Part I. Background: Equilibrium and Change

This first part of this work consists of two chapters (2 and 3).¹ 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.

In Chapter 3 I turn to the question of what really is at stake here. I offer a different perspective, a different approach to the question of equilibrium. If we say that the economy is always in disequilibrium, because plans must be inconsistent to some degree, then are we not undermining our ability to do economics, to understand human action in the economy? Or is action possible and understandable in disequilibrium? I shall contend that if we wish to adopt Hayek’s approach to equilibrium, we must mean that we can act in a world where the plans that motivate and define those actions are not mutually compatible. This is hardly controversial. After all, the market process features rivalrous actions, that is, actions that are part of mutually inconsistent plans. Successful plans tend to displace unsuccessful ones. But can we therefore say that, overall, plans tend to become more consistent so that there is a ‘tendency’ toward equilibrium? Is this important? I shall answer both in the negative. Furthermore, I shall maintain that capital accumulation and economic progress depend in a crucial way on the absence of equilibrium and in no way on our ability to discern equilibrium tendencies. More specifically, I shall argue that the Hayekian definition requires too much. Plans are complex, multilayered constructs. Overall “plan consistency” is, therefore, either impossible or hopelessly imprecise. I shall argue that at some levels plans are and must be highly compatible, while at other levels (as part of the market process, for example) they are and, if we are to have economic progress, they must be, incompatible.

The issues discussed in this part and the resolutions offered provide an important backdrop for the consideration of capital in a dynamic world.

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¹A shorter version of some of the material in this part appears in Lewin (1997c).

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)¹in 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.

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¹Interestingly 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.

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)

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

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:

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).

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).

CHAPTER 3

Equilibrium and Expectations Re-Examined: A Different Perspective

[F]rom time to time it is probably necessary to detach oneself from the technicalities of the argument and to ask quite naively what it is all about.

(Hayek 1937b: 54)

The debate referred to in the previous chapter is in many ways related to the general problem in economics of dealing adequately with the phenomenon of time. It seems that every economist of note has, in one way or another, perceived some difficulty associated with accounting for the passage of time while maintaining equilibrium and has wrestled with it (Currie and Steedman 1990). On the one hand there is the undeniable fact of human action in an ordered society. On the other hand there are the undeniable facts of novelty and disequilibrium and the inability to foresee all consequences. All action is future oriented—it rests on connecting present causes to future effects, which seems to imply successful prediction. How is one to reconcile these apparently irreconcilable perspectives?

Describing and Understanding Action

One possible resolution may lie in re-examining the concept of “expectations” and concepts related to it. I offer a scheme that will include an articulation of the following concepts: events/occurrences, laws of nature, social “laws,” acts/actions, plans, knowledge and expectations. We take note of the passage of time by recording occurrences or events that we categorize according to our understanding of them. Events that occur in nature, that do not involve humans, are understood according to what we think of as the forces (or laws) of nature. Events that occur in society, that relate to humans, are understood according to the intentions and meanings of the individuals involved. At one level it is possible to describe human events as part of events in nature; physiologically for example. So it is possible to examine human acts in terms of the biological processes, in the brain and in the rest of the body, that brought them about. But the nature of the understanding we achieve by this is of the same type as of events in nature. To acquire an understanding of events as human or social events requires examining (inter)subjective intentions and meanings.¹ We may say that events in society are the results of actions. They involve human acts.² To describe an act satisfactorily, recourse must be had to motives, means and outcomes—even if the latter are unintended. Outcomes are connected to (understood in terms of) a multitude of actions, related and unrelated. This seems to me what we mean when we talk about equilibrium in terms of the consistency, compatibility and coordination of plans. Plans embody a number of related acts. They are related by purpose. Thus different acts may be complementary, when they work towards the same purpose, or competitive, when they work for conflicting purposes, or they may be unrelated.³ The notion of “plan,” so widely used by economists, is in need of further examination.

What Do We Mean by Consistency of Plans?

