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Introduction. New Approaches to Market Process: Interdisciplinary Studies of the Market Order

Peter J. Boettke, Christopher J. Coyne, and Virgil Henry Storr

The chapters in this volume explore and engage market process theory from an interdisciplinary perspective. Market process theory explains the sequence through which the knowledge and expectations of economic actors lead toward coordination and cooperation. Our purpose in this introductory chapter is twofold. First, we provide a general overview of market process theory with the goal of providing context to the subsequent chapters. Second, we provide an overview of each of the subsequent chapters. Each chapter contains original research that explores or applies various aspects of market process theory and, in doing so, demonstrates the continuing relevance of this framework and approach within a wide variety of disciplines.

MARKET PROCESS THEORY: AN OVERVIEW

A market refers to interactions between buyers and sellers. These interactions could take place in a physical marketplace (e.g., the local shopping plaza, bazaar, or stock exchange) or in a conceptual marketplace (e.g. the domestic market for automobiles or the global financial market). Potential buyers enter the market hoping to acquire goods or services. Potential sellers enter the market hoping to find buyers for the goods and services they can provide. If a potential buyer and seller cannot come to terms (i.e., the seller wants more than the buyer is willing to pay), then both parties may leave the market without having traded; both parties may leave the market frustrated. However, if a potential buyer and seller are able to agree on terms (i.e., on a particular price for a particular quantity of a good or service), then a market exchange takes place. If an exchange occurs, the buyer leaves the market with the good or service he wanted having paid a price for that good or service that he was willing to pay. The seller, likewise, leaves the market having obtained a price that she was willing to accept for the good or service she was offering.

Market process theory is an attempt to understand how prices emerge and how economic actors respond when prices change. It was most fully developed by three economists—Ludwig von Mises (1920, 1949), F. A. Hayek (1948), and Israel Kirzner (1973, 1992, 1997).1 Mises (1949, 257) captured the essence of the theory when he wrote that “[t]he market is not a place, a thing, or a collective entity. The market is a process, actuated by the interplay of the actions of the various individuals cooperating under the division of labor.” Similarly, Hayek (1948, 86-87) highlighted the important role of the price system, noting,

It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.

Additionally, Kirzner (1973, 73) stressed the key role that entrepreneurship plays in driving the market process, emphasizing that “[w]hat drives the market process is entrepreneurial boldness and imagination; what constitutes that process is the series of discoveries generated by that entrepreneurial boldness and alertness.” It is this analytical focus on process that sets Mises, Hayek, and Kirzner apart from their peers in economics.

Market process theory seeks to understand how the knowledge and expectations of dispersed individuals are coordinated through an ongoing process of mutual discovery and learning. This theory has five defining and related characteristics: (1) markets depend on the existence of a particular set of institutions, (2) the market process is a cultural process, (3) markets are driven by entrepreneurial discovery in the face of sheer ignorance, (4) the process of discovery takes place in an open-ended system and is therefore ongoing, and (5) the market is a spontaneous order that emerges from the interactions of individuals pursuing their own ends. We will consider each of these characteristics in turn.

In order for markets to emerge and operate effectively, certain institutions must exist (see Boettke and Coyne 2003, 2009). Perhaps the most important institution is a regime of private property rights that delineate how resources are owned or used. Property rights, although often formally codified, are themselves emergent orders based on a complex, centuries-old set of moral traditions and experiences that no one planned or can fully understand (see Hayek 1973, 1983).

Property rights are crucial for the market process because they allow economic actors to engage in economic calculation, which refers to their ability to determine which of a range of technologically feasible alternatives is the most economically suitable to adopt (see Mises 1920; Vaughn 1980; Lavoie 1985; Boettke 1998).

Economic calculation operates as follows. Property rights over the means of production allow for competition and exchange between market participants. Because property owners will reap the economic benefits from their activities, they have an incentive to pay as little as they can for the goods and services they desire and to charge as much as they can for the goods and services that they are able to supply. As such, they have an incentive to compete with one another for the best deals.

Competition and exchange, in turn, lead to the emergence of market prices. These market prices capture information regarding the relative value of resources, which can then be used by economic actors to determine the expected value of alternative, technologically feasible uses of those resources. These spontaneously generated market prices allow economic actors to both evaluate past decisions and plan for the future because they effectively communicate information and tacit knowledge from throughout the economic system (see Hayek 1948, 77-91; Kirzner 1992, 139-51; Thomsen 1992). As Hayek writes, “In a system in which the knowledge of relevant facts is dispersed among many people, prices can act to co-ordinate the separate actions of different people in the same way as subjective values help the individual co-ordinate the part of his plan” (Hayek 1948, 85).

