What Makes Capitalism Tick?

Understanding the market process as a systematic, error-corrective sequence of profit-inspired entrepreneurial discoveries, continually reshuffled and redirected as a result of the ceaseless impact of exogenous changes, should drastically alter our appreciation of key features of capitalism.

—Israel M. Kirzner, Competition, Economic Planning, and the Knowledge Problem1 (page 301)

This volume of the collected works of Israel M. Kirzner, edited with a modestly brief introduction by Peter J. Boettke and Frederic Sautet, addresses deep and important questions that most economists would rather skip. These pertain to what distinguishes market activity from central planning, the economic role of entrepreneurs, and what is meant by competition.

I found the conceptual issues that Kirzner raises to be intellectually challenging, and so I imagine that many readers will as well. If you pick up the book, I recommend starting near the back with the essay “How Markets Work: Disequilibrium, Entrepreneurship, and Discovery,” in order to get a general overview before you tackle the essays from the beginning.

Here, I will focus primarily on the question of what distinguishes a market economy from a centrally planned economy. While my discussion is informed by Kirzner’s writing, I do not claim to completely understand or share his views.

In a market economy, decisions about what to produce and how to produce are made by individual entrepreneurs. In order for entrepreneurs to do this in a way that promotes more efficient economic outcomes:

1. 1. They must be guided by a profit incentive.
2. 2. They must compete in a never-ending process in which they correct mistakes and seize opportunities for improvement.

Many economists believe that the main weakness of socialism is the absence of a profit incentive. But Kirzner writes,

Our further exploration of the interface between the economics of socialist calculation and the economics of the process of entrepreneurial competition will permit us to argue, I believe, that there are analytical grounds for maintaining that the Misesian “problem of knowledge” is indeed anterior to [the] problem of motivation. (page 151)

The problem of knowledge is to discover what consumers want and how to efficiently provide for those wants. Entrepreneurial competition is a process for making such discoveries. In the absence of such competition, the central planner must rely on guesswork.

In a socialist economy, the planner lacks a means for obtaining information on what individuals want. Kirzner point out that, conversely, a market economy has no concept of what “society” wants.

A market economy is by definition made up of a multitude of independently-made individual decisions. In such a context to talk of decisions made “by society” is, at best, to engage in metaphor. “Society” does not, as a simple matter of fact, choose; it does not plan; it does not engage in the “allocation of resources”; it does not have ends; it does not have means; to talk of society facing “its” allocative, economizing problem is, strictly speaking, to talk nonsense. (pages 153-154)

Those of us who wish to defend both methodological individualism and markets are faced with a paradox. When we say that the economy works well, we are claiming to speak for the entire society. But as individualists, we would say that there is no such moral entity as “society.”

My way of dealing with the paradox is to say that I have my intuition about what constitutes a “good economic outcome for society,” and you have yours. If our intuitions have little or nothing in common, then we have no basis for further discussion. But if our intuitions are similar, then we can have a productive dialogue about what sort of institutional arrangements are likely to produce desirable outcomes relative to our respective intuitions.

During the “socialist calculation debate,” economists who advocated socialism conceded that the price mechanism performs an essential information-processing function. They suggested, however, that a government bureau (today we would say a powerful computer) could store a list of all of the economy’s inputs and outputs. Call this the WAC, for Walrasian-Auctioneer Computer. The WAC would then propose a set of prices for inputs and outputs. Consumers would decide on their demands, and firms would decide on outputs. The WAC would look at the results to see what shortages or surpluses emerged. For inputs or outputs that are in surplus, the WAC would adjust prices downward. For inputs and outputs that are in shortage, the WAC would adjust prices upward. Then it would allow consumers and firms to respond to this new set of prices, and look at those results. This process would continue until all surpluses and shortages were eliminated.

In fact, the process just described is problematic, because the economic activity that takes place at “false prices” in one iteration might alter the desired activity at a subsequent iteration. It by no means guarantees smooth convergence to the point where all markets are in balance.

An alternative is to have the WAC announce a set of prices but not allow trading to take place. Instead, the WAC asks everyone to report what they wish to trade at those prices. Based on these wishes, the WAC looks at the resulting surpluses and shortages as hypothetical. It proposes a new set of prices to eliminate these hypothetical shortages, and everyone reports what they wish to trade at these new prices. Assuming that this iterative process converges to a balanced solution, the WAC finally allows trading to take place at the market-clearing set of prices.

Some remarks about this hypothetical WAC mechanism:

1. Most mainstream economists, whether they favor socialism or not, do not worry about whether or not the WAC mechanism exists or is feasible. The standard approach is to construct economic models that assume that the economy works “as if” it used the WAC mechanism. In particular, it can be taken for granted that the economy will adjust to equilibrium states. Therefore, the task of the economist is to analyze the properties of equilibrium states and to compare one such state with another.

2. In contrast, Kirzner and other Austrian economists insist on the importance of the fact that the WAC mechanism does not exist in the real world. In the real world, central planners make their dictates using guesswork, not by using databases and trial-and-error prices. Kirzner points out that in a real-world market economy, entrepreneurs take on the task of adjusting prices and identifying opportunities to alter the mix of what is produced and how it is produced. A computer does not identify shortages, surpluses, and opportunities. Individual entrepreneurs find them.

What Kirzner calls “entrepreneurial alertness” is what grinds down inefficiencies and drives the economy in the direction of equilibrium, or market balance. Of course, the economy never actually reaches such a state, because new opportunities to improve efficiency always arise as events take place and new discoveries emerge.

3. Even if the WAC mechanism were technically feasible, I believe that it still would not be sufficient to facilitate a socialist economy. We would still be missing the element of “entrepreneurial alertness.” It is one thing to believe that a factory manager could decide how many compact cars and how many mid-size cars to produce, based on prices proposed by the WAC. But who has responsibility for coming up with the idea of a ride-sharing service? Or a self-driving car? That is neither the job of the WAC nor the car manufacturer. In addition to the WAC, would-be market socialists need a cadre of designated innovators, whose job it is to generate new products and processes.

4. I think this still leaves open the question of how to motivate firm managers and others in a socialist economy. You can tell a manager to adjust production to maximize a profit that is purely an accounting device, with no effect on remuneration. But what incentive will that provide to managers? And will designated innovators take the right risks if they are playing the game for tokens that are not real money?

5. While all of these arguments point to the difficulty of central planning, this leads to the question: how do firms manage to operate? Within a firm, activities are not guided by a price system and entrepreneurial alertness. Instead, like a central planner, the boss sets internal prices, notably the compensation rules for its workers. Like a central planner, the boss chooses projects based on informed hunches rather than leaving the selection to a market mechanism.

Skeptics of socialism like to point to North Korea or the former Soviet Union as proof that central planning fails. But can advocates for socialism point to Wal-Mart or Apple Computer as proof that central planning can work?

I would say that the difference between Wal-Mart or Apple on the one hand and North Korea or the former Soviet Union on the other is that when central planning breaks down at one of these entities, the ineffective firm will be weeded out and replaced much more quickly than the ineffective socialist government.

If we think of the firm as a locus of central planning, then a market economy consists of these planned enterprises, jostling with one another. We might use a metaphor of ships that are centrally managed, some large and some small, all trying to stay afloat in a sea of competition. Corrosion and natural disasters frequently sink some of the ships, but other ships arrive, and people’s lives generally get better because these ships are new and improved. A centrally planned economy is a like a single structure sitting on dry land. It is less likely to experience rapid improvement, and when it corrodes or is hit by a natural disaster, its population suffers for a long time.