Ch. 9, The Nature of the Market Process

The previous chapter outlined the role of the firm in the micro setting. The firm with our definition emerges as a market institution that supplies the important function of implementing novel productive innovations that are not realisable through market exchange. Indeed, sufficiently original innovations fall outside the extent of the existing market and their implementation is therefore distinct from it. In response to revealed profits, imitative entrepreneurs establish competing production processes and bring about a competitive discovery process. Through this process, the original and competing firms jointly discover the socially maximised use of resources and, by so doing, contribute to the expansion of the extent of the market through market-making for new factors and thereby undermine the rationale for integrated production. As a result, the firms dissolve as coordination of production can be provided through the market’s efficient price mechanism.

The market process can from this perspective be understood as consisting of two simultaneous processes: intra-market adjustment through arbitrage and market expansion through productive innovation. The former is akin to Israel Kirzner’s conception of entrepreneurship as primarily arbitrage within the extent of the market and so the continuous adjustments through resource reallocations for improved efficiency.[i] These adjustments are made in response to exogenous changes that cause imbalances in the market as well as to endogenous change and imperfections such as remaining inefficiencies due to errors made by previous entrepreneurs acting to exploit perceived opportunities. While this type of Kirznerian entrepreneurship is an important part of the market process, it is limited to the arbitrage opportunities that exist and arise within the extent of the existing market. The entrepreneur is responsive to changes and alert to existing inefficiencies that amount to profit opportunities. As the entrepreneur is neither omniscient nor omnipotent, and is also subject to limited knowledge and bounded rationality, he or she is unlikely to perfectly exploit an arbitrage opportunity and will therefore leave errors for other entrepreneurs to exploit. Furthermore, as the market process is subject to continuous change, the actions of entrepreneurs will eventually become misaligned with the market structure and should therefore be replaced by investments more properly adjusted to and consequently better aligned to the present state of the market.

Arbitrage versus innovation

In addition to bringing about the continuous adjustment of the market toward its new perceivable equilibrium, the actions of imitator-entrepreneurs discussed in previous chapters constitute a ‘Kirznerian’ function to the overall market by acting as arbitrageurs between the existing market structure and the productive innovation. Upon the discovery and implementation of an evidently profitable and therefore market-superior productive innovation, imitator-entrepreneurs reallocate productive resources from their current and comparatively inefficient uses in the market toward their newly discovered and more profitable uses through engaging in competition with the original entrepreneur. Market-making is therefore brought about by the process of competitive discovery that follows attempts to capture profits revealed by the original productive innovation. This process that emerges as entrepreneurs attempt to emulate and outdo the original innovation constitutes arbitrage between the present market state, the existing allocation of resources within the extent of the market, and the perceived future market state. As the market’s total resource supply is reconfigured and reallocated in response to the new knowledge that is revealed through the implemented productive innovation, the boundaries of the market are moved outward to incorporate the innovation. Market-making constitutes market expansion and a new efficient equilibrium toward which resources are allocated.

The process of arbitrage between the present and future states of the market, which essentially reshuffles the resources used in accordance with the former toward their preferred allocation in the latter, cannot exist without the innovating original entrepreneur. Kirznerian entrepreneurship without productive innovation is limited to arbitrage within the extent of the market and the entrepreneur is therefore, as Kirzner notes, primarily a responsive agent. For example, changing consumer preferences bring about changes in relative prices and therefore also in the profitability of specific resource uses. The alert arbitrageur-entrepreneur discovers profit opportunities brought about by and revealed through such changes, and exploits this new knowledge. Without productive innovations, however, the extent of the market remains essentially unchanged as only very limited innovations are realisable through producing new combinations or configurations of existing capital goods. New production techniques or products that can be implemented using existing factors, which are appropriable through market exchange, are easily imitated. Such opportunities should rather quickly be exhausted by entrepreneurs eager to capture a share of the revealed profits. Imitation may be held back to some extent by the existence of frictions such as transaction costs that make the reshuffling of resources more costly, but imitation itself and the intra-market arbitrage that it constitutes does not pose a significant problem for the equilibrating entrepreneurial function in the market.

