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VAN NOSTRAND SERIES IN BUSINESS
ADMINISTRATION AND ECONOMICS



Edited by
JOHN R. BEISHLINE
Chairman, Department of Management and Industrial Relations
Neio York University




JULES BACKMAN”Wage Determination: An Analysis of Wage Criteria
HUGH B. KILLOUGH AND LUCY W. KILLOUGH”International Economics
LEONARD W. HEIN”An Introduction to Electronic Data Processing for
Business
PAUL G. HASTINGS”Fundamentals of Business Enterprise
BETTY G. FISHMAN AND LEO FISHMAN” The American Economy
ANDREW D. BRADEN AND ROBERT G. ALLYN”Accounting Principles
ISRAEL M. KIRZNER”Market Theory and the Price System
MARY E. MURPHY”Managerial Accounting




Additional titles will be listed and announced as published.
MARKET
ÎHEORY
ana the




PRINCETON, NEW JERSEY
Toronto · New York · London
PRICE SYSTEM
By Israel M. Kir¾ner
Associate Professor of Economics
New York University




D· Van Nostrand Co., Inc.
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COPYRIGHT © 1963, BY
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Published simultaneously in Canada by
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PRINTED IN THE UNITED STATES OF AMERICA
B'EZRAS HASHEM




TO LUDWIG VON MlSES
Prefiace



D the past few years a number of
URING
competently written textbooks on price theory have appeared. The author's
excuse for adding yet another book to the elementary literature in this field
is that his approach, while in no sense original, presents the subject in an
entirely different light.
The approach adopted in this book views the market as a process of
adjustment. In this process individual market participants are being forced
continually to adjust their activities according to the patterns imposed by
the activities of others. Market theory then consists essentially in the anal-
ysis of these step-by-step adjustments and of the way the information re-
quired for these adjustments is communicated. Equilibrium positions are
not, as in other books, treated as important in themselves. They are rather
seen as merely limiting cases where the market process has nothing further
to do, all activities being already mutually adjusted to the fullest extent.
Despite the importance attached to the implications of the approach
adopted here, users of this book will find relatively few major substantive
departures from price theory as it is usually presented. The principal areas
where major differences will be found arise out of the drastically reduced
attention paid to perfect competition. Presuming the basic course in general
economics, this book is designed for an undergraduate course in intermediate
price theory.
For the rest, an author can hardly hope to have escaped revealing his
own proclivities, biases, and predilections. Determined efforts have been
made to subordinate geometry to economic reasoning. Whatever the author
may have learned from Marshall, Edgeworth, and J. B. Clark, this book
probably will reveal that he has learned more from Menger, Böhm-Bawerk,
and Wicksteed.
Besides his indebtedness to the literature, the author must acknowledge
much kind help received from several persons during the preparation of
v¡i
VÜi PREFACE

this book. To his teacher Ludwig von Mises, above all, he owes his ap-
preciation of the market process. In addition to reading the finished
manuscript, Professor Mises offered many helpful suggestions during its com-
pletion. It is with deep pleasure that the author dedicated this volume to
him upon the attainment of his eightieth year.
The author is grateful to his colleagues at New York University, as well
as to his students, for stimulating discussions on a number of points. To
Professor L. M. Lachmann of the University of Witwatersrand, South Africa,
he is indebted for several valuable insights that were made use of in exposi-
tion. The author's wife has patiently and cheerfully endured, aided, and
encouraged throughout the book's preparation. To all these he is grateful;
none of them is to be held responsible for all that remains unsatisfactory.
ISRAEL M. KIRZNER
Contents



1. T H E NATURE AND TASKS OF MARKET THEORY 1
The Individual and the Market. . . The Market System . . . The Founda-
tions of Market Theory . . . The Individual and Economic Behavior . . .
Economic Theory and Economic Reality . . . Market Theory, Economic
Theory, and Economics . . . Summary
2. T H E MARKET: ITS STRUCTURE AND OPERATION 13
The Conditions Under Which the Market Operates . . . Market Roles . . .
The Structure of the Market System: Vertical Relationships . . . The
Structure of the Market System: Horizontal Relationships . . . The Anal-
ysis of Human Action in the Market: The Concept of Equilibrium . . .
Complete and Incomplete Equilibrium . . . The Pattern of Market Ad-
justment . . . The Changing Market. .. The Market System as a Whole . . .
Summary
3. EFFICIENCY, COORDINATION, AND THE MARKET ECONOMY 33
The Economic Problem . . . Society and the Economic Problem . . . The
Problem of Coordination . . . How the Market Solves the Problems of
Coordination . . . The Coordinating Function of Profits in a Market Econ-
omy . . . Summary
4. UTILITY THEORY 45
The Scale of Values . . . Marginal Utility . . . Diminishing Marginal
Utility . . . The Marginal Utilities of Related Goods . . . Marginal Utility-
Some Further Remarks . . . Marginal Utility and the Conditions for Ex-
change . . . Summary
5. CONSUMER INCOME ALLOCATION 63
Marginal Utility and the Allocation of Income . . . The Position of Con-
sumer Equilibrium . . . A Geometrical Illustration . . . The Effects of
Changes . . . The Individual Demand Curve . . . Some Remarks on Ex-
pectations . . . Summary
¡X
X CONTENTS


6. MARKET DEMAND 85
Market Demand . . . The Market Demand Curve . . . Demand Elasticity
. . . Measures of Elasticity . . . Market Demand as Seen by the Individual
Entrepreneur . . . Demand and Revenue . . . Demand and the Prices of
Other Goods . . . Demand as a Market Force . . . Summary
7. MARKET PROCESS IN A PURE EXCHANGE ECONOMY 105
The Nature of Competition . . . A Simple Case of Price Competition . . .
Simple Price Competition Without Perfect Knowledge . . . The Market
for Several Non-Producible Goods: The Problem . . . The Equilibrium
Situation for the Multi-Commodity Market . . . The Multi-Commodity
Market Without Perfect Knowledge . . . Monopoly in a Pure Exchange
Market. . . The Agitation of the Market . . . Summary . . . Appendix
8. PRODUCTION THEORY 142
The Economic Aspect of Production . . . Production by the Isolated In-
dividual . . . Production in Society . . . Production in the Market Econ-
omy . . . Factors of Production . . . Production Functions and Isoquants . . .
The Shape of the Isoquant and the Substitutability of Factors . . . Changes
in Factor Proportions, and Changes in the Scale of Factor Employment . . .
Returns to Scale . . . The Laws of Variable Proportions: The Problem . . .
The Laws of Variable Proportions . . . Economic Implications of the Laws
of Variable Proportions . . . The Least-Cost Combination . . . Graphic
Illustration of the Least-Cost Combination . . . Summary
9. COSTS AND SUPPLY 183
Costs and Rents . . . Opportunity Costs and Supply Theory . . . Prospec-
tive and Retrospective Costs . . . Capital Goods and Cost Theory . . .
Factor Divisibility and Short-Run Per-Unit Costs . . . Short-Run Costs and
Their Effect on Supply . . . Long-Run Costs and Supply . . . Factor Prices
and Supply . . . Summary
10. PARTIAL MARKET PROCESSES”THE DETERMINATION OF PRODUCT
PRICES AND FACTOR PRICES 210
THE MARKET FOR A SINGLE PRODUCT
Long-Run Equilibrium . . . Short-Run Equilibrium in the Single-Product
Market . . . Equilibrium in the Single-Product Market in the Very Short
Run . . . Adjustment to Change in a Market for a Single Product . . .
The Market Process in a Market for a Single Product
THE MARKET FOR A SINGLE FACTOR OF PRODUCTION
Equilibrium in a Factor Market . . . The Market Process in a Market for
a Single Factor of Production.
TOWARD THE GENERAL MARKET PROCESS
Summary
11. T H E GENERAL M A R K E T PROCESS 236
A Preliminary Model . . . The Preliminary Model and the General
Model . . . General Market Equilibrium Conditions . . . A General Market
CONTENTS XI

