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that in the present problem, production decisions can and must be made,
and these production decisions also must be explained in terms of market
forces. Our present case will provide the simplest and most direct intro-
duction to the analysis of the central problem of this chapter, the explana-
tion of the general market system outlined in the previous section.
We turn, then, to consider a system where resource owners (if their
resources are not to be used for consumption or to be left idle) must them-
selves employ their resources to produce goods for their own consumption or
for sale to other consumers. Our problem is to understand how market
forces in such a system would determine the quantity of each resource con-
sumed directly by each consumer, the quantity of each product produced,
the method of its production, and the prices in the market of each resource
and each product.
The clue to analysis of such a system consists in its points of similarity
with the multi-commodity pure exchange system considered in Chapter 7.
There we considered a group of consumers each of whom was endowed each
day with a supply of consumer goods. Exchange ensued as each of the
market particpants sought to convert his intial commodity bundle into the
most desirable one obtainable by barter in the market. For each partici-
pant this involved giving up units of some commodities in order to acquire
units of other commodities. In our present case, also, each participant has
an initial endowment that he seeks to convert into the most desirable com-
modity bundle obtainable. In our present case a participant can convert
THE GENERAL MARKET PROCESS 239


his initial endowment by sacrificing quantities of resources for a price (a)
by sale of resources directly to consumers for use as commodities, and (b)
by using the resources to produce products and then selling the products to
consumers. These exchange possibilities may arise from two causes: first,
as in Chapter 7, differences in the initial endowments of the different par-
ticipants, as well as differences in their tastes for the various resources as
commodities, may create opportunities for mutually profitable exchange of
resources between participants for direct use as commodities. Second, dif-
ferences in the initial resource endowments of different participants may re-
sult in differences in their ability to produce specific products. This,
reinforced by differences in the tastes of the participants for the various
products, may again create opportunities for mutually profitable exchange
of "resources," in the derivative form of products, between participants.
The second of these two sources of mutually profitable exchange
between market participants, it should be observed, is most illuminatingly
interpreted simply as a special case of the first of the two sources. Thus,
the whole case studied in this section is seen, too, simply as a special case of
the multi-commodity market problem in Chapter 7. This interpretation
follows directly as soon as it is realized that a product is nothing, in fact,
but the whole bundle of resources used to create it. A market participant
can thus improve his position by giving up some of his initial bundle of
assets (in the form either of (a) the original resources or (b) the product
obtained from them) in order to replace the sacrificed assets by other assets
(to be bought from other participants either in the form that these assets
appeared in initially in their asset bundles, or in the form of derived prod-
ucts) which he prizes more highly.
The complication, which sets our present problem apart from that of
Chapter 7, arises, of course, from the presence of production possibilities.
It is associated, in particular, with the versatility in production of most re-
sources. In a system without production a particular commodity is simply
that commodity; but in a system where production is possible, a particular
resource may be considered as either that resource (usable, perhaps, in
direct consumption), or as part of any one of the possibly numerous products
toward whose production the versatile resource may be applied. Our study
in Chapters 8 and 9 of the principles of production theory has taught us
that this versatility of productive resources imposes upon the producer the
necessity to choose among additional series of alternatives.
In the multi-commodity pure exchange market of Chapter 7, a partici-
pant made his buying and selling decisions on the following principles.
The market prices of any two commodities (say, A and B) determine the
terms on which he may acquire specific quantities of commodity A, say,
through purchase, for the sacrifice of quantities of commodity B through
sale. His own subjective scale of values ranks the specific additional quan-
240 MARKET THEORY AND THE PRICE SYSTEM