Realigning the market’s productive structure to changing conditions such as changing consumer preferences is a comparatively simple problem since it takes place within the existing boundaries of the market. Whereas the cause of the change can be exogenous, the extent of the market persists. This is not the case where a productive innovation is implemented outside the extent of the market and therefore, in essence, challenges the current market structure. Such productive innovations cannot be established through arbitrage since they are not gradual and fully realisable through market means, but constitute radical change in the knowledge of how society’s productive resources can be used. Innovation therefore requires a different kind of function than that of the arbitrageur-entrepreneur, whose actions are limited to reallocating, recombining, and reconfiguring existing resources. The breaking of new ground through implementing novel production structures, which likely require also the production of new and highly specialised capital goods, changes not only the structure of the market and its resource utilisation, but also its extent by establishing a potentially imitable ‘island of specialisation’. This implementation of a productive innovation is structurally distinct from and outside the extent of the existing the market, and thus composes a ‘firm’ of integrated production.

The type of arbitrage imitator-entrepreneurs engage in between the existing market and the ‘island of production’ is different from the arbitrage possible within the extent of the market. It constitutes discovery as an innovation likely cannot be perfectly imitated as the resources used do not exist outside the implementation and therefore cannot easily be acquired through exchange. This type of arbitrage necessarily includes some form of innovative activity as resources would need to be created to fit the new process. More importantly, however, there is no reason to assume that the original entrepreneur has innovated an efficient production structure. Rather, as we saw in previous chapters, the entrepreneur is blind as to the efficiency in the specific implementation of the production process and therefore the firm’s ‘internal’ allocation of resources. Imitating entrepreneurs should therefore be able to improve on the original innovation by exploiting their specific knowledge and skills, which is an opportunity to create profits in addition to capturing those profits revealed by the original entrepreneur. Consequently, we should expect imitator-entrepreneurs to innovate in order to increase the effectiveness and efficiency of the original innovation and thereby increase their profitability. The discoveries made in this process brings about the structure of the future market following successful implementations of productive innovations. This suggests that imitator-entrepreneurs, while engaging in arbitrage between two states of the market akin to the Kirznerian entrepreneurs discussed previously, contribute a more significant economic function than simple market arbitrage: they create capital and cause the emergence of factor markets.

Imitator-entrepreneurs innovate but do so primarily within the bounds of the already implemented productive innovation and the profit opportunity it represents. They are in this sense knowledge brokers between the ‘island of specialisation’ and the existing market, who take inspiration from the original innovation and reconfigure its structure, recombine its parts and reuse the original thinking, introduce alternative solutions and new knowledge. Their experimenting improves on and perfects the innovator-entrepreneur’s imagined production process. The bounds of the original innovation are thereby extended as the new knowledge is introduced and used, but the fundamental purpose and aim remains intact. The original entrepreneur therefore has a distinct function in the progression of the market process by imagining a novel production possibility firmly located outside the extent of the market. The innovator-entrepreneur does not, as the Kirznerian and imitative entrepreneurs, engage in arbitrage. Rather, the innovator is here conceived of as a revolutionary force in a Schumpeterian fashion that, assisted by the discoveries made by competing imitator-entrepreneurs, fundamentally disrupts the structure of the market.[ii]

Direction of the market process

The three types of entrepreneurial function we have here discussed seem to support as many potential conclusions about the effects or implications of entrepreneurship. From the point of view of the market as it is, simple Kirznerian arbitrage provides equilibrating change through continuously improving the allocation of resources within the extent of the market. As entrepreneurs engage in exchange for profit through correcting errors and reallocating resources in response to changes, the overall effectiveness and functioning of the market is improved. Holding the boundaries or extent of the market constant, the market is equilibrated as alert entrepreneurs exploit discovered opportunities for profit. The direct effect of entrepreneurship, which generates profits by exploiting and correcting inefficiencies, is equilibrating, regardless of entrepreneurs’ imperfection and their inability to fully solve recognised errors or misaligned resources. Entrepreneurship is therefore, as recognised by Kirzner, an equilibrating force. However, whether the market tendency overall is equilibrating depends on the relative frequency of entrepreneurship as compared to exogenously effectuated change. The net effect of Kirznerian entrepreneurship and change is equilibrating only where the former exceeds the latter.

