Tuesday, March 14, 2017

Why Israel Kirzner Deserves a Nobel Prize

In the fall of 2014 rumors started circulating that Professor Israel M. Kirzner, along with William Baumol, were possible candidates for the Nobel Prize. The source of the rumor was Thomson Reuters – the scientific database company – and the basis of the rumor was citation patterns. Though it is a different database, but just for ease of search for readers of this essay so they may check for themselves, a Google Scholar search will suffice to provide some perspective on the scientific impact being recorded by Baumol and Kirzner. Baumol’s relevant contributions are the following:
  • “Entrepreneurship: Productive, Unproductive, and Destructive.” Journal of Political Economy 98(5) 1990: 893-921 with 4,641 citations;
  • Contestable Markets and The Theory of Industry Structure. New York: Harcourt Brace Jovanovich, 1982 (coauthored with John C. Panzar, and Robert D. Willig) with 6,454 citations;
  • “Contestable Markets: An Uprising in the Theory of Industry Structure.” The American Economic Review 72(1) 1982: 1-15 with 2,455;
  • “Entrepreneurship in Economic Theory.” The American Economic Review 58(2) 1968: 64-71 with 1,581 citations.
Kirzner’s relevant contributions would include:
  • Competition and Entrepreneurship. Chicago: University of Chicago Press, 1973 with 7,550 citations;
  • “Entrepreneurial Discovery and the Competitive Market Process: An Austrian Approach.” Journal of Economic Literature 35(1) 1997: 60-85 with 3,273;
  • Perception, Opportunity, and Profit: Studies in the Theory of Entrepreneurship. Chicago: University of Chicago Press, 1979 with 2,604 citations.[1]
Compare these numbers with previous Nobel Prize winners, such as F. A. Hayek, whose “The Use of Knowledge in Society” has garnered 13,935, and works such as The Road to Serfdom and The Constitution of Liberty, which have been cited over 8,000 times each. Citations to Milton Friedman’s famous “The Role of Monetary Policy” are slightly over 7,000, and his A Monetary History of the United States (coauthored with Anna Schwartz) falls just under 8,000. James Buchanan’s The Calculus of Consent (coauthored with Gordon Tullock) has been cited over 10,000 times, but his next most cited paper “An Economic Theory of Clubs” garnered slightly over 3,800 citations.
Economic science has consisted of two claims that must be reconciled with each other – the self-interest postulate and the invisible-hand explanation.

So the rumors were not incredible based on the Thomson Reuters criteria. And Baumol and Kirzner had already been recognized in Sweden with the International Award for Entrepreneurship and Small Business Research for their work in the field of entrepreneurship. So, again, the rumors were (are) plausible, though of course improbable – especially regarding Kirzner, given his outsider status. Alas neither Baumol nor Kirzner received the phone call that October day in 2014.
I am going to use this occasion to provide some reasons why they should have, and hopefully they will, receive that recognition from Sweden, and in particular why Israel Kirzner’s contributions to our understanding of competitive behavior, industrial structure, and the entrepreneurial market process should be recognized; I will also show that Kirzner’s work provides a platform for future research in price theory and the market system more generally.[2]
The aspect of the contributions that I want to emphasize is Kirzner’s insights into the rivalrous nature of competitive behavior and the market process. He raised fundamental questions in the analysis of market theory and the operation of the price system, which is at the very foundation of economic science. His writings on economic behavior in all its variety and complexity explore the institutional environment that enables a market economy to realize mutual gains from trade, to continuously discover gains from innovation, and to produce a system characterized by economic growth and wealth creation.
Self-Interest and the Invisible Hand
Economic science since its inception has consisted of two claims that must be reconciled with each other – the self-interest postulate and the invisible-hand explanation. From Adam Smith forward many have explained the relationship by collapsing one onto the other through stringent cognitive assumptions and postulating a frictionless environment, or they sought to demonstrate the inability to square these two claims due to cognitive shortcomings or a variety of postulated frictions.
Thus the political-economy debates about the role of government in the economy tended after World War II to turn on a postulate of perfect markets or the demonstration of deviations from that ideal due to imperfect markets. Kirzner from the beginning of his career had to tackle objections to invisible-hand explanations associated with questions concerning human rationality, the existence of monopoly power, the pervasiveness of externalities, and a variety of deviations from the textbook ideal of perfect competition.