Changes in prices, thus, communicate that something about the world has changed. A price increase means that a good or service has become more scarce. If, for example, there is a natural disaster in a distant area that adversely affects the availability of an economic resource, the price of that resource will rise accordingly. Likewise, a decrease in the price means that a good or service has become more readily abundant. For instance, the price of a scarce resource like diamonds would fall if a new mine was discovered that dramatically increased the availability of diamonds. Even if market actors throughout the economic system have no idea about the fundamental cause of the price change, they will respond to the price change when making their plans. In this manner, market prices communicate local information and knowledge to other market actors, allowing them to adjust their plans accordingly.

Although market prices effectively communicate information, they do not contain all relevant information and are, therefore, necessarily imperfect knowledge surrogates (see Thomsen 1992). These imperfect prices are the result of sheer ignorance and are central to the market process because they represent profit opportunities for alert entrepreneurs to reallocate resources to new and better uses.

In order to fully appreciate the institutional environment of markets, it is important to recognize that the market process, like all social processes, is unavoidably a cultural process (Grube and Storr 2015). Culture can be defined as a historically transmitted pattern of meanings that is shared by a group of people and learned by new members as they become a part of the group (Geertz 1973; Chamlee-Wright 1997; Storr 2013). Rather than being a tool or resource (like a capital good), culture is the environment against, within, and through which individuals act in and experience the world. It is the lens through which individuals process reality.

In the context of the market process, an appreciation of the role of culture is important for several reasons. First, culture (partly) determines which formal institutions are feasible and sustainable (see Boettke, Coyne, and Leeson 2008). Second, culture (partly) determines how individuals understand the formal and informal rules that govern their market activities, including the property rights regimes discussed earlier. Third, culture also (partly) determines who can buy and sell, which items can legitimately be bought and sold, and when a deal between market participants has been properly consummated. Fourth, culture (partly) determines how market participants will view and respond to market signals like price changes as well as profits and losses. Finally, culture (partly) determines which profit opportunities entrepreneurs notice and which they ignore as well as the strategies entrepreneurs pursue as they attempt to exploit the opportunities that they perceive (Lavoie 1991).

Situated within a broader institutional and cultural environment, the market process is driven by entrepreneurial discovery in the face of sheer ignorance. Kirzner emphasizes the important difference between ignorance and sheer ignorance (see Kirzner 1992, 46-49). Ignorance refers to a known lack of knowledge that one can remedy by seeking out the requisite knowledge. For example, a person may lack the knowledge of foreign business regulations because possessing this information is not necessary to their domestic operations. This is an example of ignorance as commonly understood, which could be resolved by seeking out available information on foreign regulations.

Sheer ignorance, in contrast, refers to not only lacking knowledge, but also lacking knowledge that the information exists in the first place. In the context of markets, sheer ignorance entails a lack of knowledge about potential opportunities for profit. It is the existence of sheer ignorance and the subsequent imperfect prices that create the profit opportunities that attract alert entrepreneurs to relocate resources.

The conjectures of these alert entrepreneurs, who, in turn, believe they have identified a profit-yielding opportunity, are subjected to the profit- and-loss test. A profit reveals that the entrepreneur’s conjecture was accurate—resources were previously misallocated and were in fact rearranged to generate greater value. A loss reveals the converse—the entrepreneur has reallocated resources in a manner that yields less value as compared to alternative uses. Taken together, the market process can be seen as pulling back the curtain of sheer ignorance as economic actors become aware of opportunities to which they were previously unaware. The result is, thus, improved coordination across the economic system.

The market process, as described above, is an open-ended system. It is a continuous process of discovery and resource reallocation. The complete reconciliation among individual plans is never achieved (see Kirzner 1992, 39-41). The alignment of individual plans with the constellation of individuals’ preferences as well as available technologies and resources in the economic system never occurs. There is, instead, often a conflict between the plans of some market participants. Moreover, there is often a disjoint between individual preferences, technologies, and resource allocations. Through an ongoing competitive process of discovery, past inconsistencies are removed while new ones are introduced (Hayek 1948, 92-106; Kirzner 1992, 46-49).

The market process, thus, results in a spontaneous order—that is, an arrangement that is the result of purposive individual action but not design (see Hayek 2013). In this context, order refers to an integration or coordination of activities between individual elements embedded in a system characterized by certain rules and patterns of behavior.

