A Journal for Western Man

 

Israel Kirzner's Analysis of Transaction Costs and the Entrepreneurial Nature of Resource Allocation

An Analysis of Israel Kirzner's Competition and Entrepreneurship: Part V

G. Stolyarov II

Issue CXIX - August 17, 2007

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Statement of Policy

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            Contrary to a prevalent position in orthodox economics, Israel Kirzner does not think that a world of zero transaction costs would necessarily result in all available opportunities for welfare improvement being taken advantage of. In Competition and Entrepreneurship, Kirzner outlines his difficulties with the proposition that a lack of transaction costs necessarily leads to all mutually advantageous transactions occurring. He characterizes the prevalent position thus: “The literature seems … to accept the idea that the assumed condition of unimpeded transactions at zero cost is sufficient to ensure immediate, automatic, and frictionless elimination of all resource misallocation” (Kirzner 1973, p. 227).

            On the contrary, Kirzner argues that “even where transactions are costless and otherwise unimpeded, attainment of the state of equilibrium is by no means ‘assured’ and is in any event certainly not instantaneous. This insight … draws attention to the delicate role of the entrepreneurial process in bringing about a tendency toward equilibrium…” (Kirzner 1973, pp. 226-227). For Kirzner, the mainstream theory entirely misses the crucial role of the entrepreneur in discovering opportunities for superior resource allocation. Thus, advocates of the optimal resource allocation story neglect the necessary prerequisites for entrepreneurial action to take place, even in a world of zero transaction costs.

            It is true that no transaction costs imply no costs of obtaining information. However, this is not enough for resources to be properly allocated: “the possibility of costlessly acquiring information concerning available desirable opportunities is by no means sufficient to ensure that these opportunities will ever be grasped. To have costless access to an item of information is not yet to know that information, since one may still not be aware of it” (Kirzner 1973, p. 227).

            As an example of this, consider a possible real-world case where access to information is costless for all practical purposes. Let us say that there is a fact – X – freely available online and that knowledge of X would enable a given businessman to improve the profitability of his operations by 10%. X is quick and easy to learn – and anybody who reads about it will understand it the first time. Accessing X would take mere seconds for the businessman – thus carrying virtually no opportunity cost. But if the businessmen does not somehow know that X is out there to be so easily grasped, then a profit opportunity might languish even in the absence of transaction costs.

            Kirzner outlines the possible obstacles to discovery of possibilities for superior resource allocation in a world of zero transaction costs:

Zero transaction costs do not of themselves guarantee that transaction opportunities will be discovered. Even in a world of zero transaction costs (including zero cost of obtaining all necessary information), a tendency toward equilibrium can exist only if the competitive-entrepreneurial process communicates steadily improved flows of information to market participants. There will be an absence of coordination in a zero-transaction-cost market (as in more realistic markets) until it is gradually eliminated by successive entrepreneurial steps. Assurance that such steps will be taken requires not merely that desirable transactions be available (even costlessly), but that profit-motivated entrepreneurs be alert to them and thereby set in motion a process spreading such knowledge throughout the market.” (Kirzner 1973, pp. 227-228)

            The proper allocation of resources is not an instantaneous process. Unlike the mainstream position on this issue, Kirzner’s stance incorporates a crucial element of realism by taking time into consideration. The market is a process rather than a state, and it takes time for entrepreneurs to discover profit opportunities and exploit them, thereby imparting an equilibrating tendency onto the market. Kirzner emphasizes that “we know that this process is a gradual one, in which entrepreneurs gradually feel their way toward the true temper of the market, while the course of price movements gradually communicates more and more accurate information to more and more market participants” (Kirzner 1973, p. 228).

            Kirzner outlines two levels on which the proper incentive structure must exist in order for a world of zero transaction costs to exhibit equilibrating tendencies. “First, incentives are needed when [a given] opportunity has already been perceived” (Kirzner 1973, p. 229). That is, given that an entrepreneur is alert to a possibility for better resource allocation, what reasons would he have to actually take steps and better allocate those resources? The free market provides one of the most powerful conceivable incentives for this: the profit motive. Any system that endeavors to hinder or eliminate the profit motive thereby deprives itself of the surest way to devote resources to ever better uses.