There are two ways that economists have responded to the criticisms of the operation of the market economy: first, by conceptual clarity, where the theorist insists on clarifying the underlying conditions on which invisible-hand claims are being made and demonstrates that the criticisms were based on mistaken foundations; and second, by demonstration that deviations from the textbook notion of the ideal of perfect competition do not necessarily prevent the price system from doing its job of coordinating the productive activity of some with the consumption patterns of others, such that the invisible-hand explanation of market theory follows from the pursuit of self-interest within a certain set of institutional conditions. Those institutional conditions are established by the rules of property and contract that are established and enforced and that provide the framework within which economic interaction takes place.
Kirzner directs our attention toward creative human actors who continually discover ways to realize the gains from trade and the gains from innovation.
In Kirzner’s work we will see both these responses to the critics of the market. In fact he titled an essay relatively late in his career “The Limits of the Market: The Real and the Imagined” (1994). Conceptual clarity goes a long way to straightening out loose thinking related to human rationality, externalities, monopoly power, etc., and the robustness of market processes to provide inducement to economic actors to continually adjust their behavior and adapt to changing circumstances does much of the remainder. Far from reasserting a reconstructed perfect-market theory, this Kirznerian approach compels the analyst to look carefully at the dynamic properties of the system as it is constantly evolving towards a solution and the essential role played by the framework in structuring the economic environment.
Today’s “inefficiency” is tomorrow’s profit opportunity for the individual who is able to act upon the situation and move the system in a direction less “erroneous” than before. And if the existing critical decision maker doesn’t make the necessary adjustment, another will make it for them, resources will be redirected, and a pattern of exchange and production will emerge that better coordinates the plans of the market participants. Kirzner’s work directs our theoretical attention away from exercises in optimization against given constraints and towards the alert and creative human actors who continually discover ways to realize the gains from trade and the gains from innovation.
Kirzner and Mises
Ludwig von Mises motivated Kirzner’s intellectual quest. Born in England on February 13, 1930, Kirzner and his family moved to South Africa in 1940. In 1947 he attended the University of Cape Town, but moved to the United States at the end of the academic year. After graduating from Brooklyn College in 1954, Kirzner decided to pursue a graduate degree in business with a concentration in accounting at New York University, and was awarded an MBA in 1955. While completing his coursework for the MBA Kirzner sought a challenging class as his elective, so he looked in the faculty directory for professors who had published many books and had been honored with prestigious awards. He came upon the name Ludwig von Mises. As he has told the story countless times, fellow students and even administrators warned him not to take the class because, they said, Mises was old and out of step with the times.
But Kirzner took the class anyway, and it changed his life. He was taking price theory the same semester, using Stigler’s The Theory of Price (1952) and learning about choice within constraints and the logic of perfect competition; in Mises’s seminar he was reading Human Action and learning about the agony of human decision making amidst a sea of uncertainty and that the market was not a place or a thing, but a process. Mises’s ideas intrigued him, and reconciling what he was learning from Stigler with what he was learning from Mises sparked his intellectual imagination. It changed his career path from professional accountancy to academic economist. At first Mises, who recognized Kirzner’s potential, recommended that he go to Johns Hopkins University and work with the younger and more professionally connected among contemporary academic economists Fritz Machlup. Mises even arranged a fellowship for Kirzner to do so. But Kirzner chose to stay and finish at NYU under Mises’s direction and was awarded his Ph.D. in economics in 1957. At that time he received an appointment as a professor of economics at NYU, and he taught there until his retirement in 2000.
Economics, as the most developed branch of praxeology, must begin with reflection upon the essence of human action.
Kirzner’s first book, The Economic Point of View (1960), developed out of his Ph.D. dissertation. Bettina Bien Greaves of the Foundation for Economic Education attended Mises’s seminar at NYU regularly and took careful notes throughout the years. One aspect of those notes was the research ideas that Mises would throw out to the class. The very first such idea she jotted down on November 9, 1950 was: “Need a book on the evolution of economics as a science of wealth to a science of human action.”[3] This topic is what Kirzner explored in his thesis and subsequent book. The Economic Point of View carefully and meticulously explores the development of economic thought concentrating on the meaning that economists have attributed to their subject from the classics (science of wealth) to the moderns (science of human action). The key chapter in the book seeks to elaborate the development of praxeology by Mises.
