Austrian Economists Don’t Look At Markets Like Mainstream Economists Do

For one to think that free market economics rests on the assumption of perfect competition is a blatant misunderstanding at how free market economists, particularly from the Austrian tradition, view markets, in general. So, let’s try and clear that up.

Mainstream economists are the ones that use perfect competition as their starting point (or end state), not Austrians.

Three assumptions to competitive markets from an equilibrium perspective, aka the “mainstream” way:

  1. Markets set the price, thus making buyers and sellers “price takers.”
  2. Goods and services allocated within the market are homogeneous, meaning that they are exactly the same.
  3. Buyers and sellers have perfect information.

Austrians do not view competitive markets from an equilibrium perspective, like mainstream economists. This is outlandish, thus not even considered as a viable tool for meaningful analysis by Austrian economists.

Prices are set by buyers and sellers, not “the market”

From the start, Austrians view markets as a process, in which realistic assumptions are made. First, buyers and sellers set the price, not the market. This is true even in really competitive markets, like the stock market. The “market price” for a stock is the lowest price a seller has decided to sell at, not the price the “market” set at equilibrium. Buyers and sellers set their own agreed upon price or agreed upon price set by someone else in the market. The important concept to understand here is that the market didn’t magically set an equilibrium price, it was chosen and selected upon by those engaging in the transaction. (1)

Products are different

The fact that buyers and sellers can set their own prices is because goods and services are different. A key competitive strategy for producers is to differentiate their products. They are not given a production function. They are not told what inputs to use. Individual producers decide which technologies and inputs to use and how they want to differentiate their products, wait for it…even in highly competitive markets. Think of airlines, landscapers, construction services, barbers and hair salons, food services, and electronics. These are highly competitive industries, basically selling the same type of stuff, yet firms are distinctly different from each other, and each setting their own prices, they are not price takers.

Product differentiation is a key feature of the Austrian school of thought. In competitive equilibrium analysis, anytime a producer is selling a product that is different, they must be producing at a higher cost of output and thus producing less than the other sellers. (2) This is false. This is looking at the economy from a static equilibrium perspective and with deep and outlandish assumptions.  Just look around! Look at those industries mentioned above. How about the soft drink industry? The products are all different!

Information is imperfect, but new information is generated through the market process

Thirdly, information is not perfect. Different people of have different information. This means that some, only in hindsight, will find out that they are incorrect. If some sellers feel, through newly revealed information, that they can charge more, they will raise their price. If they hit it on the mark, the “market price” will adjust to that. This means that there may be some sellers selling at “disequilibrium” prices, or below where the market can clear. If they sensed it incorrectly, then the sellers that raised the prices are selling at “disequilibrium” prices. In any case, someone will be selling at disequilibrium. Keep in mind, “the market” didn’t set or change the price. Prices are set by buyers and sellers and often different from seller to seller. Further, the differentiation by quality and price allow consumers to shop around for a combination of the two that satisfy their individual needs. This process by which markets gravitate toward equilibrium is continual and is constantly revealing new information. The key to remember here is that there is imperfect information and the market process generates more of it which allows buyers and sellers to adjust how they use their resources in a way that increases value for themselves.

“Competition” is the ongoing process of creative destruction. We see that due to the changes in prices, how producers make their goods and services, and how those goods and services change with new tastes and preferences and innovations. The unrealistic concept of competitive equilibrium ignores many of the choices market participants have to make, and assumes away how people change while they engage in the economic activity due to changing economic conditions and newly generated information. (3)

Order Defined in the Process of its Emergence

Nobel laureate James Buchanan emphasizes the importance of understanding the difference in how we should look at markets. It’s probably one of the best 400 words written about the topic in the last several decades. I would summarize it, but it’s a quick read. Though, reading through slowly and thoughtfully is recommended.