There are three important things to note about plans:

1. Plans depend on different kinds of knowledge. As already indicated, a plan is defined by its purpose or set of purposes. Its formulation depends on its purpose and on the desires (preferences) and knowledge of the planner. This knowledge is an infinitely complex phenomenon, and operates at many levels, as we shall later remark in some detail in our discussion of human capital. For the moment we note simply three types or “levels:”

(a) The individual will have knowledge of those laws of nature to which we referred earlier—knowledge type 1. This knowledge will have been gained in a variety of ways according to the individual’s perceptions and experience (and may be to some extent a priori).

(b) Second, the individual will have knowledge of the social world, “social laws”—knowledge type 2. This knowledge will depend on the existence of, and the individual’s perception and experience of, social institutions. By “institutions” we mean here those typical and stable features of the social world on which individuals come to rely. So they include rules of behavior, standard categories, habits, customs, and the like. We will discuss this in greater detail in a moment.

(c) Third, the individual will have knowledge of specific and unique events that have occurred (history) and in order to carry out the actions constituting the plan, the individual must form some mental picture of the specific possible consequences of those actions and decide on which are more or less likely. To be sure, some actions will involve greater and lesser degrees of conscious anticipation, and some may be so habitual as to seem almost reflexive. Nevertheless, even these implicitly involve imagined consequences, as would presumably be brought to the fore upon interrogation. We may hesitate to group these anticipations or expectations in the category of knowledge, but we do so, as a third level of knowledge (knowledge type 3), in the conviction that expectations may be held with greater or lesser confidence. (In the case of habitual actions referred to just now, we may imagine the relevant expectations to be held so confidently as to be indistinguishable from (tacit) knowledge as usually understood as some sort of absolute confidence.) Expectations are thus here considered to be a special aspect of knowledge. Type 1 and 2 knowledge is knowledge of an abstract kind, knowledge of general principles (related to the natural world—apples fall from trees to the ground, exposure to bacteria can cause infection; or related to the social world—people stop at red lights, dollar notes are a generally accepted means of payment), whereas knowledge type 3—historical knowledge and expectations/anticipations—is knowledge of specific unique events.⁴

2. Plans cannot be completely specified, they cannot include a specification of everything that can happen (imagined or unimagined). The notion of “plan” in the literature is very vague. Lindahl (1929 and especially 1939b)⁵ and Lachmann spent some time talking about aspects of individual plans. Of these, Lindahl’s formulation is the most developed.⁶ He distinguishes, for example, between three types of actions that affect the plan’s “degree of definiteness” (Lindahl 1939a:45) thus conceiving of some flexibility in the execution of the plan. This means that even if some anticipations are not fulfilled, if the plan contains sufficient flexibility, that is, sufficient room for contingencies, it may not be disappointed and thus need not be revised or abandoned. It may be accommodated within equilibrium. Likewise Lachmann, in different (but similar) ways, attempted to account for plans that contained contingencies.⁷ But neither of these authors, nor anyone else to my knowledge, has remedied the vagueness that continues to surround the concept. There is an aspect of paradox in this. It is because theorists have failed to make clear that real-world plans are necessarily vague and often only dimly perceived by the planners, that the plans in the theorist’s discussion have assumed a specious, but unarticulated, precision. They have fostered the (unconscious) impression that they are meant to depict detailed project analysis–type means–ends schemes, even though such details are never provided, even by way of example. The necessary vagueness of real-world plans is implied by the nature of time and the way in which we experience it; in short, by Lachmann’s axiom. As future knowledge cannot be gained before its time, and as plans must inevitably depend to some degree on future knowledge, many of the aspects of a plan must simply be unspecified. We do not plan in terms of “micro” details, but rather in terms of “macro” categories. We cannot experience future events before their time and the experience is never an exact correspondence of the anticipation, both because the difference is a matter of degree and because some of the aspects of the event could not have been imagined.⁸

