Montreal, December 15, 2004  /  No 149  
<< INDEX NO 149 
Chris Leithner grew up in Canada. He is director of Leithner & Co. Pty. Ltd., a private investment company based in Brisbane, Australia.
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by Chris Leithner
          An important strand of the Austrian School of economics, the Mises-Hayek-Rothbard theory of entrepreneurial discovery, explains much better than the contemporary mainstream how real world markets work. Israel Kirzner, a student of Ludwig von Mises and for many years a Professor of Economics at New York University, has extended and elaborated the theory and is perhaps its most prominent contemporary exponent (see in particular Competition and Entrepreneurship, University of Chicago Press, 1973; The Meaning of Market Process, Routledge, 1996; How Markets Work: Disequilibrium, Entrepreneurship and Discovery, Institute of Economic Affairs, 1997; and The Driving Force of the Market, Routledge, 2000). The Role of the Entrepreneur in the Economic System (the Inaugural John Bonython Lecture delivered by Kirzner at Adelaide on 30 July 1984) is an excellent five-page précis of this research. Investors could do far worse than to ponder and absorb its many important implications.
Disequilibrium underlies entrepreneurial activity  
          The theory of entrepreneurial discovery emphasises the very features of real-world markets that the mainstream’s model of perfect competition excises. Most importantly, disequilibrium, not equilibrium, characterises the interactions among buyers and sellers; and disequilibrium (and its associated cycle of error, detection, correction and renewed error) underlies entrepreneurial activity and discovery. Markets do indeed tend towards market-clearing prices: but they never attain equilibrium because numerous events – the constant change of plans, discovery of new information and technology, commission of errors and their discovery and rectification – intrude. Alert entrepreneurs, be they producers, consumers or investors, detect errors and, through a process of trial and error, learn how they can be remedied. Occasionally, disequilibrium also enables prescient entrepreneurs to anticipate changes in others’ plans and decisions.  
          Accordingly, movements of prices, changes of methods of production and distribution, and choice of outputs stem ultimately from changes in consumers’ plans and desires; and entrepreneurial error, discovery and correction set these market forces in motion and influence them in directions that serve consumers’ wishes. Alert and prescient entrepreneurs thus tend to reveal where and how the structure of production can be improved in order to serve consumers better. Entrepreneurial discovery is the oil that enables the market mechanism to operate and adapt so smoothly.  
          Note the gulf that separates the Mises-Hayek-Rothbard theory from the mainstream model of perfect competition. To mainstream economists, the decisions entailed by buying and selling in the market are mere mathematical derivations. A decision, in other words, is “made” by a “given” model, probability distribution and data. The mainstream model thus eliminates the real-life, flesh-and-blood decision-maker – the heart of the Mises-Hayek-Rothbard theory – from the market. Market automatons do not err; accordingly, it is unthinkable that an opportunity for pure profit is not instantly noticed and grasped. The mainstream economist, goes the revealing joke, does not take the $10 note lying on the floor because he believes that if it were really there then somebody would already have grabbed it.  
          In sharp contrast, Austrians recognise that decisions are taken by real people whose plans are imperfectly clear, indistinctly ranked, quite often internally-inconsistent and always subject to continual change. Further, at any given moment a market participant will be largely unaware of other market participants’ present and future plans. It is participation in the market that makes buyers and sellers a bit more knowledgeable about their own plans and slightly less unaware of others’ plans. Accordingly, they will inevitably make mistakes and not automatically notice them. It is not just possible – it is typical – that opportunities for gain (“pure profit”) appear but are not instantly detected. Recognising the obvious – namely that he has possibly been the first to notice it – the Austrian School economist will therefore take the $10 note inadvertently dropped on the floor and ignored by his mainstream colleague.  
