Hayek’s ‘The Use of Knowledge in Society’ – Simplified

I’m new to economics and recently read Friedrich Hayek’s ‘The Use of Knowledge in Society’. Following Karl Popper and Richard Feynman, I think people should write clearly and simply. But Hayek writes long, complicated sentences, like a native speaker of German would (I should know, being one myself). He also uses foreign words when the simpler, English words would do. These decisions are unnecessary. They may impress the reader but they make it harder to understand the text. They also make errors harder to find and correct.

So I decided to simplify Hayek’s text. Some rules of thumb I followed: replace foreign words with English words; replace English words of Latin/French origin with their German-origin match; shorten sentences; separate nested sentences; reduce the number of syllables; replace rare words with common words; change passive to active voice; and other, similar changes. Although I tried to stay as true to the original meaning as possible, these changes may remove some nuance and introduce error. All errors are my own. If I did add errors, I think the gain in clarity is worth the risk, and they should now be easier to find anyway.

The Use of Knowledge in Society

I

How do we make the best use of what we have? That’s what a rational economy is about.

The answer seems simple: if we know everything we need to know, including what we want to do and what we can do, all we need is logic. The answer falls out of the question, and it’s been solved mathematically.

But that’s not the problem society faces. No one man knows everything he needs to know about the economy. That knowledge is not ‘given’. It is spread out over many men; it is flawed and often contradictory. So the problem is not how one man at the top could use complete information to divvy up resources in some ideal way. He could never get that ‘complete information’ anyway. Instead, the problem is how we can make the best use of resources given how little we each know.

Economists have been using more math lately. That’s made it harder to study the problem of rational economic organization. So there are issues of method that I’ll come back to. At first, I was surprised to find that many of the things I’ll talk about came together from seemingly unrelated directions. I see now that this is no accident. Many disagreements about economonic theory and policy come from wrong ideas about the economic problem of society. And people got those wrong ideas because they think about social problems the same way they think about problems of nature.

II

In everyday language, ‘planning’ means deciding how to divvy up resources. All economic activity is planning in this sense. Recall that knowledge about the economy is not in one place but spread out. So, if you want to do any planning, you’ll need to get knowledge from somebody else. How do you get that knowledge? Any workable theory of the economic process has to explain that. And what’s the best use of that knowledge? That’s the problem of economic policy – of designing an efficient economic system.

Economists agree that someone should do the planning, but they can’t agree on who. Some argue there should be a central authority that steers the entire economy, whereas others say planning should be left to individuals. Nowadays, when people say ‘planning’, they mean central planning. Competition, on the other hand, is spread out over many – it’s decentralized. There’s also planning by organized industries or monopolies, which is a middle-of-the-road approach many people talk about but don’t like in practice.

Which of these ways is more efficient? The one that uses knowledge more fully. Centralized economies have to move knowledge from the people to the central authority somehow. In decentralized economies, people need to share their knowledge so they can make their plans jibe.

III

The answer to our question obviously depends on different kinds of knowledge and their importance. Regular people know more about some things, experts about others. We may look to experts for scientific knowledge, say, but it’s not the only knowledge that matters. We could kick the can down the road by asking how to put together a panel of experts. But my point is that, even if this were doable, it’s only a small part of the wider problem.

People don’t like when you say that scientific knowledge is not the sum of all knowledge. But science is about general rules, and not all knowledge is about those. You know more about your own situation, about your time and place, than anyone else. You have unique information that can be used to make decisions. This information can be put to good use only if those decisions are left to you, or at least actively involve you. Think of how much we have to learn to get good at jobs. Special knowledge of skills, people, places, and situations is valuable. For example, a real-estate agent bases his business on his knowledge of fleeting opportunities in the neighborhood. A factory owner may know of a surplus stock to draw on when other supplies are unavailable. And so on.

Some people weirdly hate this kind of situational or practical knowledge, even though it’s just as important for society as scientific knowledge. They think one shouldn’t use situational knowledge to gain an advantage over someone with more theoretical or technical knowledge. As a result, they are biased against commerce in favor of production. Even economists have this bias: they think practical knowledge should just be ‘given’, readily available to anyone. It isn’t, so they call our economic order irrational. But finding a method for sharing this knowledge as widely as possible is precisely the problem we want to solve.

IV

People downplay situational knowledge because they downplay change. ‘Planners’ greatly underestimate the changes that impact production plans. Economic plans cannot be made far in advance or followed to the point no further planning would be necessary. It’s this difficulty of total economic planning that impresses people to the point of intimidation.