The Importance of Mises' Praxeology
All of Mises’s unique contributions to the various fields of economic theory, Kirzner argues, are the result of the consistent development of the praxeological perspective on the nature of economic science. “If economic theory, as the science of human action, has become a system at the hands of Mises, it is so because his grasp of its praxeological character imposes on its propositions an epistemological rationale that in itself creates this systematic unity” (Kirzner, The Economic Point of View, p. 160).
Economics, as the most developed branch of praxeology, must begin with reflection upon the essence of human action. “Purpose is not something to be merely ‘taken into account’: it provides the sole foundation of the concept of human action” (ibid., p. 165). The theorems of economics, i.e., the concepts of marginal utility and opportunity cost, and the principle of demand and supply, are all derived from reflection upon the purposefulness of human action. Economic theory does not represent a set of testable hypotheses, but rather a set of conceptual tools that aid us in the reading of the empirical world.
What is unique about the human sciences, as opposed to the physical sciences, is that the essential point of phenomenon under the study is human purposes and plans. As Mises’s student Fritz Machlup once put it: “What if matter could talk?” The human scientist can assign purpose to the phenomena under discussion. In fact he must assign human purpose if he wishes to render those phenomena under investigation intelligible. We can understand that the pieces of metal and paper changing hands function as “money” because of the purposes and plans we attribute to the transacting parties. The human scientist can and in fact must rely upon the knowledge of ideal typifications of other human beings.
It would be completely undesirable to eliminate man, with his purposes and plans, from the study of human phenomena.
We can understand the purposeful behavior of “the other” because we ourselves are human. This knowledge, referred to as “knowledge from within,” is unique to the human sciences, and it was an utter disaster to try to eliminate recourse to it by importing the methods of the natural sciences to the social sciences to create “social physics.” Scientists forgot that, while it was desirable to eliminate anthropomorphism from the study of nature, it would be completely undesirable to eliminate man, with his purposes and plans, from the study of human phenomena. Such an exercise results in the “mechanamorphism” of the human sciences, i.e., attributing mechanical behavior to creative human subjects. In such a situation we end up talking about the economic behavior of robots, not men. But that is exactly what happened in the postwar era when the “economy” was studied as an abstract mechanism as opposed to the ongoing arena where the striving of individuals to better their condition is played out.
Constant Change and the Market Process
As emphasized by Mises, F. A. Hayek, Kirzner, and also James Buchanan, most famously in his essay “What Should Economists Do?” (1964), the economy has no teleology as such, but the actors within the economy do in fact have their individual teleologies. That is critical to understanding the nature of the market economy, since a diversity of purposes and plans are pursued and satisfied by others, potential conflicts are reconciled through exchange, and new ways of pursuing and satisfying are constantly discovered by creative and alert entrepreneurs. The economy does not have a single end; it does not have a “purpose.” It is instead merely “means-related,” a “nexus of voluntary exchanges.” The market is always in the process of becoming, always evolving toward a solution, and never in that final state of rest.
To a considerable extent this is what Mises meant when he said that the market is not a place or a thing, but a process. And what animates this ongoing process of exchange and production is the purposive human actor – with all his foibles and fears, as well as his imagination and courage to chart the unknown. The Misesian actor is neither a purely reactive animal, nor a cold calculating machine, but instead is a distinctively human actor, who has goals, seeks to creatively utilize the means available to strive to obtain those goals in a world of uncertainty and ignorance, and is capable of learning through time from previous missteps and wrong turns.
Change is a constant theme in Mises’s writings -- shifts in tastes, technology, and resource availability. The wonderful aspect of the price system is its ability to absorb change: the guiding role of relative prices, the lure of pure profit, and the discipline of loss redirect economic decision makers so their production plans and consumption demands mesh with the new reality. It is important to stress that this process is ongoing, or as Mises put it in his original 1920 essay, “Economic Calculation in the Socialist Commonwealth,” the price system provides a guide amidst the “bewildering mass of intermediate products and potentialities of production” (1975[1920]: 103) and enables economic decision makers to negotiate the ceaseless “toil and moil” (1975[1920]: 106) of the constant market adjustment and adaptation to changing circumstances.
If a market is not in equilibrium, this must be the result of ignorance by market participants of relevant market information.