in Disequilibrium . . . Disequilibrium in the General Market and Entrepre-
neurial Opportunities . . . Entrepreneurial Activity and the General
Market Process . . . Partial Analysis and the Analysis of a General Mar-
ket . . . Toward Further Extensions of the General Market Model . . .
Summary
12. MONOPOLY AND COMPETITION IN THE MARKET 265
The Monopolized Resource . . . The Resource Cartel . . . Restriction of
Supply: A Special Case . . . Combinations of Resource Buyers . . . Monop-
oly in Production . . . The Consequences of Monopoly Output Restric-
tion . . . The Monopolist-Producer as a Resource Buyer . . . Further
Remarks on Monopolized Products . . . The Single Producer Without
Monopoly . . . Some Remarks on the Model of "Pure" or "Perfect" Com-
petition . . . Monopolistic Price Discrimination . . . Summary
13. T H E PRICE SYSTEM AND THE ALLOCATION OF RESOURCES 297
The Possible Levels of "Welfare" Appraisal . . . Misallocation of a Re-
source in a Market System . . . Imperfect Knowledge, the Source of
Resource Misallocation . . . Prices, Profits, and the Reallocation of Re-
sources . . . The Entrepreneur and Resource Allocation . . . Resource
Mobility and the Allocation Pattern . . . Monopoly as an Obstacle to Cor-
rect Resource Allocation . . . Artificial Obstacles to Correct Resource
Allocation . . . Summary
APPENDIX: T H E APPLICATION OF MARKET THEORY TO MULTI-PERIOD
PLANNING 311
Multi-Period Decisions in the Pure Exchange Economy . . . The Inter-
temporal Market . . . Speculation as an Aspect of Intertemporal Mar-
kets . . . Multi-Period Decisions of Producers . . . The Place of Capital
Goods in Production
INDEX 321
The Nature and Tasks
of ÌÆarhet Theory



is devoted to the study of
HIS BOOK
the theory of the market system. In this first chapter we attempt to obtain
a clear notion of what is meant by a market; what is meant by a market
system; and how economic theory can throw light on the nature of market
processes. Our discussion will clarify the relationship between market
theory and other branches of economics. Moreover, it will indicate the
importance of the economic theory of the market for an adequate under-
standing of the world we live in.

THE INDIVIDUAL AND THE MARKET
Society consists of individual human beings. Each human being is eager
to act to improve his position, whenever this appears possible. In order
to satisfy his desires, a man may act on his own (as, for example, when he
paints his house by himself), or he may fulfill his ends indirectly through
exchange (as when he pays another man to do the painting). Where an
exchange transaction takes place freely, the two individuals involved have
both acted to fulfill separately their respective goals.
In a predominantly free society, individuals are in most respects at
liberty to act as they choose. That is, in such a society an individual is
generally at liberty to take advantage of any opportunity (as he perceives
the existence of such an opportunity) in order to improve his position (as
he understands the idea of improving his position). He is free to act in
isolation, and he is free to engage in acts of exchange with other individuals
(whenever he and some other individuals both perceive the opportunity
of mutual benefit through trade). As we shall find, such opportunities for
1
2 MARKET THEORY AND THE PRICE SYSTEM

mutually advantageous exchange arise constantly in society. Moreover, the
exploitation by individuals o£ these opportunities opens up yet further
opportunities of the same kind, both to the individuals themselves and to
others in the society. A market exists whenever the individual members
of a society are in sufficiently close contact to one another to be aware of
numerous such opportunities for exchange and, in addition, are free to take
advantage of them. A market economy exists wherever the ramifications
of the market become so widespread and the opportunities it offers so nu-
merous and attractive that most individuals find it advantageous to carry on
their economic activities predominantly through the market rather than on
their own.
The market economy is thus to be distinguished, on the one hand, from
the autarkic economy, where individuals carry on their economic activity
isolated from one another, being unaware or unwilling to take advantage of
opportunities for exchange. On the other hand, it is to be distinguished
from the centrally controlled economy where economic activity of individ-
uals is directed by a central authority so that, although transfers of goods
among individuals may be ordered by the central authority, individuals
are not free to take advantage of exchange opportunities which they them-
selves may perceive. It is unlikely that any one of these three types of
economies will exist historically in its theoretically purest form. To some
extent, limited market activity is likely to arise even in the most primitive
and autarkic of societies, whereas even the most rigid of centrally controlled
economies leaves room, legally or illegally, for some market-type activity
between individuals. Finally, even the most fully developed market econ-
omy is incapable of making it advantageous for individuals to seek the
satisfaction of all their wants exclusively through the market. (Most men,
for example, turn to the market for a haircut but not for a shave.)
In the developed market economy, the conditions of production have
become adjusted to the market requirements. Over a period of time, indi-
viduals acting through the market have succeeded in setting up an organ-
ization of production and exchange which, in turn, has widened the market
until it has embraced the bulk of all economic activity in the society. In
such a system, as in any system where the individual is relatively free to
act as he pleases, men seek to improve their positions with the means at
their disposal. But, whereas the isolated individual can improve his posi-
tion only by adjusting himself to, and manipulating, the conditions imposed
by nature, in the market economy the individual acts to take advantage
also of the conditions and opportunities made available by the market.
The salient fact that emerges from this discussion is that any descrip-
tion of market activity means the description of individual activity, but
also that the activity of each participating individual in the market is
conditioned by the actions of other participating individuals (either in the
THE NATURE AND TASKS OF MARKET THEORY 3

past or as anticipated in the future). It is this insight, we will discover, that
is the basis for the economic analysis of the market system and of the
processes that take place in the market.

THE MARKET SYSTEM
To the casual observer, market activity seems to be a bewildering and
uncoordinated mass of transactions. Each individual in the market society
is free to buy what and when he pleases, to sell what and when he pleases,
to produce or to consume what he pleases, or to refrain altogether from any
or all of these activities. Transactions may involve any of innumerable
commodities or services, they may involve any of a wide range of quantities
and qualities, and they may be concluded at any of a wide variety of prices.
Economic analysis reveals that this seeming chaos in the activity of
market participants is only apparent. In fact, analysis shows that the ex-
changes that take place are subject to definite forces at work in the market.
These market forces guide the individuals participating in the market
in their decisions. Each market decision is made under the stress of
market forces set up by the decisions, past or expected, of all the market
participants. During any given period, therefore, the decisions made by
individual market participants constitute an interlocking system embracing
the entire scope of the market. This network of decisions constitutes the
market system. The end results of all these decisions make up the achieve-
ments of the market system; and the tasks which society may seek to fulfill
by permitting a market economy are the assigned functions of the market
system.
The importance of the market system and of its analysis is not simply
the discovery that decisions are made under constraints set up by other de-
cisions. Market system analysis, we will discover, reveals a remarkable
feature in the operation of these constraints, and it is chiefly this feature
that invests market theory with its importance. The real significance of the
market system lies in the fact that the mutual interplay of these constraints
makes up a unique process through which the decisions of different indi-
viduals (who may be quite unknown to one another) tend to be brought
progressively into greater consistency with each other.
Consistency and correspondence between the decisions made by differ-
ent market participants are of the first importance in any successful execu-
tion by the market of its functions. If all potential members of the labor
force decided to train themselves as skilled watchmakers, a catastrophic
aberration of individual decisions would exist. After all, a decision to be-
come a watchmaker depends on the confident assumption that some other
people will be barbers, tailors, etc.
The free interplay of individual decisions in the market place con-
4 MARKET THEORY AND THE PRICE SYSTEM

stantly generates new forces modifying and shaping the delicate, sensitive,
and interlocking decision network that makes up the system. It is the
task of market theory to trace the consequences of these market forces, pay-
ing particular attention to the degree in which they constrain independ-
ently made decisions into mutually corresponding and concordant systems.

THE FOUNDATIONS OF MARKET THEORY
The construction by economists of the body of propositions that make
up market theory is founded upon their consciousness of the existence and
the nature of economic law. The recognition of "laws" in economic affairs
implies the understanding that apparent chains of causation prevail in
social events, just as in the physical world. Acts of individuals in the
market are perceived as taken in consequence of definite acts, prior or
anticipated, of other individuals. What goes on in the market at any one
time is to be ascribed to what has gone on in the past, or to past anticipa-
tions as to what will go on in the future. Market phenomena do not emerge
haphazardly in a vacuum; they are understood to be uniquely "determined"
by market forces.
While the essential concept of a law of economics is thus quite paral-
lel to that of a law of physical nature, the two kinds of law have little
further in common. Laws of physical nature are inferred from the obser-
vation of sequences of physical events. Economic laws, as we shall see, are
founded on our understanding of the influence that a given event will have
upon the actions of individuals.
To be sure, the laws of physical nature are also operative in the spheres
of human activities. A heater raises room temperature, and ice lowers the
temperature in the ice box; human beings are more comfortable at some
temperatures than at others, and food keeps better at some temperatures
than at others. These physical, physiological, or biological laws must be
considered in any attempt to "explain" why men buy heaters or ice. The
recognition of economic law involves the insight that, even after the physi-
cal, physiological and psychological sciences have been utilized to the
utmost in tracing the influences that have helped determine an economic
"event," there still remain significant elements that have not been traced
back to prior causes. These elements, in the absence of an economic theory,
would have to be considered as undetermined by any causal forces. The
recognition of economic law means the perception of determinate causal
chains constraining the course of events insofar as these are left unde-
termined by physical, physiological, or psychological laws.
Consider, for example, the consequences upon the price of ice of a
sudden sharp reduction in the quantity available for sale. The most com-
plete application of the physical sciences (while it might throw a great deal
THE NATURE AND TASKS OF MARKET THEORY 5

of light on why such a reduction in the supply has occurred, or upon the
possible alternative ways consumers might be able to do without ice) can
in itself tell us nothing about why subsequent ice purchases are carried out
at higher prices. Our explanation of the higher prices being the conse-
quence of the reduced supply thus invokes the concept of economic laws,
which we understand as explaining the result of the particular change that
has occurred when other aspects of the situation have remained unchanged.
The nature and existence of economic law, and its manifestation in
the interplay of market forces, must now be briefly traced back to the actions
of the individual human being.

