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Kirznerian Economics: Some Policy Implications and Issues

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 Journal des Economistes et des
Etudes Humaines
Volume 12, Number 1 2002 Article 11
NUMÉRO 1

Kirznerian Economics: Some Policy

Implications and Issues

Frédéric Sautet, New Zealand Treasury

Recommended Citation:
Sautet, Frédéric (2002) "Kirznerian Economics: Some Policy Implications and Issues," Journal
des Economistes et des Etudes Humaines: Vol. 12 : No. 1, Article 11.
Available at: http://www.bepress.com/jeeh/vol12/iss1/art11
DOI: 10.2202/1145-6396.1053
©2002 by Berkeley Electronic Press and IES-Europe. All rights reserved. No part of this
publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by
any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior
written permission of the publisher, bepress, which has been given certain exclusive rights by the
author. Journal des Economistes et des Etudes Humaines is produced by Berkeley Electronic
Press (bepress).
 Kirznerian Economics: Some Policy
Implications and Issues
Frédéric Sautet

Abstract
The aim of this paper is twofold: (a) to review briefly the main policy implications of
Kirzner’s work (and to show that Kirzner has always been careful to draw policy implications
from his analysis) and (b) to contrast these with the approach that is generally used in public
policy. The following issues are discussed in the paper: taxation and entrepreneurial incentives;
the effects of regulation on the entrepreneurial process and economic growth; monopoly and
monopoly pricing; anti-trust laws and their impact on the market process; the coordination
criterion of efficiency; and the notion of economic justice. I argue that the standard criteria of
efficiency are often not useful to policy-making and should be replaced by Kirzner’s “coordination
criterion”, which states that the institutions of the market economy must be geared toward
allowing the capture of profit (i.e. fostering entrepreneurial incentives) in order to promote the
speed and responsiveness of the market process. One of the main lessons of Kirzner’s work for
policy making is that the market process is always competitive and takes place over time.

Cet article a deux objectifs : a) passer brièvement en revue les principales implications
politiques des contributions de Kirzner (et monter que Kirzner a toujours pris le soin de tirer les
implications politiques de ses analyses) et b) distinguer ces implications kirzneriennes de
l’approche généralement retenue dans l’élaboration des politiques publiques. Dans ce qui suit,
nous discutons des questions suivantes : les impôts et les incitations entrepreneuriales ; les effets
de la réglementation sur le processus entrepreneurial et la croissance économique ; les monopoles
et leurs modes de fixation des prix ; les lois anti-monopole et leurs conséquences sur le processus
marchand ; l’efficience en tant que critère de coordination ; et la notion de justice économique. Le
papier soutient que le critère standard d’efficience est rarement utile au niveau politique et devrait
être remplacé par le “critère de coordination” de Kirzner qui énonce que les institutions de marché
doivent avoir comme point de repère la réalisation de profits (c’est-à-dire l’encouragement des
incitations entrepreneuriales) de manière à promouvoir la vitesse de capacité d’ajustement du
processus marchand. Une des principales leçons des contributions kirzneriennes pour les décisions
politiques est que le processus marchand est toujours concurrentiel et s’inscrit dans le temps.

KEYWORDS: Market process, Entrepreneurial process

Author Notes: I would like to thank Felicity Barker and Douglas Watt from the New Zealand
Treasury for their comments on this paper. The usual caveat applies.
 Sautet: Kirznerian Economics

KIRZNERIAN ECONOMICS: SOME

POLICY IMPLICATIONS AND ISSUES

Frédéric Sautet°

1. Introduction

Israel Kirzner’s work is extremely rich in analysis. Kirzner has spent the last
three decades exploring most facets of the market process concept by pursuing an
essentialist understanding of market phenomena that has characterised the Austrian
approach since Carl Menger. One aspect of this analytical quest that has perhaps
not received the attention it deserves is the policy implications that Kirzner often
draws from his analysis.
After having spent almost three years in the world of policy making in New
Zealand, I have come to realise how relevant and important the work of Kirzner is
to policy debates. This is because equilibrium analysis is pervasive in the policy
world and shapes most policy initiatives: anti-trust laws, electricity market
regulations, tax policy, etc.

Kirzner’s policy implications are scattered throughout his work and apply
to many areas ranging from taxation to monopoly pricing. Kirzner’s concern with
policy implications is probably a distinguishing mark of market process theorists,
as his early textbook, Market Theory and the Price System, shows. Therein, he
discussed various policy implications from his analysis in ways that differed quite
radically from the discussions taking place in those days.

The aim of this paper is twofold: (a) to review briefly the main policy
implications of Kirzner’s work (and to show that Kirzner has always been careful to
draw policy implications from his analysis) and (b) to contrast these with the
approach that is generally used in public policy. This way, I hope to show the
relevance of Kirzner’s work and its importance to future policy debates.

° Senior Analyst at the New Zealand Treasury. I would like to thank Felicity Barker and Douglas Watt
from the New Zealand Treasury for their comments on this paper. The usual caveat applies.

Volume 12, numéro 1, Mars 2002, pp 131-151.

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 Journal des Economistes et des Etudes Humaines, Vol. 12 [2002], No. 1, Art. 11

In this paper, I would like to restrict my discussion of Kirzner’s work to the

following policy subjects: taxation, incentives, regulation, growth, monopoly
pricing, anti-trust laws, welfare criteria and economic justice. I also try to illustrate
the discussion with a real policy case on the regulation of the electricity market in
New Zealand. Many other policy issues can be found in Kirzner’s analysis, such as
central planning and indicative planning.1 Other areas of his work, such as Kirzner’s
view on the limits of the market, may lend themselves to interesting policy
implications. However the lack of space in this paper constrains my desire to
discuss more aspects of his work.

