10 Apr 2017

Disrupting the Equilibrium on Rizzo’s Discussion

Economics, Mario Rizzo 23 Comments

The March 2017 “Liberty Matters” discussion was very nice, featuring contributions from several Austrian economists who are all my acquaintances/friends. Mario Rizzo was my dissertation chair at NYU.

Because my time is brief, I am not going to talk about the more important issues everybody discussed. Instead I am going to quibble with one little point that Mario made:

Ludwig Lachmann criticized Kirzner’s approach in a number of respects. First, purposiveness in the broad sense does imply alertness and learning. But this does not mean that people learn what is appropriate to move the system toward “equilibrium.” Second, entrepreneurs seek to make profits by exploiting price inconsistencies. However, this is not the same thing as moving the system toward equilibrium with respect to the underlying data. Consider that an entrepreneur can make money by exploiting the incorrect beliefs of others that a certain resource is undervalued. He will sell the resource to the party who overvalues it – thus making money but not correcting the error. Economists know that there can be bubbles and herd behavior. These are empirical issues.

I have retained the full paragraph so you can see the context, but I just want to focus on the part I put in bold. I think it’s wrong. Even in Mario’s example, the entrepreneur who realizes the stock is overvalued and sells it, is indeed moving the price in the right direction–relative to what otherwise would have happened. And that is surely the only relevant criterion.

First let’s make sure you get my modest point. Suppose Wise Willy knows that the “correct” price (and let’s put to the side the thorny issue of defining that concept) for Acme stock is $100 per share. But Bullish Billy comes along and is quite certain that Acme is undervalued; Billy thinks Acme should be priced at least at $130. So Billy enters the market and starts buying shares, bidding up the price of Acme.

Now as the price moves up, Wise Willy sees a growing profit opportunity. Now let’s be realistic here: Because of transaction costs, risk, borrowing constraints, a desire for a diversified portfolio, etc., it’s not the case that Wise Willy will short an infinite number of shares at any price above $100.01, or that Bullish Billy will buy an infinite number of shares at any price below $129.99. Rather, in the real world it is more accurate to say that each party will take on a certain exposure to either a short or long position (relative to their original holdings), based on how far the prevailing price is from what each believes is the correct price.

In that context, then, suppose that if Wise Willy does nothing, then Bullish Billy ends up pushing Acme’s price up to (say) $125 before he stops acquiring shares. In contrast, if Wise Willy decides to profit from what he perceives as a gross mispricing, then he sells into that counterfactual situation such that he and Billy stop adjusting their holdings when the price of Acme settles down at (say) $115.

So yes, Mario’s point is true if we take it to mean that profit-seeking entrepreneurship, even when correct, doesn’t move prices to their final equilibrium positions. However, it moves them in the right direction, relative to what would have happened in the absence of the action.

In my Acme example, it’s not correct to say that Wise Willy pushed prices away from equilibrium due to his correct entrepreneurial forecast. No, what happened is that Bullish Billy pushed prices away from equilibrium due to his incorrect anticipation of the future, and fortunately Wise Willy was there to mitigate the damage.

Israel Kirzner never argued that even incorrect forecasts would equilibrate the market. Cases like the above are hardly counterexamples to Kirzner’s views.

UPDATE: I’m not denying that there could be more complicated situations that would be better examples of what Mario is trying to get across. For example, in 2005 an investor might have thought, “I know housing is in a bubble, but I think I can flip this condo and get out before everything crashes.” In principle you can even have models where everybody is a perfect Bayesian and yet herd behavior forms if a few people early on get a bad signal; that’s presumably what Mario is talking about.

However, I thought it important to clarify that Mario’s particular illustration doesn’t work. And then once we start with that, we might extrapolate to the more exotic cases and see that even there, adding in more and more entrepreneurs who have perfect foresight is a good thing, relative to their absence.

23 Responses to “Disrupting the Equilibrium on Rizzo’s Discussion”

  1. Harold says:

    What if the entrepreneur is producing instead of dealing in shares? Bullish Billy thinks people will soon be paying $100 a bunch. Wise Willie plants a field of tulips instead of potatoes. We get more tulips and less potatoes.

    In this example, we again somehow know that the “real” value of tulips is $10/bunch.

    In other words, if he is selling a resource he already has you are right, but if he sells a resource he has to produce then Mario may be right.

