Courtesy of Professor Fekete @ NASOE:
PART THREE: THE DISEQUILIBRIUM ANALYSIS OF RETAIL TRADE
In dismissing the supply/demand equilibrium theory we must explain price formation in the retail trade on the basis of disequilibrium principles. As we shall see, the adjustment mechanism works not on the prices of goods but on the marginal productivity of social circulating capital as measured by the discount rate. (We must sharply distinguish between the discount rate and the rate of interest. The former is regulated by the propensity to consume, the latter by the propensity to save. Either rate may move while the other is stationary; if both move, then they may move in the same or in the opposite direction.) An autonomous increase in demand for consumer goods has no inevitable effect on prices but will, instead, lower the discount rate. A lower discount rate is synonymous with an increase in social circulating capital, that is, the supply of consumer goods. In other words, an increase in demand automatically brings out an increase in supply; a decrease has the exact opposite effect. There is no such thing as an auto- nomous change of supply in the retail trade: supply is closely regulated by demand through the discount rate. The myriad of goods passing through the hands of the producers and distributors on its way to the market undergoes remarkable changes when it gets within sight of the consumer. The uncertainty and unpredict-ability characterizing production at the earlier stages disappear, as if by magic, and are replaced by increasing certainty and predictability to the effect that the goods will finally be removed from the market by the ultimate consumer. There is a dramatic reduction in the risks involved in handling merchandise as it enters the gravitation of consumption. This fundamental observation motivates the following concept.
Social circulating capital
That mass of provisions and finished or semi-finished goods which has reached sufficient proximity, and is moving sufficiently fast, to the ultimate cash-paying consumer so that its destiny of being consumed presently could no longer be in doubt, is called social circulating capital. It does not include semi-finished goods that will not reach the consumers within 91 days (the length of the seasons of the year). Nor does it include goods that are moving too slowly or not at all (e.g., a store of goods held in anticipation of a price rise; goods to be sold on an installment plan; specialty and collectors’ items, such as the surgeon’s knife or artwork, which may or may not find an ultimate buyer within 91 days). As we shall see, the volume and composition of social circulating capital is completely flexible. The dividing line between items that do or do not belong to it is subject to the change of the whim and fancy of the sovereign consumer on the shortest possible notice. Skipping ropes, as a rule, are not a part of social circulating capital — except during periods of skipping- epidemic among schoolgirls.
The risks and uncertainties, so characteristic of production in the early stages, all but disappear by the time the goods become part of social circulating capital. Speculation and other forms of risk-taking give way to the automatic and highly predictable processes of distribution. The reduction or disappearance of uncertainty and risks, occurring pari passu with the maturation of goods on their way to the final consumer manifests itself in a most dramatic fashion in the form of liquidity. The movement of merchandise in great demand is mirrored by the opposite movement of bills of exchange. Liquidity refers to the spontaneous circulation of goods and bills of exchange. Goods which are part of social circulating capital are liquid in their own right and on their own merit, merely by virtue of their proximity and fast pace of movement to the consumer, which is mirrored by the bills drawn on them. The emergence of the bill market has made the circulation of purchasing media elastic. Henceforth only finished goods are sold against cash at the retail counter; semi-finished goods at various stages of production and distribution are traded against bills of exchange (equivalently, against bank deposits created by a commercial bank upon the collateral security of such bills). Before the end of each quarter all transactions are cleared, and all outstanding bills are paid out of the proceeds of the final sale of first-order goods into which fast-moving higher-order goods have matured.
The marginal shopkeeper
For the purposes of our analysis changes in the volume of social circulating capital, and changes in its composition, are of the highest importance. We shall now see how those changes are put into effect through arbitrage between the bill market and the consumer goods market. The arbitrageur is none other than the marginal shopkeeper. He makes the crucial decision which items to put on the shelf and which ones to withdraw. In these decisions he is guided by one considerations alone: the wishes of the sovereign consumer. For this reason, the propensity to consume can be identified with the volume or composition of social circulating capital. In fact, volume and composition are changing together. An increase (decrease) in its volume is manifested by an increase (decrease) in the variety of the component parts of social circulating capital.
It is curious that the agency translating the wishes of the sovereign consumer into changes in the stocks of retail shops through arbitrage between the bill market and the consumer goods market has escaped the attention of economists. The details are as follows. Each merchandise on the shelf of the shopkeeper has its own productivity measured by a ratio. This is the ratio between the percentage of the retail markup and the average length of the sojourn of this merchandise on the shelf (with due allowance to overhead costs). Thus, if the retail markup on $1 worth of sauerkraut is 1⁄2 cent, and the average sojourn of a bottle of sauerkraut on the shelf is three months, then the productivity of sauerkraut is 1⁄2÷3/12 =2% per annum.
