Wednesday, October 10, 2012

The Market and Entrepreneurship

These past few papers have feverishly banged at the door shouting, "Economics is not a science based entirely on allocations!" This new round of articles from Hayek and Kirzner are making the same point, however, with different emphasis. Rather than a particular focus on the economic calculation problems of social planners ---the aim of the previous articles by Mises and Hayek (I will write about these soon) --- these articles attempt to articulate the processes inside of markets.

All intro students of economics are acquainted with the model of perfect competition. The intersection of supply and demand curves determines equilibrium price and quantity. However, Hayek and Kirzner do not portray the market with the stillness and tranquility of equilibrium, but, a market in which entrepreneurs are restless in their attempts at improvement. Ironically, this competitive process (where each entrepreneur attempts to provide better products at lower costs) is completely removed from the competitive model. All of the action, so to speak, occurs outside of the model.

This might seem like an academic exercise and you might be asking yourself, "So what?" The big point here is that in our focus on outcomes we turn our attention away from process. Turning our backs on process is detrimental because there are good economic lessons to be learned from the process. For Hayek the "good economics" being missed by the model of perfect competition is discovery. Discoveries and innovations lead us to new products and decrease costs of providing products. But, these innovations and dynamics which are the engine of growth in our economy are not captured in the model of perfect competition ---not even close.
//Start wonkiness
Our mathematical models are completely incapable of handling the Austrian critiques for two reasons: (1) Disequilibrium behavior, and (2) Surprise. First, there is a French word used in general equilibrium analysis called "tatonement" which translates as groping. Agents are always groping towards an equilibrium resting place. Like water poured into a bowl it will stop swirling once it reaches a resting place. Bottom line, we always model things as moving towards equilibrium and do not know how to model things moving out of equilibrium. Second, our rational expectations models presume that there is no surprise. With respect to discovery this means that if you want to build innovation in a model you must presume a probability distribution over the arrival of new inventions. But, how do you know the probability distribution? At present, this is the best we can do. In a rational expectations framework you cannot start with innovations having a measure of zero and then suddenly have a non-zero measure.
//End wonkiness

Akin to the criticism Hayek and Kirzner levy against the competitive model I have a similar example culled from game theory. George Akerlof's work on asymmetric information  is a canonical model in economic theory where the common example is used cars. Imagine you are shopping for automobiles at a used car lot.
You are not certain whether you're buying a good car or a lemon. Since you are a rational shopper you form an expectation about the value of the car.  However, the dealer knows this expectation is less than the most valuable car on his lot. Thus, he removes that car from the set of cars he offers you. Now you form a different expectation about the value of the remaining cars. The dealer continues to remove cars he values more than your expectation. This keeps going and can result in an equilibrium of complete market failure. However, we observe in the real world that used car dealers have developed warranties to overcome some of these problems. Other entrepreneurs have developed ideas like Carfax.

The point? Entrepreneurs turn Akerlof's lemons into lemonade.

This point is not as evident when we focus on equilibrium rather than process.

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