2. Tax policy and the two types of incentive

In Taxes and Discovery: An Entrepreneurial Perspective, Kirzner presents a

positive agenda for a reconstruction of taxation theory, especially with regard to the
effects of taxes on the market process. The main insight of the paper rests on the
distinction between “already perceived alternatives” and “unnoticed opportunities”.
Mainstream analysis considers the effects of taxes on what has already been
perceived by individuals, while a process view of the issue primarily considers the
effects of taxes in a world of radical uncertainty. In other words, Kirzner is
concerned with the idea that “taxation may affect what it is that decision makers
discover to be the situation in which they act”.2

This distinction led Kirzner to develop another theory of incentive. In the

usual approach (where alternatives are already recognised), the notion of incentive
refers to the “provision of an encouragement for a decision maker to select a
particular one out of an array of already perceived alternatives”.3 Incentives of the
first kind refer to the returns to an activity that has already been recognised. Thus
taxation, in so far as it affects the returns to known courses of action, will only
affect the opportunity cost of an activity. This is what the mainstream theory of
taxation is concerned with: the impact of taxation on labour supply, the level of
savings and investment, factor productivity, etc. This branch of economics is very
well developed and has established some important results, such as the notion of
dead weight cost, even if, in my opinion, the important issue of incidence has been
largely under-explored.

Another type of incentive “operates to encourage the adoption of A by

making A more likely to be noticed by the decision maker”.4 This type of incentive

1 See also Cordato-1992 for a study of welfare economics and externality issues.
2 Kirzner-1985, p. 94.
3 Kirzner-1985: pp. 94-5.
4 Kirzner-1985, p. 96.

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 Sautet: Kirznerian Economics

takes place in an open universe where undiscovered courses of action exist. Thus,
it does not refer to the opportunity cost of selecting a certain course of action, but
to the idea that potential courses of action will attract attention in different ways
under different incentive structures. This type of incentive refers to the inducement
to discover a certain course of action, not to the inducement to undertake a course
of action that has already been perceived.

Pure entrepreneurial profit is what is left once all the costs (including
interest) to a course of action have been taken into account; it is not necessary to
the existence of the good sold. Thus the taxation of pure entrepreneurial profit will
not affect the incentive to provide the good; it will only affect the incentive related
to pure profit, that is, the discovery of hitherto unknown courses of action. Pure
profit provides an incentive only in the second sense of the term discussed above:
it affects the noticeability of undiscovered courses of action.

A Kirznerian approach to a theory of taxation primarily considers the

effects of taxation on pure profit. The insight that Kirzner provides consists of
understanding that if one were able to tax away pure profits only (leaving all other
returns untouched), one would destroy the incentive of the second kind, that is,
the incentive to discovery new valuable courses of action. As Kirzner puts it: “The
complete taxing away of pure entrepreneurial profit can, it is clear, succeed only in
removing from potential entrepreneurs all incentive for paying attention to
anything but the already known”.5

This is to be contrasted with the mainstream approach where taxing all

profit away is seen as a good idea.6 In fact, discussions generally revolve around the
issue of the taxation of rents.7 It is usually asserted that taxing rents is efficiency
enhancing and thus the more completely rents are taxed away, the more efficient
the economy may be.8

Kirzner provides two main avenues for future research on taxation in an

open-ended world: (a) the issue arising out of the disincentive impact of taxation
on pure profit (e.g. impact on economic performance and growth) and (b)
problems related to understanding the impact of different types of taxes on pure
profit (e.g. is capital gains taxation more damaging to pure profits than corporate
taxation?). One may view Kirzner’s main policy insight as: beware of the effect of
taxation on the pure profit component of income.

5 Kirzner-1985, p. 111.
6 This is, for instance, in the case of monopolistic competition. Also, most models of optimal taxation
are set in the perfect competition framework and assume zero profit in the economy, as there is no
profit in equilibrium.
7 In the tax literature, rents generally refer to above normal producer surpluses: they are a type of
monopoly income.
8 See below the issue of dynamic efficiency.

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 Journal des Economistes et des Etudes Humaines, Vol. 12 [2002], No. 1, Art. 11

More work needs to be done to find out whether a general theory of

taxation in an open-ended world would provide valuable insights into the actual
design of tax systems, as it may be the case that this theory would only re-
emphasize what mainstream tax theory already shows.9 This being said, Kirzner’s
insights shed a valuable light on long-standing debates such as the impact of
taxation on long-term economic performance.

It is fundamental to realise that this second type of incentive is extremely

important and is at the basis of an Austrian theory of policy. The value that
Austrian economics can add to the policy debate precisely resides in the
recognition of the open-ended framework. Whether one deals with taxation,
industry regulation or anti-trust issues, the Kirznerian notion of entrepreneurial
incentive is primordial.

3. Regulation and the stifling of the entrepreneurial

process

In The Perils of Regulation: A Market-Process Approach, Kirzner explains

that many economists support intervention because of the impossibility to achieve
the conditions described by perfect competition theory, even if this consensus has
started to deteriorate since the 1970s, as the notion of government failure has
become more accepted and the conclusions of public choice theory more
widespread.

Kirzner explains that his approach differs substantially from that of

mainstream economists who defend free markets in the sense that Kirzner does not
emphasize (a) the efficient properties of general equilibrium, (b) the undesirable
distortions introduced by government interventions (dead weight cost and so on),
and (c) the slippery slope (more regulation is needed to correct the effects of
earlier regulation). Kirzner is not concerned with public choice explanations of
regulation either, as he assumes in the paper that regulation is designed to address
genuine concerns with respect to market outcomes. Instead, Kirzner argues that
while the conventional critiques of government intervention are undeniably useful,
they overlook one of the main problems of intervention: its interference with the
entrepreneurial process.