Spontaneous orders have several defining characteristics. The market process satisfies all of them. First, spontaneous orders emerge from human action but not from intentional design. That is, in purposefully pursuing their particular and diverse goals, individuals contribute to a broader order or integration of activities. In the context of the market process, each individual participant is pursuing his or her own ends. In doing so, each one must interact and coordinate with others who are simultaneously pursuing their own goals. These interactions tend to produce mutually beneficial outcomes for the immediate participants to the interactions. At the same time, they contribute to the broader market order that we observe when we step back and take a broader view of the market at any point in time. Ludwig von Mises (1949, 338) captured this point when he wrote:

The pricing process is a social process. It is consummated by an interaction of all members of the society. All collaborate and cooperate, each in the particular role he has chosen for himself in the framework of the division of labor. . . . All people are instrumental in bringing about the result, viz., the price structure of the market, the allocation of the factors of production to the various lines of want-satisfaction, and the determination of the share of each individual. These three events are not three different matters. They are only different aspects of one indivisible phenomenon which our analytical scrutiny separates into three

parts. In the market process they are accomplished uno actu.

As Mises emphasizes, the interactions of dispersed individuals bring about the broader allocation of resources that we refer to as “the market.” On a daily basis, each and every market participant contributes to the broader market order without even realizing it. In fact, one of the most stunning aspects of the market process is that it functions to achieve desirable outcomes without anyone needing to understand exactly how it operates.

Second, spontaneous orders can meaningfully be described as orders meaning there is an identifiable pattern emerging from the interaction of the individuals in the system. As Hayek (1973, 36) writes, an emergent order is “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 . . . part of the whole to form correct expectations concerning the rest.” The market process satisfies this condition because clear relationships, tendencies, and patterns emerge through interaction in markets. For example, prices will tend to correspond to opportunity costs through the entrepreneurial process described earlier. Similarly, through that same process resources tend to be reallocated to their highest valued uses.

Third, spontaneous orders require mechanisms to provide both positive and negative feedback to the individual actors so that they can adjust their behaviors accordingly to achieve coordination. These feedback mechanisms enable the order to be self-enforcing. In markets, the profit-and-loss mechanism serves this function. Entrepreneurs are alert to potential profit opportunities. The profit-and-loss mechanism provides feedback as to whether these perceived opportunities were accurate or inaccurate. Economic actors are incentivized to adjust their behavior to feedback received through the profit-and-loss mechanism. For example, a business earning a loss will be incentivized to adjust its behavior because if it fails to do so it will be unable to survive.

The fourth characteristic of spontaneous orders is that the actors in the system follow general rules of conduct. These rules, which are informal or formal in nature, are embedded in a cultural environment and govern the interactions between actors, and hence the kind of order that emerges. In the context of markets, there is an array of rules that govern the behaviors of participants. As discussed, private property rights delineate what can be owned and the range of permissible activities by property owners. Private property rights also allow for economic calculation and provide an incentive to act on that knowledge through the feedback mechanisms just discussed. In addition to property rights, there is an array of other institutions that allow markets to function. For example, social relationships and norms of trust and etiquette facilitate coordination and cooperation between people (see Granovetter 1974; Storr 2008, 2013).

Finally, spontaneous orders are abstract, meaning they cannot be fully grasped using human reason. This has two implications. First, since spontaneous orders are not the result of human design, the participants in the system do not need to understand, or even be aware of, the broader order and their contribution to the order. This is clearly the case with markets. Each participant pursues particular goals and, in doing so, contributes to the broader “economy” without realizing that he or she is doing so. Second, and related, the abstract nature of spontaneous orders means that they are able to extend beyond the limits that human reason can imagine as a potential state of affairs. No person, or group of people, can centrally plan the markets necessary for advanced material production and, historically, efforts to do so have led to devastating consequences precisely because the abstract nature of the order generated by the market process was ignored.

In sum, market outcomes are a spontaneous order. This order emerges from an institutional setting of private property that allows for the emergence of market prices and the operation of the profit-and-loss mechanism. Property rights, prices, and profit and loss are embedded in a broader cultural environment that influences how these variables are interpreted and acted upon. The entrepreneur who is alert to profit opportunities resulting from past ignorance and error is the central driver of the market process. Through an open-ended discovery process, these errors are corrected and adjustments are continually made as new knowledge becomes available. The result is social cooperation and coordination.

 
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