Hayek on the “Use of Knowledge in Society”

The “knowledge problem” according to Hayek consists in explaining how a market economy overcomes the problem of dispersed, decentralised knowledge of supply and demand and the many individual plans and preferences of both consumers and producers. His classic article on the subject was published in 1945 in the American Economic Review (35.4 [1945]: 519–530).

But, curiously, various Austrians – mainly Misesians and Rothbardians – are unsatisfied with Hayek’s paper. Even Kirzner complains that in the “Use of Knowledge in Society” Hayek made “it appear that the function of prices in communicating knowledge was a function that is filled, in principle, also in the state of equilibrium” (Kirzner 2000: 157).

Salerno argues that Hayek’s “knowledge problem” is different from Mises’s “socialist economic calculation” problem, and even Kirzner concedes that Mises did not formulate the “calculation problem” in terms of knowledge (Kirzner 2000: 158).

What is Hayek’s argument?

The economic data for a whole society are never given to a single mind (Hayek 1945: 519) or given to any person “in its totality” (Hayek 1945: 520). A rational economic order is characterised by a state of affairs in which the relevant information exists “solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess” (Hayek 1945: 519). Planning is obviously done by very many individuals in a decentralised manner (Hayek 1945: 521).

Therefore the “various ways in which the knowledge on which people base their plans is communicated to them is the crucial problem for any theory explaining the economic process” (Hayek 1945: 520). At the same time, specific knowledge of “particular circumstances of time and place” is also very important (Hayek 1945: 521): that is, the knowledge that individual business people have of their markets, stocks, trades and capital goods, and so on.

In dealing with economic change, the best people to make the decisions are those who know their businesses, resources and markets: the “man on the spot,” as it were (Hayek 1945: 524).

Yet business people need to fit their decisions into the “whole pattern of changes of the larger economic system” (Hayek 1945: 525).

For Hayek, the price system communicates this knowledge (Hayek 1945: 526). As an example, Hayek thinks of an increase in demand for tin. The price of tin rises: buyers of tin now know they must economise tin.

What are the problems with Hayek’s theory?

We can set the problems out below:

(1) the implied assumption of Hayek’s argument (so his Misesian critics argue, perhaps not unfairly) is an economy near equilibrium, or (that is to say) in a “proximal equilibrium” state.

(2) the failure of Hayek to understand the role of Knightian uncertainty;

(3) the role of fixprice markets and administered prices, and

(4) the destabilising role of speculation in prices.

First, the role of “proximal equilibrium.” Hayek briefly nods his head at the reality that price adjustments in the real world are never “perfect” as in equilibrium analysis (Hayek 1945: 527), but his actual theory does require reasonably flexible – if not perfect – price adjustments in all markets. It is no surprise that even Austrian critics of Hayek complained that his theory treats the world as if it is in a state of “proximal equilibrium.”

Salerno contends that:

“as Hayek points out, in order for prices to fulfill their knowledge-disseminating and plan-coordinating functions, the economy must subsist in a state of what I will call ‘proximal equilibrium,’ wherein realized prices are always fairly accurate indicators of future prices.” (Salerno 1993: 128; cf. Horwitz 2004: 314–315).

That is a wholly unrealistic idea.

Secondly, more serious difficulties emerge in Hayek’s neglect of Knightian uncertainty:

“Uncertainty for Hayek means that each individual decision maker only has a small piece of the puzzle. However, as a whole, the aggregated set of all decision makers have a complete set of all relevant knowledge. There are no pieces missing, lacking or unavailable from the puzzle. Market prices organize and synthesize the aggregate amount of knowledge so that market price signals, understood only by savvy, knowledgeable entrepreneurs, [eliminate] … any uncertainty.” (Brady 2011: 14).

“Keynes, Knight and Schumpeter deny Hayek’s claim that the market generates price vectors which concentrate the knowledge so that savvy, knowledgeable entrepreneurs can act on this information and solve the problem of uncertainty. Uncertainty means vital important information is missing. Pieces from the puzzle are missing and will not turn up in the future” (Brady 2011: 14).

“Hayek could not accept the standard concept of uncertainty as defined by Keynes, Knight and Schumpeter because it would then be impossible for market prices to concentrate knowledge that did not exist. In conclusion, nowhere in any of Hayek’s three articles on Knowledge in Economics in 1937, 1945 and 1947 does Hayek deal with the standard view that uncertainty means knowledge that is not there.” (Brady 2011: 15).

Thirdly, factor (3) above – the extensive role of fixprice markets – means Hayek’s vision is deeply flawed.

Prices that remain essentially rigid in response to demand changes (quite frequent in the real world) cannot have the knowledge-communicating role of Hayek’s theory.

And finally Hayek’s theory never considers the destabilising role of commodity speculation. How can relevant information be communicated if prices are distorted by speculative activity, and therefore are not related to underlying supply and demand?

Finally, there is one statement in the paper that Hayek never develops:

“We must look at the price system as such a mechanism for communicating information if we want to understand its real function—a function which, of course, it fulfils less perfectly as prices grow more rigid. (Even when quoted prices have become quite rigid, however, the forces which would operate through changes in price still operate to a considerable extent through changes in the other terms of the contract.)” (Hayek 1945: 526).

It never occurs to Hayek that, in the advanced capitalist economies of his day, prices had already grown rigid in many markets because of administered prices. Yet economic coordination continued to occur, and economic growth and markets continued to function, and after 1945 far better than in previous periods.

And what other forms of the business contract allow economic coordination without flexible prices? Hayek never tells us, but in reality it is “quantity signals” that are the fundamental factor in fixprice markets that equate supply and demand, but Hayek never understood that.

Probably he never properly understood it at any point in his life.

In short, the price system mostly has a secondary coordination role in modern markets: “in actual adjustment of supply and demand, prices play only a very subordinate role, if any” (Kaldor 1985: 25).

BIBLIOGRAPHY

Brady, Michael Emmett. 2011. “Comparing J.M. Keynes’s and F. von Hayek’s Differing Definitions of Uncertainty as it Relates to Knowledge,” January 30.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1751569

Hayek, F. A. von. 1945. “The Use of Knowledge in Society,” American Economic Review 35.4: 519–530.

Horwitz, S. 2004. “Monetary Calculation and the Unintended Extended Order: The Misesian Microfoundations of the Hayekian Great Society,” Review of Austrian Economics 17.4: 307–321.

Kaldor, Nicholas. 1985. Economics Without Equilibrium. M.E. Sharpe, Armonk, N.Y.

Kirzner, Israel M. 2000. The Driving Force of the Market: Essays in Austrian Economics. Routledge, London and New York.

Salerno, Joseph T. 1993. “Mises and Hayek Dehomogenized,” Review of Austrian Economics 6.2: 113–146.