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