears in Lewin (1997c).
• 2[The market] cannot make bulls and bears change their expectations but it nevertheless can coordinate these. To coordinate bullish and bearish expectations is, . . . the economic function of the Stock Exchange and of asset markets in general. This is achieved because in such markets the price will move until the whole market is divided into equal halves of bulls and bears. In this way divergent expectations are cast into a coherent pattern and a measure of coordination is accomplished . . . asset markets are inherently ‘restless,’ and equilibrium prices established in them reflect nothing but the daily balance of expectations. (Lachmann 1976b:237–238, italics added)
• 3Becker (and others using the ‘Chicago approach’) have used this type of reasoning to explain regulation-busting behavior (bribes, black markets, etc.) where individuals are seen as weighing all of the costs and benefits involved in violating regulations, etc. (Becker 1971:106ff.)
• 4It is possible to conceive of a situation of “statistical” equilibrium where mutually offsetting individual errors are such as to leave the price unchanged. In such a situation, although individual plans are not mutually compatible, we have equilibrium as a kind of balance of forces. Individuals are right “on average.” Hayek discusses this case in passing (Hayek 1937b:43n.) In a way this anticipates aspects of the rational expectations literature developed since the 1970s. As we shall be concerned with equilibrium in terms of its implications for individual perceptions, we shall not consider this case in any more detail. A sufficient, though not necessary, condition for price stability in the partial equilibrium static (non-growth) case, is the compatibility of plans to buy and sell.
• 5Machlup identifies four basic steps in equilibrium analysis:
• 6This phrase is from O’Driscoll and Rizzo (1996:24). See generally Machlup (1958).
• 7See also the discussions in Rizzo (1990, 1992).
• 8I will use this designation to distinguish in general a higher level than individual equilibrium, whether it be the entire economic system or a subsystem of it (for example, an isolated market). As will become clear from the text, the crucial distinction is between equilibrium as it applies to an individual mind and as it applies to the interaction between two or more minds.
• 9See also (Hicks 1965:24).
• 10Once in equilibrium, will the system remain there (stability); and starting from any arbitrary point, will it converge to equilibrium?
• 11In particular, Lachmann’s analysis of equilibrium appears in its most uncompromising version. It is probably from here, more than from any other time and place, that Lachmann’s reputation as a “radical subjectivist” gained momentum and has since tended to dominate in evaluations of his work.
• 12For a recent statement see Kirzner (1992). Since the first edition of this book was published in 1999, Kirzner has continued to explain and refine his ideas as they have gained in exposure and popularity especially in the field of management studies. See Kirzner (2009).
• 13Lewin (1994:236). “According to a well-known Austrian axiom, ‘Time cannot elapse without the state of knowledge changing’ ” (Lachmann 1986:95).
• 14For an in-depth examination of this debate, see Karen Vaughn (1992; 1994:ch. 7). The debate continues, though in muted terms since Lachmann’s death in 1990. Kirzner has attempted to restate and refine his position (1992) and Mario Rizzo has provided a further critique (Rizzo 1996). For a summary of Kirzner’s position, see Kirzner (1997). For a more recent summary, see Kirzner (2009).
• 15See the appendix to this chapter.
• 16Originally published soon after O’Driscoll and Rizzo (1996, first edition 1985) in the Market Process Newsletter. For references to some of the contributions to this debate see Boettke, Prychitko, and Horwitz (1994).
• 17This first part of this work consists of two chapters (2 and 3). In Chapter 2 I summarize briefly some issues connected with the meaning and existence of equilibrium. This controversial area has been made difficult by the fact that the term “equilibrium” is often used in an inconsistent manner, either by a single theorist in different places and times or as between different theorists. So I try first to clarify what is meant (or what should be meant) by equilibrium. I adopt the Hayekian definition—the mutual consistency of individual plans. From this point of view I examine a current debate, one that is specific to modern Austrian (market process) economics, but is relevant to and, in many ways, reflective of, economics in general. This is the debate about the presence or absence (and, indeed, meaning) of equilibrating tendencies in the economy. The chief (friendly) protagonists in this discussion are Ludwig Lachmann and Israel Kirzner. The legacy of this debate is still with us.
