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 coördinate the separate actions of different people in the same way as subjective values help the individual to coördinate 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!