Marginal productivity of social circulating capital
Merchandise with the lowest productivity on the shelf of the marginal shopkeeper, called the marginal item of social circulating capital, is critical to this analysis. This is the first item that will disappear from the shelf. As the propensity to consume declines, the marginal item will not be re-ordered by the marginal shopkeeper. No more bills will be discounted against its movement from the producer to the consumer. Another item on the shelf with a higher productivity will take its place as the marginal item. Conversely, as the propensity to consume rises, the marginal item is the new merchandise that is introduced on the shelf. Effective immediately, bills can be discounted against its movement to the final consumer. It replaces another item with a higher productivity.
The productivity of the marginal item is called the rate of marginal productivity of social circulating capital. It is the rate at which the opportunity cost of carrying the marginal item on the shelf becomes critical to the marginal shopkeeper (the first shopkeeper to change the composition of his stocks in response to changes in the propensity to consume). The reference is to the marginal shopkeeper’s opportunity to carry in his portfolio bills drawn on other shopkeepers against faster-moving merchandise, rather than carrying on the shelf a marginal item. Indeed, the marginal shopkeeper is the arbitrageur who lets his stock of marginal merchandise run down without replenishing it while buying bills with the proceeds from this saving whenever the propensity to consume declines.
This is arbitrage between the bill market and the consumer goods market. It enables the marginal shopkeeper to participate in the earnings of others operating with a higher productivity, thereby smoothing out variations in his income due to seasonal and other variations in demand. The marginal shopkeeper is also doing arbitrage in the opposite direction. As the propensity to consume rises, he sells bills from his portfolio and orders some heretofore submarginal item which he may now be willing to carry on his shelves. We shall now see that the rate of the marginal productivity of social circulating capital varies inversely with the propensity to consume: the lower the propensity, the higher is the rate of productivity, and vice versa. Slackening consumer demand increases the length of the sojourn of the marginal item on the shelf of the marginal shopkeeper.
He will react by eliminating the old marginal item from the shelf. The new marginal item must have a higher productivity, otherwise it would also be eliminated. Thus lower propensity to consume brings about an increase in the marginal productivity of social circulating capital. The converse is also true. In case of a brisker demand for consumer goods the marginal shopkeeper can afford to widen his offering of goods. He will display a new marginal item on the shelves with lower productivity than the old marginal item. Thus higher propensity to consume thus brings about a decrease in the marginal productivity of social circulating capital. This arbitrage of the marginal shopkeeper between the bill market and the consumer goods market is the centerpiece of disequilibrium analysis of price formation at the retail level. But what is the signaling system that carries information back-and- forth between shopkeepers concerning the propensity to consume and the marginal productivity of social circulating capital?
The discount rate
This signaling system is embodied by the discount rate. It is a change in the discount rate which alerts shopkeepers that coordination between the propensity to consume and the marginal productivity of social circulating capital has become necessary. The discount rate is determined by the rate of the marginal productivity of social circulating capital. This is just the rate at which the opportunity cost of carrying the marginal item on the shelf becomes critical to the marginal shopkeeper. He is the first one among the shopkeepers to eliminate the marginal item from the shelf at the next uptick in the discount rate (conversely, to display a new marginal item on the shelf at the next downtick) — in view of his opportunity to carry in his portfolio bills drawn on other shopkeepers against faster- moving merchandise, rather than carrying slow-moving items on his shelves.
The short version of this theorem asserts that the discount rate is in fact identical with the rate of marginal productivity of social circulating capital. In order to prove this, first assume that the rate of marginal productivity of social circulating capital falls short of the discount rate. Then there is a spread between the two rates and, hence, a profitable arbitrage opportunity exists for the marginal shopkeeper. He can sell out his marginal merchandise and buy bills of exchange with the proceeds. Clearly, this activity of the marginal shopkeeper lowers the discount rate while it increases the rate of marginal productivity of the social circulating capital. This arbitrage will continue until the spread between the two rates is closed. The same argument, mutatis mutandis, shows that the spread between the two rates will also be closed in the case when the discount rate falls short of the rate of marginal productivity of the social circulating capital.
In any case, the two rates are equalized, and we are justified in identifying them. It is important to realize that a rise in the discount rate is heralding a fall in the propensity to consume, telling the marginal shopkeeper to discontinue the marginal item, making social circulating capital shrink. Conversely, a fall in the discount rate there is heralding a rise in the propensity to consume, telling the marginal shopkeeper to introduce a new item on his shelf, making social circulating capital expand. The arbitrage of the marginal shopkeeper between the consumer goods market and the bill market is analogous to (but conceptually quite different from) the arbitrage of the marginal entrepreneur between the stock market and bond market, which is a regulator of rate of interest.
