The Use of Knowledge in Society by Frederich Hayek simplified by Una GPT.
We want to create a rational economic system. This is simple if we know everything, have clear preferences, and understand all resources. The main challenge is logical: finding the best use of resources. The solution follows specific rules, best expressed mathematically. It requires equalizing the trade-off rates between any two items across all uses.
The real economic challenge society faces differs from this logical problem. Our current economic methods help but don't fully solve society's issues. This is because no single person can know all societal data needed to make these calculations.
The real challenge in creating a rational economic order is that knowledge is scattered among many individuals, not held by a single person. It's not just about allocating known resources. It's about using resources effectively based on the knowledge of all society members, who understand their own needs and priorities. In short, it's about using collective knowledge that no one person fully possesses.
Recent advances in economic theory, especially in mathematics, have sometimes made it harder to understand the key issue: creating a rational economic system. This paper focuses on this issue, highlighting its link to methodological questions. I've found that different reasoning paths lead to similar conclusions. Current disagreements in economic theory and policy often stem from a common misunderstanding about society's economic challenges. This confusion arises from wrongly applying methods used in natural sciences to social phenomena.
In simple terms, "planning" refers to deciding how to use resources. All economic activity involves planning. In collaborative societies, planners must base decisions on knowledge they don't initially have but receive from others. The key issue for economic theories is how this knowledge is shared. Figuring out the best way to use knowledge spread across many people is a major challenge in economic policy and in designing an efficient economic system.
The key question is who should do the planning. The debate isn't about whether to plan, but whether planning should be centralized by one authority or decentralized among many individuals. Central planning means directing the entire economy under one unified plan. In contrast, competition involves many separate people making individual plans. A middle ground, often discussed but less favored, is delegating planning to specific industries, leading to monopoly.
The efficiency of these systems depends on which one better uses all available knowledge. It's about whether a central authority can gather and use knowledge that's spread among many people, or whether we can give individuals the extra knowledge they need to align their plans with others.
The efficiency of different planning systems depends on the type of knowledge involved. The key question is whether specific individuals or a central authority with chosen experts can better handle this knowledge. Currently, there's a strong belief in the superiority of expert authorities, mainly because of the high regard for scientific knowledge. Experts might indeed best handle scientific knowledge, but selecting these experts is a challenge. Even if we solve this, it's just a small part of a bigger problem, as other types of knowledge are also crucial.
It's often seen as unconventional to say that scientific knowledge isn't the only important knowledge. There's also a crucial, unorganized knowledge of specific time and place details. Individuals often have unique, useful information about their circumstances. This knowledge is invaluable and can't be fully utilized unless individuals make or influence decisions. Practical experience in any job teaches us this. For example, using underutilized machinery, someone's skills, or surplus stock is as valuable as knowing better techniques. People like shippers using empty cargo spaces, real estate agents knowing temporary opportunities, or traders exploiting price differences in different locations, all rely on this fleeting, specialized knowledge.
It's odd that today, practical knowledge is often looked down upon, and those who gain an advantage through it are seen as almost disreputable. Using knowledge of communication or transport to gain an edge is sometimes viewed as dishonest, even though it's crucial for society to use these opportunities just as it uses scientific discoveries. This bias affects how people view commerce compared to production. Even many economists overlook the value of acquiring practical knowledge, assuming it's already "given" to everyone. The common belief is that such knowledge should be easily accessible to all, and criticism of the current economic system often comes from the fact that it isn't. This view ignores that finding a way to distribute this knowledge widely is exactly the challenge we need to address.
Today, people often downplay the importance of knowing specific, current details. This attitude is linked to a reduced focus on change itself. Planners and their critics mainly differ on how often and significantly changes affect production plans. If we could make detailed, long-term economic plans that don't need major adjustments, creating a comprehensive plan for all economic activity would be easier.
Economic problems only occur due to change. If things stay the same, or as expected, there's no need for new decisions or plans. The belief that changes or daily adjustments are less important today suggests that economic issues have also become less significant. This belief often comes from those who think that technological knowledge has overshadowed economic considerations.
Is it accurate to say that in modern production, economic decisions are only needed occasionally, like when building a new factory or introducing a new process? Once a plant is built, is everything else almost automatic, with little need for adjustments to changing circumstances?