Kirzner considers four distinct levels where government regulation may

impact the market process: (a) regulators’ ignorance of the course the market
would have taken in the absence of regulation, (b) in the absence of profit (for
policy makers), the impossibility of government officials to discover opportunities

9 E.g. see Cordato-1994.

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for coordination improvement, (c) the potentially stifling impact of regulation on

the discovery process and (d) the likelihood that government regulation may
propel the market in a different direction, not necessarily desired by consumers. As
I view these four issues as extremely important to policy making, I now briefly turn
to Kirzner’s analysis of these four points.

Those who support regulation need to show that the undesirable state of
the market is in one way or other a permanent state (e.g. the economy is in a sub-
optimal equilibrium) and the removal of these conditions cannot be expected
from market participants in the future. This generally implies denying that the
entrepreneurial process is at work replacing unsatisfying states of affairs by more
satisfying ones. Thus the desire for regulation may be driven by (a) a failure to
realise that the market may have already discovered every possible opportunity for
profit or (b) a failure to realise that unsatisfactory conditions may come to be
corrected in the course (i.e. over time) of the market process. Market process
theory argues that a tendency exists in the market process to discover opportunities
for improving market situations; regulation advocates generally deny this.

Kirzner then asks how can governments possess the knowledge to

“correct” market outcomes in the absence of the incentives to discover what would
improve current market patterns. The important point, stresses Kirzner, is that
government institutions do not generally operate with the profit motive and when
they do, they do not face the same constraints as private firms: there is no
entrepreneurial process at work where regulation would be tested by the market in
the same way as new products face market competition. “No systematic process
seems at work through which regulators might come to discover what they have
not known,” explain Kirzner, “especially since they have not known that they enjoy
less than complete awareness of a particular situation”.10 This is because not only
regulators face poor incentives of the first type (as the literature on public choice
has shown) but even more so because they operate in an environment without any
incentive of the second type.

The third point that Kirzner makes is that the most serious consequence of
government intervention might be the interference with the coordinative
properties of the market system, which may stifle the entrepreneurial discovery
process. It is well known that government regulation generally imposes costs (and
especially deadweight costs) upon the economy. Kirzner focuses on the open-
ended aspect of the issue and argues that another problem with regulation (e.g.
price and standards regulation, anti-trust laws, etc.) is that it may bar the discovery
of yet unknown opportunities for profit.

10 Kirzner-1985, p. 140.

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The last point that Kirzner emphasizes is the idea that regulation creates
opportunities for entrepreneurial discovery that would not have existed in its
absence, as those that would have existed are negatively affected by regulation.
This is, in Kirzner’s words “the wholly superfluous discovery process”, that is, the
process that is set in motion by the sheer existence of regulation, which leads to
market outcomes that are often different from those intended by regulators and
that does not allow a full expression of consumers’ sovereignty.

These problems with government regulation lead to three institutional and

policy implications:

1. As Hayek11 emphasized, in the legislative process one should

favour stable general and abstract rules that allow time to solve what may
appear to some as inherent deficiencies in the market system. The selection
of rules may be constrained by constitutional design so as to overcome
voters’ ignorance and the desire of pressure groups to legislate in their
favour;12
2. While introducing the profit incentive in legislation design seems
extremely difficult, removing government activities from areas where profit
motivated individuals can operate is often feasible. This reduces the areas
in which governments are involved and thus limits the circumstances
under which regulators act on the belief of knowledge that they generally
do not possess;
3. Governments often interfere with the coordinative properties of
the market process in the name of efficiency (e.g. natural monopolies)
and/or equity (e.g. universal service obligations in telecommunication).
These interventions may stifle the entrepreneurial discovery process: they
act as legal barriers to entry. Regulators should always be careful to
maintain free entry (in the legal sense) so that the potential for future
discovery is never reduced. Free entry generally also means avoiding
discriminatory regulation (i.e. maintaining the level playing field) and the
use of general rules.

4. Regulation and economic growth

The possibility to capture profits in a stable legal environment also

contributes to economic growth. Kirzner13 argues that policies that stimulate the
potential for discovery contribute to the growth of knowledge and thus to higher
economic performance (i.e. higher factor productivity). What is important, explains

11 Hayek-1973, Hayek-1976.
12 See Buchanan-1993.
13 Kirzner-1984 [1985].

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Kirzner, is never to take the entrepreneurial role for granted. Interestingly enough,
governments have become more and more interested in entrepreneurship and
innovation in the recent years. However, governments want more entrepreneurial
activity, but they do not want the regulatory framework (e.g. stable legal
framework and low taxes) that would bring this process in motion. As Kirzner puts
it: “To take the entrepreneur for granted is to overlook the dangers of regulatory or
fiscal or antitrust policies that block or discourage entrepreneurial entry into
perceived avenues for profitable activity. The entrepreneurial spirit, the potential
for discovery, is always waiting to be released. Human ingenuity is irrepressible
and perennial, and its release requires an environment free from special privileges
or blockages of new entrants. For the successful allocative functioning of the
market, and for the stimulation of dynamic growth, the entrepreneur must not be
taken for granted.”.14

Kirzner’s view of regulation expands on Mises’ approach. Mises 15

distinguishes between, on the one hand, the government running (some)
businesses and providing services and, on the other, the regulation of the
economy, “which forces entrepreneurs and capitalists to employ some of their
factors of production in a way different from what they would have resorted to if
they were only obeying the dictates of the market”.16 What matters most for Mises
is the interference of government’s regulations with the coordinative properties of
the market. Kirzner’s work provides a detailed account of the ways regulation may
stifle the entrepreneurial process.