          An “Austrian School” act of entrepreneurial discovery, then, occurs when a market participant notices what others have overlooked. Warren Buffett discovered a lucrative opportunity (one of the first of many in his long and successful career) when he worked at Graham-Newman Corp. Mr. Buffett recalls that “Rockwood & Co., a Brooklyn based chocolate products company of limited profitability, had adopted [Last In First Out] inventory valuation in 1941 when cocoa was selling for $0.50 per pound. In 1954, a temporary shortage of cocoa caused the price to soar to over $0.60. Consequently Rockwood wished to unload its valuable inventory quickly. But if the cocoa had simply been sold off, the company would have owed close to a 50% tax on the proceeds. The 1954 Tax Code came to the rescue. It contained an arcane provision that eliminated the tax otherwise due on LIFO profits if inventory was distributed to shareholders as part of a plan reducing the scope of a corporation’s business. Rockwood decided to terminate one of its businesses, the sale of cocoa butter, and said 13 million pounds of its cocoa bean inventory was attributable to that activity. Accordingly, the company offered to repurchase its stock in exchange for the cocoa beans it no longer needed, paying 80 pounds of beans for each share. For several weeks I busily bought shares, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts. The profits were good and my only expense was subway tokens.”  
          It is important to emphasise that this discovery, like Buffett’s (and Benjamin Graham’s) many others, did not derive from information that other buyers and sellers could not possess. These acts of entrepreneurial discovery stemmed from the alert analysis of publicly available information and the superior detection of opportunities that others had simply overlooked. On numerous occasions, in effect, Mssrs Buffett and Graham have known where to look and have been the first to detect the huge piles of $10 notes that others have disregarded and left lying on the floor. Anybody, for example, could also have bought parts of American Express, The Washington Post, GEICO and Coca-Cola when Mr. Buffett did; but few saw what he saw and reasoned so clearly. Instead, most were distracted by myriad worries and irrelevancies, and so few followed Buffett’s lead. 
          It bears repeating that the theory of entrepreneurial discovery recognises that market participants will be largely unaware of others’ present and future plans, and therefore that they will inevitably make mistakes. This unawareness may take two general forms. The first is an error of commission (or of “undue optimism”). It occurs, for example, when sellers of a good expect buyers to be more eager to buy than they really are. A price that is too high to clear the market reveals that these sellers’ expectation is mistaken. Disequilibrium prices signal to some market participants that their original plans will be disappointed and that revisions are therefore required. The change of price signals to market participants that the previous price was a disequilibrium price; and its reversion towards a market clearing level brings market participants’ plans into greater harmony. 
     “Entrepreneurial discovery is the oil that enables the market mechanism to operate and adapt so smoothly.”
          Unawareness of other market participants’ present and future plans may also take the form of errors of omission (or of “undue pessimism”). Sellers, for example, may underestimate buyers’ eagerness to buy; and buyers may underestimate the eagerness of sellers to sell. This type of unawareness generates more than one price for the same good. Errors of undue pessimism thus occur when opportunities are overlooked. Those paying the higher price do so simply because they are unaware that a lower price is available; those accepting the lower price do so because they are unaware of the higher price being paid. Such price differentials – whose existence, it is important to emphasise, mainstream economists routinely deny – provide opportunities for pure profit. Sooner or later, they tend to attract the attention of alert entrepreneurs; and their detection of these opportunities for profit will erode these price differences. Somebody, in other words – but presumably not the mainstream economist, who has been trained to discount or ignore the possibility that it exists – will eventually notice and take the $10 note lying on the floor. Until somebody does – until, in other words, the notion of entrepreneurial alertness and discovery is introduced, there is no endogenous basis for any change in a market situation.  
Two Paradoxes of Entrepreneurship 
          Markets in the real world work so well, then, because alert entrepreneurs – that is to say, canny producers, savvy consumers and intelligent investors – detect and correct price discrepancies (“bargains”). The producer finds consumers who are prepared to pay a higher price for a particular good or service, and this opportunity exists until other producers also locate these consumers and offer a lower price. The consumer finds a producer prepared to offer a lower price than the consumer would have taken from other producers, and this opportunity continues until other consumers also discover the bargain and offer a higher price. Entrepreneurial discovery, and the opportunity for profit created by this discovery, is a powerful force pushing (for the sake of simplicity, let us say two) prices towards one another. This process eliminates price differentials and opportunities for profit, and thereby helps to coordinate buyers’ and sellers’ plans. 
          In a market economy – even one hobbled by vast and growing government interference – entrepreneurship plays a vital but paradoxical role. Contemporary mainstream economics can say little or nothing about entrepreneurship and opportunities for profit because they are unpredictable. Entrepreneurship is uncertain in the sense that one cannot “model” it with a particular probability distribution (although, trust them, some particularly silly mainstream economists have tried). Boldness, impulse, hunch and accident are the raw materials of human success and failure, and these passions and motivations render implausible the possibility that chains of human action will be remotely as determinate as the laws of natural and physical science.  