It’s always change that causes economic problems. If things continue as expected, there’s no need for a new plan. So people who downplay change also downplay economic problems. They’re usually also the ones who think technological knowledge trumps economic considerations.

Are they right? Does modern production mean we can make economic decisions less often? Once a factory is built, is its operation more or less immune to change?

Businessmen answer ‘no’, based on their experience. There’s a constant struggle to keep costs from rising. Producers and engineers always want higher budgets. A manager can make or break a profitable business. But economists are out of touch with this reality.

One reason economists underestimate change is their focus on aggregates. Aggregates are more stable than details. But that stability isn’t due to the ‘law of large numbers’ or random changes canceling each other out, as statisticians claim. The numbers we deal with aren’t large enough. The constant flow of goods and services is due to people’s readiness for change. If things change from one day to the next, they respond accordingly. B steps in when A fails to deliver. Even a highly automated factory has failsafes for many unexpected events: tiles for its roof, stationery for its forms, and so on. It cannot make everything it needs – it has to get things from the market.

Situational knowledge cannot enter into statistics. So it cannot be shared with any central authority in statistical form. That’s because putting together statistics requires ignoring details and lumping together different resources, even though their differences may be important when making decisions. Central planning that is based on statistics cannot account for situational knowledge; the central planner will have to leave decisions to the ‘man on the spot’.

V

The economic problem of society is largely about being able to react to changes on the spot. So we have to leave decisions to people who have intimate knowledge of a situation and the resources to address it. We can’t just share this knowledge with some central board that issues orders after integrating all knowledge. Instead, we need decentralization. It ensures that situational knowledge is put to good use. But decentralization is only part of the solution: compared to the economy as a whole, the ‘man on the spot’ only has limited knowledge.

How can he get the information he needs to fit his decisions into this larger context? How much information does he need to get? Which events beyond his horizon does he need to know about?

Any event could affect his decision-making. But he doesn’t need to know of these events as such, or about all their effects. It doesn’t matter why some screws are now harder to get, say. What matters is how much harder they are to get, and how this difficulty and urgency compares to other issues he wants to address.

Prices solve this problem. Even if you knew everything there is to know about some self-contained economic system, you wouldn’t go over all the effects some small change in the allocation of resources might have. You’d instead assign a number to each resource. This number would tell you the value of that resource in the larger economic context. With this information, you can promptly react to changes without having to solve the whole puzzle all over again each time.

Recall again that everyone has limited knowledge; the total knowledge is spread out over many men. Prices help them coordinate their actions much like subjective values help one man coordinate parts of his plan. Here’s a simple example. Say some place needs more tin. Maybe it’s because somebody figured out a new way to use tin, or maybe it’s because some of the supply was destroyed. My point is that it doesn’t matter for our purposes which of these two causes has made tin more scarce. All the consumers of tin need to know is that they need to save it. Most of them won’t even have to know the place that needs more tin. It’s enough if some of the people who are aware of the new demand switch resources over to it, and those aware of the new gap fill it from still other resources. This effect quickly spreads throughout the entire economy and affects not just the use of tin but also of its replacements, the supply of anything made of tin, and so on. This happens even though most of the people making the replacements don’t know the original need for them. Everyone acts as one market, not because any of them survey the whole field, but because their limited individual fields of vision overlap enough for the information to spread to all. Prices help many men communicate scattered information and coordinate actions in ways a central planner could only dream of.

VI

That’s the purpose of the price system: to communicate information. But the more rigid prices get, the less the price system meets this purpose. (That said, in contracts with quoted prices that have become rigid, forces otherwise set off by changes in price are still set off, to a degree, through changes in other terms of the contract.) What’s remarkable about the price system is its economy of knowledge: in other words, how little each man needs to know to take the right action. Only key information is passed on, and only to those concerned. The price system is a kind of change log. It shows a producer how a few pointers move, as an engineer might watch a few dials, to respond to changes about which he may never know more than is reflected in the price movement.

Of course, his response is probably never ‘perfect’ in the sense an economist thinks. But the assumption that people have almost perfect knowledge has blinded us to the true purpose of the price mechanism. It’s also caused us to apply misleading standards when judging its efficiency. Recall the marvel of the tin example: one raw material gets scarcer, and without an order being issued, without more than maybe a handful of men knowing the cause, tens of thousands of men whose identity couldn’t be found after months of investigation, use it more sparingly. In other words, they move in the right direction. This is marvelous enough even if some of them don’t perfectly maintain their profit rates.