While many non-Austrian economists would agree with the policy

prescriptions above, they would probably disagree with the idea of extending the
free entry rule to every market situation. Cases of small numbers of players where
entry seems to be restrained not by legal barriers, but by economic ones, generally
require regulation in order to maintain efficiency. I now turn to the monopoly case
to expand Kirzner position.

5. Monopoly and monopoly pricing

Kirzner analyses the issue of monopoly in, among other places, Competition
and Entrepreneurship 17 and The Driving Force of the Market 18. In order to
understand Kirzner’s position, two points must be kept in mind. (a) The market

14 Kirzner-1984 [1985], p. 92.

15 Mises-1980.
16 Mises, quoted in Ikeda-1997, p. 242. See Ikeda-1997, pp. 241-5 for a presentation of Mises’ view.
17 Kirzner-1973, pp. 104-12.
18 Kirzner-1997.

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 Journal des Economistes et des Etudes Humaines, Vol. 12 [2002], No. 1, Art. 11

process is always competitive, even when its outcome (at one point in time) results
in a small number of suppliers or one supplier only in a market. In the market, the
interests of suppliers and demanders converge as entrepreneurs are forced to serve
consumers to the best of their abilities. (b) Kirzner sees the entrepreneurial
function as independent from ownership of resources. While entrepreneurs use
resources in their (arbitrage) activities to capture profit opportunities, the function of
entrepreneurship itself does not involve the ownership of resources. Entrepreneurship
is not a resource, “it consists of an alertness in which the decision is embedded
rather than being one of the ingredients deployed in the course of decision
making”.19 In other words, entrepreneurship for Kirzner is a function, not a class
of productive factor.

The difference emphasized in (b) is crucial to the issue of monopoly.

Kirzner, following Mises20, sees the concept of monopoly as restricted to the level
of resource ownership, not to the number of players in an industry. A monopolist
is defined as a supplier that possesses total control over the entire supply of a
resource and that can choose to deliberately restrict supply in ways that would
harm consumers (i.e. the interests of suppliers and consumers would diverge, as
the monopolist would be better off restricting supply21). Absolute control of the
resource is crucial, for without total control the supplier would be exposed to
competition from other suppliers.

It follows from this analysis that entrepreneurial profit is of a different

nature from monopoly rent. Entrepreneurial profit is the result of a pure arbitrage.
This arbitrage was available because of the state of discoordination of individuals’
plans in the market due to widespread sheer ignorance and radical uncertainty.
Monopoly rent on the other hand is the result of the capacity of a supplier to
restrict the supply of a resource: it is the result of monopoly pricing and the return
that one obtains from the complete control over a productive factor. It can be
inferred from Mises’22 analysis that the test to differentiate between the two types
of income is to use the equilibrium situation as a foil. In equilibrium, monopoly
prices and rents exist, whereas entrepreneurial profits are absent.23

19 Kirzner-1979b, p. 181.
20 Mises-1963, p. 358, Mises-1998.
21 As Mises (Mises-1963, p. 360; Mises-1998) explains, every producer limits its supply to some extent.
This is because beyond a certain level, increasing production would withdraw factors from the production
of other goods, which would have satisfied more urgent consumers’ needs. As Mises puts it: “Under
competitive conditions, the specific factors of production are in the long run used to the extent permitted
by the opportunities of alternative uses for the non-specific complementary factors” (Mises-1998, p. 5).
Thus in the market system no producer can produce and sell an infinite amount of product (as is
assumed in perfect competition). The monopolist is not in this situation: increasing production would
more fully satisfy consumers’ needs, but the monopolist deliberately chooses to restrict production to
his/her advantage.
22 Mises-1998, p. 14.
23 The distinction between entrepreneurial profit and monopoly rent is completely overlooked in the
textbook case on monopolistic competition. This is why, while seeming perhaps more realistic,
monopolistic competition does not explain the market process (see Mises-1998, pp. 15-6).

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In so far as there are no legal barriers to entry, entrepreneurial profits can

be contested by anyone who is alert enough to find better ways and cheaper ways
to satisfy consumers’ needs (i.e. the fear of competition disciplines entrepreneurs).
The process during which other entrepreneurs may eat away the profits that the
first entrepreneur has discovered may be of various length of time (depending on
how alert other entrepreneurs are, the state of the underlying variables, etc.) and
this has important policy implications, as I argue below.

The case of total control of the supply of a resource is different. As long as

consumers (or other producers) need the resource and no substitute is available, its
sole owner will have the incentive to use her control to restrict supply and thus
monopoly price.24 While the rents derived in this situation certainly attract other
entrepreneurs, they cannot compete the rent away because the resource is entirely
controlled by one single individual.25

It follows that the number of players in the market is not an important

issue: a monopoly situation (i.e. one supplier), in itself, should not be a source of
concern. This is because in the absence of total control over a resource, a supplier
cannot restrict entry and will always have to compete with (a) currently available
substitutes (as seen by consumers) and (b) future substitutes (the availability of
which will depend on the speed and responsiveness of the market process, which
itself depends on the institutional structure and entrepreneurial incentives).