          In order to perceive regularities amidst the vagaries of real-world markets, it may at first glance seem sensible to imagine a world in which irregular things like entrepreneurship play no role. Yet, paradoxically, exactly the opposite is true: it is only when we acknowledge the critical importance of entrepreneurial discovery that we can appreciate how and why markets work. Without the possibility of entrepreneurship, no explanation – aside from the postulate that coordination always fully and instantaneously prevails, or that the government’s agents somehow possess brains, information and morals that are above and beyond those available to benighted buyers and sellers – of coordination in the market is possible. To introduce the scope for entrepreneurial discovery is to emphasise the human liberty – and hence the ingenuity and folly – that enables errors to be committed, detected and corrected. It is ultimately on this basis of trial and error that civilisation advances.  
          Human error is as perennial as the grass. But unlike entrepreneurs, a government (or an entity privileged by government) has no incentive to detect and correct errors. In an unfettered market, errors are detected and rectified; but when governments supplant markets, errors are ignored and denied, and grow into problems, crises and eventually catastrophes (see in particular Thomas Sowell, The Vision of the Anointed: Self-Congratulation as a Basis for Social Policy, Basic Books, 1995). In a market, competition among producers improves the quality of goods and services; and consumers reward good producers and punish the poor ones such that consumers and good producers prosper. In politics, however, the contest to hold the reins of power generates perverse results. Quality constantly declines and “innovations” occur only with respect to lying, cheating, manipulating, stealing and killing. The price of political services constantly increases and there is no obsolescence – planned or otherwise. In politics, as Friedrich Hayek demonstrated in The Road to Serfdom (see Leithner Letter 57), “the worst get on top.” The paradox for mainstream economists, then, is that one requires the “anarchy” (in the proper sense of that term) of entrepreneurship in order to explain the relatively smooth, systematic and peaceful character of real-world market processes.  
          As a result of market participants’ reactions to unwarranted optimism and undue pessimism, not only will the prices of raw materials, capital goods and consumer goods and services constantly change: just as importantly, resources will tend to shift from less urgent uses (as measured by the prices consumers are prepared to pay) to more urgent uses; less productive technologies will be replaced by more productive technologies; and new technologies and new sources of materials will tend to be discovered. Motor cars, for example, will replace horses and buggies; assembly lines will replace slower and costlier means of assembling cars; new sources of coal and iron will be discovered; more productive means of mining coal and iron and of fabricating steel will be devised; and synthetic rubber will replace natural rubber. Each of these “discoveries” will stem from errors of commission and omission; and in each case entrepreneurs will detect, and their responses will tend to attenuate, these errors.  
          Whenever an entrepreneur moves from one line of production into another, or whenever she devises a new method of production or good or service – whenever, in other words, she senses the possibility of pure profit – she responds to what she believes is an erroneous assignment by market participants of two different prices to what is, in economic reality, exactly the same item. Accordingly, not only will the prices of existing goods and services tend towards equality throughout the market: the present value of today’s capital assets and prices of resources will also tend towards equality (discounted by the rate of time preference) with future product prices. William Jevons’s “Law of Indifference,” in other words, which he introduced in The Theory of Political Economy (1871), subsumes the driving force of the real-world market. Hence the second paradox: the insights of the Austrian School – whose founder, after all, was a vital contributor to the neoclassical (Jevons-Marshall-Menger-Walras) synthesis of the 1870s – are required in order to explain phenomena that either escape the attention of, or utterly baffle, contemporary neoclassical (i.e., Walrasian) economists. 
Equilibrium versus Entrepreneurship: A Vital Distinction for Investors  
          William F. Buckley Jr. once remarked that he would sooner be governed by the first 2000 names in the Boston White Pages than by the 2000 members of the faculty of Harvard University. Similarly, I have much more respect for the views of self-made entrepreneurs than of prominent economists and politicians. This is not because the former are unerringly insightful; it is because the latter are necessarily myopic and demonstrably self-serving (see in particular Henry Hazlitt, The Failure of the New Economics: An Analysis of the Keynesian Fallacies, Foundation for Economic Education, 1959, 1994). When some economists and one or two politicians concede that the perfectly competitive market “works,” they refer exclusively to a rarefied, abstract and never-never world, far removed from flesh-and-blood people and the gristle of everyday experience. They do not seriously intend that this model’s assumptions explain phenomena such as the behaviour of buyers and sellers in real markets. Quite the contrary: they use the model to imply that real-world markets cannot and will not work and therefore that considerable and aggressive government intervention – guided, of course, by mainstream economists and policymakers – is required.  