    • Bob Murphy says:

      Even in your case, he pushes tulip prices down toward their correct value by selling. But yes he arguably makes resource allocation worse by obeying price signals in such a case. However, Rizzo didn’t talk about resource allocation in this specific passage.

      • Harold says:

        Then yes, it does seem that selling must move price in the right direction.

      • Major-Freedom says:

        Interesting analysis Murphy.

        It is one of the tools we speak of ad nauseum: counter-factuals.

        When we read economics from any author, we can see whether they are thinking historically or counterfactually. Economists need to think counterfactually.

  2. Tel says:

    I don’t see any way to avoid the thorny question of defining the “correct” price here.

    Equilibrium is by definition where the system comes to rest, so whatever price you get at that point is the “correct” price (even if it might be more than one price). Unless I’ve been misreading a lot, from an Austrian perspective, the market is an information processing machine. It takes inputs from various places (including both Willy and Billy as well as others) and the information churns around, goes where it goes and out pops a price.

    To say this price is “incorrect” is to imply you have a better information processing machine; something that either gathers better inputs (from somewhere) or takes the existing inputs and does something better in the middle to pop out a more “correct” price than the standard market machine does. If you have this device, then you should be the one making a profit, and therefore your machine becomes the new standard… and we call that the “market”.

    Here’s an example: suppose I grow strawberries and I have a sign out the front gate, “Strawberries for sale: $1 per pound,” but at the same time just around the corner is an old lady who makes a lot of strawberry jam for her church and she has a sign at her front gate, “Wanted to buy: Strawberries, will pay $2 per pound.”

    Since I never go to church, I haven’t met the old lady, and strangely enough I’ve never noticed her sign out the front. The paper boy does the rounds and sees both signs and gets to thinking about this. When delivering the paper he buys a few pounds of my strawberries on the way through and sells them to the old lady, thus supplementing his paper run. I’m happy about this to see the strawberries selling and the old lady is happy because she gets a supplier. The paper boy provides two services: [1] the physical transport of goods, and [2] the market maker position based on the knowledge of where to buy and sell plus the network effect of having good relations with both buyers and sellers. Let’s presume [1] is very easy to do.

    As the paper boy buys more strawberries from me, basic supply and demand kicks in and my price goes up. After all, my production capacity is finite. Similarly, as the paper boy sells more to the old lady, her buy price goes down again because of basic supply and demand. Thus, the paper boy does a calculation, charts out my elasticity of supply, and the old lady’s elasticity of demand, then optimizes the profit maximizing amount to transport each day:

    * Any more than that would cause his profit to drop because margin will be too small.

    * Any less than that would cause his profit to drop because volume will be too small.

    Let’s suppose neither me, nor the old lady are capable of learning or adaptation… then the system reaches equilibrium. That is to say, everything is stable; all information that can propagate has propagated. The paper boy makes a steady profit, and no additional action on his part can increase this profit. Both the old lady and myself are better off with the paper boy than we were without, so we both independently decide not to shoot the rascal… and that’s good for everyone. Indeed, given that producers and consumers are deemed incapable of alertness and learning… that’s as good as it ever can get from our point of view.

    Maybe I’m just not interested in learning about markets, but I am interested in improving strawberry production so with the extra money I get from higher prices I buy fertilizer and now produce a greater quantity each day. Similarly, the old lady is not interested in markets either but she puts the money she saved into better jam making equipment. The paper boy’s profits end up increasing due to our efforts after he recalculates his optimal transport volume based on new supply and demand curves.

    This would be a monopoly equilibrium (not a competitive equilibrium) because there is only one paper boy. If more paper boys came along, they would squeeze each other’s margins and the system would reach a new equilibrium at a different price. Many economists presume that every equilibrium must also be assumed to be fully competitive but there’s little evidence that really happens (although in some areas it does). Government may decide to regulate paper runs (perhaps the paper boy’s dad happens to be Mayor) or could be the paper boy has his own gun to chase away competitors, there’s various possibilities available.

    • Major-Freedom says:

      The correct price is that which the good tends towards at any given time in accordance with individual preferences subject to supply and demand forces.

      If the price set yesterday is too high today, it will tend lower, and vice versa.