Comparison of the two arbitrage operations reveals that the discount rate is fundamentally different from the rate of interest. The forces driving these rates are different. The engine bringing about a change in the rate of interest is a change in the propensity to save, while the engine bringing about a change in the discount rate is the change in the propensity to consume. In either case, the rate varies inversely with the propensity. Of course, the person of the marginal shopkeeper and his choice of the marginal item x are subject to change. In choosing x the marginal shopkeeper is simply trying to read the mood of the sovereign consumer. When another shopkeeper takes over that role from the first, his choice of the marginal item x’ may well be different from x. In effect, he is comparing the productivity of x’ to that of x.
Indeed, at the time when the discount rate undergoes a change hundreds of different people may, one after another, play the role of the marginal shopkeeper, while x sweeps through a large number of candidates to serve as the marginal item of social circulating capital. This picture can be simplified if we personify the marginal shopkeeper and imagine that he is the gate-keeper acting on behalf of the sovereign consumer. He admits some items to social circulating capital while expelling some others. He constantly examines the credentials of items within his purview. He admits x whose productivity is higher, and expels x’ whose productivity is lower than the discount rate. This, then, is the mechanism whereby the market integrates the scattered knowledge and power residing in individual shopkeepers concerning the marginal productivity of social circulating capital. This, then, is the intelligence whereby the mood of the sovereign consumer is perceived. The relevant information is crystallized in the form of a single variable, the discount rate.
Theory of the retail trade
It follows from the foregoing disequilibrium analysis that the law of supply and demand does not apply in the retail trade. The adjustment mechanism works, not on the prices of goods, but on the marginal productivity of social circulating capital or, what is the same, on the discount rate. An autonomous increase in demand for fast- moving consumer goods has no inevitable effect on prices but will, instead, lower the discount rate. This is synonymous with an instantaneous increase in the volume of the social circulating capital, that is, the supply of consumer goods. Increased demand automatically brings out an equivalent increase in supply. A decrease in demand has the exact opposite effect. There is no such thing as an autonomous change of supply in the retail trade: supply is closely regulated by demand through the mechanism of the bill market and the discount rate. The coordination problem, as applied to the retail trade in consumer goods, is solved by arbitrage operations of the marginal shopkeeper between the bill market and the consumer goods market. He is the gatekeeper who regulates the entry of consumer goods into social circulating capital.
Critique of the quantity theory of money
Equilibrium economics, more especially the quantity theory of money (the latter-day champion of which is Milton Friedman), holds that a regime of floating foreign exchange rates is absolutely necessary as a balancing mechanism of foreign trade. If a country imports more than it exports, then the value of its currency will drop in the foreign exchange markets. As a result, the price of imported goods will rise, limiting imports and, at the same time, the price of this country’s exports in foreign markets will drop, boosting exports.
These effects redress trade imbalance. As a corollary, it is further asserted that if a drop in foreign exchange rates does not occur on its own accord, then the government is fully justified in pushing them down by hook or crook. This is a vicious theory concocted to justify the government in engineering a destruction of the value of the currency. For decades, the U.S. government has been trying to reverse its unfavorable trade balance with Japan by crying down the value of the dollar. However, in spite of the great “success” of the U.S. government to debase its currency, trade imbalance has continued to worsen. It showed signs of abating only when the Japanese government also started debasing its own currency, the yen. Disequilibrium analysis shows that if a country runs export surpluses, this will not cause an inevitable increase in domestic retail prices as predicted by equilibrium theory. The discount rate will drop in response to the inflow of foreign exchange. Merchants will draw bills on foreign countries with a higher discount rate. This will repel the invasion of foreign exchange.
Higher consumer demand will be met by an expanded offering on the shelves of the shopkeepers, thanks to the lower discount rate. By the time the consumer is ready to spend the extra income, the extra merchandise will be in place. Conversely, if a country is stricken with a bad harvest or by some other natural calamity destroying crops, property, and goods, then there will be an immediate increase in the discount rate. Retail prices will not rise inevitably. The stricken country, thanks to its higher discount rate, is an attractive place on which to draw bills. This translates into an immediate influx of short-term capital from abroad in the form of the most urgently needed consumer goods. Of course, if the bill market is sabotaged through government intervention (in allowing the banking system to preempt the spontaneous circulation of bills of exchange), then the influx of foreign exchange will spill over to the stock, bond, and real estate markets, where rampant speculation may cause huge price increases.
This may indeed lead, in due course, to a collapse — as it has happened in Japan, and as it will probably happen in the United States. The collapse must squarely be blamed on the vicious equilibrium theory of foreign exchange suggesting that trade imbalances can be cured by government- inspired debasement of the currency. Disequilibrium theory treats the problem of trade imbalances as a coordination problem. It analyses short-term capital movement as it responds to the widening spread between the discount rate and the marginal productivity of social circulating capital. It takes into account arbitrage between the bill market and the consumer goods market. The mechanical quantity theory of money and other equilibrium theories are blind, barren, and misleading.