I say ‘marvel’ because we often take the price mechanism for granted. If someone had designed it on purpose, and if the men guided by it understood that their decisions have impact beyond their direct goals, they’d see it as one of the greatest triumphs of the human mind. Not only was it not designed, but the men guided by it usually don’t know why it makes them do what they do. Some demand ‘conscious direction’; they can’t believe that something that has evolved without design, without us understanding it, can solve problems we can’t solve consciously. They should remember that the problem is just that: how to extend the use of resources beyond the control of any one mind; how to do away, therefore, with the need for conscious control; and how to get men to do what they should without anyone having to tell them to.

At this point, we face a problem not unique to economics. It comes up in all truly social matters, including language and most of our culture. It’s really the central theoretical problem of all social science. As Alfred Whitehead has said in another context, “It is a profoundly erroneous truism, repeated by all copy-books and by eminent people when they are making speeches, that we should cultivate the habit of thinking what we are doing. The precise opposite is the case. Civilization advances by extending the number of important operations which we can perform without thinking about them.” This is very important in the social field. We constantly use formulas, symbols, and rules we don’t understand, to get access to knowledge we don’t have individually. We’ve grown these practices and institutions by building upon habits and institutions that have proven successful in their own sphere. In turn, they’ve become the foundation of the civilization we’ve built up.

The price system is just one of those formations man stumbled upon without understanding it. He then learned to use it, but he is still very far from making the best use of it. It has enabled not only the division of labor but also the coordinated use of resources in the face of equally scattered knowledge. Some people dismiss this idea as miraculous: why should just that sort of system that is best suited to modern civilization grow spontaneously? It’s the other way round: man was able to develop that division of labor our civilization is based on because he stumbled upon a method that made it possible. If he hadn’t, he might have built some other type of civilization, something like the ‘state’ of termites, or something we can’t even imagine. But we do know that no one has designed an alternative with features from the price system even its opponents want to keep. Those features include man’s ability to choose his own pursuits and use his knowledge and skill freely.

VII

At first, people rejected the idea that a price system is needed to divide labor and make rational calculations, mostly for political reasons. Today, the rejection is no longer mainly political, which means discussions can be more reasonable. Leon Trotsky argues that “economic accounting is unthinkable without market relations”, and Professor Oscar Lange promises Professor von Mises a statue in the marble halls of the future Central Planning Board. Professor Abba P. Lerner rediscovers Adam Smith and emphasizes that the price system makes man do what’s in the general interest while seeking his own. Clearly, remaining differences are no longer due to political bias – they’re intellectual and methodological.

Professor Joseph Schumpeter recently made a statement in his Capitalism, Socialism, and Democracy that’s a good example of the methodological differences I have in mind. He’s a positivist economist. To him, resources directly affect each other, without any human intervention. He argues that rational calculation is possible without markets for the factors of production. He says it’s possible due to “the elementary proposition that consumers in evaluating (‘demanding’) consumers’ goods ipso facto also evaluate the means of production which enter into the production of these goods.”¹

Taken literally, that’s just not true. Consumers don’t do anything of the kind. Maybe by “ipso facto” Schumpeter means that the valuation of consumers’ goods implies the valuation of the factors of production. But that isn’t true, either. One statement implies another only if they appear to the same man simultaneously. But the values of the factors of production clearly don’t just depend on the valuation of the consumers’ goods but also on the conditions of supply of the various factors of production. Only someone who knows all of these facts simultaneously would be able to get the answer. But the practical problem is that these facts are never given to one man. So the solution has to refer to knowledge that is scattered across many people.

We do not solve the problem by showing that all facts uniquely solve it if they are given to one man (an economist, say). Instead, we have to show how several men arrive at a solution by dealing with each other based on limited knowledge. If we just assume that one man knows everything he needs to know, then we assume the problem away.

I suspect there’s something fundamentally wrong with Schumpeter’s approach. It ignores an important part of the problem: man is fallible, so he needs to communicate in order to learn. Any approach, including mathematical economics with its simultaneous equations, that starts from the assumption that people’s knowledge corresponds to the objective facts of the situation, ignores this problem. Equilibrium analysis is useful, but it fools our leading thinkers and does not deal with the social process at all.