THE INDIVIDUAL AND ECONOMIC BEHAVIOR
The possibility of perceiving chains of cause and effect uniquely eco-
nomic is due to the presence in human action of categories that have no
parallel in the realm of physical laws. And because the mind of the indi-
vidual investigating causation in economic affairs is capable of directly
understanding these categories (since, as we shall see, they are self-evident
to the human mind), he is capable of directly grasping the existence of
economic laws. The human mind is immediately conscious of the funda-
mental and all-pervasive category embedded in the web of all conscious
human action. This category is purpose. Actions are undertaken for
specific purposes. We are aware of the purposive character of our own
actions, and we understand that the conscious actions of other human be-
ings also are purposive. However much we may either despise or fail to
understand the particular purposes behind the actions of our fellows, we
do not doubt that their actions aim at securing for themselves some situa-
tion that they prefer over what they expect to prevail in the absence of
their actions.
Moreover, because we assume all action to be purposive, and because
we live in a world which offers at each instant the possibility of many
different kinds of action, we are immediately aware, too, that every human
action must be the embodiment of a choice among alternatives. At each
instant man must choose between the courses of action (including inaction)
that are open to him. Any such adopted course, we understand, has been
adopted as preferable to the rejected courses of action.
Thus, human action involves the categories of purpose, of alternatives,
of choice among these alternatives, of the preferred (that is, the adopted)
alternative, and of the rejected alternatives. These categories suffuse all
transactions of men, both in isolation and in the market. They are the
categories upon which economic theory depends for its very existence.
Economic theory approaches complex social and market phenomena by
searching for the individual actions from which these phenomena arise.
6 MARKET THEORY AND THE PRICE SYSTEM

Any such individual action is understood as having involved the adoption
of one alternative and the rejection of others. The adopted alternative is
understood as having been compared with, and preferred over, the other
alternatives; that is, it was considered as being either the means to the
attainment of the most cherished possible purpose or the most efficient of
the available means to the attainment of a specific purpose. Economic
theory understands that each action inevitably involved a cost. The
adopted alternative has been adopted at the expense of the rejected alterna-
tives. The rejected alternatives, which in themselves may have been highly
desirable, have been renounced for the sake of the adopted alternative.
Economic theory "explains" individual actions, therefore, by tracing them
to the circumstances that made them "profitable"; that is, to the circum-
stances that made the "costs" worthwhile. Changes in the patterns of
human action are traced in this way either to changes in the terms on
which alternatives are available relative to each other, or to changes in
the framework of purposes within which the worthwhileness of the relevant
costs are valued.
Market phenomena lend themselves readily to analysis in this way as
soon as it is realized that the terms on which alternatives are offered to an
individual are, in a market economy, determined in large part by the
actions of other individuals rather than merely by natural events. It be-
comes illuminatingly possible to view every transaction in the market as,
on the one hand, a consequence of the particular complex of alternatives
presented to the individual by the market before the action was undertaken,
and, on the other hand, as in some way affecting the complex of alterna-
tives that will be subsequently faced by the individual market participants.
Even the most intricately entangled web of market phenomena can be re-
duced to the elementary actions that they consist of. Systematic analysis
of market phenomena in this way is able to yield propositions linking chang-
ing patterns in prices, qualities and quantities of output, of consumption,
and the like, to logically prior changes in the "data." These logically prior
changes may be either in the circumstances (arising both inside and outside
the market) affecting the alternative opportunities open to individuals pur-
suing their purposes, or in the structure of purposes with reference to which
individuals appraise the relative usefulness of opportunities open to them.
To revert to an example mentioned several pages previously, a sharp
decrease in the quantity of ice supplied to the market can easily be linked,
by this kind of reasoning, to a subsequent price rise. As ice purchasers
find the availability of ice sharply reduced (other things being unchanged),
they find it necessary to restrict the obtainable limited quantities of ice to
only the most important of the uses to which the previously larger quantity
of ice had been put. Thus, any additional ice block that they contemplate
to purchase after the decrease in supply involves the potential fulfillment of
THE NATURE AND TASKS OF MARKET THEORY 7

a purpose held more important than the purpose whose fulfillment, be-
fore the decrease in supply, depended on the purchase of an additional ice
block. It follows that some of the alternatives that, before the decrease in
supply, were more important than an additional ice block may now be less
important than an additional ice block. An alternative whose sacrifice
for the sake of an additional ice block had hitherto been considered as not
worthwhile will now be considered, perhaps, as highly "profitable." In
other words, the cost that individuals will be prepared to incur (that is, the
price that they will be willing to offer) for an additional block of ice, has
risen. Further examination of the machinery of a competitive market
would then readily explain the subsequent higher market prices for ice.
The simple causal chain shown thus to link a decrease in supply with
a subsequent price rise has been adduced merely as an illustration of the
concatenation of decisions that make up any period of market history, and
of the kind of reasoning that can reveal the operation of economic law in
this way. The theory of the market that we study in this book applies
this kind of reasoning to the isolation of the principal types of causal chains
that express themselves through market forces and that make up the skele-
ton of the market system of economic organization.

ECONOMIC THEORY AND ECONOMIC REALITY
Our ice block illustration, at the same time, is able to clarify the rela-
tionship between the world of economic theory and the world of economic
reality. This relationship must be kept firmly in mind throughout what
might otherwise appear as the unrealistic or abstract chapters that make
up the bulk of this book.
Our theory of ice prices, it will be observed, did not depend upon the
particular physical properties of ice. Although we may know what physical
properties of ice make it an economic good, all that is required for our "ice
price" theory is simply the fact that ice is an economic good”simply, that
more of it is preferred to less of it. In fact, everything which we were able
to conclude concerning the price of ice can be asserted with equal validity
concerning economic goods in general.
Thus, abstractness and generality are the twin aspects of economic
theory that emerge from our illustration. Economic theory is abstract, in
the sense that the reasoning does not depend on the numerous particular
properties of the data we are theorizing about. Economic reasoning throws
light, for example, on situations that human beings associate with specific
sensations. The demand for food has to do with feelings of hunger or of
satiety; the demand for reading material has to do with the thrills of explora-
tion, suspense, or learning; the supply of labor has to do with feelings of
weariness and fatigue. It is emphasized that economic theory does not
8 MARKET THEORY AND THE PRICE SYSTEM


refer to these specific sensations. Economic theory abstracts the element
of preference”bare and colorless”that emerges in each of these situations.
In geometry a proposition may throw light on properties of rectangular
objects, including restaurant tables, milk cartons, and billboards. Geome-
try, however, has nothing essentially to do with eating in restaurants, drink-
ing milk, or advertising. Economic theory is in similar case: it abstracts
from actual situations those elements to which it is relevant.
Economic theory is, as a consequence, general, in that its conclusions
have validity for sets of data that may be widely different from each other
in every particular aspect other than the economic. (To relieve the abstract-
ness of the reasoning, numerous concrete examples are given of situations
that may be quite general; these examples will serve only as illustrations of
general propositions.) In the theory of the market economy, our proposi-
tions will relate to such entities as "goods that consumers desire more
urgently," or "resources that are in relatively short supply," or "production
processes that are relatively more efficient." Any such proposition may
apply to many different situations.
Our "ice block" illustration demonstrates, in addition, the possibility
of deducing economic propositions whose validity does not depend upon
the accuracy or completeness of any empirical observations. Since our
theory of ice prices did not depend on any particular physical properties of
ice, nor upon any particular psychological attitudes towards ice (except
that it be considered an economic good), our theory required no laboratory
experiments upon ice nor any psychological observations of behavior.
Our theory depended only on the logic of choice; that is, it required only
that we understand what human beings will do when they find that the
use that can be made today of a block of ice is more important than the use
that could have been made of it yesterday. We are able to develop proposi-
tions of this kind because we are acting human beings. We know, without
empirical observations, how a change in the attractiveness of the terms on
which a human being is free to choose will tend to affect the choice of any
being whose behavior is guided by reason similar to our own. Economic
theory is founded on this kind of knowledge that we possess. We can
analyze the effects of changes upon human action, in the abstract, because
we are immediately aware of the logic that governs all human action. The
logic that governs human action is the same logic that the economic theo-
rist applies in analyzing this action. If molecules had preferences and acted
purposefully to achieve them, then the physicist would have a source of
knowledge concerning the behavior of physical matter quite independent of
any empirical findings that he might make. This source would be his
own immediate understanding of how purposeful beings tend to behave
under changing patterns of alternatives. The economic theorist finds him-
self in precisely such a favored position.
THE NATURE AND TASKS OF MARKET THEORY 9