  3. Harold says:

    Nice story – I like it. However, you say “Many economists presume that every equilibrium must also be assumed to be fully competitive”. Is that the case?

    Do not most economists recognize that monopoly situation can be stable?

    Your question was how can we have an incorrect price. If we use your example, and we know that the old lady died last night, but the paper boy does not. He will buy he strawberries from you because he does not have enough information.

    This will result in a loss for the paper boy.

    This will result in the market re-setting to the correct price. In your example, this will be zero, since there are no other buyers (unless the paper boy likes strawberries).

    Which was the correct price in that day? Was it zero, because that is where the equilibrium settles, or was it the original price, because that is what the market produced. I would say that the paper boy bought at an incorrect price.

  4. Capt. J Parker says:

    When an engineer hears this discussion he thinks the following:
    The market is a dynamic system. The entrepreneur acts as a feedback mechanism. Feedback mechanisms can push a dynamic system back toward equilibrium. However if the feedback mechanism is too aggressive the feedback can actually cause the dynamic system to go unstable and have sustained oscillations. Focusing on equilibrium conditions alone will not allow you to impute the behavior of a system that will actually exhibit sustained oscillations because an equilibrium may exist for such a system but that equilibrium will be unstable. Also, perfect knowledge of the equilibrium point is not sufficient to be able to design a system with non-oscillatory behavior. Knowledge of how the system will respond over time is necessary to avoid oscillations.
    https://mitpress.mit.edu/sites/default/files/titles/content/9780262015738_sch_0001.pdf

  5. guest says:

    “Even in Mario’s example, the entrepreneur who realizes the stock is overvalued and sells it, is indeed moving the price in the right direction–relative to what otherwise would have happened. And that is surely the only relevant criterion.”

    What you mean is “relative to stock being overvalued and there being no Wise Willy to correct the valuation”.

    But Mario’s Austrian view of “toward equilibrium” precludes over/undervaluation because, apart from the fact that humans don’t have static preferences, an equilibrium price could only theoretically be attained when all preferences get are satisfied.

    Over/undervaluations would be malinvestments, and therefore are moves away from equilibrium.

    He’s not denying that all actions *ultimately* tend toward equilibrium (but will never be attained) – the malinvestor will choose to stop taking losses at some point.

    • Bob Murphy says:

      guest wrote: “But Mario’s Austrian view of “toward equilibrium” precludes over/undervaluation…”

      guest, if I understand what you are claiming, then you are wrong. There are *some* Austrians who would say “over/undervaluation” makes no sense, because we as outsiders can’t second-guess others’ subjective views.

      However, that’s clearly not Mario’s take. He literally wrote, “He will sell the resource to the party who overvalues it – thus making money but not correcting the error.”

      So if you think Mario is arguing that there’s no such thing as an overvalued stock, you are wrong. But maybe I’m misunderstanding you.

      • guest says:

        “So if you think Mario is arguing that there’s no such thing as an overvalued stock, you are wrong. But maybe I’m misunderstanding you.”

        Right. I’m not saying that Mario doesn’t believe in under/overvaluation – just that those are, according to his formulation, moves away from equilibrium.

        The imaginary notion of “equilibrium” implies no opportunity for profit. So transactions “in the direction of equilibrium” are transactions with no malinvestments (that is, no over/undervaluations).

        • Craw says:

          So, guest, you think Murphy overvalues direct quotation?

          • guest says:

            Mario’s direct quote acknowledges an opportunity for profit, yet maintains that an error still exists.

            This is not inconsistent, as my comments attempt to show.

            Do you overvalue *my* direct quotation of Mario?

        • Bob Murphy says:

          guest, I’m not sure how we’re disagreeing.

          We both agree that Mario thinks an overvalued stock is a mistake. If someone’s action pushed the price down, that would be a move toward equilibrium, right?

          So I’m saying that when an entrepreneur sells a stock he “knows” is overvalued, he is moving the price down, toward equilibrium. It doesn’t matter that he is selling at a price higher than the “correct” one; he is still moving the price down. If he refrained from selling, then the stock would be more overvalued than it would when he sells.

          Do you disagree with anything I just wrote?

          • guest says:

            “So I’m saying that when an entrepreneur sells a stock he “knows” is overvalued, he is moving the price down, toward equilibrium. It doesn’t matter that he is selling at a price higher than the “correct” one; he is still moving the price down.”

