Applying equilibrium analysis
Let us now turn to the problem of applying equilibrium analysis. The comparative analysis of success and failure gives us a tool for the understanding of reality that is both realistic and a priori. We have seen that there is no need to prove that people do not or tend not to err, for such a proof is irrelevant for the applicability of equilibrium analyses. All possible cases are covered by the theory of equilibrium prices and its comparative counterpart, the theory of profits and losses. This view is realistic because success and failure are potential features of human action. And it is a priori because success and failure cannot be perceived on the basis of mere sense impressions and thus cannot be validated or refuted by observations. The problem of applying equilibrium analysis, then, is to identify instances of success and failure in the real world.
This problem of identification defies mechanical rules and generalizations. It is the problem of the specific Verstehen of historical investigations. Observation allows us to identify two cars running into each another, or a factory closing its doors, but one cannot see an accident or a bankruptcy. Identification of the latter requires understanding on the part of the historian, who must treat each case on its own. In other words, every instance of success and error must be identified in individual historical cases. One cannot single out some kind of action and claim that, in general, it is successful or erroneous. Rather, its success and failure must be determined by reference to the individual conditions in which it takes place. Saying “Hi, old chap!” might be the right thing to do when meeting a friend. It would most likely be wrong to do so when introducing oneself to a potential employer. Building a football stadium might be profitable in a prosperous society. It would most likely be a waste of resources if the society went to war and the population starved. To be sure, one cannot explain success and failure as a necessary consequence of the conditions of action. Introducing oneself to a potential boss, one can do the wrong thing and say “Hi, old chap!” even if we would qualify such behavior as either silly or pathological. Implied as possibilities in choice itself, success and failure are possible under all conceivable circumstances. Man can choose the most important of realizable alternatives, but can also fail to do so.
However, once a choice is made, its success or failure depend exclusively on the circumstances of the individual case. In other words, before a choice is made its success or failure is self-determined, and all other conditions of action are irrelevant. After the choice is made its success or failure depends exclusively on empirically given conditions. One has to look to see whether the chosen action was indeed the most important one among the realizable alternatives, or whether it rendered impossible the performance of a more important action. Only in the first case could we speak of success; the second would be failure. Applying our a priori equilibrium analysis, we make errors intelligible by comparing their implications to the implications of better courses of action that could have been taken. Or ,we make successful action intelligible by comparing its implications to the implications of erroneous actions that could have been taken. Again, the important point is that equilibrium analysis can be applied only by reference to concrete conditions of the individual case. One has to identify other concrete actions that would have been possible and determine whether they would have been more important. In short, one cannot apply equilibrium analysis by reference to any a priori standards. The standard of comparison must be a concrete action that also could have been performed in the same concrete historical situation.11 We will discuss the problems of identifying such actions in the remainder of this section.
The crucial problem in applying equilibrium analyses is a twofold lack of evidence that concerns both, the value scales of acting persons and the possibility of alternative actions.
These problems are particularly difficult to solve in Crusoe economies—that is, when one analyzes the actions of isolated persons. One can observe Crusoe’s actions, but cannot observe his value scales or what he could have done instead of what he did. The only way to deal with such cases is to guess what he might have tried to do. Except for instances of what strikes us as pathological behavior, we will have to assume that he wanted to produce the effect his behavior brought about, thus assuming what is commonly called “rational” behavior on his part. Still in our interpretation of his behavior, we will sometimes suppose that he failed to pursue the most important project, namely, when we are convinced that he acted against his own rightly-understood interests. We then look at him as a mother looks at her child when it does something that strikes her as stupid, or as a benevolent dictator looks at his subjects when they behave in a manner he deems improper. We could also suppose that Crusoe has failed if we know of a better alternative action by which he might have tried to attain the same end that he supposedly attempted. Again, we assure the perspective of enlightened parents or of a higher civilization. There is only one way to establish some (although insufficient) evidence about Crusoe’s value scales, namely by relating his currently observed actions to his past actions. If we assume that his value scales are by and large stable over time, we can interpret a change of behavior as a discovery of past error (but to be sure, it could also be interpreted as a change of value scales).