The belief that frequent economic decisions are unnecessary in modern business is not supported by real-world business experience. Especially in competitive industries, managers constantly strive to keep costs down. This task takes up much of their effort. It's easy for an inefficient manager to lose the profit margin, and the same technical facilities can produce varying costs. Businesspeople often express a strong desire to work without worrying about money costs, highlighting how much these considerations impact their daily work.
Economists often overlook constant small changes in the economy due to their focus on statistical aggregates, which appear more stable. This stability doesn't come from random changes canceling each other out, as there aren't enough elements for that to happen. Instead, stability results from continuous, deliberate adjustments. Businesses make new decisions daily based on fresh information. For example, if one supplier fails, another steps in immediately. Even large, mechanized plants rely on a network for unexpected needs like roof tiles or stationery. They can't be self-sufficient and need various supplies readily available in the market
The kind of knowledge I'm discussing can't be captured in statistics or conveyed to a central authority in this form. Statistics used by such an authority must generalize, grouping together diverse items as if they were similar. This approach overlooks significant details like location and quality, crucial for specific decisions. Therefore, central planning based on statistics can't directly consider these specific circumstances. The central planner needs to delegate decisions affected by these details to the "man on the spot.”
If we agree that society's economic problem is mainly adapting quickly to specific, changing circumstances, then people familiar with these changes should make the ultimate decisions. They know the relevant changes and available resources. Communicating all this knowledge to a central board for decision-making isn't practical. Decentralization is needed to ensure prompt use of this specific knowledge. However, decentralization only partly solves the problem. The "man on the spot" can't decide based only on his limited knowledge of his immediate environment. We must also communicate additional information to him, so he can align his decisions with the broader economic system's changes.
How much knowledge does the "man on the spot" need to make successful decisions? What relevant events beyond his immediate awareness should he know about to inform his decisions?
The "man on the spot" might be affected by almost anything happening worldwide. But he doesn't need to know every event or all its effects. He doesn't need to understand why certain items like screws, paper bags, or specific tools are in varying demand. What matters to him is how these changes affect their availability compared to other relevant items, or how the demand for what he produces or uses shifts. He's focused on the relative importance of specific items in his environment. The underlying causes of these changes are irrelevant to him beyond their immediate impact.
The "economic calculus" concept helps us understand how the price system solves the problem of decision-making based on limited knowledge. Even someone with all data for a small economy wouldn't analyze every possible effect for each small adjustment. The key idea in decision-making logic is the use of equivalence rates or values. These rates, given to each scarce resource, don't come from the resource's intrinsic properties but reflect its importance in the overall scheme. For small changes, this person only needs to consider these values, which summarize all relevant information. By adjusting these values one by one, he can rearrange his plans without having to rework the entire system from scratch or understand every detail at once.
In a system where many people hold pieces of relevant knowledge, prices help coordinate their separate actions, much like how an individual uses subjective values to plan. Consider a simple example: if tin becomes scarcer, either due to new demand or reduced supply, it doesn't matter which caused the scarcity. Tin users only need to know they should use less tin because it's being used more profitably elsewhere. Most don't need to know where the demand shifted or for what purpose. If some people know about the new demand and adjust their use, this information will spread, affecting not just tin but its substitutes and their substitutes, and so on. This happens without most people knowing the original cause of the change. The market acts as one because these individual knowledge pieces overlap and spread through intermediaries. Local prices, linked by transport costs and other factors, solve the problem as if one mind with all the information made the decisions. This shows how prices communicate dispersed information and coordinate actions across the economy.
To understand the price system's real role, view it as a mechanism for sharing information. This role is less perfect when prices become rigid, but even then, changes in contract terms still reflect underlying forces. The key aspect of this system is its efficient use of knowledge: individuals need to know very little to make correct decisions. Essential information is condensed into prices and shared only with those involved. The price system acts like a machine registering changes or a telecommunications system. It allows producers to respond to changes by just observing price movements, similar to an engineer watching dials, without needing to know all the details behind these changes.