            In Mario’s example, it does matter what the “correct” price is (the quotes are, of course, appropriate); Which is why over/undervaluations are precluded as moves away from equilibrium.

            The Austrian view of equilibrium (an imaginary construct) is one in which all preferences are satisfied / no profits can be made.

            Moves “toward equilibrium”, therefore, are moves without malinvestments – that is, no over/undervaluations.

            Mario would not disagree with you that over-valuations can be corrected by the market. He’s just saying that malinvestments do not satisfy preferences and are therefore moves away from equilibrium.

            In Mario’s example, equilibrium can remain unattained, yet progressed toward, without over/undervaluations – each transaction results in preference satisfaction as prices or interest rates converge.

            Errors in judgment as to the desired profitability of a given transaction are, therefore, moves away from equilibrium.

            • Bob Murphy says:

              If someone else wants to jump in, be my guest, but I can tell I’m not going to make any progress with “guest.” Further posts from me will not move us toward mutual coordination…

              • guest says:

                You have always treated me well, and better than any guest account should expect.

                I appreciate your time.

          • guest says:

            “We both agree that Mario thinks an overvalued stock is a mistake.”

            Maybe it helps to say that, in Mario’s example, not all (or even most) opportunities for profit are considered to be overvaluations.

            Maybe Mario could drop in and comment.

            • guest says:

              Here we go:

              10. Mario Rizzo, “Local versus Broader Equilibrium” [Posted: March 30, 2017]
              http://oll.libertyfund.org/pages/lm-kirzner#lm-kirzner_conversation10

              “It is no doubt true, as Pete and Fred say, that entrepreneurs intend or strive to uncover price discrepancies which they can exploit in order to make profits. Even when they are successful in so doing, they do not necessarily move the system in an equilibrating direction. Here we must avoid defining the equilibrium as simply the elimination of the particular inconsistency. Mere local inconsistency is not what Kirzner was talking about and most assuredly not what Ludwig Lachmann was talking about. The local equilibrium may be of interest for some purposes. Instead, the larger issue is whether this particular entrepreneurial act contributes to a more general sustainable equilibrium or whether it exacerbates the errors in the system.

              “If a large number of traders are fooled by animal spirits and believe housing stocks are going very high, a clever entrepreneur may buy from the pessimists and sell to the optimists, and he will make money. And as optimism grows he may be able to continue selling at higher and higher prices. He will have eliminated price inconsistencies. But the market, ex hypothesi, is not sustainable. So the local equilibrium did not contribute to producing an overall equilibrium.

              Hope this helps.

              • Harold says:

                Guest.
                “And as optimism grows he may be able to continue selling at higher and higher prices.”

                I note that in Bob’s example the entrepreneur action resulted in a lowering of price, whereas in this example the action results in a boost to confidence and an increase in price.

                Is it not unusual for an increase in the supply to lead to an increase in price, or have I missed something entirely?

              • guest says:

                “I note that in Bob’s example the entrepreneur action resulted in a lowering of price, whereas in this example the action results in a boost to confidence and an increase in price.”

                In Bob’s example, the price is lowered from an initially overvalued state – a misplaced confidence had caused the price to rise before a more circumspect valuation corrected it toward a lower price.

                Same thing is happening in Mario’s example, but without reference to a “Wise Willy”.

                Yes, an increase in supply leads to lower prices, all other things equal.

                But an increase in buyers – especially speculative buyers – is the same thing as a lowered ratio of goods to buyers.

                Instead of the goods decreasing relative to buyers, the buyers are increasing relative to goods.

              • Harold says:

                I am still confused, but I suspect I will remain so.

                We have pessimists who want to sell and optimists who want to buy. What role is the entrepreneur playing here?

              • guest says:

                “What role is the entrepreneur playing here?”

                Assuming you mean the producer of the overvalued good, he’s trying to sell to the highest bidder. Nothing special.

                The discussion is about what the correct Austrian position is with regard to the concept of equilibrium.

                One of the things that logically follows from Methodological Individualism is that prices (and interest) tend toward, but will never attain equilibrium.

                They tend toward equilibrium because different valuations of a good provide opportunities for profit.

                They never attain equilibrium because of changes in preferences, if not also changes in supplies/opportunity costs.

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