These cursory observations help us draw two preliminary conclusions. First, we get a glimpse of just how muddy the waters of such historical analysis are. Nothing is left of the clarity and apodictic certainty that characterized our theoretical exposition. Although we are certain that there is only one historical truth (because to assume otherwise would be contradictory), we cannot prove that we have captured it. Arguing our perspective on Crusoe’s value scales and the alternatives he faced, we cannot refer readers to an objective basis they cannot circumvent. We can only try to understand, and try to make our understanding intelligible. Second, we also clearly see that all assumptions about stability of value scales, “rationality,” homo oeconomicus, etc. are nothing but crutches for historical research. They have nothing to do with economic theory, entering the scene only when necessary to apply economic theorems to understand concrete reality. What economics has to say about equilibrium is apodictically true and, as we shall argue in more detail, highly relevant for a correct assessment of the political significance of profits. However, as far as our understanding of real-world action is concerned, equilibrium analysis merely gives us a few—although valuable—tools. These tools need to be complemented with empirical ad hoc assumptions that spring from our personal understanding of each case under consideration.
One can derive still further insight from the case of the Crusoe economy. One of the problems of applying equilibrium analyses, we have stated, is in establishing the value scales of the acting person. We can exclude one view of his value scales from the outset, namely his own view at the moment of decision. The reason, of course, is that at the time he is convinced he is performing the most important action. He does not err intentionally, and he could not do so if he tried. Even if someone consciously brought about a “failure,” it would be no failure at all. The very fact that the action was intended to produce an ostensible failure implies that it was a success. For example, let us suppose that it is my intention to bring about a failure by jumping from the top of a skyscraper and smashing myself on the ground. If I am smashed, I have not proven that one can err intentionally, for it was my very purpose to be smashed. My action was successful. What we see here is that, as a phenomenon, error can occur only ex post an action (see Menger 1871, pp. 21ff.). If the effects of action did not spread in time, all would be present in the very moment of choice. There could be no difference between expectation and reality, we would thus always engage in the best possible action, and there could be no error.
Equilibrium analyses, therefore, cannot fruitfully be applied by referring to the acting person’s ex ante perspective on his own value scales. However, once a choice is made, any person can meaningfully analyze this choice in equilibrium terms. One does not have to resign oneself to contemplation and wait for all the effects the choice will bring about. Both acting persons and outside observers can criticize the choice, pointing out that it is not the most favorable that could have been made. Business observers in newspapers and journals, for instance, do this all the time. Instead of waiting for evidence of the error to manifest itself they anticipate it. This kind of critique is legitimate because error manifests itself ex post an action only insofar as it is a phenomenon, that is, only insofar as it is evidence of our senses. Objectively, however, error is always manifest in the very action that brings it about. From the sole fact that no acting person thinks he errs, one may not infer that there is no such thing as error or, to take a more specific example , that markets are always in equilibrium. Thus, error is revealed in ex post deviations between plans and reality. But these deviations are not errors themselves, only their manifestations. Error is committed in decision itself. As soon as a decision is made, that is, as soon as choice becomes an ultimate given, a legitimate critique can set in and offer recourse to the terms of equilibrium analysis.12
Now let us turn to the application of equilibrium economics to analyses of entrepreneurs in a market economy. The first thing to emphasize is that we are still interested exclusively in the success or failure of individual actions. It would be groundless to argue that the choices of other market participants determine which of our actions are right or wrong, for this does not affect whether our actions actually are right or wrong. General equilibrium is reached when all individuals choose what is for each the most important course of action. We do not have to bother with the question of whether general equilibrium is ever reached, however, as long as we are sure that it can be reached.