          Hence a dangerous inferential leap: if the activities of individuals dovetail only when the stringent assumptions of the model of perfect competition prevail – which is never – then the real world requires a virtually omniscient, omnipotent and benevolent economic czar who is able to survey all endowments, preferences and potentialities. This real-world benevolent dictator must also devise and enforce a pattern of decision-making that coordinates all decisions. In a way he never intended, Adam Smith’s “invisible hand” is an apt metaphor for what is, in effect, the analytical black box that mainstream economists have bequeathed to us. In two respects, then, contemporary economics as mainstream economists practice it resembles a debased and bastardised religion. First, matters that lie at its heart, such as market processes and dynamics, are dismissed via ex cathedra pronouncements as things that do not exist in this world (and in any case as matters beyond the flock’s comprehension); and second, the grasping priesthood of economists and politicians seeks divine status (see in particular Robert H. Nelson, Economics As Religion: From Samuelson to Chicago and Beyond, Pennsylvania State University Press, 2001).  
          In sharp contrast, the theory of entrepreneurial discovery shows how decentralised, individual-level plans and decisions in this world harmonise themselves into a reasonably – indeed, remarkably – coordinated state of affairs. The Austrian School theory explains why there is a powerful tendency – without any central direction or control – for transactions in the market to coordinate disparate individuals’ myriad plans. It shows how real world markets work so well. It thereby does something that mainstream economists purport to do but never seriously intend to do. 
          How can these insights assist investors? Kevin Duffy, in an excellent article entitled "Investing as an Entrepreneurial Endeavour," lists three ways: 
    1. Seek cautious “business entrepreneurs” and avoid reckless “political entrepreneurs.” Cautious business entrepreneurs incorporate healthy margins of safety into their decisions. They seek well-established businesses, reasonable valuations and solid financial statements. A rising tide, says Duffy, makes it more difficult to identify true entrepreneurs. Better, then, to wait for the tide’s ebb – which exposes the market participants who, in Mr. Buffett’s words, have been “swimming without a bathing suit.” Above all, avoid the political entrepreneurs (Enron Corp. springs to mind) who, in Duffy’s words, “attempt to circumvent the whims of the consumer and the vagaries of the competitive marketplace by convincing government to grant them some sort of privilege or protection.” 
    2. When looking for investment opportunities, stand apart from the crowd. Mr. Buffett once told his shareholders “correctly observing that the market was frequently efficient, [the efficient markets enthusiasts] went on to conclude incorrectly that the market was always efficient. The difference between the propositions is night and day.” Price and value, in short, are not synonyms; and sometimes the one deviates sufficiently from the other such that an investment operation can be undertaken with a reasonable margin of safety. But for neither lemmings nor people does safety reside in the crowd. An investor does not need a crystal ball or a “consensus view” to prosper: he needs valid and reliable information, an ability to reason soundly and a calm and patient temperament. 
    3. Avoid the crowd’s mainstream economic follies. The typical investor is unaware that the central bank’s creation of credit not backed by savings creates artificial booms; that the trouble with booms is that, sooner or later, they are followed by busts; that busts are salutary phenomena because they liquidate the “malinvestments” that fuelled the artificial boom; and that despite governments’ efforts to prove otherwise, the laws of economics ultimately prevail. Perhaps the typical investor is unaware of these things because mainstream economists and politicians are either oblivious to them or relentlessly obscure them.
          The fundamental lesson for market participants is that real-world markets really do work. They work despite what mainstream academics say, and they work despite what politicians do. The theory of entrepreneurial discovery explains how markets work; and the less the meddling from economists and politicians, the better they will work. Best of all, the benefits of voluntary exchange are moral as well as empirical. The great British pamphleteer of laissez-faire capitalism, Richard Cobden, therefore has the last word: “I see in the [principle of voluntary exchange and free trade] that which shall act on the moral world as the principle of gravitation in the universe, drawing men together, thrusting aside this antagonism of race, creed, and language, and uniting us in the bonds of eternal peace.”