3. Plans are multilayered; that is to say, an individual at any one time will have a very large number of plans by which he conducts his life. Each will relate to a different purpose and usually will have very different frames of reference including a different time frame. So for example, I may at a moment of time be acting within plans to teach my class (as planned) today, finish a first draft of this chapter this week, fulfill the expectations of my children to help them with their homework this entire year and save enough money to see them through college over the next ten years. Plans may be nested (within one another) or parallel. And while it might be possible ideally to conceive of all of an individuals plans as existing within one giant “life plan,” this, as we shall see, can hardly advance our understanding. Rather we should realize that although the plans may exist in a structure of sorts, one being related to the other in terms of purposes and means, this relationship, this structure, is likely to be only dimly and partially perceived and is, moreover, likely to be ever changing as individual plans are adopted, revised and abandoned. So when we speak of plan coordination across individuals, and whether or not there is a necessary tendency for them to become more coordinated, our disagreement may be related to the fact that the concept of plan coordination has not been clearly understood. It may be that some types of plans do exhibit such a tendency while others do not; and that the functioning of the market system depends crucially on this difference. In particular, it may be, as we shall argue, that plans based heavily on knowledge types 1 and 2 are very likely to cohere and that the opposite is true for plans that depend heavily on knowledge type 3.

Before continuing it may be useful to approach this from a slightly different angle. Plans are based, to a greater or lesser extent, on expectations (knowledge type 3). Expectations are, of course, widely believed to influence actions, and the essential difference between theories is often to be found in the different way in which expectations are treated. While the rational expectations (RE) approach implicitly assumes that everyone has the same expectations, at the other extreme Lachmann emphasizes the dire consequences of expectations that necessarily diverge. But we may now pause to ask: expectations of what? RE approaches relate primarily to prices (or price indexes)—they refer to individuals’ expectations of prices. Lachmann is less specific except to say that they are bound to be disappointed, from which we should infer that he is referring to expectations of the things about which individuals differ. Realizing that expectations, like the plans in which they are embodied, are multidimensional makes us realize that the expectations concerning the vast majority of things (events) about which we have expectations will be fulfilled. We may thus question whether Lachmann’s statement that “experience teaches us that in an uncertain world different men hold different expectations about the same future event” is universally true and realize that it depends crucially on the type of event in question. For a large number of events there is widespread agreement of expectations.

How are Activities Synchronized and Coordinated?

We may be more specific. Expectations and plans are, for the most part, fulfilled because of the existence in the social world of shared categories and standards that facilitate the synchronization and coordination of activities. These operate to give individuals hard knowledge (type 2) of the actions of others on which these plans and expectations (type 3 knowledge) depend. This is most obvious and most crucial with regard to the way in which we cope with time. Currie and Steedman have drawn attention to a remarkable work by P. A. Sorokin originally published in 1943 (Currie and Steedman 1990:201–203; Sorokin 1964). In this work Sorokin points out that the devices we use to organize and cope with time are cultural (rather than natural). We invent (or, more accurately, we “evolve”) cultural time units. Thus Sorokin contrasts “sociocultural time” with “continuous, infinitely divisible, uniformly flowing, purely quantitative time of classical mechanics” (Currie and Steedman 1990:201). Consider the week.

Factually, our living time does not flow evenly, is discontinuous, and is cut into various qualitative links of different value. The first form of this qualitative division is given by our week. Mathematical or cosmic time flows evenly, and no weeks are given in it. Our time is broken into weeks and week links. We live week by week; we are paid and hired by the week; we compute time by weeks; . . . we walk and exercise or rest so many times a week. In brief, our life has a weekly rhythm. More than that: within a week, the days have a different physiognomy, structure, and tempo of activities. Sunday especially stands alone, being quite different from the weekdays as regards activities, occupations, sleep, recreation, meals, social enjoyments, dress, reading, even radio programs and newspapers. . . . A week of any kind is a purely sociocultural creation, reflecting the rhythm of sociocultural life but not the revolution of the moon, sun, or other natural phenomena. Most human societies have some kind of week, and their very difference between weeks is evidence of their independence from astronomical phenomena. The constant feature of virtually all . . . is that they were always found to have been originally associated with the market . . . our week is not a natural time period but a reflection of the social rhythm of our life. It functions in hundreds of forms as an indivisible unit of time. . . . Imagine for a moment that the week suddenly disappeared. What havoc would be created in our time organization, in our behavior, in the coordination and synchronization of collective activities and social life, and especially in our time apprehension?

