The Use of Knowledge in Society

Welcome to the second installment in our series of discussions of the Most Insightful Articles in economics. This post is going up a little later than I had planned, but hopefully you have stuck around. Today we are discussing Friedrich Hayek’s 1945 article The Use of Knowledge in Society.

Whereas Coase invites us to consider (and dismiss) a world without transaction costs, Hayek invites us to consider (and dismiss) a world in which all information is known to a single mind. In this world, Hayek points out, allocating resources in the most rational or efficient way is strictly a math problem, a more complicated version of some of the problems I make my Intermediate Micro students do. “This, however, is emphatically not the economic problem which society faces.” In the real world, information is dispersed, incomplete, and frequently contradictory. How can we use all this dispersed, incomplete, and contradictory information to make the best use of the resources we have?

When we engage in decision-making about resource allocation—whether collectively or individually—we are engaging in what Hayek calls “planning.” This raises two questions. First, how can those who possess some fragments of information communicate them in a useful way to the planner? Second, who should do the planning—one person or many people—and should it be centralized or decentralized? Under what arrangement can we make the best use of all the knowledge that is dispersed in society?

Most of the knowledge that exists in society is not universal, like F=ma. Instead, it is local; in Hayek’s words, “the knowledge of the particular circumstances of time and place.” Everyone knows at least something that no one else knows. For instance, I need a new holder for my EZ Pass because my old one melted in the sun. How likely is it that anyone else would know that? For society to make the best use of its resources, it must develop a method to collect and exploit local knowledge, not just universal knowledge.

It is essential that this method be robust in the sense of being able to withstand constant change. The world is not static. Statistical aggregates hide the innumerable small changes that occur. For instance, if my demand for eggs rises and my neighbor’s demand for eggs decreases by the same amount, my neighborhood’s demand for eggs has not changed. Nevertheless, the optimal allocation of eggs has changed; this suggests that statistical aggregates are not an appropriate basis for allocating resources.

“[T]he economic problem of society is mainly one of rapid adaptation to changes in the particular circumstances of time and place.” To solve the problem, we need some form of decentralization. Decentralized actors need to be able to 1) exploit their local knowledge while 2) making use of some sort of summary of the local knowledge possessed by others that is relevant to their decisions. This summary can strip out a lot of “why” questions. The actor does not need to know why some resource is more or less scarce than before, but he does need to know if it becomes more or less scarce.

The problem is solved by the price system. “[P]rices can act to co├Ârdinate the separate actions of different people in the same way as subjective values help the individual to co├Ârdinate the parts of his plan.” If there is some new and valuable use for tin, the price of tin will rise and people will economize on tin without even knowing why they are doing it. “The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all.”

“We must look at the price system as such a mechanism for communicating information if we want to understand its real function…The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action.” This is not to say that the system operates with 100% efficiency. But it is nevertheless a marvel that changes occur and tens of thousands of people adapt by moving in the right direction, without any orders being issued. “I have deliberately used the word ‘marvel’ to shock the reader out of the complacency with which we often take the working of this mechanism for granted. I am convinced that if it were the result of deliberate human design…this mechanism would have been acclaimed as one of the greatest triumphs of the human mind.

Hayek was more aware than most intellectuals of the extent and significance of our ignorance, and of the importance of extending the range of human cooperation beyond that which could be imagined by a single mind. The idea of a spontaneous order, that some phenomenon could be the product of human action, but not of human design, has been around since at least Adam Ferguson of the Scottish Enlightenment. It is striking that so many people persist in attributing both omniscience and deliberate design to society. We will discuss something else that people erroneously attribute to society next time when we review Ken Arrow’s 1950 paper, A Difficulty in the Concept of Social Welfare.

Suggestions for discussion: I have quoted extensively from this paper because it is very quotable. What are the best quotations that I have left out? Approximately how many bytes of local knowledge are there? Is it conceivable that a very powerful computer could solve the economic problem society faces? Are there other difficulties beyond the sheer quantity of information? What is it about undesigned phenomena that makes people uneasy? What is the greatest deliberately-designed triumph of the human mind and how does it compare in importance to the discovery of the price system? Is there any value at all to the math problems I make my Intermediate Micro students do? Does Hayek’s way of thinking about prices yield any insight into what happens when relative prices are distorted by taxes and subsidies? I look forward to your comments!

10 replies to “The Use of Knowledge in Society

  1. Adam

    In response to your first question:

    “There is hardly anything that happens anywhere in the world that might not have an effect on the decision he ought to make. But he need not know of these events as such, nor of all their effects. It does not matter for him why at the particular moment more screws of one size than of another are wanted, why paper bags are more readily available than canvas bags, or why skilled labor, or particular machine tools, have for the moment become more difficult to obtain. All that is significant for him is how much more or less difficult to procure they have become compared with other things with which he is also concerned, or how much more or less urgently wanted are the alternative things he produces or uses. It is always a question of the relative importance of the particular things with which he is concerned, and the causes which alter their relative importance are of no interest to him beyond the effect on those concrete things of his own environment.”