Now, the logical validity of a proposition of economic theory does not
mean that the real world presents any instances of the truth of the proposi-
tion. In mathematics, for example, it does not follow from the geometrical
proposition that states that the base angles of an isosceles triangle are equal,
that we will ever be able to find such a triangle. Similarly a proposition
linking a restriction in the supply of ice or of any economic good (other
things being unchanged) to a subsequent rise in its price does not, in itself,
mean that in the real world there has been or will ever be such a restriction
in supply (and it certainly does not mean that with any such a restriction
in supply, the "other things" will remain unchanged). All that a proposi-
tion can assert is that, if given changes occurred under given conditions,
then certain consequences would follow.
It is clear, then, that if the economic theorist is to be of any assistance
in understanding the real world, he must develop theorems concerning
situations that do occur. The economist who analyzes concrete economic
problems applies propositions of far-reaching generality to particular situa-
tions in which he recognizes the dominance of conditions similar to those
governing the relevant propositions. The application of economic theory
in this way certainly cannot be done without careful, accurate, and complete
factual and statistical descriptions of the real world situations in which it
is proposed to detect the operation of the economic laws that are expounded
by theory.
Therefore, the work of the "practical" economist, who aims at explain-
ing what has happened in the real world or at predicting the likely conse-
quences in the future of some proposed or adopted policy, must of necessity
include close attention to "facts." Important and indeed indispensable as
the examination of the "facts" of economic history”remote or current”may
be for these purposes, this task is clearly distinguished from that of con-
structing theories. The theorist makes assumptions and uses his reasoning
to develop the consequences implied in his assumptions. He may take his
assumptions from wherever he pleases, including the real world. Economic
theory refers to the reasoning out of consequences from assumptions, not
to the task of selecting assumptions.
Economic theory emerges then as a tool that can be used in understand-
ing the external world. The tool itself is "abstract," to be judged for its
truth not for its realism. A proposition of economic theory is, to repeat,
very much like a theorem in geometry: we prove its truth, and then we may
be able to discover in the real world a situation that illustrates its truth.
The economist applying theory to real world situations will clothe the
abstract propositions of theory with "actual" data. His final pronounce-
ments will "explain" one set of historical events by relating them to other
historical events. These pronouncements on the chains of causation, which
he claims to have detected in the real market, may certainly be properly
10 MARKET THEORY AND THE PRICE SYSTEM


judged for their realism. If a decrease in the supply of one good was
found to have been followed by a rise in the price of a second good, the
economist, applying theory, may perhaps explain the chain of events by say-
ing that the second good is a close substitute of the first. The theory on
which he bases his explanation is unquestionably true: the restriction of
the supply of one good, other things being unchanged, leads to a rise in
the price of substitutes. But whether the economist's explanation is real-
istic and relevant depends on whether the second good is or is not a substi-
tute for the first; whether other things were unchanged; and so on.
In carrying out his task of explaining what has happened in the real
world, or in predicting the likely consequences in the real world of a par-
ticular event, the economist thus combines theory with empirical fact.
For these purposes it is frequently quite unnecessary to analyze his final
report into its theoretical component on the one hand, and its factual
component on the other hand. The skillful economic commentator will
combine keen observation of events with statements revealing the theo-
retical interdependency of these events. A particular case of local unem-
ployment may be linked to a shift in consumer tastes or to the emergence of
new, cheaper resource markets elsewhere; an outflow of gold may be linked
to particular governmental monetary policies; a particular pattern of in-
dustrial organization may be traced back to the tax structure, and so on.
It would not be necessary, nor even helpful, in these cases, to separate
economic theory from economic fact.
In studying a book such as this one, however, it is imperative that the
distinction between theory and fact be kept clear. This book deals essen-
tially with theory. It presents the kinds of logical procedures that must
be used to understand the operation of a market economy. It presents
the basic tools that the trained economist will use repeatedly in interpret-
ing events in the real world. If these tools are to be used with success, they
must first of all be forged as ends in their own right. Economic theory
must first be recognized for what it is in and of itself: a body of abstract
propositions deduced from hypothetical assumptions.

MARKET THEORY, ECONOMIC THEORY, AND ECONOMICS
We are now in a position to state how the subject matter of this book
relates to economic theory as a whole and, even more generally, to the entire
discipline of economics.
The theory that we study in this book makes up the core of economic
theory, but by no means exhausts it. We investigate here the structure and
operation of a market economy in its broadest theoretical outline; and it
is within this general body of theory that most other branches of economic
theory find their place. We are provisionally able to refrain from paying
THE NATURE AND TASKS OF MARKET THEORY 11

attention to these other branches of theory only by drastically simplifying
the hypothetical market economy we deal with. Once the theory of the
simplified market process has been mastered, then more complex and
particular market situations can be dealt with by logical extensions of the
theory.
In our study, for example, we ignore the possibility of trade between
two separate market economies; we therefore do not study the theory of
international trade with its impact on the market process within each
country. Again, in our study, we almost completely ignore the special role
played by the government as an economic agent; we therefore do not study
the theory of public finance and the modifications brought about in the
market process by governmental taxation, expenditures, or debt. We do
not consider, in our study, the numerous complexities that are introduced
into the market process by the various possible institutions connected with
money; we therefore do not study monetary theory. In the same way (and
partly as a result of these simplifications) we do not consider the possibility
that market forces might arise that can disrupt periodically the smooth
operation of the market process; in other words we ignore the necessity to
construct a theory of the trade cycle; and so on.
In our study, therefore, we construct the theoretical framework within
which all aspects of the economic theory of a market economy must be set.
We follow through the fundamental market forces upon which and through
which the impact of any special, additional economic forces will be felt.
The theoretical attack upon any particular economic problem in the
market must then be carried out against the background of this general
and widely accepted theory of the market.
Economic theory thus embraces a range of theorems covering many
more problems than are treated in this book. Moreover, as we have seen,
the subject economics, in turn customarily involves much besides economic
theory. The study of an economic problem will typically involve much
more than theory, and even for the purely theoretical aspect of such
a study, the propositions of general market theory will be only partially
satisfactory. The skilled economist must scan the data, using his theo-
retical competence to suggest or to detect matters requiring further explana-
tion. In seeking such explanation he must apply his theoretical tools to
the masses of data he believes to be relevant. It is not the task of market
theory to set forth the methods by which the economist can most success-
fully use the empirical data at his disposal or the methods by which he can
most skillfully apply theoretical tools to such data.
Market theory provides the basic tools required for even the most pre-
liminary approach to economic problems. More specialized tools, in the
form of the propositions of particular branches of economic theory, may be
required to analyze specific problems. These tools, too, depend on the
12 MARKET THEORY AND THE PRICE SYSTEM


availability and quality of the basic tools we are about to assemble. The
scope of market theory, within economic theory generally and within
economics as a whole, is indeed narrow. Despite its narrowness, however,
it is market theory that nourishes these wider fields. And in this lies its
paramount importance.


SUMMARY
Chapter 1 clarifies the relationship between the theory of the market
and other branches of economics.
Society consists of individuals seeking to act to improve their positions.
A market exists where the individuals are in close enough contact with one
another to be aware of mutually profitable opportunities for exchange.
A market system exists where the individuals in a society conduct their
economic activities predominantly through the market.
Economic analysis reveals chains of cause and effect linking together
and coordinating the mass of transactions taking place in the market.
Market theory investigates these chains of cause and effect. Market theory
is made possible by the unique properties of human actions. These prop-
erties are embodied in the act of choice among alternatives, an act that the
observing mind of the economist can "understand." Complex market
phenemona may then be "understood" by relating them to individual acts
of choice.
Economic theory is abstract, selecting only the key features of an
economic situation for use in subsequent reasoning. Economic theory is
general; its conclusions have validity for a wide range of possible real
situations. Market theory provides the general framework for the analysis
of a market system. Within this broad framework the various specialized
branches of economic theory deal with more complex special cases. The
theory in this book thus proceeds by drastic simplification.