This relates to the issue of “industry” or “sector”. As Kirzner26 explains, the

industry concept must be postulated in the neoclassical theory of monopoly in
order to insulate the monopolist from the reactions of other market participants (in
other “industries”) to remove the possibility of entry.27 However, in the process
view, the protection does not come from the nature of the industry, it comes from
the existence of control over a needed resource. As no one is insulated from
competition, even a monopolist would be subject to it over time as competitors
discover ways to satisfy consumers without using the monopolised resource. The
competitive process is always at work.28 However, in the absence of government
protection (i.e. legal barriers to entry) or full control over a valued factor, every

24 This may involve destroying part of the supply of the product. This being said, there is no reason to
think that information on the state of demand would be readily available to a monopolist: no
monopolist knows in advance the shape of his demand curve, i.e. discovery must take place.
25 Mises (Mises-1998, p. 15) finds six cases where competition may be prevented from counteracting
the monopolist’s activity. However, it seems to me that the only relevant cases are those where there is
exclusive ownership of an essential resource (i.e. I do not think that Mises’ case (Mises-1998, p. 4) of
transportation costs and bulk goods leads to monopoly pricing).
26 Kirzner-1973, pp. 123-4.
27 The same can be said of the notion of “homogenous commodity” (see Rothbard-1963, p. 591). See
also the work of Jane Jacobs on innovation in urbanization economies that always cut across conventional
classification systems (see Desrochers-2001).
28 Kirzner-1997, p. 228.

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 Journal des Economistes et des Etudes Humaines, Vol. 12 [2002], No. 1, Art. 11

entrepreneur is always under the threat of competition. In the market all products
compete with each other in the general connexity of all human activities.

6. Monopoly pricing in practice

What are the policy implications of the above analysis on monopoly?

Kirzner emphasizes that Mises did not consider the possibility of true monopoly
pricing as of much practical importance because absolute control of a resource is
extremely rare. This is analytically consistent with market process theory. 29
However, from a policy perspective one question is important: how does one
know when monopoly pricing occurs in practice?

As far as my knowledge goes, I do not know of any paper or book where

Kirzner provides an answer to this question, and I do not think that Mises provides
one either.30 This is a real difficulty, for if one follows the Mises/Kirzner view on
the subject, there may be cases where political intervention in the marketplace
would improve the situation (i.e. the interests of consumers and producers could
be realigned). This difficulty perhaps gives weight to Rothbard’s view31 that in
practice it is not possible to differentiate, in the unhampered market, between a
monopoly price and a competitive price.

Brand names, copyrights and patents present interesting cases. Brand

names, if legally protected, are property rights and once developed they may
confer the potential for a supplier to obtain high (accounting) profits. Are these
profits entrepreneurial profits or monopoly rents? In so far as any other entrepreneur
is free to develop another brand name, there is no reason to think that monopoly
rents are involved. However, it is true that since no other entrepreneur can use a
protected name, a brand name may provide the potential to derive (temporary)
monopoly rents (the same is true for patents). Mises recognised this, but explains
that it is beyond the realm of economics to determine whether patents (and the
like) should be part of the legal framework.32

29 In the words of Mises: “The outstanding fact which we must keep in mind is: there is no tendency [in
the free market] toward a general substitution of monopoly prices and monopolistic restraint of trade for
competitive prices” (Mises-1998, p. 28).
30 Mises (Mises-1963, p. 366) mentions the case of some commodities, such as diamonds and mercury,
the supply of which is limited to a few sources and where monopoly pricing could take place. He also
provides, in Monopoly Prices, an analysis of cases of monopoly pricing. However, it is not clear to me
that this analysis provides any direct policy guidance.
31 Rothbard-1993, pp. 604-15.
32 Mises-1963, p. 662. For Mises and Kirzner, the institutional framework under which markets operate
is exogenous. However, Mises (Mises-1998, pp. 23-4) seems to be saying that the patent system,
copyrights and trademarks, while possibly leading to monopoly situations, have been beneficial to
economic development.

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 Sautet: Kirznerian Economics

This also refers to the issue of the entrepreneur who becomes a monopolist.33
In the unhampered market, cases where entrepreneurs acquire the entire control
of a valuable resource may exist.34 “From the short-run viewpoint the producer’s
profits arise from his monopoly of the resource;” argues Kirzner, “from the long-
run point of view, these profits arise not from resource ownership but from the
decision to acquire the resource.” From a policy perspective, the important point is
that “[n]either description is less ‘true’ than the other; from its own perspective each
description is the only correct and relevant one”.35

This statement is somewhat frustrating, as it does not provide much policy

guidance. In an unhampered market, the only situations of monopoly pricing
policy makers would have to confront would be entrepreneurial in origin. Thus
regulators would have to decide whether they favour the discovery aspect (as in
the case of patents for instance) or they limit subsequent monopoly pricing. An
answer to this question would also shed some light on more common cases, such
as radio spectrum auctions where the issue of caps on what companies can bid for
is always problematic.

While the Austrian view on monopoly provides a clear theoretical criterion

to differentiate entrepreneurial profit from monopoly rent (i.e. the total control
over the entire supply of a valuable resource), it does not provide an applicable
policy criterion that would permit the recognition of cases of monopoly pricing.
The ownership test (i.e. whether one controls the entire supply of a resource) in
itself is not enough. This is because total control over a resource does not
necessarily imply monopoly pricing for the reason that all products compete
against all products in the marketplace. Also, as seen above, it is analytically
possible to use equilibrium as a foil to help determine the existence of monopoly
pricing situations. Kirzner does not seem to pursue this avenue in his work and it is
not clear to me how this approach could be used in policy, as perhaps a great deal
of judgement on the part of policy makers would be involved. The default position
might well be that of Rothbard’s who argues that economists should not lose their
time with this issue since such criterion does not exist.

7. Natural monopolies and the electricity market

Beyond the absence of valuable policy criterion (which would apply only
to a handful of cases anyway), the chief problem that one meets in the application

33 Kirzner-1973, pp. 131-4; pp. 200-1.

34 This explains why, despite free entry, a monopolist can maintain its position over time. This also
relates to “winner-take-all” situations, which are extremely rare and limited to monopolistic cases of
complete control over a resource (and are not a general feature of competition).
35 Kirzner-1973, pp. 201-2.