tities of A either higher or lower than the quantities of B required to be
sacrificed. If the quantities of A rank the higher, he will seek to sell B and
buy A until, through the law of diminishing utility, the marginal utility of
A drops, and that of B rises sufficiently to make further exchange on market
terms no longer desirable. All that the market participant needs to con-
sider, then, are the prices of the commodities and their respective utilities
to him at the margin.
In the case we are now considering, the decisions of a resource owner
depend upon a number of additional factors. In contemplating the pur-
chase of a specific quantity of product A in the market (or the purchase
of a specific quantity of resource C for direct personal consumption), through
the sacrifice by sale of quantities of resource B (one of the assets in his own
initial endowment), it is not sufficient for a participant to know merely the
prices and marginal utilities to himself, of A (or C), and B. The prices, it
is still true, of course, determine the quantity of B he must sacrifice in order
to acquire specific quantities of A (or C). It is still true, in addition, that
the desirability for him of acquiring specific quantities of A (or C) will de-
pend upon the marginal utility to him of A (or C).
But in weighing the wisdom of sacrificing the required quantity of B,
it is now not enough to consider merely its marginal utility to him in direct
consumption. He must consider also the additional sacrifices possibly in-
volved in the sale of this quantity of B. These potential sacrifices include
the difference that this quantity of B is able to make (either when used as
a single unit, or when used in smaller quantities) in the production of
all the various products it is a potential factor for. In considering the
sale of the required quantities of resource B, the resource owner must con-
sider in turn all the alternative sets of possible ways these quantities of B
could be turned (in cooperation with other resources, of course) into prod-
ucts. All of these sets of possible ways B might be used in production must
then be compared with each other. The most significant set, among all
these alternative sets of possible productive contributions that the quantity
of B is able to make, will be then the sacrifice involved in withdrawing this
quantity of B from production. (The significance of any set of productive
contributions will of course be measured by whichever the resource owner
thinks more preferable: (a) the additional revenues obtainable from the
relevant marginal increments of product through sale of the finished prod-
ucts in the market, or (b) the differences in the utility for direct consumption
that can be derived from the relevant marginal increments of product,
through the direct personal enjoyment of the finished products.)
In weighing, therefore, the sacrifice of the quantities of B required by
market conditions for the sake of acquiring specific quantities of A, a market
participant will rank on his scale of values not only the marginal utilities
of the relevant quantities of A and of B, but also this opportunity cost
THE GENERAL MARKET PROCESS 241


involved in the withdrawal of B from potential production. Only if the
specific quantity of A ranks higher on his scale of values than the full sacri-
fice involved in the sale of B”that is, both higher than the sacrificed con-
sumption of B and also higher than the alternatively sacrificed potential
productive possibilities embodied in B”will a resource owner sell B and
buy A on the terms available in the market. (Of course, once a resource
owner has produced a product, the considerations involved in a decision to
sell units of the product in order to buy quantities of other products, or of
resources to be used directly in consumption, are no different from those
that a participant in a multi-commodity pure exchange market needs to con-
sider.)
We will now consider what conditions have to be fulfilled if our system
is to be in equilibrium. The following sets of decisions by market partici-
pants will have to be mutually consistent throughout the system: the deci-
sions (a) to sell resources, (b) to produce products, (c) to sell products, (d) to
buy resources, and (e) to buy products. In an equilibrium system prices
will prevail for each of the resources and products, so that each participant
is motivated to make consumption, production, buying, and selling plans,
none of which need be disappointed. The quantity of each resource that
resource owners wish to sell at this equilbrium resource price will exactly
equal the quantity that other participants wish to buy at this price for
direct consumption. The quantity of each product that resource owners
wish to sell at the equilibrium price will exactly equal the quantity that
other participants wish to buy at that price.
Each resource owner will have adjusted his consumption, production,
buying, and selling activities completely to these market prices, so that he
sees no way of rearranging his activities in any more desirable way. He is
producing those products that yield the highest revenue for the expended
resources; he is producing each product with a set of input proportions and
on a scale that yields the highest aggregate sales revenue obtainable. He
can find no way of removing any unit of any of the assets in his initial daily
bundle from one disposition to any other, without rendering himself worse
off. (1) The marginal utility that he obtains from the last unit of each of
his initial resources that he himself consumes directly is just higher than the
marginal utility of whatever else he could either: (a) buy with the additional
revenue obtainable by the sale of this last unit that he consumes, respec-
tively, of each resource; or (b) buy with the additional revenue obtainable in
the market by virtue of the marginal increment of product that these last
units, respectively, of each resource could contribute in any branch of
production; or (c) enjoy directly as the marginal increment of product that
these last units, respectively, of each resource could contribute to any prod-
ucts he might consume himself. (So that were he to consume directly either
more or less units of any of the resources in his initial endowment, he would
242 MARKET THEORY AND THE PRICE SYSTEM