• 18Examining this further, we note that equilibrium as a balance of forces (as the word implies) in some sense is at the base of all other equilibrium concepts. And if “change” (and its absence) is defined appropriately, definitions 1 and 2 are seen to be equivalent. So, for example, the traditional supply and demand equilibrium is a balance of forces that acts to keep prices stable (at rest). In the case of the price of an asset, we may say that if the price is stable, the bulls balance the bears. In the case of a perishable good, those forces (whatever they are: technology, price expectations, etc.) which tend to influence the amounts offered for sale and purchase at various prices in a way that tends to push the price up are balanced by those that tend to push it down. This is one way to think of stable prices. If neither supply nor demand change, price (once in equilibrium) will not change. It is also an optimum (definition 5) of sorts in the well-understood sense that, given the fundamental conditions of supply and demand, buyers and sellers are doing the best they can. From another perspective, it is a constrained maximum (definition 4) in that buyers and sellers maximize the perceived opportunities to buy and sell, and thereby achieve a maximum of “satisfaction” as determined by their preferences in relation to the (perceived) opportunities. It may not be an optimum, however, if there are opportunities of which the economic agents are unaware (see Kirzner 1990), or if their actions affect opportunities in other markets adversely. Also, it is possible to see how momentary equilibrium can be generalized to a situation of uniform change (definition 3)—for example, where demand and supply increase proportionately.
• 19So while, in an appropriate sense, equilibrium as a balance of forces is also a state of rest (or a situation of uniform change) and a constrained maximum, it may not be an optimum. Also, in each case it is possible to conceive of situations that are not in equilibrium. Some theorists have found it helpful, however, to define the constraints so broadly as to conceive of individuals as being always in equilibrium (see Shmanske 1994). So, again using the example of simple supply and demand, a situation of non-price rationing, not allowing the price to rise and clear the market, can be seen as an equilibrium situation if we include in all individual decisions the costs imposed by rationing—like waiting in line. Indeed, using this approach, one may predict that the lines at the checkout counter of a supermarket would tend to an “equilibrium” size that equalizes waiting time. Thus the supply curve becomes vertical at the fixed price below the market-clearing price. In effect, the money price has been reduced, but the real price (including waiting cost) has gone up because of a “shift” in the supply curve to the left (from an upward slope to a vertical one). So demand always equals supply if we are careful to include all relevant factors. While it is clear that this approach may prove enlightening in some cases, when extended to the level of all agents for the entire economy it can involve disturbing and paradoxical implications. Thus, considering all possible costs and benefits, the world is at all times in a Pareto optimal equilibrium, a Panglosian “best of all possible worlds” given the relevant constraints. Things are what they are because we understand how individuals had to act the way they acted in order to maximize, given the constraints that existed and were perceived by them (again see Shmanske 1994 for a complete discussion). This approach uses equilibrium to characterize rational action (definition 6) where “rational” is understood to refer to the system as a whole and not just to individuals. For normative (policy) purposes this is obviously not very helpful. The policy-maker is, after all, subject to the same, universally perceived, constraints. We shall see that the difficulty arises because of the lack of a distinction between individual and system equilibrium.
• 20In a lecture delivered in 1936, Hayek defined equilibrium as a situation in which “the different plans which the individuals composing [a society] have made for action in time are mutually compatible” (Hayek 1937b:41). This is my definition 7. As this is the definition that we shall adopt in the rest of this work, it is worth examining in some detail. An important aspect is the move away from the purely physical dimensions of equilibrium as a state of rest or balance of forces, to one firmly based in the human mind. Equilibrium is here conceived as a situation in which individual knowledge and expectations, and the actions based on these, are compatible with the “data,” where the “data” for one individual include the actions of other individuals. Scratching the surface of any of the definitions offered above indeed reveals that it is impossible to think of equilibrium in economics without bringing in the perceptions of individuals. After all, we are dealing with human actions and these are determined by the perceptions of the actors. So, in the case of the supply and demand of a single well-defined market, for example, the price will not be observed to change when all individuals are fulfilling their mutually related plans to buy and sell; and where such plans are not fulfilled we may expect these plans to be revised.
• 21It will be immediately apparent that equilibrium thus defined is an extremely unlikely event. It is patently unrealistic. One might wonder at its widespread acceptance as a standard of reference. This raises the important question of the function of equilibrium constructs in economic theory. Obviously, theoretical constructs are, to a greater or lesser extent, unrealistic. They all abstract from reality in order to illuminate it. For example, one common use to which equilibrium constructs are put is the tracing of the (ultimate) consequences of any change while imagining all other possible relevant changes to be absent. In this way a general idea of cause and effect can be built up by isolating the effects of different causes. The crucial question is: what are permissible abstractions, and what abstractions render a theoretical construct useless? When is the usefulness of the model compromised so that its results (the cause-effect connections that it suggests) are no longer reliable guides to reality? This is an involved question that we shall not be able to answer here in any detail. I shall contend, however, and hopefully motivate in the course of our discussion, that theoretical constructs that abstract completely from the implications for human action of the passage of time and its implications for changes in knowledge are not likely to be very helpful in understanding economic processes. While it is true that equilibrium “is in the model and not in the world,” I want to build a bridge between the “model” and the “world” and maintain that timeless models cannot do this. This is most clearly seen in discussing the stability of equilibrium.