Fortunately, one can neglect the question of whether other market participants, consumers in particular, act according to their best interests. Their actions are data for the entrepreneur under consideration. He has to adapt his actions to prevailing conditions, and the choices of other market participants are part of these conditions. Analyzing the individual actions of entrepreneurs on the market, we enjoy the considerable advantage market action affords in yielding evidence for valuations and alternatives. When Jackson exchanges ten ounces of gold for Jefferson’s car, we can infer that Jackson had the chance to keep his gold or sell it to somebody else, and that Jefferson could have kept his car and put it to other uses. Moreover, we know that Jackson valued the car more highly than the gold, Jefferson valued the gold more highly than the car.
Most importantly, however, we know that action on the market determines several types of income, and that one such type is profit and loss. On the market, the error of an entrepreneur leads to monetary losses. The returns he realizes for his product do not cover what he paid for capital goods and interest. In other words, the prices he paid for his factors of production were excessive in comparison to his returns, which, in short, constitutes his error. Paying “excessive prices” means that he would have been better off not exchanging his property at all, or purchasing other factors of production and engaging in other enterprises. This way, he would have either realized higher returns, or avoided losses. Similarly, the existence of profits is also an infallible sign of error, for it demonstrates that other producers could have done better by engaging in the profitable activity. The existence of profit implies that some market participants would have been better off making other investments, just as the very existence of loss implies that it would have been wiser not to engage in this (or, eventually, any) market transaction. Moreover, it is clear that the market compares the action of the individual entrepreneur not only to the alternatives he considered when choosing, but to the alternatives constituted by the activities of all other entrepreneurs on the market. This is the market’s ruthless quest for economic truth. Consumers constantly compare products of entrepreneurs by selecting only the most important ones.
Even on the market, though, evidence for success and failure is not absolutely clear cut. Even in the realm of money calculation, where the categories of wage rate, interest, and profit and loss are especially precious tools, one must guess the entrepreneur’s value scales, as well as the alternatives he faced, to establish which part of his income is profit or loss.
Consider the case of two ice cream dealers selling the same product—which buyers also perceive as the same product—at different prices. The one with the higher income sells in front of a school, the other in front of an old-age home. Let us analyze the impact of value scales on this situation from two sides. First, suppose that the second dealer hates teenagers. In this case, as we shall see, his behavior might not involve error. Selling in front of the school would increase his monetary income, but reduce his psychic income, and it is the latter which counts. We might identify error on the side of other persons who could have sold ice cream in front of the school, thereby increasing their psychic income. We might also find that there is no other person who might successfully step in to sell ice cream in front of the school at a lower price. In this case, there would be no profit in the present dealer’s monetary income. All of his receipts would be wages for his specific labor services.
Now suppose that the students love the present ice cream dealer. They will buy only his product, and would renounce ice cream altogether rather than buy it from someone else. Again, there might be no profit in his income, only wages. Without reference to the value scale of potential customers, one cannot tell whether an action on the market will represent profit or loss.
Let us now consider the problem of standards of comparisons. The central difficulty is in gauging whether other market actions would have been economically realizable. When analyzing the market, we enjoy advantages arising from the fact that the actions of other market participants sometimes provide the evidence necessary to solve the problem. Consider again the case of our two ice cream dealers. The fact that both sold the same product permits us to say that both could have sold at either place. We can tell the dealer selling in front of the old-age residence, “Look, you could have taken your car and sold in front of the school.” Yet, again, this evidence does not enable us to make apodictical judgments, such as in the field of pure theory. For it is possible that no other dealer than the present one could sell in front of the school. (The present dealer might be the only one strong enough to defend himself against a gang of nasty schoolboys, for instance.) In this case, there would once again be no profits in his income, merely wages for his specific labor services. Thus, the fundamental difficulty is that we cannot provide clear-cut evidence to answer the question of what the person under consideration might have otherwise done. The very fact that he did what he did prevented him from performing other actions and thereby demonstrating what he might have done. There can be no empirical evidence for his specific alternatives, because there is no evidence for the counterfactual.
