Why Hayek’s Theory of Prices and Knowledge is Flawed

Frederic S. Lee explains in the passage below from insights by the British economist George Richardson:

“After reading Friedrich Hayek’s article on economics and knowledge (Hayek, 1937), Richardson became concerned with the theoretical problem of the market conditions under which the enterprise could expect to generate the necessary information on which to base its investment decisions. Approaching the problem theoretically, Richardson first argued that the perfectly competitive model used by economists was incapable of answering the problem. He then argued that the market conditions which enabled the enterprise to obtain the requisite information generally included coordination among the market enterprises and social constraints on their market action. More specifically, Richardson argued that the information necessary for making investment decisions could be only obtained in markets where the market price was unchanged for many sequential transactions and did not represent the market conditions peculiar to each transaction. It was in this manner that Richardson came to consider the relationship between social-economic rules and institutions and the market price … .

Richardson approached the relationship between social-economic institutions and market prices by considering two types of prices with respect to investment decisions – short-period fluctuating prices and long-period stable prices. The former prices, through short-period price competition, were responsive to the conditions surrounding each and every transaction in the market and, hence, were market-clearing prices. Thus, as the short-period conditions continually changed, so would the market price change. However, because of its fortuitous, flexible nature, the short-period market price could not generate the information needed by enterprises for making investment decisions. On the one hand, buyers could not make long-term buying plans, such as the buying of investment goods or consumer durables, based on the goods’ relative prices since they could change in a haphazard unpredictable manner; on the other hand, if the total sales of the enterprise were associated with many different prices, then it could not make long-term sales predictions based on sales trend, stock movements, state of orders, or market share. The information needed by the enterprise to make investment decisions would consequently simply not exist.

To eliminate short-period fluctuating prices, Richardson argued, enterprises resorted to developing codes of behavior and social-economic institutions to enforce them. For example, to eliminate secret price shading and therefore the possibility of price wars, a social rule against price cutting would be propagated throughout the market and backed by social-economic institutions such as open-price systems, price notification schemes, cartels, trade associations, or price leaders. Specifically, to eliminate short-period fluctuating market prices, the market enterprises would establish codes of social behavior and social institutions which would establish a single market price based on the normal cost prices of the enterprises in the market that would remain unchanged for many transactions – that is, a stable long-period market price. As a result, sales trends would provide the information enterprises needed to make long-term investment decisions, since the price/quantities combinations which make it up would not be related to short-term market conditions. Thus not only was the socially determined market price stable over time, it also generated the investment information the enterprises required since the indicators would reflect the permanent market conditions.” (Lee 1998: 135–136).

Of course, inside the comparatively small sector of the economy where flexprices really are important, the informational role of prices in terms of communicating knowledge about supply and demand has some merit, but so much of any modern market economy is not flexprice.

The private sector mostly shuns the price flexibility of neoclassical and Austrian price theory, and itself establishes many practices and conventions for stabilising prices.

But, above all, it is administered prices which allow the price stability that is highly useful in investment decisions. As Nicholas Kaldor argued, in normal times (outside, say, a very severe recession) “in actual adjustment of supply and demand, prices play only a very subordinate role, if any [sc. role]” (Kaldor 1985: 25).

In the mark-up pricing sector, therefore, prices cannot be communicating relevant and important Hayekian information about changes in demand and supply or relative scarcity.

For Richardson’s work in general, see Richardson (1960, 1965, 1967 and 1972).

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

Lee, Frederic S. 1998. Post Keynesian Price Theory. Cambridge University Press, Cambridge and New York.

Richardson, G. B. 1960. Information and Investment: A Study in the Working of the Competitive Economy. Oxford University Press, Oxford.

Richardson, G. B. 1965. “The Theory of Restrictive Trade Practices,” Oxford Economic Papers 17: 432–449.

Richardson, G. B. 1967. “Price Notification Schemes,” Oxford Economic Papers 19: 359–369

Richardson, G. B. 1972. “The Organization of Industry,” Economic Journal 82.327: 883–896.