Norman Barry states, at one point in his essay, that the patterns of spontaneous order “appear to be a product of some omniscient designing mind” (p. 8). Almost everyone who has tried to explain the central principle of elementary economics has, at one time or another, made some similar statement. In making such statements, however, even the proponents-advocates of spontaneous order may have, inadvertently, “given the game away,” and, at the same time, made their didactic task more difficult.

I want to argue that the “order” of the market emerges only from the process of voluntary exchange among the participating individuals. The “order” is, itself, defined as the outcome of the process that generates it. The “it,” the allocation-distribution result, does not, and cannot, exist independently of the trading process. Absent this process, there is and can be no “order.”

What, then, does Barry mean (and others who make similar statements), when the order generated by market interaction is made comparable to that order which might emerge from an omniscient, designing single mind? If pushed on this question, economists would say that if the designer could somehow know the utility functions of all participants, along with the constraints, such a mind could, by fiat, duplicate precisely the results that would emerge from the process of market adjustment. By implication, individuals are presumed to carry around with them fully determined utility functions, and, in the market, they act always to maximize utilities subject to the constraints they confront. As I have noted elsewhere, however, in this presumed setting, there is no genuine choice behavior on the part of anyone. In this model of market process, the relative efficiency of institutional arrangements allowing for spontaneous adjustment stems solely from the informational aspects.

This emphasis is misleading. Individuals do not act so as to maximize utilities described in independently existing functions. They confront genuine choices, and the sequence of decisions taken may be conceptualized, ex post (after the choices), in terms of “as if” functions that are maximized. But these “as if” functions are, themselves, generated in the choosing process, not separately from such process. If viewed in this perspective, there is no means by which even the most idealized omniscient designer could duplicate the results of voluntary interchange. The potential participants do not know until they enter the process what their own choices will be. From this it follows that it is logically impossible for an omniscient designer to know, unless, of course, we are to preclude individual freedom of will.

The point I seek to make in this note is at the same time simple and subtle. It reduces to the distinction between end-state and process criteria, between consequentialist and nonconsequentialist, teleological and deontological principles. Although they may not agree with my argument, philosophers should recognize and understand the distinction more readily than economists. In economics, even among many of those who remain strong advocates of market and market-like organization, the “efficiency” that such market arrangements produce is independently conceptualized. Market arrangements then become “means,” which may or may not be relatively best. Until and unless this teleological element is fully exorcised from basic economic theory, economists are likely to remain confused and their discourse confusing. (4)

This is what laissez-faire economists assume and what they believe works at the implementation of the policy proposals. Many of their proposals, look at this as the “end state” rather than some kind of optimum point. This is ridiculously far from “perfect competition.”

Laissez-faire economists don’t assume perfect competition because they don’t look at markets the same way “mainstream” economists look at it.

How can free market economists assume perfect competition when they don’t even incorporate it into their models? This is where I’m having a hard time understanding where folks are getting this idea from. If they don’t even try to pretend they can measure consumer surplus, producer surplus, or deadweight loss in any meaningful way, how can they assume that perfect competition will happen if markets are left unfettered?

What they do believe is that decentralized knowledge is probably more accurate than what a centralized government can conjure up. Therefore, the idea of imposing blanket regulations over industries because of supposed “market failures” is looked at with a very skeptical eye. This is not an anti-regulation post, but a post that clarifies how free market economists look at markets. They assume markets as an ongoing process that is in constant flux that comes about from imperfect individual actors acquiring newly revealed information and adjusting their behaviors accordingly (to the best of their abilities.)

The only time you see perfect competition mentioned in Austrian literature is when they are about to describe how ridiculous of a concept it is and how mainstream economists love to use it in their models. Austrians don’t need perfect competition. In fact, they don’t want it. Because perfect competition is a boring world with no economic progress.

References:

  1. Randall G. Holcombe, Advanced Introduction to The Austrian School of Economics, 2014, pp. 19-20 
  2. ibid., pp. 60-61
  3. ibid., pp. 20-21
  4. James M. Buchanan, Order Defined in the Process of its Emergence, 1999

 

 

 

 

 

 

 

 

 

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