Suggested Readings
Robbins, L, An Essay on the Nature and Significance of Economic Science, The
Macmillan Co., London, 1935.
Hayek, F. A., "The Facts o£ the Social Sciences," in Individualism and Economic
Order, Routledge and Kegan Paul Ltd., London, 1949.
Mises, L. v., Human Action, Yale University Press, New Haven, Connecticut, 1949,
pp. 1-71.
Stigler, G. J., The Theory of Competitive Price, The Macmillan Co., New York,
1942, Ch. 1.
The Market: Its Structure
ana Operation



chapter and in the next, we sur-
I N THIS
vey the market, its over-all operations and achievements. Later we will
analyze, separately, the different functional sectors that compose the market,
and how these various sectors interact within the market. Here, we will
contemplate the forest in its entirety, before scrutinizing the separate trees,
and then examine the consequences for the other trees of the existence and
growth of each separate tree.

THE CONDITIONS UNDER WHICH THE MARKET OPERATES
We are considering the theoretical operation of a market system.
The model of the market we will be working with can be characterized by
the set of ideal conditions governing the model, which we construct for
the purpose.
In a market system each member of the society is free to act, within
very wide limits, as he sees fit. Moreover, the system operates within a
framework of law which recognizes individual rights to private property.
This means that each individual is free at each moment to employ the means
available to him for the purpose of furthering his own ends, providing only
that this should not invade the property rights of others. At the same
time each individual can plan his activities with the assurance provided
by the law, first that the means available to him at any one time are secure
against appropriation by others, and, then, that he will not be prevented by
others from enjoying the fruits of his productive activities.
The system recognizes the rights of individuals to enter into arrange-
ments with one another which they believe will be of mutual benefit. Indi-
13
14 MARKET THEORY AND THE PRICE SYSTEM


viduals may act cooperatively either by pooling their resources to produce
jointly, or by each agreeing to specialize in one kind of production and
to exchange parts of their production, or by the one agreeing to furnish
productive services to the other in return for finished products or their
equivalent. Our ideal system may be thought of as, in one way or another,
ensuring the smooth fulfillment of such cooperative arrangements. Contracts
are made in good faith, and contractual obligations are fulfilled to the
letter.
Members of the system, being human beings, at any one time have
likes, dislikes, and preferences; each follows his own moral standards.
Each member acts to fulfill "his own" purposes: but these purposes are not
necessarily "selfish" ones and they may be directed toward alleviating the
pain of others; and so on. Each member has more or less imperfect knowl-
edge of the facts surrounding his field of action; each, in some degree,
possesses curiosity, intelligence, determination; each has potential or actual
talent for some or other activities, depending on his (natural or acquired)
physical and other qualities.
Members of the system need not be aware of the entire scope of the
market system or of the theory of its operation, but we may assume them
to be generally content to seek to achieve their purposes within the frame-
work of the system as they find it. In other words, while we make no other
assumptions concerning the nature of the actions of individual members,
we are assuming that no activity is expended with the sole purpose of re-
placing the market system by some system of societal organization governed
by conditions substantially different from those outlined here. The sys-
tem is thus consistent with the existence of the political and coercive ap-
paratus associated with government, only to the extent necessary to ensure
the maintenance of the conditions of a market system.
A society based on these conditions, starting from a previous state of
individual autarky, without any specialization or exchange, can be seen
as rapidly developing into an intricate exchange system. For such a suc-
cessful development to occur it is however necessary that some commodity
emerge in the market which is a generally accepted medium of exchange.
With exchange confined to direct barter of goods or services for other goods
or services, there can be only a limited scope for market activity. It can be
confidently assumed however that the existence of market activity, even if
limited, will create numerous opportunities for individuals to improve their
positions by engaging in indirect exchange. An individual would give goods
or services in return for goods that he does not himself desire, in hope of
being able to exchange these goods later on for others that he does desire
(but that cannot be had in exchange for his original goods or services).
Widespread activity involving such indirect exchange can in turn aid the
emergence of a commodity generally accepted as a medium of exchange.
THE MARKET: ITS STRUCTURE AND OPERATION 15


Individuals will readily accept this commodity (money) in exchange for
their goods or services, having complete confidence in their ability to use
this commodity whenever they wish, to buy other goods or services at prices
(in terms of the money commodity) more or less definitely known in advance.
For the purposes of the market system analysis undertaken in this book,
we may assume that the system's history includes the evolution of a fully de-
veloped monetary machinery. The market has become completely adjusted
to a system of money; all economic calculation is carried out in terms of
money values, all prices are money prices, and all market transactions are
exchanges of goods or services against money. (Nevertheless, for our pur-
poses, we assume that the market operates exactly as it would operate with-
out the existence of a money supply, but simply enjoys freedom from the
inconveniences connected with direct barter. In other words money is
assumed to succeed in lubricating the wheels of exchange, without itself
actively directing exchange activity into channels other than those that
would in principle be used in the absence of money.) * •

MARKET ROLES
With the conditions governing the market system firmly in mind, we
may turn to observe the different roles within the market process that can
be filled by individual market participants.
Classification of roles as carried out by the economic theorist is quite
different from classifications carried out from other points of view. A
difference between two individuals is significant for the theorist only as
it corresponds to a difference in market function. Market theory is or-
ganized within a conceptual framework that recognizes distinctly several
such market functions.
1. Consumers. At the root of the whole matter lies the concept of
action. Human beings act, we have seen, to improve their positions, so
far as they believe themselves able to do so. Individuals participate in
the market only with this final goal of improving their positions. An
individual may find it necessary to undertake many different activities
within the market, but the ultimate purpose of all these activities will
always be to purchase (or obtain the power to purchase) goods and services
whose possession enables him to enjoy directly an "improvement in his
position." Such goods and services are spoken of as being purchased for
1 It must be emphasized that in a real world, money can never be "neutral." The
introduction of a medium of exchange into an economic system necessarily alters the ac-
tions of market participants because a medium of exchange is always more than just a
medium of exchange. (Tn particular, people may seek to hold money as a particularly
desirable form of asset under conditions of uncertainty.) It is the task of monetary
theory to investigate these complications arising from the use of money in a market sys-
tem. In this book we abstract from these complications.
16 MARKET THEORY AND THE PRICE SYSTEM


consumption. The primary role of every participant in the market, is
thus that of consumer.
The consumer enters the market with money to purchase goods and
services for consumption. This money has come into his possession as
a result of his activities in the market (in some other role). In his role
of consumer, each individual chooses between alternative patterns of con-
sumption spending. He finds numerous opportunities to buy different
kinds and quantities of consumer goods and services, each at its announced
price. His means are clearly insufficient to make it possible to take ad-
vantage of more than a few of these opportunities. As a consumer, he
must choose between the alternatives available to him. In analyzing the
market behavior of men in their roles of consumers, market theory pri-
marily focuses attention on the way consumers react to different possible
patterns of available alternatives.
2. Resource Owners. Consumption goods and services, as a rule, are
not directly available in nature for the taking. They must be produced
from available resources. Raw materials may have to be transformed.
Different materials may have to be combined. Goods may have to be
transported to where they are to be consumed. All these productive ac-
tivities are in general necessary; all such activities have something in
common. They invariably involve the planned combination of the pro-
ductive services of many different resources. The various possible ways
of classifying resources will be considered in a later chapter.2 Here it is
sufficient to notice that in order to produce it is necessary to combine,
say, the services of raw materials, manmade tools and equipment, physical
space, human labor of a number of different varieties, and so on. In a
system based on private property, it is likely that most, if not all, productive
resources are the private property or are under the control of individual
members of the system. These individuals are resource owners.
They are owners of raw materials, men with labor services to sell,
and so on. Resource owners have an obvious role in the market system.
All productive activity must begin with the purchase of the services of
the necessary productive resources. These purchases are made from re-
source owners. Market theory analyzes the way resource owners respond
to the alternative opportunities of resource sale presented to them by the
market and to changes in these opportunities.
3. Entrepreneurs. Under the heading "resources," we have included
everything whose services are necessary to obtain products. There is no
productive service necessary for the production of any desired good or
service that can be purchased from anyone other than the proper resource
owner. And yet there still remains one further role in the market system,