(Sorokin 1964:190–193, italics added in the last sentence)

What is true of the week is equally true of other shared time unit categories, like days, months, seasons and years, even though these may have an original basis in astronomical regularities. In their evolved, developed state they provide us with predictable social rhythms. And this is even more true of the division of days into hours, minutes and seconds. In our interactions we all mark time in the same way and with reference to the same clock so that we are able to synchronize (consciously and subconsciously, overtly and tacitly) most of our actions or, more accurately, our activities (referring to action types or repeated actions).

The knowledge of the main kinds of sociocultural rhythms—no matter whether periodical or not—is by itself very important knowledge. . . . Stripped of their specific qualities, all rhythms and punctuations would disappear, and the whole sociocultural life would turn into a kind of gray flowing fog in which nothing would appear distinct.

(ibid.: 201)

The synchronization of activities is most obvious in contracts, which often refer to units of time. For example, we rent space by the day, week, month or year. But it occurs in all spheres of life where contracts are implicit or nonexistent. We expect people to work between the hours of 8 a.m. and 6 p.m. and not usually outside of that. We expect people to be asleep between midnight and daylight. The few exceptions give rise to disappointed expectations and discoordination. But the overwhelming conformity ensures routine expectation fulfillment. Knowledge of these time categories is a prerequisite for, and gives rise to, knowledge of people’s typical activities.

This insight may be extended to other types of shared categories. For example, we share categories for measuring space—distance (miles and kilometers), area (acres of land), and volume (gallons of gasoline)—and weight (pounds of sugar), figuring accounts, classifying occupations,⁹ driving on the roads, walking along pathways, and innumerable other conventions, customs, habits, and the like, which make our actions predictable to others. These institutionalized categories and modes of behavior (which we may designate as institutions broadly understood) are the cumulative unintended results of individual actions and they represent a real convergence of expectations. Starting out from a position of many different standards or modes of behavior that converge to one or a few implies that individuals come to expect certain kinds of behavior, with a degree of confidence related to degree of conformity of the particular standard. These institutions

enable each of us to rely on the actions of thousands of anonymous others about whose individual purposes and plans we can know nothing. They are the nodal points of society, coordinating the actions of millions whom they relieve of the need to acquire and digest detailed knowledge about others and form detailed expectations about their further action.

(Lachmann 1971:50, italics added)

Processes of Convergence

We have a fairly good idea of how social processes that converge work. A prototype case has been provided in the emergence of a single medium of exchange (Menger 1976:248ff.; Selgin 1988:ch. 2; Horwitz 1992:ch. 2). Money is the unintended result of individuals adopting one out of many goods as the preferred medium of exchange. Its spontaneous emergence is facilitated by the property that the more people use it, the greater its advantage for further use. It is a graphic case, but only one case, of similar processes where the advantages of the adoption of a particular standard—for example of a particular product or set of products to accomplish given tasks, like playing video cassettes, word processing, software development—as well as geographical location, language, and many other things, depend positively on the extent to which it has already been adopted (Arthur 1994; Krugman 1991; Kirzner 1990; Liebowitz and Margolis 1994;¹⁰ see also Horwitz 1992). In such processes, once a critical level of adoption has been achieved adoption tends to be cumulative. Individuals are led by the clearly perceived advantages of adoption to follow suit, and the process feeds on itself until it has become an institution. Not all institutions emerge in this way, but many do.

It should be clear that these convergent processes do not exist in isolation but are crucially related to each other. So, for example, the emergence of money depends on the prior existence of established practices of trade, in particular the tacit or conscious enforcement of contracts. The institution of repeat purchase tends to enforce certain practices of honest dealing. And the existence of money, of course, supports a number of dependent institutions, like financial accounting practices (see Chapter 10 below). There is, in short, an intricate institutional structure. There is an essential complementarity between enduring institutions (Horwitz 1994).¹¹ The market system is itself dependent on the existence of important aspects of the legal structure. This brings up the question of institutional change.