The disequilibrium analysis of retail trade and of short-term capital movements across international borders gives us an insight strikingly different from that offered by equilibrium economics and the quantity theory of money. In the retail trade, the law of supply and demand does not apply. An increase in the volume of purchasing media due to higher spending has no inevitable effect on prices but will, instead, lower the discount rate. This is equivalent to an increase in the marginal productivity of social circulating capital. Hence, increased demand automatically and instantaneously brings out an increased supply sufficient to accommodate it without an increase in prices. Price changes, whenever they occur, reflect other changes, having to do with the competition of producers and consumers. In case of an influx from abroad of short- term capital foreign exchange first flows the bill market. It causes bill prices to rise. This is tantamount to a fall in the discount rate. Excess foreign exchange is absorbed by a commensurate increase in social circulating capital.
Conversely, in case the country is losing short-term capital, foreign exchange is drained from the bill market. Bill prices fall, causing a rise in the discount rate. The outflow of foreign exchange corresponds to a shrinkage of social circulating capital. There is no reason to assume that across-the- board price changes take place in unison with an inflow or outflow of short-term capital. The static, black-and-white and one- dimensional supply-and-demand equilibrium analysis of price formation is superseded by a dynamic, full-color, three dimensional bid-asked disequilibrium analysis, provided that we put arbitrage into the center of inquiry. Then can we present the problem in its proper context as a coordination problem. The price-quantity nexus of old-line equilibrium analysis is replaced by the multivariate price-quantity-quality nexus. Input and output become variables in their own right, as indeed they are in real life. There is no need to pay lip-service to a spurious supply-demand equilibrium. We have seen that the marginal shopkeeper is doing arbitrage between the bill market and the consumer goods market, the outcome of which is the discount rate. Similar to this, although not treated here, is the arbitrage of the marginal producer between the bond market and the stock market, the outcome of which is the ceiling for the rate of interest; as well as the arbitrage of the marginal bondholder between the gold market and the bond market (i.e., between present goods and future goods), the outcome of which is the floor for the rate of interest.
These are instances of arbitrage, examples of marginalism introduced by Menger, the prototype of which is the arbitrage of the marginal consumer between the consumer goods market and cash; and that of the marginal producer between the consumer goods market and the producer goods market the outcome of which is the asked and bid price. Every one of these instances of arbitrage is a manifestation of the coordination problem in economics as it starts from a state of relative disorder, or a lower state of coordination, and ends at a higher state of coordination, as measured by the asked and bid price of consumer goods, the asked and bid price of bonds (i.e., the ceiling and the floor for the rate of interest) the discount rate, etc. We still have the two poles of contest. The formation of prices, the discount rate, etc., is still seen as the result of a reconciliation between a pair of opposing forces (represented by the arbitrageur and the marginal arbitrageur). Yet it is more appropriate to describe ours as a disequilibrium model.
The marginal arbitrageur is not a person but a role played by different protagonists changing the role from one moment to the next. Moreover, each protagonist playing that role may have a different set of values, different preferences, opportunities, foregone alternatives, and he may have a different time-horizon. Only the disequilibrium analysis of price formation can, when worked out in full detail, account for these differences. Only disequilibrium analysis can bring out the coordination problem confronting the entrepreneur, the producer, and the shopkeeper, not to mention the consumer himself. Only the disequilibrium analysis of price formation can qualify as a theory of action. The old-line equilibrium paradigm is a theory of non-action. It is tantamount to a stage production of Hamlet in which the Prince is not allowed to appear.
 Carl Menger, Principles of Economics, New York: N.Y.U. Press, 1981 (Originally published in German under the title Grundsätze der Volkswirtschaftlehre in 1871)
 Friedrich A. Hayek, Prices and Production, New York: A.M. Kelley, 1967 (Originally published in 1931)
 Ludwig von Mises, Human Action, Chicago: Henry Regnery, 1963 (Originally published in 1949)
 Israel M. Kirzner, Market Theory and the Price System, Princeton: Van Nostrand, 1963
 Israel M. Kirzner, Competition and Entrepreneur ship, Chicago: U. Chicago Press, 1973
 Jesús Huerta de Soto, The Ongoing Methodenstreit of the Austrian School, Journal des Economistes et des Etudes Humaines, vol.8., no.l, Mars 1998, pp 75-113
 Antal E. Fekete, Towards a Dynamic Microeconomics, Laissez-Faire (Revista de la Facultad de Ciencias Economicas, Universidad Francisco Marroquín, no. 5., Septiembre de 1996, pp 1-14