2 See Ch. 8, p. 150.
THE MARKET: ITS STRUCTURE AND OPERATION Ì7

without whose successful fulfillment production would be hopelessly in-
efficient. This is the role of the entrepreneur. The entrepreneur's role is
to decide what resources should be used, and/or what goods and services
should be produced; he makes the ultimate production decisions. These
decisions must involve speculation concerning an uncertain future, since
in its pure form an entrepreneurial decision is an act of purchase followed
by a subsequent act of sale of what was previously purchased.
Among market roles, the entrepreneurial role is the least simple to
grasp. The source of its elusiveness lies in the fact that some element
of the entrepreneur's speculative function is exercised whenever human
beings act. In fact we must recognize that in theorizing about the making
of decisions, we may be concerned with two analytically distinct kinds of
decisions. First, there is the decision between definite alternatives. Here
the adoption of any one definitely known objective is accompanied by
the sacrifice of a no less precisely known set of alternative potential ob-
jectives. This kind of decision making is clearly never possible in the real
world of uncertainty (in which we wish our market system to have its
setting). In a world of uncertainty men must invariably make a second
kind of decision, one choosing between courses of action whose outcomes
are quite uncertain, being susceptible to numerous possible unforeseeable
modifications by external events. Although we can never expect to find
actual instances of the first kind of decision, we may sometimes theorize
concerning decisions of the second kind by temporarily reasoning as if
the outcomes were not clouded by uncertainty. In reasoning in such a
way the economist is abstracting from the speculative or "entrepreneurial"
element in the making of the particular decision.
In speaking, however, of a distinct entrepreneurial role to be filled
by hypothetical agents to whom we assign the name entrepreneurs, we
are drawing attention to a unique class of decisions that it is essential for
market theory to distinguish. In a system where specialization and di-
vision of labor have been carried to a fairly advanced stage, there is room
for a class of decisions for which uncertainty is of the essence (thus to speak
about such decisions as if they were made in a world without uncertainty
would be self-contradictory). In such a specialized market system, it is
possible to purchase all the productive services necessary for the produc-
tion of a proposed good, at a definite total money cost. Similarly, when
the good has been produced, it too can be sold in the market for a definite
sum of money. By itself, a decision simply to buy a group of resources,
or their productive services, involves no essentially speculative element;
neither does a decision to sell a finished product, once it has been produced.
But the decision to buy a bundle of productive resources at one price in
order to resell "them" (that is, the finished product for whose production
these productive services suffice completely) later at a higher price, is
18 MARKET THEORY AND THE PRICE SYSTEM


essentially speculative. In a market there is constant opportunity for
this kind of decision to be made, and we distinguish the "pure" function
of making this kind of decision by referring to it as the role of the en-
trepreneur. The entrepreneur must simultaneously make the decisions
concerning which good he will produce and which resources he will use
in its production, under the condition that he can expect only an un-
certain price for the product when it will be sold. The entrepreneur
makes one such speculative decision out of innumerable possible specu-
lative decisions.
Of course, we must immediately point out that in a market system any
one person is likely to fulfill more than one of these three "market roles."
All resource owners and entrepreneurs are also consumers. We have
already noticed, too, that a decision by an individual in his role of con-
sumer or resource owner invariably involves an entrepreneurial element.
Similarly, an individual whose activities are primarily entrepreneurial is
likely to combine with them activities belonging to one or both of the
other possible market roles. A producer may be contributing his own
capital, and will quite probably be directly supplying supervisory labor
services to the production process. In this way, he is acting in part as
a resource owner. A producer may engage in entrepreneurial speculation
not only in order to secure profits, but also because he obtains a peculiar
thrill from taking bold risks. In this way, he is acting in part as a con-
sumer. The resolution by the theorist of the integrated activities of a
market participant into the three general, distinct, functions is purely a
matter of analytical expedience. We understand the market process more
fully, we will find, because we understand that individuals perform a variety
of functions that are susceptible to a separate theoretical "explanation."

THE STRUCTURE OF THE MARKET SYSTEM:
VERTICAL RELATIONSHIPS
The analytical isolation of the various possible market roles leads
directly to the perception of a unique structure of human actions within
the market system. The recognition of market structure is in turn the
indispensable step toward the understanding of market operation.
In asserting that there is a structure in the decisions made in the
market place, we mean simply that the decisions belonging to each of
the various market roles are linked in a stable pattern of relationships.
Decisions of resource owners, for example, are conditioned on the one hand
by the urge to gain money income, and on the other hand by the different
alternatives offered by various entrepreneurs. The decisions of consum-
ers are conditioned on the one hand by his own tastes and income, and
on the other hand by the different alternatives offered to him by various
19
THE MARKET: ITS STRUCTURE AND OPERATION

entrepreneurs. The decisions of the entrepreneur, in turn, are conditioned
by a simultaneous appraisal of the various alternatives offered to him by
those he is able to buy from, and of the various alternatives offered to him
by those he may be able to sell to; and so on.
In this section we notice, first of all, markets related to each other
"vertically." A vertical relationship can be said to exist between two
markets when goods or services bought in one of the markets are sold
(either alone or in combination with other goods or services) in the other
market. The simplest possible notion of vertical structure within the
market system may perhaps be obtained from Figure 2-1. The figure

Resource
\
Owners


Market for
Productive Services



Entrepreneurs
)


Market for Products



Consumers



Figure 2-1

shows here that the market system consists of two markets; a market for
products (in which entrepreneurs are the sellers and consumers are the
buyers), and a market for productive services (in which resource owners
are the sellers, and entrepreneurs are the buyers).3 The structural rela-
tionship between the markets is seen, for example, by noticing that the
prices consumers are willing to pay for particular products in the product
market will determine the prices entrepreneurs can offer for particular
resources in the market for productive services (also termed the resource
market or the factor market).
A more realistic view of the vertical structure of a typical market
system would recognize that the activities of the entrepreneur may result
in the production not only of goods for the consumer, but also of produced
goods that can provide productive services with which other producers may
3 Later in this chapter, the legitimacy of speaking of separate "markets" within the mar-
ket system is discussed. In reality, of course, there is only one market where all participants
meet.
20 MARKET THEORY AND THE PRICE SYSTEM


produce goods or services for the consumers. The Austrian economist
Menger introduced the concept of the "order" of a good to express this
kind of complexity. A good demanded for consumption is a good of
"lowest order." The goods required for the production of goods of lowest
order are goods of second order, those required for the production of second
order goods are the third order goods, and so on. The point is that entre-
preneurial activity will be possible wherever there are two "vertically
adjacent" markets; one market for a particular good, and another market
in the goods of higher order with which the particular good can be pro-
duced. The complex vertical structure of a developed market system can
now be glimpsed more fully. There are not merely the two markets whose
relationship is indicated in Figure 2-1; there are likely to be numberless
markets related vertically to each other in such a way. Between each pair
of adjacent markets, there will be entrepreneurial activity. The entre-
preneur will buy in the one market, produce, and sell in the market
"below" it. (Here again, incidentally, the entrepreneurial role is closely
integrated with that of resource owner. The initial decision to buy and
sell in the different markets is an entrepreneurial one; but once the
entrepreneurial decision has been made, and the good of higher order has
been produced, the entrepreneur finds himself selling in the "lower"
market just as any other resource owner.)
Moreover, although the vertical relationship between two markets may
appear to stamp one of them as being "higher" than the other, there may
be some other equally valid point of view from which the order of relation-
ship is reversed. For example, iron ore is used in the production of steel
which in turn is used in the production of equipment which plays a part
in the mining of iron ore. The decisions of entrepreneurs buying iron
ore in order to produce steel will be influenced in part by the decisions
of those to whom they sell; that is, the entrepreneurs engaged in the pro-
duction of mining equipment. But these latter decisions will clearly be
partly influenced by the decisions of those buying this equipment”the
miners of iron ore.
There are certainly strands of a vertical relationship existing between
the market for iron ore, and the market for mining equipment, where
the latter market is the higher; but there are, no less clearly, other strands
of a vertical relationship between the two markets where the market for
iron ore is the higher.

THE STRUCTURE OF THE MARKET SYSTEM:
HORIZONTAL RELATIONSHIPS
Two markets may be said to bear a horizontal relationship with one
another, either when the goods or services sold in each of the separate
THE MARKET: ITS STRUCTURE AND OPERATION 21

markets were both bought, in part (directly or indirectly), in the same
"higher" market, or when the goods or services bought in each of the
separate markets is to be sold (in combination with other resources) in
the same "lower" market. Thus the market where washing machines are
bought and sold, is related horizontally to that where automobiles are
bought and sold, since the entrepreneurs in either of these markets will
be bidding against one another in the same higher market”that for steel.
Similarly, the labor market is related horizontally to the market where
labor-saving machinery is bought and sold, since buyers in each of these
markets are likely to be selling their products in the same lower market.
Or again, the market in skilled labor for the production of automobiles
is related horizontally to that for steel, because the resources sold in both
these markets are combined and sold jointly in the automobile market;
and so on.
Clearly, the decisions of buyers or sellers in any such markets will have
to be between alternatives that are conditioned, not only by the decisions
of competing buyers or sellers in the same market, but also, in part, by
the decisions of buyers or sellers in the horizontally related markets. The
price of steel to producers of washing machines will be determined partly
by the strength of the demand for automobiles; the price that a skilled
automobile worker can obtain for his labor will be determined in part
by conditions in the steel market; and so on.
It should be clear from our discussion of the complexity of vertical
market relationships that horizontal relationships, too, may be far from
straightforward. Two markets may be related by different strands of
connectedness, some of which may be vertical, others horizontal, in charac-
ter. For example, sellers in the iron-ore market and sellers in the steel
market may both buy the services of unskilled labor in the same labor
market.
Several points of great importance ought to be made at this stage
concerning the division of the market system into separate "markets." It
must be recognized that any such division is quite arbitrary and is made
by the market theorist only as a matter of convenience. Moreover, there
are significant problems where the theorist finds it convenient to stress
the lack of such watertight divisions. The fact is that in the most impor-
tant sense, the entire market system is one market. Each market participant
is a potential customer for each good offered for sale and a potential en-
trepreneur in the production of every conceivable product. There is inter-
connectedness between every single market decision and every other single
market decision made in the system. The price paid for a shoeshine at
one end of the country is connected, however tenuously, with the prices
paid for the rental of high-speed computers at the other end of the coun-
try, so long as both points are within a single market system. Nevertheless,
22 MARKET THEORY AND THE PRICE SYSTEM


there are clearly various degrees of connectedness. The price of computer
rentals is obviously more directly sensitive to changes in the attitudes of
buyers and sellers of computers than to changes in the tastes or incomes of
customers for shoeshines. Thus, the theorist finds it convenient to mark
off arbitrarily different "markets" within which the connectedness of de-
cisions is more direct than is the case between decisions in different markets.
In pointing to various structural patterns between the markets that make
up the market system, the theorist is indicating the less direct, more subtle”
but over the long run no less powerful”influences that different markets
exercise over one another.