The designation “institution” connotes an image of permanence, of reliability. The institutions that we have been talking about exist as fixed points in the landscape of time within which individuals can make their choices in the knowledge (knowledge type 2) that they, the institutions, at least, will remain unchanged. We will look at this a little more closely in a moment. It is evident, however, that this permanence must be relative, for we have the fact of institutional change. Standards come and go. Categories change. Rules appropriate to one society often disappear as the society changes. Even language evolves. How does this affect the functioning of institutions as facilitators of coordination? The answer must be in the rapidity of change. A society in which everything changed rapidly would be one devoid of any perceptible order. History is possible only because the historian is able to know something about the enduring orientations inside people’s minds. The historical context is defined by the meaning of the institutions of the society under examination. But as the context changes, institutions may be seen at one point in time as fixed points, while at another they may be seen as aspects of change. It depends on the purpose of the analysis and the time span involved. What is fixed and what evolves is itself a matter of context. There seems to be a continuing interaction between the foreground and the background, and which is moving depends very much on which you have in focus, much like a three-dimensional holographic picture. Commercial law is necessary for the conduct of economic life and indeed facilitates the emergence of unpredictable novelty in economic life. But economic (and technological) changes of certain types put a strain on aspects of the law that prompt it to change. For example, the emergence of electronic communications has suggested the acceptance of facsimile signatures and has raised difficult legal questions relating to copyright and privacy on the Internet.

So convergence and permanence are relative phenomena. Nevertheless such permanence is necessary for the existence of and for our understanding of dynamic economic processes. The hectic procession of new products and productive processes—that is, the result of the activities of a multitude of individuals organized as companies, operating within the constraints of contract law, and so on, some of whom succeed in their endeavors, many of whom do not (as defined by the ability to earn positive accounting profits)—is dependent on these underlying institutions. While we cannot predict who will succeed and who will not, while we cannot predict which products will emerge and be popular, while we cannot foresee the nature of future technologies, we strongly believe that the process will be peaceful and will be orderly; we confidently expect those who are unsuccessful to accept their losses peacefully and perhaps try something else, those who lose their jobs to move on in the hope of greener pastures, and those who do succeed to continue to try to do so. The fruits of this dynamic process depend crucially on our willingness to accept the consequences of its unpredictability. That willingness is the vital predictable part. We have the emergence of “chaos out of order.”¹²

The analogy with organized sports has been suggested by a number of theorists (for example Hayek 1973:115; Loasby 1994:32). The game is played according to certain fixed rules (although from time to time the rules “evolve” to reflect new realities). The rules (both written and unwritten) are highly predictable. Given a hypothetical contingency, we can predict its resolution. The actual outcomes are uncertain and infinitely variable. That is the point of playing the game. By “outcome” we mean not only the score, but also the pattern of the game in its infinite detail, which is part of the attraction. If we cared only about the score it would be a simple betting game; we are also interested in seeing how it is played and what unexpected variations are around the corner to delight, intrigue, shock, or disgust us. The game of life, and the game of economic life in particular, is like this in many respects. Most notably it depends on written and unwritten rules and on the resources (the abilities, the equipment, and the experience) of the players. We hope that our team will win, but we usually do not go to war if they do not. If we did, the game would not exist and we would not be able to enjoy it.

We cope with the complexity in the world by converging on institutions. Thus once the arrival of a new range of products, made possible by the development of a new technology, has been digested, new categories of classification tend to be developed, into which these products are grouped. The categories emerge spontaneously out of individual attempts to communicate the attributes of the new products. A good example is the products of the computer industry. A whole range of products exist, whose workings remain a mystery to the vast majority of people, but whose purposes needed to be explained. Laptops evolved into notebooks, microcomputers into desktops. At another level a series of technical standards and categories has been developed in order to cope with the complexity. The attributes of computer monitors include its refresh rate, its dot pitch as well as simply its screen size. All these shorthands provide the increasingly informed public with a way to tailor their expectations when choosing between products. They enhance predictability by enhancing the interpretability of information. But these relatively predictable elements change with time and it is no accident that conscious innovation involving product differentiation is often referred to using the phrase “category killer.”

