I recently discovered a magnificent paper titled “The Use of Knowledge in Society,” by the great economist, F.A. Hayek. This paper looks at the most basic economic question of how resources can be used in their most effective manner. Hayek begins by critiquing the popular method of approaching this problem. Commonly, in economics, the belief is that one can find a mathematical solution in resource management problems. But to find this solution, one must assume full information of all individual preferences within the market. Hayek explains why this is not realistic, and therefore, finding a solution based on the assumption of full information is no solution at all.
He states that the problem, in reality, is to make use of resources in the best possible way with only individuals knowing their respective preferences. This means that we face the problem of making the best possible use of what individual knowledge exists. He believes this has been hidden through use of mathematics in economic problem solving. Interestingly, Hayek relates this failure to see the real problem to issues in public policy. Many policymakers believe that we can find economic answers through mathematical analysis, but in doing so, oversimplify a complex system of individuals in which we do not have full knowledge of individual preferences.
I find this particular point to be extremely important. It seems that for the last century or so, the world has been run by scientists. Many of these scientists, while well-intentioned, believe the world to be made up of physical problems. They are quick to blame problems like the low supply of water in some countries on simply not having enough water. In reality, physical water shortages are uncommon, and economic water shortages are all too common. The scientists who do realize this seem to believe the solution lies in changing people minds or coercing people into managing the water supply more effectively. Either way, they believe that governments or people in power can directly manage the water supply efficiently. But these scientists must have never heard of Hayek. The only way that a resource can be managed effectively is through free markets and a pricing system.
Hayek goes on to explain why free markets are most efficient. There are three possible systems that can address the question of how we make the best use of resources, he states. The first is central planning, which he defines as, “direction of the whole economic system according to a unified plan.” Another option is competition, or “decentralized planning by separate persons.” The final possibility is through “delegation of planning to organized industries,” or monopolies.
The question of which system should be used depends on which makes the best use of knowledge. The answer depends on the type of knowledge we seek. Hayek clearly differentiates between two types of knowledge- scientific and specialized individual knowledge. He concedes that if scientific knowledge is the most important, a centrally planned economy may make the best use of it. However, he refutes the popular claim that science is the most important knowledge available. This is because of the power that lies in knowledge gained from individual specialization. The latter sort of knowledge tends to be more unique, as it often comes from years of training, education, or experience in a particular field. For this reason, individual knowledge is extremely important.
Hayek emphasizes how frictional the economy is. There are numerous changes that occur in the day-to-day economy, which must be dealt with through the use of individual knowledge. While some claim to account for these changes in aggregate statistics, Hayek discredits this. He does not believe such statistics can effectively consider the constant changes in the economy. A centrally planned economic system must take into account these numerous, daily changes. But since they cannot account for them in numbers, even a centrally planned economy will be forced to leave some decisions to the discretion of “man on the spot.” But to accept this is to admit the need of at least some decentralization.
Hayek more closely examines the aforementioned “man on the spot.” He asks, what and how much knowledge does this person need? Sufficient knowledge is passed to this person through the price system. Pricing is what allows individuals to neglect all outside factors of a decision. It also eliminates the need for individuals to make complicated mathematical calculations to determine the correct course of action for every decision. One must only examine prices.
This is explained further by Hayek through an example of a realistic resource – tin. The example asks us to assume tin has become more valuable in another part of the world. The effect this would have, assuming all else remains constant, is an increase in the price of tin. This acts as a signal to people everywhere that tin is now more valuable. The price forces people to consider their use of tin and realize it is now more expensive. Hayek sees beauty in this, as the individuals do not need to know why or where tin has become more valuable. It also takes no central decision maker to force people to economize their use of tin. The pricing system allows people to act rationally in managing world resources, while only considering their own options.
Considering the magnificence of the price system, Hayek is very critical of the desire for central planning in society. While many people are concerned with solving the world’s problems by themselves or from a central authority, Hayek does not believe this should be the goal. Instead, he believes the goal should be “extending the number of important operations which we can perform without thinking about them.” In the competitive price system, there is no significant thought or decision making required by any planner. People must only consider prices. Therefore, this system makes the most sense in working toward Hayek’s goal of limiting difficult decision making.
He also discusses another benefit to the price system. It is highly compatible with freedom. It is a system that not only allows for economic efficiency, but also maintains the rights of individuals to their choice of pursuits and use of knowledge and skills. A centrally planned economy would often conflict with individual freedoms, with individual decisions being made by a single planner.
In concluding, Hayek states that to assume a certain entity can have full knowledge is to assume away the true problem in economics of resource management. To truly address this problem, one must consider how this knowledge can be gained and communicated. The system that solves the problem of gaining and communicating knowledge is the price system.
While reading this paper, it is easy to see the relevance of Hayek’s argument to the traditional study of economics. One thing that came to mind was how most economic students study utility. In a typical utility problem, we are given a budget constraint and a utility function for two goods. Given this, we must solve the problem of what choice the individual will make. As a practice problem, this is fine. But I believe Hayek would argue that to use this sort of analysis related to policy making, would be erroneous. If we assume that we have full knowledge of individual utility functions, the problem becomes one of mathematics. However, it seems unlikely, not only to gain specific knowledge of preferences, but to be able to represent them easily in a function. Many topics in modern economics deal with similar assumptions. Could this possibly be why our economic leaders have failed us so terribly as of late? Gaining the knowledge portrayed by these assumptions, in reality, is much more difficult than solving the problems with the given assumptions.
I hope that our policymakers will begin to see that they do not have, and never will attain, full knowledge of individuals or resources. Markets cannot function properly when dictated by a central planner. Both the theoretical and empirical evidence lie on the free market’s side. Hayek views economics as the study of individual interactions, rather than the study of how to control these interactions. He was ahead of his time, and almost surely an outcast in 1940s Austria for his beliefs. Luckily, Hayek has found a great appreciation for his work in a new generation of economics students, including myself.