• 22It will be immediately apparent that equilibrium thus defined is an extremely unlikely event. It is patently unrealistic. One might wonder at its widespread acceptance as a standard of reference. This raises the important question of the function of equilibrium constructs in economic theory. Obviously, theoretical constructs are, to a greater or lesser extent, unrealistic. They all abstract from reality in order to illuminate it. For example, one common use to which equilibrium constructs are put is the tracing of the (ultimate) consequences of any change while imagining all other possible relevant changes to be absent. In this way a general idea of cause and effect can be built up by isolating the effects of different causes. The crucial question is: what are permissible abstractions, and what abstractions render a theoretical construct useless? When is the usefulness of the model compromised so that its results (the cause-effect connections that it suggests) are no longer reliable guides to reality? This is an involved question that we shall not be able to answer here in any detail. I shall contend, however, and hopefully motivate in the course of our discussion, that theoretical constructs that abstract completely from the implications for human action of the passage of time and its implications for changes in knowledge are not likely to be very helpful in understanding economic processes. While it is true that equilibrium “is in the model and not in the world,” I want to build a bridge between the “model” and the “world” and maintain that timeless models cannot do this. This is most clearly seen in discussing the stability of equilibrium.
• 23It will be immediately apparent that equilibrium thus defined is an extremely unlikely event. It is patently unrealistic. One might wonder at its widespread acceptance as a standard of reference. This raises the important question of the function of equilibrium constructs in economic theory. Obviously, theoretical constructs are, to a greater or lesser extent, unrealistic. They all abstract from reality in order to illuminate it. For example, one common use to which equilibrium constructs are put is the tracing of the (ultimate) consequences of any change while imagining all other possible relevant changes to be absent. In this way a general idea of cause and effect can be built up by isolating the effects of different causes. The crucial question is: what are permissible abstractions, and what abstractions render a theoretical construct useless? When is the usefulness of the model compromised so that its results (the cause-effect connections that it suggests) are no longer reliable guides to reality? This is an involved question that we shall not be able to answer here in any detail. I shall contend, however, and hopefully motivate in the course of our discussion, that theoretical constructs that abstract completely from the implications for human action of the passage of time and its implications for changes in knowledge are not likely to be very helpful in understanding economic processes. While it is true that equilibrium “is in the model and not in the world,” I want to build a bridge between the “model” and the “world” and maintain that timeless models cannot do this. This is most clearly seen in discussing the stability of equilibrium.
• 24Before turning to this, however, we should pause to note some other aspects of equilibrium, understood as the mutual compatibility of individual plans, including the relationship between micro and macro equilibrium, or between individual and system equilibrium. Hayek makes an important distinction between these:
• 25So equilibrium is not only a relationship between individuals at a point of time, it is necessarily also a relationship between actions over time. For equilibrium to exist during a period of time it must exist at every point of time within that period. If equilibrium exists at a point of time, then individuals’ plans are consistent with each other and with the technical facts of the world such that each plan can be successfully implemented. This means that in the absence of any change (meaning the arrival of new knowledge) equilibrium will exist at every point of time. This definition of equilibrium thus implies intertemporal equilibrium.
• 26In the history of the development of the equilibrium concept economists have been concerned with certain basic properties that equilibria may or may not exhibit. The most basic is the question of existence—whether or not an equilibrium can be shown logically to exist. According to our definition this involves showing that a situation exists (logically) such that all plans can be implemented. In the voluminous mathematical literature on general equilibrium such a proof was ultimately discovered, but at the expense of the imposition of a set of heroic restrictions on knowledge, preferences and technology. It was also possible to show that under certain even more restrictive conditions such an equilibrium was unique (Ingrao and Israel 1990). It is clear, however, that the importance that these properties assumed is directly related to the formal, technical, mechanistic nature of the conception of equilibrium that tended to dominate this literature (and still does). For Hayek, equilibrium was never understood as a state that could ever actually be said to exist, although its logical existence is clearly implied. He was more concerned with the question of whether or not it could be shown or argued that a tendency toward equilibrium (“a greater degree of plan coordination”) characterized the actual market process. This is related to the questions of stability and/or convergence that the mathematical economists have been unable to answer satisfactorily. But for Hayek (and those who followed his lead) it was not a theoretical matter. As this will be quite important, I will quote at some length from Hayek:
• 27The revival of the Austrian research program, in its market process variety, since the 1970s, has seen a return to this issue of equilibrating tendencies in a more energetic fashion. In particular, it has emerged as a defining issue within the Austrian School of economics in a way that was clearly foreshadowed during some historical moments in June 1974 in South Royalton, Vermont, at a conference marking the start of this revival (Dolan 1976). At that conference two papers in particular outlined the two key perspectives that have appeared to be in conflict ever since—by Ludwig Lachmann and Israel Kirzner (Lachmann 1976a; Kirzner 1976). In these two papers (and some others by the same authors in the conference volume) we find a clear, concise articulation of the issues. Both Kirzner and Lachmann regard the market as a process in time, out of equilibrium. Both regard the question of equilibrating tendencies to be problematic. But for Kirzner the problem is resolved by the actions of the entrepreneur in noticing disequilibrium situations and profiting by their removal, thus providing a reason to believe in, and an explanation of, a tendency in markets towards equilibrium.