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of Austrian analysis to certain policy issues is incomprehension (on the part of

regulators). This is especially true with regard to industries, which are considered, at
least to some extent, as “natural monopolies” (e.g. electricity and telecommunication)
and that have been recently “deregulated”. Let me provide an example with which
I have some familiarity, that of the electricity market in New Zealand.

In the case of electricity, deregulation has often led to “organized markets”.

In New Zealand the state owned company that used to produce and distribute
electricity has been dismantled and replaced by (a) a series of firms that produce
electricity (the generation side), (b) a company that owns the grid (which carries
electricity over long distances), (c) a series of companies that distribute electricity
from the grid to the final customers and (d) a series of retailers that sell electricity
and serve as an interface between the distributors and the final customers.36

The regulation of this market is extremely complex because the New

Zealand government wants to make sure that none of the actors obtain “market
power”. Thus the generators compete against each other (even though 75% of
them are state owned) within the limits dictated by the government. For instance:
most mergers are forbidden (although not between generators and retailers) and
prices are generally free but regulators regularly check if the “price equals marginal
cost” benchmark is achieved in line businesses.37 The regulation is very complex:
there will soon be a Governance Board in charge of determining new rules for the
industry and monitoring compliance with existing rules. In addition to the Commerce
Commission, which is a government body that, among others things, controls the
electricity market, there will also be a Market Surveillance Committee that will
oversee the Governance Board. The job of the Commerce Commission is delicate
for it relies on information that it sees as extremely difficult to obtain,38 while
trying to provide the right incentives for the line businesses to invest in new
technology in order to reduce prices in the future.39

The organisation of the New Zealand electricity market is entirely based on

the notion of perfect competition. In fact, one may argue that the regulation itself

36 Ordinarily, economists see the distribution of electricity as a “natural monopoly”, but not its
generation.
37 Many countries have adopted rules that fix a ceiling on electricity prices (based on the CPI). New
Zealand has not chosen to follow this road. However, the Commerce Commission has the power to
impose price ceilings on line businesses (considered as natural monopolies) for a limited period. The
power crisis in California in 2001 was probably largely due to bad regulation, such as price fixing at the
retail level while wholesale electricity prices were free to fluctuate. Also, because of bad incentives, new
investments in generation capacity had not been undertaken for the last decade (see Joskow-2001).
38 This is according to Geoff Thorn, a Director at the Commerce Commission, in a presentation he gave
in November 2001.
39 High rates of returns on assets are generally seen as a sign of “market power”. Many countries have
adopted rules limiting the rate of returns on assets companies (especially line companies) can derive.
New Zealand does not have regulation regarding the rate of return on assets.

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creates a monopoly situation. As said above, in New Zealand, a single company

(Transpower) currently owns the grid that carries electricity over long distances.
This situation is the result of the disestablishment of a former state owned
monopoly. The property rights over the grid were given to Transpower (which is
state owned) when the deregulation occurred. Anyone is currently free to set up
cables to carry electricity over long distances, just like anyone is free to enter the
distribution market. However in the last seven years since Transpower was
established, no other company has decided to invest to compete against it. Is this
lack of entry a proof that electricity grids are monopolies (or natural monopolies as
many economists think) or just the result of the fact that, under the current
regulatory regime, it makes no economic sense for any company to compete with
Transpower? I would tend to think that the latter is true, as the current regulatory
framework maintains a cap on Transpower’s profits (through the threat of price
controls). By restricting profits, the regulators restrict entry.40 The problem is that
regulators do not see the situation in this light, as they think that (allocative and
productive) efficiency, that is, “consumer protection”, should be the primary goal
of regulation.

The Kirznerian approach provides invaluable insights into the regulation

problem surrounding natural monopolies (especially with respect to the effects of
legal barriers to entry). However, the actual application of Kirznerian analysis to a
case such as the New Zealand electricity market is difficult because the notion of
natural monopoly still dominates the expectations of government regulators and
industry participants.41 The same expectations dominate the debate in the EC and
the USA.

8. Anti-trust laws

Kirzner’s approach provides valuable insights regarding the role of anti-

trust laws. In How Markets Work42, Kirzner argues that the above approach to
the monopoly problem casts doubts on the idea of anti-trust laws maintaining
competition. Collusion and mergers should not be seen as a threat to competition
for the following reasons: (a) collusion among ‘dominant’ (at a moment in time)
firms in order to keep prices up cannot prevent entry; and (b) collusion is among
the possible outcomes of free competition and is always the result of the discovery
process. As Kirzner puts it: “If the size of such a large firm [resulting from collusion]

40 This is a very important issue, as investments in electricity generation are capital intensive and run
over many decades. Had market arrangements evolved freely over time, one would certainly have
observed another situation, such as those described in Walter Primeaux (ed.) (Primeaux-1986).
41 This is in addition to political economy issues.
42 Kirzner-1997b, pp. 58-63.

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permits economies of large-scale production which potential entrants may not be

able to match, that does not constitute an entry barrier. Quite the contrary; it is
desirable that such economies should be reaped through alert entrepreneurial
action. Merger activity motivated by the prospect of lowering costs is precisely the
kind of competitive entrepreneurship of which the market discovery process
consists”.43 By impeding entrepreneurial activity from capturing possible profit
opportunities, anti-trust laws do not promote competition; they reduce it. “To
encourage the spontaneous dynamism of the competitive process what is required
is not large numbers of small producers producing exactly the same product
in exactly the same way;” writes Kirzner, “the requirements are freedom of
entrepreneurial entry and the elimination of privileges to incumbent producers that
might switch off alertness of potential competitors to superior innovative
possibilities”.44

This is to be contrasted with the work done in industrial organisation on

the detection of collusion and predation. Current thinking uses game theoretic
models to detect collusive behaviour.45 The problem is that these models are set in
a closed universe.46 Perfect competition has shaped (or reinforced) regulation, as
issues of monopoly pricing and collusion, while theoretically distinct, have been
lumped together in legislation.