    I think that passage is the best explanation of how the price system works in practice that exists anywhere in writing.

    It helps provide an answer to your question about a powerful computer, too–the price system may provide positive signals about how much more or less difficult it has become to obtain some specific resource, but there is no program that can anticipate the response that the billions of individuals involved will have to these changes. Should I drive less because gas has become more expensive or should I cut back on my consumption of other things in order to be able to afford the same level of gas consumption? Questions like this are a matter of preference, and only individuals working within the price system are able to make these kinds of trade-offs and judgment calls.

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  3. Stephanie

    I like this sentence: “[T]hose who clamor for conscious direction . . . should remember this: The problem is precisely how to extend the span of our utilization of resources beyond the span of the control of any one mind; and therefore, how to dispense with the need of conscious control and how to provide inducements which will make the individuals do the desirable things without anyone having to tell them what to do.”

    I don’t think that it is the undesigned nature of the price system that makes people uneasy; rather, it is our inability to control it. We seem to have an instinct to want to harness natural phenomena and “improve” upon it. But as Hayek points out, “nobody has yet succeeded in designing an alternative system in which certain features of the existing one can be preserved which are dear even to those who most violently assail it.”

  4. Pete

    “The price system is just one of those formations which man has learned to use (though he is still very far from having learned to make the best use of it) after he had stumbled upon it without understanding it.”

    Today’s modern marvel, in my opinion, is the internet. Its potential for connecting millions of humans in an infinite number of ways amazes me. Last summer, for example, I used Skype to stay in touch with family and friends while I was abroad. My computer allowed me to maintain those personal relationships more easily. Currently, I’m holding a conversation with people I’ve never met about an article written by an economist 60+ years ago. The internet has made both of these possible.

    And I think, like the price system, the internet is a system we fail to appreciate. We are not even close to harnessing its full potential to coordinate human action, communicate ideas, or anything else (though we get better every day). It is not anywhere close to as pervasive in the lives of people across the world as the price system, but its influence has increased tremendously in the past decade (think about academic research in a pre-internet world, for example). If and when the internet becomes a part of peoples lives across the globe, however, it has the potential to rival the price system as one of the most important institutions in human existence.

  5. Eli Post author

    Adam, that’s kind of what I was thinking. Even if you had a computer that could handle the sheer quantity of data, you would still need some mechanism for communicating your preferences to it, and that seems pretty technically daunting.

    Stephanie, I agree that control is a *major* issue. That’s a great point. Nevertheless, I don’t think it’s the only issue. For instance, a lot of people are uncomfortable with the idea of evolution. I don’t think it’s because they think they can’t control it (though they can’t). I think it’s because they see order and they can’t fathom that the order is self-generating.

    Pete, the Internet certainly is a modern marvel. To what extent do you think it is a product of human design, and to what extent is it a product of spontaneous order? I think no one could have foreseen when they started building it what it would eventually become, so at least somewhat spontaneous. Also, it’s interesting to think about the interdependence of the Internet and the price system. DarpaNet was built by the government (mostly by command and control, not the price system), but to what extent has the price system been crucial in the evolution of the Internet?

  6. Adam

    The internet provides some interesting case studies from an economist’s perspective, I think.

    My better half is a neighborhood blogger in DC. She gives out content for free, like all blogs. Yet even though there isn’t a price at work, there are signals that help her decide what people care about. Some are very particular–she can tell what people are searching for. If she’s getting a ton of traffic from people searching for a new restaurant that’s opening, and she only has a two sentence post up about it, she usually feels encouraged to go out and take more pictures, get more info, put up a longer post, and so forth.

    I think that local blogging is a very Hayekian phenomenon in the sense of “The Use of Knowledge in Society”, even though the signals at work aren’t always directly a part of the price system.

  7. Pete

    To me, the internet plays right into Hayek’s quote you have in bold. It is certainly more “the result of deliberate human design” than the price system, but it has similar aspects of spontaneous order in its development. I hope that people will marvel at it, to use Hayek’s term, and that over time, appreciation and understanding of the internet will lead to increased appreciation and understanding of the price system.

    As far as interactions of the internet and the price system, just look at the way the news industry has changed. Magazines and newspapers are barely profitable and prices have forced them to re-write their business model. I agree with those predicting that the iPad will ultimately be seen as the turning point, after which newspapers and magazines began offering content designed for consumption over the internet rather than content primarily designed for print.

    And to Adam… doesn’t that tie back into Coase? Transactions costs have been lowered to the point where individuals can signal to one another directly, without the price system or a firm as the intermediary.

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