THE ANALYSIS OF HUMAN ACTION IN THE MARKET:
THE CONCEPT OF EQUILIBRIUM
With the mutual influences that may be operative between markets
well understood, it is desirable to consider what goes on inside a market.
This is, after all, the kernel of market theory”the logical tracing through
of the consequences within a market of given sets of data that impinge
upon it.
A market process can be defined as what goes on when potential buy-
ers and potential sellers are in mutual contact. We have seen that the
market system as a whole can be treated as a single market, or that it may
be treated for convenience as consisting of a number of interconnected
markets. Within any market, however conceived, the theorist recognizes
that at any one time each participant has definite attitudes concerning
what is being bought and sold. At a given point in time, each participant
has a particular eagerness to buy or to sell; for each participant there is
on his "scale of values" a unique position assigned to each quantity of
the commodity to be bought or sold. When a large number of such
potential market participants come into contact with one another, many
find opportunities for gainful action. Some buy at the going price, others
sell; some find it gainful to bid prices higher than those currently quoted;
some find it gainful to offer prices lower than the current prices.
The theorist usually attacks the problem of market analysis in the
following way. He takes the attitudes of the various market participants,
as they are assumed for any one date, and imagines that these attitudes
are maintained continuously over an indefinite period of time. He may
then describe a pattern of actions for the various participants that, if
actually adopted, would not have to be revised. For example, the theorist
may suppose that milk suppliers come daily to market with a continuous
and constant supply of milk (concerning which their selling attitude is
assumed to continue unchanged), and that prospective milk consumers
similarly maintain, from day to day, an unchanged degree of eagerness
THE MARKET: ITS STRUCTURE AND OPERATION 23


concerning the purchasing of milk. The theorist may then describe terms
on which suppliers might sell and consumers buy milk, that, if actually
put into practice, would leave no opportunity for any market participant
to improve his position in the future through a change in his actions.
This fictional construction of the economic theorist is known as the state
of equilibrium. The prices the milk is sold at, and the quantities of milk
bought at these prices, are equilibrium prices and quantities.
Should the market participants (whose attitudes are assumed to be
maintained without change) take actions that do not correspond to those
that characterize the equilibrium market, then pressures will emerge on
the participants that will lead them to alter their actions. Should, for
example, the sellers of milk offer their milk at a price higher than the
equilibrium price, then some sellers will find that milk sales are so low
that it would be profitable for them to undercut the existing price. The
non-equilibrium price would generate economic forces that would ensure
that subsequent prices are different; and so on.
The state of equilibrium should be looked upon as an imaginary sit-
uation where there is a complete dovetailing of the decisions made by all
the participating individuals. Every single supplier of milk, for example,
who has decided that he values twenty-five cents more highly than a
bottle of milk (and offers milk to the market at this price), is successful in
discovering some consumer who happens to prefer a bottle of milk over
twenty-five cents (and is willing to buy milk at this equilibrium price).
A market that is not in equilibrium should be looked upon as reflecting
a discordancy between the various decisions being made. Some of these
discordant decisions cannot be successfully consummated in market action;
they do not mesh. If sellers of milk charge too high a price, they will
not find sufficient buyers. Decisions will have to be revised until a
compatibility is attained between decisions that is the condition of a
market in equilibrium.
The theorist who fastens his attention on a particular market upon
a particular date is well aware that the decisions being made are different
from the decisions that would be made in a market that had attained
equilibrium. Whatever the current buying and selling attitudes of the
market participants might be, they are likely to be somewhat different
than on previous dates. Thus, even if previous market activity had suc-
ceeded in achieving equilibrium, from the point of view of the previous
market attitudes, the situation is no longer one of equilibrium with respect
to the new attitudes of buyers and sellers. But the theorist knows that
the very fact of disequilibrium itself sets into motion forces that tend to
bring about equilibrium (with respect to current market attitudes). If
current attitudes were maintained unchanged (and the theorist is of course
well aware that they will do nothing of the kind), then the initial state
24 MARKET THEORY AND THE PRTCE SYSTEM


of disequilibrium would itself tend to bring about an eventual equilibrium.
The very fact that some of the decisions and plans currently being made
are incompatible with others, so that some individuals must be disap-
pointed, will force market participants to revise their plans in the direction
of closer harmony with the other plans being made in the market. If
current attitudes, to repeat, were to continue unchanged, then one might
expect the plans of market participants to reach eventual full compatibil-
ity. Until then, decisions would be continually revised and adjusted.
When equilibrium would have been attained, all plans would be carried
out successfully and would be therefore maintained without alteration
for as long as the basic attitudes continue unchanged.
The market theorist distinguishes, therefore, (a) a process of adjust-
ment during which the market is in agitation, and (b) a state of equilibrium
(the imaginary situation that would be achieved if the adjustments set
in motion by the current market attitudes would be permitted to work
themselves out fully; that is, if current market attitudes continue without
change). In his analysis, the theorist may determine the conditions that
would prevail on a market where equilibrium had been attained; he may
do this by describing the actions that will be taken in a given disequilibrium
market, tracing the tendency of such actions toward the attainment of
equilibrium.

COMPLETE AND INCOMPLETE EQUILIBRIUM
Some further attention to these various analytical approaches is in
order, and will help us, incidentally, toward a clearer grasp of the market
process. A market process, we have seen, is essentially a process of ad-
justment. In this process, individuals adjust their actions to take ad-
vantage of the opportunities offered by the market; that is, they adjust
their actions to "fit" the actions of other market participants. So long
as unexploited opportunities exist that can be grasped through a change
of action, the process of adjustment is not yet complete; somebody's plans
must go unfulfilled”equilibrium has not yet been attained. Until the
attainment of equilibrium, there will be unspent forces at work in the
market. These forces will impel men, sooner or later, to produce different
quantities or qualities of goods, to try to buy or to sell at different prices,
to move in or out of industries, and so on. All these forces, it will be
borne in mind, are set in motion by the simultaneous existence of two
sets of factors: first, a given set of basic buying and selling attitudes (im-
agined by the theorist to be continuously maintained); and second, a set
of prevailing decisions by market participants that have not yet been
"shaken down" through the market process into a harmoniously fitting,
self-renewing pattern.
THE MARKET: ITS STRUCTURE AND OPERATION 25