The price system's adjustments are never "perfect" like in equilibrium analysis. Our assumption of near-perfect knowledge has made us overlook the price mechanism's true role and judge its efficiency unfairly. The real wonder is how, in situations like a raw material shortage, without explicit orders or widespread knowledge of the cause, thousands, whose identities are unknown, are prompted to use the material more sparingly. This alignment of actions towards the right goal is remarkable, even if it's not perfect in a constantly changing world, and doesn't always maintain consistent profit rates.
I chose the word "marvel" to highlight how we often overlook the price mechanism's effectiveness. If this system were a human invention, understood and intentionally used by those influenced by price changes, it would be hailed as a monumental achievement of human intellect. Its disadvantage is that it wasn't designed by humans, and people influenced by it often don't understand why they're doing what they do. Critics who demand "conscious direction" and doubt solutions evolved without design or understanding should remember this: The challenge is extending resource use beyond any single mind's control. This means moving away from the need for conscious control and creating incentives that lead individuals to desirable actions without direct instructions.
The challenge we face in economics also appears in social phenomena like language and culture. It's a key issue in all social sciences. As Alfred Whitehead noted, contrary to common belief, civilization progresses by increasing the number of important tasks we can do without thinking. This holds great importance socially. We often use formulas, symbols, and rules without fully understanding them, tapping into collective knowledge beyond our individual grasp. Our civilization is built on these practices and institutions, rooted in habits and institutions that were successful and became our foundation.
The price system is a tool humanity has learned to use, even though we haven't fully mastered it. It was discovered by accident, not by design. This system enables both labor division and resource coordination, relying on shared knowledge. Critics often misrepresent this by suggesting it claims the current system is perfectly suited for modern society. In reality, our civilization developed this way because we found a method enabling such progress. Without it, we might have a completely different civilization, like that of termite ants or something unimaginable. No one has yet designed an alternative system that retains key features of the current one, especially the freedom for individuals to choose their paths and use their knowledge and skills.
The debate on the price system's necessity for rational decision-making in complex societies is no longer just a political argument. When Mises first proposed this idea 25 years ago, it faced scorn. Now, the resistance to it isn't mainly political, allowing for more rational discussion. Notable figures like Leon Trotsky acknowledge the need for market relations in economic accounting. Oscar Lange humorously suggests honoring Mises in a future Central Planning Board, and Abba P. Lerner highlights the price system's role in aligning individual pursuits with general interest, echoing Adam Smith. These shifts suggest that current disagreements are more about intellectual and methodological differences than political biases.
Joseph Schumpeter, in "Capitalism, Socialism, and Democracy," illustrates a key methodological difference in economic thinking. Schumpeter, influenced by a certain type of positivism, sees economic phenomena as direct interactions between quantities of commodities, with minimal human mental intervention. This perspective leads to his striking claim that rational calculation without factor markets is possible. He argues that when consumers value consumer goods, they also, by extension, value the production means of these goods. This statement highlights a distinct approach to understanding economic processes.
Schumpeter's statement, taken at face value, is incorrect. Consumers don't directly value the factors of production. He seems to suggest that valuing consumer goods inherently means valuing the production factors. However, this isn't true. Implication is a logical concept requiring simultaneous presence in one mind. The value of production factors depends not just on consumer goods' valuation but also on supply conditions. Only a mind with all this information could draw the necessary conclusion. The real challenge is that no single mind holds all this information. Therefore, we must use dispersed knowledge among many people to solve the problem.
The real challenge isn't solved by hypothetically assuming all facts are known to one mind, as economists often do. The key is to show how a solution emerges from the interactions of people, each with only partial knowledge. Assuming a single mind has all knowledge, like economists in their analysis, ignores the actual complexity and significance of real-world situations. It's about how dispersed knowledge among many leads to solutions, not about a central, all-knowing entity.
Schumpeter's error, given his stature as an economist, points to a deeper issue with an approach that overlooks a crucial aspect: the inherent imperfection of human knowledge and the ongoing process of communication and acquisition of knowledge. Approaches like much of mathematical economics, which assume people's knowledge matches objective reality, miss our main explanatory goal. While equilibrium analysis in economics is useful, its application to practical problems can mislead even leading thinkers. It doesn't address the actual social process and is only a preliminary step in studying the real issue.