Novelty and Equilibrium

About some events there is no predicting. These are the specifics of any given (future) historical situation. Lachmann’s axiom implies the uniqueness of every experience. Perhaps it is better to say that each experience contains unique elements, although we are able in retrospect to describe it in terms of recognizable categories. Describing a situation is never the same as being there. Each moment is unique and therefore cannot be precisely predicted. Thus plans are never coordinated in every detail. Such a situation is inconceivable, it is a world without time. In that sense we are never in equilibrium. Nevertheless, in peaceful, lawful societies behavior is ordered. Hayek, in his later work, spoke less of equilibrium and more of order. He quotes from “a distinguished social anthropologist”:

that there is some order, consistency and constancy in social life is obvious. If there were not, none of us would be able to go about our affairs or satisfy our most elementary needs.

(Evans-Prichard 1951:49, quoted by Hayek 1973:36)

It is evident that there must be uniformities and regularities in social life, that society must have some sort of order, or its members could not live together. It is only because people know the kind of behavior expected of them, and what kind of behavior to expect from others, in the various situations of life, and coordinate their activities in submission to rules and under the guidance of values that each and all are able to go about their affairs. They can make predictions, anticipate events, and lead their lives in harmony with their fellows because every society has a form or pattern which allows us to speak of it as a system, or structure, within which, and in accordance with which, its members live their lives.

(Evans-Prichard 1951:19, quoted by Hayek 1973:155n.)

Thus:

By “order” we shall . . . describe a state of affairs in which a multiplicity of elements of various kinds are so related to each other that we may learn from our acquaintance with some spatial or temporal part of the whole to form correct expectations concerning the rest, or at least expectations which have a good chance of proving correct.

(Hayek 1973:36, italics removed)

The (extended) order which is the society is clearly a result of the component orders which we have called institutions. And the latter indeed are the results of a process by which society has (without planning to do so) converged towards their adoption. They are “spontaneous orders” and they represent equilibria of a sort, in that they are states of convergence (rest) around which expectations are formed and conform. In this sense, we may say that the social process is composed of equilibrating, disequilibrating and non-equilibrating sub-processes. Economic growth, the arrival of new and better products and better methods of production is the result of unpredictable, disequilibrating and non-equilibrating processes. There is no tendency for expectations to cohere in these processes. They are “non-expectable,” the results of events that could not have been expected.

The degree of predictability of any event is related, then, to the extent to which it tends to exhibit repeatable, typical, or recognizable characteristics. Many routine events fall within the “very predictable” range. However, in the realm of productive activity, in modern economies, many events fall very definitely outside of this range. Methods of production, consumer goods, and services embody and depend on new knowledge to a high degree and their emergence is intimately related to and crucially dependent on the divergence of expectations.

Predictability in one sphere is thus the necessary ingredient for coping with its absence (novelty) in another sphere. The amazingly wide range of products and the persistent improvement in methods of production (in terms of reducing opportunity costs) are the results of a multitude of unintentional experimentations. Of the outcomes that we observe in the market system, we cannot say that they are the most “efficient” or the “best” of any that we could have had, and they are not an equilibrium in any Hayekian sense. But to the extent that we judge them to be better than many alternatives, to the extent that we judge progress to be occurring in that our lives are made more convenient and more exciting, we must recognize these outcomes to be the beneficial result of the kaleidic changes of the modern world.

Prices in Disequilibrium

The prices that economic agents observe and to which they respond are not equilibrium prices. That is, they are not prices that reflect an underlying compatibility of the plans of the various economic actors in the market. If expectations were consistent across individuals, in the sense that they were all destined to be fulfilled, then prices would reflect the unanimous judgments of individuals of the values of the goods traded; they would also accurately reflect the tradeoffs involved in trading one good for another, or refusing to do so. In this sense the prices would lend a degree of objective expression to the subjective, non-comparable valuations of individuals. While subjective valuations are not observable and there is no way of knowing subjective value scales, in an equilibrium situation prices provide hard information about what individuals are prepared to do and what various goods and services are “worth” to them. In this context, the exercises of modern welfare economics, employed in the service of normative investigations of alternative policy scenarios or institutional structures, make some sense. It is possible then to use price as a “proxy” for a measure of “utility” reflecting social losses and gains in some indirect sense.