Apart from this problem, there are questions as to which kind of alternative action should form our base for comparing market actions. Should it be an action that the decision maker considered at the moment of choice, or should it be any better action, even one he did not think of when choosing? Consider the case in which two groups, while ignoring each other, exchange the same good at different prices. Is this a case of error, or not? According to Stephen Shmanske (1994, p. 210), “this market is only in disequilibrium with reference to some perfect information benchmark; this perfect information does not exist in the hands of the relevant actors in the market and, therefore, is irrelevant.” Shmanske concludes that the market is in equilibrium—that is, that no error can be identified. Israel Kirzner (1985, p. 158f.), by contrast, sees here a case of disequilibrium. Who is correct?
Remember that we can use the distinction between success and failure as an analytical tool for comparison. It is obvious that, in the case cited above, the group selling at a lower price could have sold at a higher price somewhere else. We can therefore meaningfully compare their actual actions to actions they did not consider when making the choice. This is a common practice of daily life. With the benefit of hindsight, we look at a choice and compare what has happened to what could have happened if we had made other choices. We might be able to “forgive” ourselves more easily if we look back convinced that we did not even think of other actions at the time. (As an outside observer, one of course has the additional difficulty of finding evidence that the alternative really was considered.) However, this does not change the fact that one can meaningfully compare past actions to alternative actions that were ignored at the time of the decision. A completely different question revolves around which importance should be accorded the errors we so identify. Everyone might judge for himself whether this kind of comparison is relevant or not.
In retrospect, one always finds evidence that puts past decisions in a new light. Although in many cases it might be difficult to say whether our past actions have indeed been successful, such difficulties do not at all invalidate the fact that there is always a best or optimal action. They often stem from the reality that not all effects of our actions have as yet become visible. We often have to wait to see whether our past judgment was or was not the best possible. If we wait long enough, we shall always be in a position to gather evidence to gauge whether or not we chose the most important action. For example, investments that at first seemed to be ruinous can eventually realize important returns. And even the most initially promising enterprise might go bankrupt because of unforeseen events. If, looking back, we find no fault with our past decisions, if we find that we always chose the best option possible, our life has been optimal. And if, in retrospect, we discover errors, we are only capable of identifying them because we can conceive of a better alternative that we could have realized instead.
The fact that the future might produce new evidence for and against the success of past endeavors implies that the standards of comparison by which we gauge such success are constantly being modified. What was formerly considered the best option now seems only second-best, or, in other words, wrong. We see it as wrong now because we realize that carrying it out prevented the execution of a more important alternative. What does this imply for the writing of history, as far as history is an application of economics? It implies that history must of necessity be “revisionist.” It criticizes our old view of what was right and wrong in light of the new evidence. Although we always employ means that, in our ex ante judgment, realize the most important end, we sometimes discover ex post that another course of action would have been more favorable. We then see that our ex ante judgments deviated from what events now show us was reality. This deviation is the manifestation of error. Ex ante, we always choose what we think is the most important option. Ex post, we compare what is with what would have been, and thereby discover our errors.
It would be groundless to object that this conception of success and failure is too restrictive, that it would lead to every plan being thwarted except that made by a clairvoyant or a very lucky planner. As should be clear from our foregoing discussion, equilibrium is nonetheless realistic, and nonetheless important for economic analysis, even if nobody attains it.
The purpose of the foregoing discussion was to highlight the intricacies of applying equilibrium analysis and to contrast it with the result that this kind of research can bring. Instances of proper applications can be found in investment newsletters and business reports as well as in biographies of business executives and other leaders. Let us emphasize that these applications do not add one iota to the political debate surrounding profit, income, and distribution, however. This is not because applications of equilibrium analysis refer to individual cases instead of to the economy as a whole, but because applications themselves teach us nothing about the nature of profit, but rather use this category as a tool. Theory, not historical applications thereof, must guide us in political decision making.
— Jorg Guido Hulsmann, A Realist Approach to Equilibrium Analysis