From the point of view of the existing market, the disruptive innovator-entrepreneur is, as Schumpeter recognised, a disequilibrating force as it reveals new opportunities and can make previously recognised opportunities void. But it would be to jump to conclusions to assert that the innovator-entrepreneur disrupts the market. As we saw in the previous discussion, the innovator-entrepreneur has little effect on the market structure unless the implemented productive innovation is sufficiently profitable to attract imitator-entrepreneurs. It is the latter who bring about the innovation’s potential disruptive effect by extending the market to incorporate the imagined production structure. Forming a firm, as is how we can observe the implementation of the original entrepreneur’s innovation, is not sufficient to disrupt the market. Only to the degree that the firm is successful and mimicked by others, and markets for the specialised factors utilised within it emerge, does the innovation disrupt the existent market. Disruption is in this sense constituted by a change to the division of labour in the market, which is effectuated by the introduction of a productive innovation that causes a change to the extent of the market.

The tendency of the market, and therefore the direction of the market process, therefore depends on the relative frequencies of all three types of entrepreneurial action, and the firm is necessary for its continued development. Without potentially disruptive innovation there are no firms and the market is then fully reliant on the price mechanism for resource allocation and equilibrating. With productive innovation the market’s overall production structure undergoes changes that affects the direction of the market process but ultimately facilitates increased resource utilisation and therefore wealth creation. Disruption is made possible only through the firm, since the firm enables productive action outside the extent of the market and thereby offers a means to escape the ‘specialisation deadlock’ – which is necessary for innovative, radical changes to the existing production structure. The firm, then, is a prerequisite for the evolution of the productive market process, since it is only through firms that productive innovations can be implemented and imitated, and factor markets consequently emerge.

It would be wrong to conclude that the existence of firms necessarily means disequilibration of the market, however. The formation of a firm is a sign of impending disruption of the market should other entrepreneurs establish firms to compete head on with the original firm’s production process. From the point of view of the existing market, holding constant the extent of the market prior to the incorporation of the productive innovation in the market, the disruptive action of innovative entrepreneurs can indeed be disequilibrating. However, it should be noted that the original firm is not within the market; this is, after all, how we perceive of it as integrated and how it is distinguishable from market coordination of production. The competing firms, following the original firm to capture a share of the revealed profits, are also not acting within the market, but will bring about the creation of new market space for factors between them and the original firm. As their generated profits, which signal a more socially efficient use of resources, attract capital investments from production processes within the previous extent of the market, the extent is expanded. The state of rest that previously indicated the direction of the market then no longer exists, since the market has expanded to include new capital and production structures. Opportunity costs have changed and with them relative market prices. In other words, the newly expanded market has a different equilibrium, the tendency toward which is established through profitable market action. This is not a case of disequilibration, unless we assess the direction of the newly expanded market using the theoretical equilibrium applicable only on the market prior to the expansion. But doing so would be inaccurate, since the previous equilibrium cannot be considered an equilibrium from the point of view of the expanded market.

As soon as markets are created through the competitive discovery process, and the extent of the market consequently has been expanded to include the productive innovation, entrepreneurial arbitrage for profit brings about an equilibrating tendency. Whether this implies a shift from a single productive technology to another, or a fundamental reshuffling of capital and human resources, is of little import to our analysis of the overall tendency of the market. With the expanded extent of the market, and the new production structures and other possibilities thereby placed within the reach of market exchange, the equilibrium has shifted and with it other arbitrage opportunities will appear profitable. The observable direction of the process may have changed, but the tendency is still a progression toward equilibrium.