In a disequilibrium situation, however, this is obviously no longer possible. If expectations across individuals differ and are inconsistent, then prices can no longer be used to reflect a unanimous judgment of value. The theorems of welfare economics no longer apply and, as is widely acknowledged, albeit ignored, notions of “economic efficiency” have no unambiguous meaning. One might wonder, then, what it is that prices actually do in disequilibrium.

It should be clear that a price is a social institution. When a price is established between a buyer and a seller there is a shared understanding of what it is and what it means. In the first instance, the price is an expression simply of the “terms of trade”; you give me this and I will give you that. It is a general shorthand description for expected action, action that involves hypothetical, yet-to-be-expressed details. For example, an advertised general price is an offer to do business that says: I will trade an unspecified amount of this for so many dollars per unit. And although the quantities acceptable may not be unlimited, there is usually understood to be an acceptable trading range. So price is, first, a statement of mutual expectations and obligations involving real things.

Second, prices enable individual calculation. Prices make budgets possible. In this regard the role of prices in monetary economies depends crucially on the existence of money as a universal medium of exchange and therefore unit of calculation (and one presumes, if exchanges are recorded, a unit of account; this is discussed further in Chapter 10 below). Since money is universal purchasing power it facilitates production and exchange over time. Prices play a pivotal role in these production and exchange activities. Without market prices, calculation would not be possible (Mises 1981). There would be no way for an individual to estimate what someone might be willing to exchange for various items. The prices involved in any budget calculation are either an expression of past transactions that actually occurred or they are expected prices of hypothetical trades that might occur in the future. It depends on whether one is doing accounting (attempting a judgment of past action) or budgeting for future action. That is, past prices express past trading achievements, while expected prices express perceived potential future trading achievements. Either way, and connecting the two, prices (third) enable trading decisions. If expected prices bore no relationship to the actual prices that materialized, they would serve no purpose. Indeed there must be a close relationship, close enough to yield a positive net value to the traders involved on both sides of the market, if there is to be a continuing market. So enduring trade in something is evidence that expectations have not been disappointed to the extent that trading is no longer worth while. (On the inertia of prices, see Mises 1971:108–123.)

Changes in prices (actual and/or expected) thus induce budgetary adjustments. They enhance or restrict the value of a budget and produce the familiar individual demand and supply responses. And price discrepancies (if noticed) provoke arbitrage activities that, if unimpeded, would continue until they were removed, until one price only were established. But price discrepancies are often in the eyes of the (entrepreneurial) beholder, the more so when such discrepancies refer to a comparison between present and future prices. Some arbitrage (for example, production) “opportunities” may be inconsistent with others and may not succeed. Once again, then, we affirm the impossibility of deriving the necessity of converging expectations and prices in the market process.

An individual budget has meaning only in terms of the prices that the trader faces (now and in the future) and his subjective scale of values. So, just as with other institutions, the institution of price qua price must exhibit some permanence if it is to serve its purpose. Individuals understand what a price, any price, is; they understand prices as a phenomenon. Individual prices are instances of price as an institution. And although they do not reflect equilibrium values, because they are contextually meaningful they motivate and facilitate economic activity.

Conclusion: Predictability Together with Disequilibrium

Hayek’s notion of equilibrium as perfect plan coordination is limited because plans can never be completely specified. Thus complete plan coordination ex ante is not even logically possible. In a way, perhaps ironically, Hayek’s own extensive work on the importance of tacit knowledge and the inherent limits of perception and articulation (for example 1945, 1967) point in this direction.

Thus we may conclude our examination of equilibrium by saying that the market process in general is not equilibrating. There is no tendency for expectations in general to become more coordinated. Expectations operate at many different levels, however. And at most of these levels, for most types of things there is a tendency towards coherence. We tend to cohere around certain rules of conduct, standards, categories, and other institutional phenomena, and most of our expectations are thus fulfilled. We have predictability together with disequilibrium where the latter refers to the characteristics of the market process. Divergent expectations lead, through rivalrous activity, to the emergence of new products and methods of production. In this process, the production and use of specific capital goods and the acquisition of the knowledge that enables us to produce and use such goods, play a crucial role. We turn now to a closer examination of this.

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¹While differing from his approach in some respects, this echoes Mises’ insistence on “methodological dualism” (see for example Mises 1957:ch. 1). Mises’ approach to this can be described as somewhat “pragmatic.”

