Disequilibrium Analysis of Price Formation – Part 3


Courtesy of Professor Fekete @ NASOE:


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. Continue reading

Disequilibrium Analysis of Price Formation – Part 2

Courtesy of Professor Fekete @ NASOE:


We are now ready to discuss the co-ordination problem of economics and to see how entrepreneurs approach it through arbitrage. It will appear that our introduction of arbitrage as the generic form of human action, that underlies all the multifarious activities of entrepreneurs in pursuit of pure entrepreneurial profits, is insightful. It focuses on what is important while deemphasizing what is less important or unimportant in the activities of entrepreneurs when looked at from the point of view of the market process. It also leads to the classification of entrepreneurial strategies as we treat the coordination problem.

The coordination problem and the landscape of spreads

Lack of coordination or the presence of disorder in society represents an opportunity for gain, even though every instance of this remains hidden to most observers until it is exposed by entrepreneurship. Once the opportunity is being exploited, coordination overtakes disorder and the profit potential disappears. There prevails in society a spontaneous tendency for greater co- ordination driven by entrepreneurship. In fact, it is the existence of this process that makes it possible to have theoretical economics as opposed to economic history. But how does the entrepreneur diagnose the presence of disorder? He surveys the landscape of spreads. The latter furnishes an accurate picture of the state of coordination or the lack of it. In more details, narrow spreads indicate a higher and wide spreads indicate a lower state of coordination.

The entrepreneur picks a spread that appears unreasonably wide to him. He then exerts his coordinating influence on the spread through arbitrage using the corresponding straddle. The landscape of spreads is not to be visualized as rigid relief map but rather as a fine cobweb, every node of which is inter- connected with every other. Disturbance at one node will affect the state of every other node. Accordingly, the entrepreneur attacking one spread through arbitrage will transmit information to and will influence the width of every other spread. In order to understand the coordination process more fully we must look at various entrepreneurial strategies. We isolate two of them: the defensive or retrospective (backward-looking) strategies utilizing horizontal arbitrage, and the aggressive or prospective (forward-looking) strategies utilizing vertical arbitrage. As we have seen, producers of nth order goods act as arbitrageurs on three counts: (1) they are doing vertical arbitrage between the nth and (n + l)st order goods; (2) they are doing horizontal arbitrage at the level of output (goods of order n); and (3) at the level of input (goods of order n+1). Different types of arbitrage have different roles to play in the market process. First we look at the role of horizontal arbitrage. Continue reading

Disequilibrium Analysis of Price Formation – Part 1

Courtesy of Professor Fekete @ NASOE:


 Jesús Huerta de Soto writes that economics, far from being a theory of choice or decision, is a theory of processes describing social interaction that bring about coordination displacing disorder; see [6]. It establishes the fact that, through the intervention of entrepreneurship, disorder (a state of coordination at a lower level) is promoted to a state of coordination at a higher level. Economics also establishes the fact that entrepreneurs generate and disseminate information through a system of various indicators such as prices, wages, rents, interest and discount rates.

But how do entrepreneurs diagnose disorder and, having done so, how do they bring about coordination at a higher level? How do they generate and disseminate information through the price system or other systems of economic indicators? And how does the market integrate fragmented bits of information and power residing in individual entrepreneurs, making it the driving force of coordination? These are some of the questions we wish to answer in this essay.

One important effect of entrepreneurship is the modification of the perception of means-ends nexus. New ends emerge and means for their attainment must be perfected. New means are discovered while old ones are abandoned. Coordination dispels disorder here, creating new disorder there. The parade of new opportunities for entrepreneurial action is unceasing. The never-ending sequence of disorder- coordination-disorder is the driving force of economic progress and civilization. Of particular importance is the co-ordinating activity of the shopkeeper. He is in constant touch with the consumer, learning at first hand the extent to which the latter is dissatisfied with the kinds and prices of consumer goods displayed on the shelves. How is information represented by the scattered knowledge residing in individual shopkeepers processed?

How is intelligence about the changing mood of the sovereign consumer transmitted? Only when the problem is presented in this way does it become clear that simplistic models such as the equilibrium theories, the equation of exchange and the quantity theory of money, are wholly inadequate and can never account for the complex processes involved in the formation of prices. The static supply/demand equilibrium analysis of price formation and its offspring, the quantity theory of money, are one- dimensional. They project a black-and-white image. They look at goods in total isolation. They admit no insight into the effect on the price of alternative products either at the input or at the output end of the production line. They make no allowance for deliberate variation of product quality on the part of 1 the producer. A disequilibrium theory of price formation would have to be three-dimensional. It must project an image in full color. It must take the inter-dependence of the price with those of the substitutes at both the input and output level into full account. In this essay we attempt to lay the foundations of such a disequilibrium theory. In the first part we establish arbitrage as the very driving force of the market process.

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