I would like to conclude these sections on natural monopoly and anti-trust

laws by emphasizing two aspects of the issues:

1. When the regulation of competition is based on an equilibrium

approach, the entrepreneurial process may be stifled or greatly reduced.
Because changes in an industry structure (driven by entrepreneurial
discovery) are not instantaneous and may take time, regulators do not
usually possess the patience to let the market process unfold. In addition,
the demand for regulation on the part of incumbent firms and the public is
often extremely difficult to resist. Regulators and the public alike do not
realise that the process of competition is always at work, especially when it
is the least visible. The failure to realise that unsatisfactory conditions are
the source of entrepreneurship drives the growth of regulation and control.
This shows the importance of designing an institutional framework that
promotes the speed and responsiveness of the entrepreneurial process;47

43 Kirzner-1997b, p. 62.
44 Kirzner-1997b, p. 63.
45 E.g. see Phlips-1996.
46 Selten’s view that with 4 (or less) competitors, the probability of collusion is 1 has recently been
reformulated using game theory (Phlips-1996).
47 One could try to justify regulation on the basis of the “slowness of the market process”. However,
this would not overcome the problems identified above. Thus a relatively slow process of discovery is
probably always preferable to a regulatory framework that stifles it.

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2. The will to organise an industry, such as the electricity market,

according to the benchmark of perfect competition is doomed to failure.
While it is true that electricity prices in New Zealand have gone down in
real terms and that companies use fewer inputs (especially labour) to
produce the same output, it seems difficult to attribute these results to the
regulation of line businesses. As we saw above, regulators cannot obtain
the information that would allow them to regulate according to the criteria
of perfect competition. They also know that profit is necessary to obtain
(so-called) dynamic efficiency gains. Therefore, it is probable that the
results were obtained in spite of the regulatory framework and because the
entrepreneurial process was left almost free to operate in the generation
and retail side of the market.48

9. Efficiency criteria and the correction of errors

I argued above that perfect competition is generally used as a benchmark

in the world of public policy. The electricity market (especially line businesses)
that I described above is regulated with direct reference to perfect competition and
so are many other markets that governments regulate. This means that regulators
pay most attention to the efficiency criteria that maintain the markets in all its
(perfect) integrity, which entails pursuing the goals of allocative efficiency and
productive efficiency (as well as dynamic efficiency).

Allocative efficiency and productive efficiency are straight applications of

the perfect competition framework. They mostly involve making sure that prices
are equal to marginal costs. They also imply removing most price distortions that
would impede a correct allocation of resources so that the relevant ratios of prices
are equal to the relevant marginal rates of transformation and substitution. In this
way the economy can reach its productive optimum at the frontier of its production
opportunity set.

The notion of dynamic efficiency is more and more often used in the
policy world. This notion tries to deal with the idea that over time economies
experience growth in their production opportunity set (the notions of productive
and allocative efficiency do not encompass this phenomenon). Dynamic efficiency
implies the growth of knowledge and genuine change in the economic system;
and this cannot be dealt with by equilibrium economics and perfect competition
(although savings and investments are empirically seen as related to dynamic
efficiency).

48 Arguably, while constraining lines businesses and restricting the structure of the industry, regulations
in New Zealand leave more room to the market process than regulatory frameworks in most other
countries (e.g. no price and rate of returns controls in generation and retail).

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The problem is that regulators cannot obtain the information that would
help them monitor whether firms are pricing at marginal cost and they don’t know
where the production frontier is located. Moreover, as regulators often want to
ensure that investments take place (in order to obtain dynamic efficiency gains),
firms must have the possibility to obtain good returns on their investments. This
means that firms must be allowed to reap at least some (accounting) profits from
their activities. As this latter goal is directly in opposition to the former ones
(because high returns on assets implies in the neoclassical framework that firms are
exploiting a monopoly situation), regulators are in a position where they constantly
juggle with the various aims of their regulatory framework. Because these aims are
contradictory and cannot be sustained (because of the information problem), the
use of efficiency criteria to mimic a perfect market is an impossible endeavour.

The distinction between the three types of efficiency is an outcome of the

equilibrium-always view. In the process approach there is no need of distinguishing
between these three types of efficiency. In disequilibrium, misallocations of
resources are everywhere; that is, individuals’ plans are not perfectly coordinated
and there is room for entrepreneurial activity. Entrepreneurs may discover ways to
improve coordination of individuals’ plans by reallocating resources and this may
imply production (i.e. arbitrage in time) and also technological innovation.49
Therefore it is precisely because of the misallocation of resources (i.e. the first
efficiency criterion of perfect competition) that the market process is set in motion
and that production (i.e. the second efficiency criterion) and productivity increases
(i.e. the third efficiency criterion) may occur.

If one takes the view, as Kirzner does, that the function of an economic
system is to coordinate the activities of its participants, then “coordination” (or the
state of coordination of individuals’ plans) is probably the best criterion for
“economic goodness”.50 However “coordination” as such is just as difficult to
use in policy as the price equals marginal cost rule. But we know that more
coordination may occur if entrepreneurs can capture discovered profits. This
means that economists, in their quest for efficiency, should turn their attention to
what permits the achievement of higher levels of coordination, or more exactly,
what permits entrepreneurs to rapidly discover situations of discoordination. What
matters to process theorists, in this context, is the speed and responsiveness of the
market system to states of discoordination. Therefore the existence of an
institutional framework that permits profit opportunities to be discovered and
exploited is fundamental to economic goodness; in other words, institutions must
be geared towards the capture of pure profit. The efficiency issue in economics is
an institutional problem.

