THE MARKET PROCESS AS A SOLUTION TO THE KNOWLEDGE PROBLEM
The knowledge problem, alongside incentives problems, is a barrier to social coordination that formal models cannot capture in its entirety. This is because such models assume a given range of choices and cannot include unknown choices within a set that have yet to be discovered. An institutional framework that enables the market process helps to ameliorate this problem.
How does the market process operate? In the first instance, markets allow actors to summarize some of the relevant characteristics of their inarticulate knowledge in a way that can usefully guide the choices of others throughout a community. An actor may need widgets as part of a production plan but lack the personal knowledge or skill to create them. Market prices inform the actor what the going rate for a widget is, which is a sufficient guide so far as their particular business plan is concerned. It means that dispersed knowledge that is relevant for evaluating a range of given choices become accessible to decision makers.
Moreover, prices also act as a signal to potential price makers, or entrepreneurs, showing them where demand for particular resources is currently outstripping supply (Kirzner 1997, 2013). They represent a signal of unmet needs that someone with relevant knowledge or expertise can use as a guide to where their efforts could be productively employed. These entrepreneurs are alert to how the given price data may fail to reflect other observations that they have based on their particular circumstances. In this sense, entrepreneurs act in disagreement with the given price, believing it to be erroneous from their subjective standpoint (Kirzner 1978, 11).
This aspect of the process is not one of narrow, rational economizing precisely because agents are not optimizing their choices within budgetary constraints (Kirzner 1996, 127). Instead, these agents engage in the creative and speculative activity of challenging publicized prices, winning profits should they be correct and experiencing loss should they turn out to be mistaken. It is this open-ended feature of the market process, impossible to conceptualize in a formal rational choice model, that allows for the discovery of previously unknown options in a given choice situation. It is a mechanism that does not merely discover what choice produces the best outcome within a given set, but also allows people to identify and explore “blank” or hidden areas in the choice set.
This market process understanding adds an epistemic emphasis to prevailing neoclassical economic accounts of the function of market institutions. The cornerstone of neoclassical economic theory is the notion of competitive equilibrium. On this account, institutions that support market activity work because they are technically efficient. Assuming rational agents and perfect information, markets allocate resources to their most valuable uses and encourage self-interested actors to accumulate capital without fear of expropriation (Alston, Eggertsson, and North 1996; North 1990). They remove “dollars from the sidewalk.” Institutions that unnecessarily impede the price mechanism fail to address transaction costs, or enable predation to reduce long-run economic welfare (Olson 1996). For sure, economists in this tradition do not ascribe such simplistic notions to reality. They only suggest that the abstraction is sufficient to explain a great deal of the variation between regimes.
For the RPE account, this is lacking part of the answer because it fails to explain how individuals with bounded rationality and limited information could ever even approach, much less satisfy, the conditions required for this model to be relevant. The presumption that markets work only to coordinate given information suggests that they are apt to fail in cases where such information is absent, calling for a different explanation of what makes liberal markets historically workable. It would also mean that, in principle, any institutions similarly designed to follow price signals (such as market socialism) could serve in the place of liberal market institutions (Meade 1945). Yet, historical observation suggests that only regimes with substantial allowance for market activity within a system of private property have consistent welfare gains (Boettke 1993).
This is where the contribution of market process theory differs from neoclassical approaches. As Hayek (1945, 2014) and Kirzner (1996) describe, market institutions facilitate a process of social learning whereby agents discover more valuable uses of resources. In participating in this process, people seeking to satisfy their own ends come to contribute to the ends of their fellow participants. Although limited knowledge is the primary economic problem to be overcome on this account, incentives remain central. Without objective, stable, given information; incentives; and the subjective experience of gains and losses, essential feedback to individual decision makers will not be provided: “What renders the market process a systematic process of coordination is the circumstances that each gap in market coordination expresses itself as a pure profit opportunity” (Kirzner 1996, 12).
Critically, this establishes a realistic baseline for comparing institutional efficacy and viability. A model of markets based on perfect competition implies that any observed deviation from equilibrium, such as supra-normal profits, is a sign of a market failure, whether the result of a diseconomy or information asymmetry. On a market process account, optimality is not the relevant baseline for judgment. Instead, the question is whether the framework in place allows alert actors to discover inefficiencies and failings, and engage in an ongoing open-ended process of experimentation in an attempt to ameliorate them. In this sense, the market process bears some similarity to theories of democratic processes that, under certain conditions, possess similar opportunities for piecemeal experimentation and self-correction (J. Knight and Johnson 2007; Cf. Pennington 2003, 2010).