be worse off.) (2) The marginal increment of product derived from a
specific quantity of any one of his resources devoted to the production of a
particular product possesses, for each of the products to whose production he
might allocate this resource, approximately the same market value. (So that
were he to switch resources from the production of one product to the pro-
duction of any other, he would be worse off.) In equilibrium the prices
of resources and products each day enable each participant in the market
to successfully carry out plans fulfilling these optimal conditions, without
disappointment.
As we have been led to expect, it will be observed that the sets of resource
and product prices required for equilibrium in such a system must bear
strong formal resemblance to the equilibrium set of commodity prices for
a multi-commodity pure exchange market. In the pure exchange model a
market participant could improve his position by converting some of his
assets by exchange into other assets. In the present model a market partici-
pant can transform his assets, in addition, by converting them into products
and then, if he wishes, converting these products into commodities through
exchange. The technologically determined terms upon which a particular
participant can convert his resources into products, coupled with the market
terms upon which these products can be exchanged for other products,
yields sets of "exchange rates" on whose basis the resources of this partici-
pant, in effect, are converted into the products produced by a second par-
ticipant. Going one step further, by taking note of the terms upon which
this second participant was able to convert his original resources into
his products, one notices a set of terms upon which the originally endowed
assets of one market participant can be exchanged (either in their original
forms or in the form of derived product) for the originally endowed assets
of a second participant (again, in either form). By the end of each trading
day, in equilibrium, asset ownership will have been rearranged, through
production and exchange, so that no further possibilities remain for mutu-
ally profitable exchange (in the wider sense that includes production)
between any two participants. Observed in this way the equilibrium condi-
tions of prices and production in our present system are seen as reducible in
principle to the same conditions that were sufficient for equilibrium in
the multi-commodity pure exchange market analyzed in Chapter 7. Just
as we saw, in that case, that perfect knowledge on the part of all participants
in the market must lead immediately to equilibrium conditions, so also in
the present case equilibrium conditions can be seen to follow from perfect
knowledge”except that in the present context knowledge must of course
include knowledge in detail of all possible methods of combining resources
in order to obtain products.
Absence of perfect knowledge must of course lead to a group of decisions
that will be far from being mutually consistent. As usual in such a situa-
THE GENERAL MARKET PROCESS 243


tion, the discovery of this absence of consistency will take the form of dis-
appointments suffered by participants who have formulated plans of market
action on the basis of assumptions concerning market conditions that prove
to have been mistaken. We may discard the possibility of more than one
price emerging for a particular resource or product since we are already
familiar with the market movements that will be generated by the eventual
discovery of such price discrepancies. Disequilibrium will exist whenever
the price of any resource or product results in a greater or smaller aggregate
quantity of it asked to be bought, than the aggregate quantity of it desired
to be sold. In general, the aggregate quantity of a resource asked to be
bought will be, we know from earlier chapters greater as its relative price
in terms of other goods is lower, since more people will then wish to
acquire it for consumption, as compared with the alternative consumption
and productive opportunities available. The fact that a given price for a
resource generates a demand for it in the market that cannot be satisfied
at the price is a result of the absence of mutual recognition between (a)
those who own the resource and, being less eager sellers than others, are
not prepared to sell more of it at the low price; and (b) those who are disap-
pointed in their attempt to buy the resource at the ruling price, and who
would have been prepared to offer higher prices had they known that this
was necessary. The first of these two groups are those for whom either
the marginal utility of the last units of their respective supplies of the re-
source, or the value of the relevant marginal increments of product obtain-
able from these units, ranks higher than the marginal revenue obtainable
through sale of the resource in the market. The second of the two groups
are in precisely the opposite position. Mutually profitable exchange possi-
bilities thus exist ready to be exploited. As knowledge is spread, members
of the second group will offer higher prices for the resource.
Generally, any set of resource and product prices motivates each market
participant to transform his initial asset endowment by sacrificing the direct
consumption of his resources for the sake of acquiring other commodities
either through direct exchange, or through production, or through the
combined process of production and subsequent exchange. We have seen
that the technological laws governing the various relevant production func-
tions, together with the market prices of resources and products, determine
the terms upon which, through these various ways, he can acquire at the
margin additional quantities of any particular product by sacrificing other
assets. With the terms of technological transformation given, a set of mar-
ket prices that induces (to take one possibility) too many people to convert
the resource A (either by direct exchange, or by production followed possibly
by exchange) into the asset B (which may be in the form of a derived prod-
uct), as compared with the quantity of B desired to convert to A, will result
in disappointments. These disappointments will result in a revision down-
244 MARKET THEORY AND THE PRICE SYSTEM