In Kirzner’s 1967 paper, “Methodological Individualism, Market Equilibrium, and Market Process,” he pursues the implications of Hayek’s point that economic problems result only, and as consequence, of changing circumstances. As Kirzner puts it: “This is the basic character of the market process set in motion by the existence of a disequilibrium situation. The crucial element here is the discovery of error and the resulting reconsideration by market participants of the true alternative now open to them. The market process proceeds by communicating knowledge. The all-important assumption is that men learn from their market experiences” (italics original, 1967: 795). This is an insight that can first be seen in his paper “Rational Action and Economic Theory” in the Journal of Political Economy in 1962, but later more fully developed in his Competition & Entrepreneurship (1973). His insistence in each of these works is on the human decision maker, who is more than the pure maximizing homo-economicus, but a more open-ended creature homo-agens, and thus the creative and alert entrepreneur who acts on the gaps in the system that are reflected in the disequilibrium state of affairs.
In Market Theory and the Price System, Kirzner states: “If a market is not in equilibrium, we have seen, this must be the result of ignorance by market participants of relevant market information.  The market process, as always, performs its functions by impressing upon those making decisions those essential items of knowledge that are sufficient to guide them to make decisions as if they possessed the complete knowledge of the underlying facts” (emphasis in original, 2011 [1962]: 240).
In The Meaning of Market Process, Kirzner would make the important distinction between the underlying variables of the market (tastes, technology, and resource availability) and the induced variables of the market (prices and profit/loss accounting), and he explained how the market process can be described as the continuous activity that results from individuals on both sides of the market trying to satisfy their plans for betterment (1992: 42).  When the production plans of some perfectly dovetail with the consumptions plans of others, the induced and underlying variables are consistent with one another.  If no mutual consistency exists, then economic activity continues because it will be in the interest of the parties to continue to seek a better situation than they are currently realizing.
Profit Signals and Entrepreneurship
Relative prices guide us in decision-making; profits lure us in our decisions; and losses discipline us in our decisions.  This is how the price system impresses upon us the essential items of knowledge required for plan coordination. Or, as Kirzner would summarize the point in “Entrepreneurial Discovery and the Competitive Market Process”: “The entrepreneurial process so set into motion, is a process tending toward better mutual awareness among market participants. The lure of pure profit in this way sets up the process through which pure profit tends to be competed away. Enhanced mutual awareness, via the entrepreneurial discovery process, is the source of the market's equilibrative properties” (Kirzner 1997: 72).
Markets may “fail,” but the best response is to allow the market to fix the “failure.”
Kirzner’s theoretical contribution offers an answer to one of the critical questions of pure economic theory -- the convergent path to equilibrium guided by price changes – a vexing problem recognized by Kenneth Arrow in his 1959 paper on the theory of price adjustment, by Franklin Fisher in his Disequilibrium Foundations of Equilibrium Economics (1983), and more recently by Avinash Dixit in Microeconomics: A Very Short Introduction, where he states the most basic idea of supply-and-demand analysis of market equilibrium: “The trouble with this answer is that in the logic of supply and demand curves each consumer and producer responds to the prevailing price, which is outside the control of any one of them. Who then adjusts the price toward equilibrium?” (2014: 51).
Kirzner answers: it is the alert and creative entrepreneur who acts on the gaps in prices and costs to realize the gains from trade and the gains from innovation and who adjust the market behavior of participants to coordinate the production plans with consumption demands. The market process exhibits this tendency toward pursuing the gains from trade (exchange efficiency), striving to utilize least-cost technologies in production (production efficiency), and satisfying the demands of consumers (product-mix efficiency), but it does so not by pre-reconciling all plans prior to revealing a price and quantity vector that would clear all markets as if in an unreconstructed Walrasian model of general competitive equilibrium. Rather it does so through the ongoing process of exchange and production guided by relative price adjustments, the lure of pure profit, and the penalty of loss, which reconcile the diverse and often divergent plans of economic actors through the market process itself.
Markets always fall short of the abstract ideal of “efficient” allocation, but the market itself is adaptively efficient in constantly signaling to alert entrepreneurs what changes must be made and rewarding those who adjust correctly and penalizing those who don’t. Markets may “fail,” but the best response is to allow the market to fix the “failure.” Efforts to fix failures by actors external to the ongoing process of market adjustment and adaptation will be unaided by the price system and, by definition, the structure of incentives that property rights provide, the guiding presence that relative prices offer, and the selection process made possible by the calculation of profits and losses.