We therefore see that even though we can distinguish between three different types of entrepreneurship that have different types of effect on the physical production apparatus of the market, they do not constitute different types of tendencies of the market. Rather, the entrepreneurship types interact to expand the extent of the market through an intensification of the division of labour, which shifts the position of a theoretical ‘end point’ for the market process should all errors in the present structure be corrected. Yet we should also expect the extent of the market following an entrepreneurially caused expansion to be disrupted, and the extent of the market consequently expanded further, again. The position of market equilibrium as a perceivable end point or ‘state of rest’ shifts with the frequency of implemented productive innovations.

What has here been drafted is a theory of the market process as ever changing both within its present extent, through entrepreneurial arbitrage, and in terms of its extent, through entrepreneurial productive innovations. The former is an ongoing process that is necessarily subject to the changes of the latter, since the latter shifts the direction of the market process by introducing changes to the fundamental structure of the market’s productive apparatus. The implementation of a productive innovation – a ‘firm’ – changes the conditions for market exchange, since alternative production processes are made possible. This causes ripple effects brought about by market arbitrage for profit that shifts production toward the newly attainable level of productivity. In this sense, the instituting of a firm with its increased specialisation intensity can change the structure of the whole productive apparatus of the market. Entrepreneurship is disruptive primarily through organising production within firms, which incentivises competition that brings about change to the overall market structure – and this ultimately undoes the firm’s rationale by incorporating its innovative discovery and subjects specialised production to efficient market coordination through the price mechanism. We can now see how the specialisation deadlock, while limiting to market coordination, does not in fact constitute an insurmountable barrier, since entrepreneurs eager for profit can and will choose non-market means to organise imagined production structures that utilise more intense specialisation that expand the division of labour, and – where successful – changes that very market structure. It should be noted, however, that it constitutes enough of a barrier for entrepreneurship to provide both disruptive and gradual improvements to production.

The question whether a specific market tends to over time get ‘closer’ to its end point or equilibrium, which has been subject to some debate, does not here become a question of theoretical significance. Our view of the firm as a means to by-pass the specialisation deadlock by implementing novel, disruptive production structures within firms outside the extent of the market incorporates tendencies that are often in the literature referred to as equilibrating, disequilibrating, and kaleidoscopic: equilibrating in the gradual and continuous improvement of production through arbitrage, disequilibrating through the implementation of disruptive production in firms, and kaleidoscopic in the effective unpredictability of implementing production plans based on productive innovation. Yet whereas such tendencies can be found in the dynamic of the market process, and the expansion of its extent through the formation of firms around productive innovations, they are immaterial for our understanding of the market process. The overall tendency of the market is the development of greater wants satisfaction incentivised by the profit motive, but whether the overall effect at any time period is deemed to be equilibrating, disequilibrating, or kaleidoscopic is based on the relative frequencies of each of the three types of entrepreneurship. To illustrate, the market process will appear to gradually approach its theoretical state of rest where entrepreneurial arbitrage is relatively more frequent; it will appear disruptive where entrepreneurial imitation is more common; and it will appear indeterminate in cases where entrepreneurial innovation is recurrent. The exact functioning and tendency of a particular market process at a particular point in time is entirely an empirical matter and is not the subject of this discussion. The contribution here is the identification of the three distinct functions of entrepreneurship and their outlined interdependence in producing progression of the market process. The interaction of the different levels of economising and coordination in production show the symbiotic and mutually supportive nature of the different aspects of an economy. In our discussion, entrepreneurship cannot be understood without involving organisation and capital theory. Similarly, neither organisation theory nor capital theory would be complete without the other as well as entrepreneurship theory. While they address issues on different analytical levels, they are highly interdependent – to the degree they are not different sides of the same coin. By addressing the working of the market process toward greater value creation, we can outline how they interact and indeed are interdependent – and together comprise a means to understand overall economic development.

[i] See I. M. Kirzner, Competition and Entrepreneurship (Chicago, IL: University of Chicago Press, 1973).

[ii] See J. A. Schumpeter, The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle (1911) (Cambridge, MA.: Harvard University Press, 1934).