ward of the relative price of A, and a revision upward of the relative price
of B.
The resulting fluctuations in the price of resources and products are
completely homogeneous with those we have discussed earlier, especially
in Chapter 7. In the present case, of course, we realize that an alteration
in the price of any one resource or product will immediately upset the attrac-
tiveness of the opportunities available to its owner through exchange and
production involving other resources or products. As knowledge of price
changes spreads spasmodically one can expect disappointed plans and con-
sequent plan revisions to be generated in a highly irregular fashion. The
direction of adjustments, however, will always be toward the elimination of
those disappointments generated at the prior set of prices. Market agita-
tion will proceed in this way initiating changes in consumption and pro-
duction in a continual tendency away from existing inconsistencies among
decisions. Of course, especially with production decisions, the changes
prescribed by current disappointment of past plans may not be implemented
immediately but may require considerable time. It would be possible, as in
the preceding chapter, to spell out analytically the conditions for the
achievement of various levels of incomplete "equilibrium."
Any alterations in the basic data of the system will generate the appro-
priate market forces that will bring about corresponding adjustments in the
decisions made by the market participants. Thus, a change in technology
will alter the terms on which resources can be converted into products, and
also alter the effective terms of "exchange" between the original assets of
two producing participants. This will bring about changes in the set of
consumption, production, buying, and selling plans of the affected persons,
resulting possibly in corresponding pressures toward changes in the sets
of resource and product prices. A shift in consumer tastes, or a sudden
alteration in the composition of the various initial daily asset endowments,
will all alter the terms upon which participants would be eager to convert
one asset, directly or indirectly, into another asset. In all these cases, equi-
librium can result only after the knowledge of the impact of these changes
has been transmitted by the market process to all the participants.

THE PRELIMINARY MODEL AND THE GENERAL MODEL
Once again it will be helpful to focus attention on the differences
between the assumptions underlying the preliminary model of the market
analyzed in the preceding section, and those that define the more general
model of the market which it is our principal purpose to examine. In the
preliminary model production could take place only with resources obtained
by the producer at the start of each day as part of his resource endowment.
Where resources were bought in the market, they were bought for direct
THE GENERAL MARKET PROCESS 245


consumption as commodities, not for use as inputs in production. The
range of production possibilities was thus limited drastically by the composi-
tion of each producer's initial asset endowment. It was entirely possible
for a unit of a particular resource to be more efficient at the margin in one
branch of production than in another and yet to remain employed in the
area where its productivity was lower.
No less interesting from an analytical point of view, perhaps, was that
there was, in effect, no direct market for resources, as resources. In calcu-
lating his costs of production, the only market values that a producer could
use directly in the appraisal of the value of his inputs, were the prices being
paid for these resources as commodities. (Nevertheless, the market value
of a unit of resource would to some degree reflect indirectly its usefulness
also as a factor of production, since no owner of a resource would sell a
unit of it for a price lower than its worth to him, as reflected in the value
of the marginal increment of product that it could bring about.)
The most important implication, however, of the special assumptions
of the preliminary model, was that each resource owner necessarily had to
be his own entrepreneur. In calculating the worthwhileness of using a
particular quantity of a resource in production instead of for consumption,
or vice versa, a resource owner had to consider not only the marginal utility
of the resource and the price of the resource, but also the prices of the
products in whose production the resource could be allocated, and the mar-
ginal efficiency in production of the resource. In the preliminary model
of the market there was no division of the decision making responsibility
possible between resource owner and producer-entrepreneur.
In the more general model of a market system we now turn to, things
are different in these respects. Production can be carried on with resources
acquired out of the initial asset endowment of any market participant. In
the production of any one product a producer is not limited, as in the pre-
liminary model, by the quantity that he possesses of the scarcest of the re-
quired complementary factors of production. Generally, there will be
little likelihood that some resources will have to be consumed, or left lying
idle, or used in branches of production where their effectiveness at the
margin is unnecessarily low, merely because any one producer lacks the
necessary complementary factors of production.
In the more general market model there will be a genuine market where
the various resources will be bought and sold. The price paid for a re-
source will most probably directly reflect its usefulness to buyers, at the
margin, in production rather than in consumption.
Most important of all, in the general market model, it will now be
feasible to focus analytical attention upon a distinct and separate entrepre-
neurial function. In the general market model resources are bought in the
market by entrepreneurs who sell "them" (that is, in the form of products)
246 MARKET THEORY AND THE PRICE SYSTEM