Now, it must be emphasized that the twin notions of adjustment and
equilibrium, while seeming to pertain only to a world of unchanging basic
attitudes, are in fact the tools with which the theorist analyzes the effects
of change. A new tax is imposed, a new oil field discovered, a wave of
immigration is expected, a revolution in tastes is considered”the theorist
explains the consequences of these changes by means of the analysis of
adjustment and the description of equilibrium. In all these problems the
theorist imagines a market that, before the occurrence of the change, had
been in equilibrium; he imagines the state of disequilibrium such a market
would be thrown into by the postulated change; he traces through the
process of adjustment that would be touched off by this disequilibrium;
and he finally describes the new state of equilibrium that can be attained
when all the forces of adjustment have worked themselves out, imagining,
of course, that throughout the adjustment period no other change in basic
attitudes has occurred.
In his analysis of the consequences of such a change in the basic data,
the theorist frequently finds that ripples of market forces set off by the
change do not completely spend themselves until adjustments have been
made in market actions far removed from the initial change. The discovery
of a new oil field not only affects the price and sale of oil, but eventually
affects numerous other industries; and so on. If the theorist ignores any
of the adjustments”however remote”that must sooner or later be made,
his system will, of course, not be one of full equilibrium. Nevertheless,
economists frequently are content to trace out the market consequences of
a particular event only insofar as it directly entails adjustments. The
theorist may mark out either a time range, or a market area, within which
he is especially concerned to discover the course of adjustment. When the
forces which change the actions of market participants can be held to
have spent themselves within this selected range”even though further
adjustments will eventually have to be made beyond it”the theorist, loosely,
may describe his selected range of the market as having attained equilib-
rium. Such an "equilibrium" obviously is quite incomplete; there are still
market descisions (outside the "range") that will be disappointed and will
have to be revised.4 Nevertheless, it may clearly be expedient for the
analyst to concentrate his attention on particular waves of adjustment, and
the concept of "incomplete equilibrium"”although self-contradictory”
may be of considerable usefulness.
Two kinds of incomplete equilibrium may be distinguished, depend-
ing on the criterion by which the theorist selects his "range."
1. The theorist may discover that certain market forces work them-
selves out fully within a relatively short period of time, while other such
4 Moreover, revisions in decisions made outside the range may bring about secondary
repercussions, in turn, upon decisions within the range.
26 MARKET THEORY AND THE PRICE SYSTEM


forces are felt generally only after a longer interval. He may confine his
attention to the first group of forces. When these have spent themselves,
he may describe his system as being in equilibrium”as it may be, in fact,
for the duration of the selected time period.5 The incompleteness of this
kind of "equilibrium" is indicated by referring to it as short-run equilib-
rium”it being understood, of course, that the nature of the problem under
consideration will dictate the "shortness" of the selected period, and also
that a number of different such periods may be possible with correspond-
ing equilibrium positions of different degrees of incompleteness.
2. The theorist may mark off, secondly, certain kinds of activity on
the part of market participants that he believes to be more likely affected
by the initial change in market data. He may believe, for example, that
the discovery of a new oil field is likely to cause a more marked alteration
in the willingness of oil producers to sell oil at given prices, than in
the willingness of landlords to purchase new oil burners. The theorist
might then confine his attention to the market activities of those buying
and selling oil. When the decisions governing these activities are mutually
compatible, then "the oil market" may be described as in equilibrium.
The incompleteness of this kind of "equilibrium" is indicated by referring
to it as partial equilibrium; that is, an equilibrium existing only in one
selected "pocket" of the entire market system.6 The possibility, discussed
in earlier sections of this chapter, of distinguishing separate "markets"
between which definite interrelationships exist, arises, of course, out of the
kind of analysis described here. The term "general equilibrium" is re-
served for the condition where all adjustments have been carried through
to completion, so that no decisions made in the entire system, however
remote from the initial change, are found to be disappointed.7

THE PATTERN OF MARKET ADJUSTMENT
We have seen that a market system may be divided by the theorist
into more or less distinct areas of activity where market forces bring about
adjustments with especial speed and directness. In considering the par-
ticular course of economic forces within such a distinct area of activity, the

5 It should be realized, however, that long-run forces may start to operate well before
shorter-run forces have worked themselves out. See Ch. 10, pp. 217-222.
6 Of course, the changes brought about in the "oil-burner market" as a result of
changes in the "oil market" may simply take a longer time to work themselves out. In
this sense "partial" equilibrium may be "short-run" equilibrium.
7 In the later chapters in this book, the various separate markets within a market
system are frequently called "partial markets" to emphasize the partial character of analy-
sis confined exclusively to such a separate market. On the other hand, when, as in
Ch. 11, we analyze the complete market process as it embraces all the separate "mar-
kets," the market as a whole is called the "general market."
THE MARKET: ITS STRUCTURE AND OPERATION 27

area is referred to as a "market"”in the same way as the economy as a
whole is called a market (when we are interested in the ripples of economic
forces as felt throughout the system). The simplest form of market where
the forces set up by human action can be analyzed is that marked out by
considering only the activities of those buying and selling the same good
or service.
We speak”and will be doing so frequently in this book”of a market
for shoes, wheat, a particular kind of labor, and so on. We bear in mind
at all times that any equilibrium achieved in such a market may be quite
incomplete from the standpoint of the entire market system. It is the
especial directness with which changes in the data in one part of such a
market make their impact on actions through this market, that justifies
our undertaking this kind of separate analysis.
In the actions taking place in the market for any one commodity, such
as wheat, there is always, we find, the same market process at work. In
any such market there is a general tendency on the part of potential buyers
and sellers to continually revise their bids and offers, until all bids and
offers are successfully accepted in the market. This general tendency ex-
presses itself in three specific ways. First, so long as there is a discrepancy
in the prices offered by different would-be buyers, or in the prices asked
by different would-be sellers, there will be disappointments and subsequent
revisions in bids or offers.8 Second, so long as the quantity of the com-
modity offered for sale at any one price (or below it) exceeds the quantity
that prospective buyers are prepared to buy at this price (or above it),
some of the would-be sellers will be disappointed and will be induced to
revise their offers. Third, so long as the quantity of the commodity offered
for sale at any one price (or below it) falls short of the quantity that pros-
pective buyers are prepared to buy at this price (or above it), some of the
would-be buyers will be disappointed and will be induced to revise their
bids.
Thus, the agitation of the market proceeds under the impulse of very
definite market forces. Prices offered and bid would be continually
changing”even with constancy assumed in the basic production and con-
sumption attitudes of the market participants”as would-be buyers or sellers
find themselves forced to offer more attractive terms to the market. A
would-be buyer might offer a higher price than before because his previous
offer did not fit in with the plans of any prospective seller. Apparently
all sellers aware of this previous offer found more attractive alternative
ways of disposing of their commodities. A seller would be forced to lower
8 In Ch. 7 and subsequent chapters, where the process outlined here is worked out in
greater detail, it will be shown that these initial discrepancies in prices offered or asked,
are the result of imperfect knowledge.
28 MARKET THEORY AND THE PRICE SYSTEM


his price because buyers found more attractive uses for their money”either
elsewhere in this market, or in some other market altogether.
The general direction toward which agitation in the market is tending
should be clear. If unlimited time were allowed for a market to reach its
own equilibrium position”that is, if we assumed no change to occur
indefinitely either in consumer valuation of the commodity or in pro-
ducers' assessment of the difficulty of its production”it is easy to imagine
what would finally emerge. There would be a single price prevailing in
the market; all sales would be effected at this price. Individuals would
offer to sell the commodity at this price, and the quantity that they offer
for sale would be exactly sufficient to satisfy those other individuals who
are offering to buy the commodity at the prevailing price. No would-be
buyer is disappointed in his plans to buy, and no would-be seller in his
plans to sell.9

THE CHANGING MARKET
Much of our discussion thus far has concerned the attitudes of in-
dividuals at a given point in time, or over a period during which these
attitudes are assumed not to change. The analysis of the market under
these artificial conditions makes it possible, in addition, to grasp the course
of the market process as it would operate in the absence of these restrictive
assumptions. Let us consider again the pattern of adjustment discussed
in the previous section.
If we permit change to occur in the urgency with which prospective
buyers are anxious to acquire the commodity sold in the market, or if
we permit change to occur in the conditions governing the production and
supply of the commodity to the market, a number of new elements enter
into the situation. It is clear, first of all, that with respect to the attitudes
of buyers and sellers toward the commodity as of each moment, a different
equilibrium situation occurs toward which the market would tend if the
attitudes of that moment were maintained indefinitely. Since attitudes
are permitted to change, it follows that the market process, the ceaseless
agitation of the market, is being continually pulled toward a different
equilibrium position. Would-be buyers and sellers who were disappointed
in their past market activity”or who, even if not disappointed in the past,
do not wish to be disappointed in the future”must revise their bids or
offers to make them more attractive to the current market. A quite differ-
ent importance is now attached to the skill of anticipating future market
conditions. Disappointment of plans made by would-be sellers will spur
9 It may be observed that in this case (as in all others in economics) a state of equilib-
rium is not the same thing as a state of perfect happiness. All that exists is a state in
which no one is misled into making plans that cannot be executed.
THE MARKET: ITS STRUCTURE AND OPERATION 29


them to undertake production only by their assessment of future demand
conditions.
But the basic pattern of market adjustment is applicable in this chang-
ing market as well. The disappointments engendered at any one time by
the existing absence of equilibrium will help to guide subsequent plans to
anticipate the correct future conditions. Since the changes in market data
can be expected to proceed only gradually, the success or failure of past
plans can provide a fairly reliable indicator of how these plans must be
revised in the future. Thus, market forces are still able to direct the
agitation of the market in the direction of a uniform market price, and of
a correspondence between the quantities offered and demanded in the
market at given prices.
Where a considerable change in the basic market attitudes has occurred
with abruptness, the consequences are not difficult to understand. The
change will make itself felt initially by severely disappointing the plans
of buyers and sellers who had been unable to foresee the change. If, for

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