49 It is important to emphasize that entrepreneurial activity may imply production through time and
technological innovation, but this is not necessary.
50 Kirzner-1998. As Kirzner explains (Kirzner-2000 [1998], p. 143) the notion of “goodness” does not refer
to a measure of (aggregate) well-being, but to a desirable situation (or process) of an economic system.

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In Kirzner’s view, what matters for an economic system is its capacity to

identify and correct past errors (and not that every firm faces a flat demand curve).
“Equilibrium is not an attainable ideal”, argues Kirzner, “nor are perfect or ‘near
perfect’ competition attainable. What is important is to ensure that opportunities
for mutual gain are rapidly noticed and exploited; that market participants are not
misled by over-optimism or by over-pessimism to undertake activities which they
will subsequently regret. Dynamic competition offers the incentive and the
pressure which alert entrepreneurs to the opportunities created by such errors of
over-optimism and over-pessimism”.51 The focus on the traditional efficiency
criteria weakens the coordinative properties of the market system by reducing the
tendency to discover and correct past errors. Therefore, the use of neoclassical
efficiency criteria in public policy is not only impossible, but it is also regrettable.

10. Economic justice

The above also relates to Kirzner’s criterion for economic justice. In

Discovery, Capitalism, and Distributive Justice, Kirzner explains that in order to
answer questions of economic ethics (such as the value of competition to human
societies), a thoughtful understanding of the market system is fundamental. This is
especially true with respect to one question: the justice of the assignment of
income in the capitalist system. The issue of entrepreneurial discovery (which is
the central feature of the market process) has generally been ignored in debates on
economic justice. However, Kirzner explains that a fundamental criterion of
economic justice emerges once one has realised the role of discovery and profits in
the marketplace. This criterion is popularly expressed as the “finder keeper” rule.
Therefore the existence of institutions that allow for the full capture of profits does
not only lead to the highest levels of plan coordination possible, it is also
economically just that those who discover profit own it.

The analysis on efficiency and justice leads to three important implications

for policy making and public debates on economic justice (which often underlie
many policy views, such as the progressive taxation of personal income):

1. The distinction between the three types of neoclassical efficiencies

is useless to policy-making and should be replaced by the “coordination
criterion”, which states that the institutions of the market economy must be
geared toward allowing the capture of profit (this implies free entry, etc.).
In this way, past errors will tend to be as rapidly corrected as possible;
2. Trying to achieve some “efficiency” (however defined) without
allowing for pure profits to be captured is impossible (this amounts to the

51 Kirzner-1997b, p. 59.

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 Journal des Economistes et des Etudes Humaines, Vol. 12 [2002], No. 1, Art. 11

removal of entrepreneurial incentives). Thus eliminating profits (i.e.

entrepreneurial incentives) from the list of criteria of public policy (as it is
mostly the case in the public utilities area) is the surest way to achieve the
opposite of what one wants to achieve;
3. Allowing the capture of profit by the one who has discovered it
does not only lead to the highest levels of coordination possible, it is also
economically just.

11. Conclusion

In this paper, I have tried to show that Kirzner’s work yields extremely
important policy implications, which primarily focus on the institutional
prerequisites for nurturing and fostering the entrepreneurial activity that will
discover and correct market participants’ mistakes and thus improve economic
performance.

The fundamental message that comes out of Kirzner’s work is that “there is
no market process other than the competitive one”. Even in the case where the
market brings about a genuine situation of monopoly pricing (which is probably
extremely rare in practice), this is the result of the entrepreneurial process. This
entails one strong policy implication: market institutions must be geared towards
empowering entrepreneurs to capture pure profits. This means no legal barriers to
entry (i.e. free entry), broad base low rate taxation and a stable and simple legal
environment (based on abstract and general rules) enforcing the laws of property
rights, contract and tort.

This also means that the institutions of the market must be robust enough
to resist the call for regulation when markets do not display outcomes that please
voters or industry participants: the discovery process of the market is not
instantaneous, as it may take time to discover past errors and to correct them (i.e.
to exploit new opportunities for profit). I view this issue as one of the most
important points for policy making that only the process view can fully explain.

Kirzner’s emphasis on discovery is very important with regard to policy

issues. For instance, even a genuine monopolist must discover the shape of the
demand that it is facing. When an activity produces externalities, this too must be
discovered, as it is not necessarily obvious from the outset. Thus the evolution of
the legal framework may also depend on market discoveries.

While often purely analytical, Kirzner’s work provides a strong ground to

develop policy prescriptions that can fully be implemented in the real world. In
many cases (especially regarding the regulation of so-called “natural monopolies”)
Kirznerian policy prescriptions are very different from ordinary regulators’ views
(who reason within an equilibrium framework), and this makes it difficult to use
the Kirznerian approach in the policy world. However, as Kirzner’s analysis shows,

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ordinary policy prescriptions that were meant to defend the capitalist system, are in
fact, weakening it.

As Hayek argued, the failure of many economists to guide public policy

more successfully probably stems from the scientistic error and the constructivist
view that promote the idea that economic systems can be steered like ships. In
many, if not most, cases, governments’ policy prescriptions are guided by the idea
that bureaucrats possess the knowledge that would make these very prescriptions
effective. Kirzner’s work and its policy implications provide ammunition to the
economists and policy makers who do not want to fall into the pretence of
knowledge trap. In this light, Kirzner’s work is extremely important not only to the
advancement of the current debates on policy making but also, and especially, to
the future of economic systems.

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