back to the market. We have already seen in earlier chapters that this kind
of activity differs sharply from that of the resource owner who, in his
capacity of resource owner, simply sells resources to the market; or from that
of the consumer who, in his capacity of consumer, simply buys products from
the market. A very important implication of the existence of the entre-
preneur concerns the terms upon which a resource owner is able to convert
his resources into products for his own consumption. In the preliminary
model these terms followed from his knowledge of the technological laws he
is able to operate with, and from his estimates of the prices of the products
that he can produce, and those of the products he might wish to buy. In
the more general model, the terms on which a resource owner can convert
resources into products are yielded directly by two sets of market prices,
the prices of the resources that he is able to sell, and the prices of the prod-
ucts that he might wish to buy. In the event that entrepreneurs obtain
superior knowledge of technological opportunities and of consumer tastes,
the terms of "exchange" available to a resource owner will more faithfully
reflect the best available conversion opportunities.
Despite these important differences between our present market model
and that discussed in the preceding section, our analysis will place much
emphasis on the fundamental similarities between the two systems. In both
systems resource owners are endowed each day with a bundle of assets, and
each seeks to transform his initial endowment, through "exchange," into
the most desirable bundle of assets obtainable. (In the present general
market model, it is possible for many participants to be able to act as
consumers even though they do not receive any daily endowment of assets.
Successful entrepreneurial activity may provide them with the income to
buy products in the market for their own consumption.) In both systems
resources can be transformed into products for one's own consumption by
sacrificing quantities of resource and obtaining products. (In the present
model this can be done without any act of production on the part of the
resource owner himself; he can sell resources to the entrepreneurs and buy
back products from entrepreneurs.)
The similarities between the two systems lead, as we shall see, to close
formal parallelism in the analysis of market equilibrium conditions (in
both systems), as well as in the analysis of market processes set in motion
(in both systems) by the non-fulfillment of equilibrium conditions.

GENERAL MARKET EQUILIBRIUM CONDITIONS
The mental construction of a general market in complete equilibrium
demonstrates most illuminatingly this fundamental similarity between this
market and that of the preliminary model. When one constructs a model
of a general market in equilibrium, one realizes that the equilibrium condi-
THE GENERAL MARKET PROCESS 247


tions have wiped out that single element in the general market system that
is its most important distinguishing feature, as compared with the prelim-
inary model treated earlier in this chapter. In a general market, as we
shall see, equilibrium conditions can exist only when there is, in effect,
nothing left for entrepreneurs to do.
For a general market to be in equilibrium, it is necessary that all deci-
sions made within the entire system dovetail perfectly with one another.
The decisions of the owners of each resource, with respect to selling this
resource, must fit in perfectly with the decisions of entrepreneurs with re-
spect to buying this resource. The decisions of consumers, with respect
to the purchase of each possible product, must fit in perfectly with the long-
run and short-run decisions of entrepreneurs with respect to the production
and sale of this product. Of course, the buying, production, and selling
decisions of each entrepreneur must show perfect internal consistency (or
else he would rapidly find that he must reorganize his plans). Moreover,
the decisions of each entrepreneur-producer must be consistent with the
decisions of the rest of the market in the sense that he know of no alterna-
tive arrangement that in the long run might prove more lucrative from his

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