What the sciences of human action must reject is not determinism but the positivistic and panphysicalistic distortion of determinism. They stress the fact that ideas determine human action and that at least in the present state of human science it is impossible to reduce the emergence and transformation of ideas to physical, chemical or biological factors. It is this impossibility that constitutes the autonomy of the sciences of human action.

(ibid.:93)

The ultimate givens in social science are the ideas of individuals, including their judgments of value. There is no accounting for these in terms of more ultimate (physical) causes. “Saying that judgments of value are ultimately given facts means that the human mind is unable to trace them back to those facts and happenings with which the natural sciences deal” (ibid.:69).

²“Act noun 1 A thing done; a deed b An operation of the mind” (The New Shorter Oxford English Dictionary).

³This chapter uses material from Lewin (1997c). An anonymous referee has pointed out that an important distinction must be made between the plans of a given individual and the plans made by different individuals. A question arises whether an individual is always aware of the complementary or contradictory nature of his or her plans. Does the harboring of plans contradictory in their likely outcomes imply irrationality or just ignorance? Presumably a “rational” individual would not knowingly adopt contradictory plans. For groups of individuals, contradictions are inevitable in market economies. These contradictions, and also some complementarities, are mostly unknowable to individuals ex ante and are only revealed (if at all) ex post with the unfolding of the market process.

⁴This discussion is, in many ways, similar to (perhaps the same as) O’Driscoll and Rizzo’s distinction between typical and unique elements in any situation and between pattern and detail prediction (1996:76–91). And, once again, there are close similarities to and differences from Mises. Mises was concerned with the sources of knowledge. I am less so. So his distinction is twofold, first on the basis of whether or not knowledge can be considered a priori, and second, whether or not it yields certain (unambiguous, eternal) knowledge. My scheme is elaborated very specifically in the service of trying to describe how action is possible in disequilibrium (with reference to a Hayekian equilibrium of consistency of plans). So I distinguish between different types of knowledge, not according to their sources, but according to their degree of certitude, and second, according to their subject matter (human or natural). In this latter regard my methodological dualism is not that different from Mises’. So I lump together knowledge that is (or might be) a priori with that gained by experience, but distinguish it according to whether it is about the social or natural world. Mises would put mathematics in praxeology together with economics, whereas I put mathematics in natural (nonhuman) science.

⁵See also Currie and Steedman (1990:chs 4 and 5).

⁶ “It can hardly be pretended that every individual has a clear conception of the economic actions that he is going to perform in a future period. Nevertheless, in the greater number of cases it will certainly be found that underlying such actions there are habits and persistent tendencies which have a definite and calculable character comparable to . . . explicit plans . . . we may accordingly without danger proceed to generalize our notion of ‘plans’, so that they will include such actions. Plans are thus the explicit expression of the economic motive of man, as they become evident in his economic actions” (Lindahl 1939b:93).

⁷See Lachmann (1978:4, 53; 1971:40) and Lewin (1994:247–250).

⁸“No matter how I try to imagine in detail what is going to happen to me, still how inadequate, how abstract and stilted is the thing I have imagined in comparison to what actually happens! . . . For example, I am to be present at a gathering; I know what people I shall find there, around what table, in what order, to discuss what problem. But let them come, be seated and chat as I expected, let them say what I was sure they would say: the whole gives me an impression at once novel and unique. . . . Gone is the image I had conceived of it, a mere pre-arrangeable juxtaposition of things already known!” (Bergson 1965:91, quoted in Rizzo 1994:117n.).

⁹See Ebeling (1986:48).

¹⁰There is a growing literature on the many aspects and implications of these cumulative processes. We shall have occasion later to take note of some of them. For now we shall be content to note their existence and culmination in social institutions.

¹¹“Company Law, as it has emerged in the Western world in the course of time, is a delicate web within which many interests, some conflicting, some complementary, have been woven into a pattern of harmony. . . .” (Lachmann 1979:254)

¹²With apologies to Progogine and Stengers (1984). The market process is not chaotic in the colloquial sense, but it is complex and unpredictable.