• 28This approach can be generalized to equilibrium in contexts other than the isolated market. The problem of explaining convergence to equilibrium is a problem of explaining how individuals out of equilibrium obtain the information necessary for them to have knowledge of, and incentives to make, the appropriate adjustments. In the process of developing the solution Kirzner reaffirms the Hayekian definition of (dis)equilibrium. “Disequilibrium is a situation in which not all plans can be carried out together; it reflects mistakes in the price information on which individual plans were made” (ibid.:118). It is the Kirznerian entrepreneur who notices these mistakes and is able to take advantage of them. Kirzner’s well-known, and justly admired, theory of entrepreneurial action in the removal of all manner of price discrepancies will not be summarized here. Suffice it to say that the entrepreneur is “an all-purpose arbitrageur” (my term) who is alert to profit opportunities that exist as a result of price differences at a point of time, price differences between two points in time (after accounting for interest and holding costs), or price and cost differences (that is the price of a finished product and the cost of all the resources, including interest, necessary to produce it). By exploiting these generalized price discrepancies the entrepreneur tends to remove them, thus providing the answer to the original uncomfortable question. The tendency to equilibrium is supplied by entrepreneurial action. Kirzner then states clearly the issue that we are investigating:
• 29Lachmann makes it clear that he does not believe in a “determinate market process.” While he is readily prepared to endorse the notion of individual equilibrium, he has no use for general equilibrium (and, as is clear from the context, any equilibrium other than that of the individual) or tendencies toward it. “The notion of general equilibrium is to be abandoned, but that of individual equilibrium is to be retained at all costs, It is simply tantamount to rational action. Without it we should lose our ‘sense of direction’” (Lachmann 1976a:131). The reason for his rejection of market equilibrium is his understanding of the implications for action of the passage of time. Once again, as with Kirzner, I shall not stop to summarize in any detail Lachmann’s well-known views in this regard. I merely note some implications. He considers it axiomatic that the passage of time cannot occur without the arrival of new knowledge. Each moment in time is unique and time is irreversible. “As soon as we permit time to elapse, we must permit knowledge to change” (ibid.: 127–128, italics removed). I have referred to this as Lachmann’s axiom.
• 30There is thus no way to know which of the “opportunities” perceived by the Kirznerian entrepreneurs are “real” and which are (perhaps inconsistent) figments of their disparate expectations. In this way Lachmann departed company from Kirzner and Hayek and was not prepared to assert the existence of any tendency toward equilibrium. “What emerges from our reflections is an image of the market as a particular kind of process, a continuous process without beginning or end, propelled by the interaction between the forces of equilibrium and the forces of change” (Lachmann 1976b:61).
• 31The issue of convergence, of a tendency toward equilibrium, thus remains a contentious issue in which a lot is perceived to be at stake. From Lachmann’s lead, further investigations of the meaning and implications of Lachmann’s axiom have followed, the most elaborate of which is the in-depth examination by O’Driscoll and Rizzo (1996). The varying reactions to this book bear testimony to the depth of the rift within the subjectivist Austrian family. This is well captured in the two reviews by Kirzner (1994a) and Lachmann (1994). Although intrafamily disputes are often the most vociferous, where there is so much agreement on everything else of significance it is perhaps surprising. Yet it appears to be fundamental.
• 32The issue of convergence, of a tendency toward equilibrium, thus remains a contentious issue in which a lot is perceived to be at stake. From Lachmann’s lead, further investigations of the meaning and implications of Lachmann’s axiom have followed, the most elaborate of which is the in-depth examination by O’Driscoll and Rizzo (1996). The varying reactions to this book bear testimony to the depth of the rift within the subjectivist Austrian family. This is well captured in the two reviews by Kirzner (1994a) and Lachmann (1994). Although intrafamily disputes are often the most vociferous, where there is so much agreement on everything else of significance it is perhaps surprising. Yet it appears to be fundamental.