As a result, regulators face certain perils, as Kirzner pointed out in his essay “The Perils of Regulation” (1985 [1979]), and run the risk of generating perverse patterns of exchange and production and of leading entrepreneurs into superfluous discoveries rather than discoveries that better coordinate the plans of economic actors and ameliorate the conflicts that originally motivated the desire for regulation in the first place. Interventionism is not only self-defeating from the point of view of its advocates, but produces unintended and undesirable consequences throughout the economic system.
Market Dynamism and Monopoly
It is not the size of firms that matter most in assessing the existence of monopoly power, but the legal conditions of entry that matter.
Kirzner’s work is as critical to understanding the dynamics of the marketplace today as it was when economists first studied industrial structure and competitive behavior. If one looks at the emerging market structure that has followed from the Internet, one would certainly have to recognize the market dominance of Amazon, Apple, and Netflix, yet one would also have to recognize the great level of consumer satisfaction associated with these firms. Despite their dominant market share, these firms provide quality goods and services at low prices. And there is no expectation that these firms will do anything but continue to strive to provide high quality products for the lowest price. This is because they compete in a contestable market.
Consider the classic browser wars from a decade ago, Netscape vs. Microsoft Internet Explorer. How monopolistic can a firm behave if its product can be used to freely download its competitors product? The standard textbook model of perfect competition, and the structure-conduct-performance paradigm in industrial economics built upon that textbook model as a benchmark, simply are incapable of providing a clean explanation for the Internet marketplace. Market leaders will fall by the wayside unless they keep moving forward faster to further satisfy consumer preferences.
And, this isn't just about the Internet marketplace. It is about any marketplace once one examines closely the historical operation of markets. This is how markets function, as understood by Carl Menger, Eugen von Böhm-Bawerk, Mises, Hayek, and Kirzner, and I think one could argue effectively that it was understood by Smith, Say, and even Mill. It is not the size of firms that matter most in assessing the existence of monopoly power, but the legal conditions of entry that matter. It is important, perhaps, to stress again the conceptual clarity and robustness of the responses to claims of market failure based on monopoly power.
Regarding conceptual clarity, most notably in the Austrian tradition represented by Murray Rothbard, it is argued that monopoly power is a consequence of a government grant or privilege. However true that statement is, the robustness-of-markets response might demonstrate that a firm can grow large and possess significant market dominance at any point in time, but precisely because it faces the threat from entrants (real or imagined), it will be compelled to behave competitively, rather than as predicted by the model of monopoly, if it is to have any hope of maintaining its market dominance. The two sort of responses, again, can go together, but they are distinct. Kirzner’s entrepreneurial theory of the competitive market process does employ both, but stresses the robustness of the market process.
And, as recognized by classic economists such as Frank Knight and Joseph Schumpeter, the central actor in managing this process of changing circumstances and adaptation to new opportunities is the entrepreneur. The entrepreneur’s central function is to act on hitherto unrecognized opportunities for mutual gain – whether those come in the form of arbitrage opportunities or technological innovations which cut costs of production and distribution or the discovery of new products that meet consumer demand. It is entrepreneurial action that sets in motion the competitive market process and which results in the adaptations and adjustments to changing conditions such that complex coordination of economic plans is achieved, wealth is created, and economic progress is perpetuated.
For these reasons, and more, I believe that Kirzner has (along with Baumol, whom I have mentioned, and Harold Demsetz, whom I have not) done more than any other living modern economist to improve our understanding of competitive behavior and the operation of the price system in a market economy, and thus deserves serious consideration for the Nobel Prize in Economic Sciences. Kirzner has provided fundamental challenges to the prevailing orthodoxy of textbook perfect competition and its implications not only for economic theory but economic policy as well.
His work provides deep insight into the nature of how competitive markets coordinate the plans of disparate economic actors and organizations. The foundational role of property rights in structuring incentives, of relative prices guiding production and consumption decisions, and of profit-and-loss accounting as vital to the process of economic calculation in economic affairs takes a central place in his work. Thus Kirzner’s work provides an economic foundation for our inquiry into the political and economic system most suitable for a society of free and responsible individuals.

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