            But incentives for exploiting already known opportunities are not all that is required: “a second level of incentive is needed to motivate alertness to the possibility of as yet unperceived opportunities that may be lurking around the corner” (Kirzner 1973, p. 229). No system can compare to the free market in achieving this. After all, what stronger reason can one have for remaining on the lookout – for instance – for price discrepancies and opportunities for reducing costs than the possibility that one might personally benefit if certain resources were better allocated? In a society where the government controls large portions of the economy, there exists a far reduced motivation for most people to even think about the possibilities for improving those aspects of life. Under any statist regime, the government actively deters individuals from undertaking entrepreneurial roles and putting their alertness to good use. Many thus cease to see the point in remaining alert to resource misallocations. The worse governments even actively persecute individuals who might suggest opportunities for improvement – even if those individuals demand no material compensation for their services.

            But mainstream theory overlooks the second level of incentives that Kirzner describes: “The writers on zero transaction costs certainly recognize the crucial role of the first kind of incentive. But they seem to take the second entirely for granted, assuming that if useful information is freely available it will immediately become known – every bit of it – in one instantaneous step” (Kirzner 1973, p. 229). Yet by ignoring this, mainstream economists also render themselves unable to account for many of the activities in a real-world market economy:

“We need this incentive – imperfect a mechanism as it is – to explain why entrepreneurs try new ventures, why they experiment with new prices and new qualities of product, why they search for something they are not sure exists. Most important, we need it to show how pioneering changes in prices and product qualities systematically communicate to less alert imitators the information which their own entrepreneurship has not yet discovered.(Kirzner 1973, p. 229)

            If the above passage seems to describe not just aspects of a real-world economy but virtually the entirety of such an economy, this is because it does. Omitting such elements leads to deeply flawed premises for economic policy. Many advocates of the “zero transaction costs implies optimality in allocation” view think that government control of certain economic activities is justified if government can obtain desired results at lower transaction costs than the free market. Kirzner’s view explains the fallacious nature of such a position. To conclude that resources would be optimally allocated in a government-controlled economy, “we would have to assume not merely that government could acquire information costlessly, but that government was already omniscient” (Kirzner 1973, p. 230). After all, “[t]he crucial question for government-market comparisons must concern the capacity of each of the two systems to bring available opportunities to the attention of decision-markers” (Kirzner 1973, p. 230). If there happen to be difficulties in the market for bringing certain kinds information to the attention of entrepreneurs, what basis is there for presuming that government officials would have superior access to information or superior alertness regarding how any given piece of information might be used?

            If anything, government direction suffers from a greatly diminished incentive structure for recognizing and remedying resource misallocations – since the profit motive and often the price system itself have been at best tainted, at worst eliminated. “Under government direction, it is not at all clear what substitutes for the profit incentive are available, in the absence of omniscience – not merely to spur the exploitation of socially desirable opportunities, but to direct attention to their very existence” (Kirzner 1973, p. 230). Kirzner’s analysis suggests that the free market offers a far superior mechanism for cultivating entrepreneurial activity and for bringing about a more efficient allocation of resources compared to allocation by government – with or without transaction costs.

Works Cited

Kirzner, Israel M. 1973. Competition and Entrepreneurship. University of Chicago Press.

G. Stolyarov II is a science fiction novelist, independent philosophical essayist, poet, amateur mathematician, composer, contributor to Enter Stage Right, Le Quebecois Libre,  Rebirth of Reason, and the Ludwig von Mises Institute, Senior Writer for The Liberal Institute, weekly columnist for GrasstopsUSA.com, and Editor-in-Chief of The Rational Argumentator, a magazine championing the principles of reason, rights, and progress. Mr. Stolyarov also publishes his articles on Helium.com and Associated Content to assist the spread of rational ideas. His newest science fiction novel is Eden against the Colossus. His latest non-fiction treatise is A Rational Cosmology. His most recent play is Implied Consent. Mr. Stolyarov can be contacted at gennadystolyarovii@yahoo.com.

 

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This TRA feature has been edited in accordance with TRA’s Statement of Policy.

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Learn about Mr. Stolyarov's novel, Eden against the Colossus, here..

Read Mr. Stolyarov's new comprehensive treatise, A Rational Cosmology, explicating such terms as the universe, matter, space, time, sound, light, life, consciousness, and volition, here.

Read Mr. Stolyarov's new four-act play, Implied Consent, a futuristic intellectual drama on the sanctity of human life, here.