Thursday, November 17, 2016

Understanding Hayek's Knowledge Argument (1): Prices as Signals

How should we decide what gets made, when it gets made, and who should get it once it is made? This is one of the foundational questions of economics. Proponents of the free market insist that private individuals, interacting with one another via a marketplace, responding to a price mechanism, should determine the answers; proponents of central planning think that a suitably organised government bureaucracy should do the work; others prefer a mixed approach.

Friedrich Hayek’s knowledge argument is a famous contribution to this debate. It extolls the benefits of the free market over central planning. Although there are many explanations and commentaries on Hayek’s argument, I have yet to come across one that I really like — one that both does justice to the nuances of Hayek’s original claims while at the same time highlighting their flaws. Richard Bronk’s article ‘Hayek on the wisdom of prices: A reassessment’ is the closest thing I have read, but Bronk’s article lacks concision and clarity.

I want to make up for this. I want to extract the logical core of Hayek’s argument, revealing the key premises and assumptions that go into it, and then subject it to critical scrutiny. I am going to do this over the course of two posts. In this first post I’ll just go through the main steps in Hayek’s argument, briefly commenting on its flaws. In the second post I’ll look in more detail at the weaknesses in the argument, focusing in particular on Bronk’s own arguments about the flaws of the price mechanism.

1. From the Distribution Problem to the Knowledge Problem
Let’s call the ‘what gets made, who gets it’ (etc) problem the ‘distributional problem’:

Distributional problem: All societies need to figure out how best to distribute their scarce resources (material resources, labour, time etc.), i.e. they need to figure out what gets done, when and by whom.

It is important not to underestimate the difficulty of the distributional problem. Human society is both complicated and complex. It consists of many different, dynamically interrelated parts. Figuring out who wants what, who needs what, and how they relate to one another is a fiendishly difficult thing. There are thousands of distributional decisions that need to be made on an minute-to-minute basis. How many shoes should be made? How many shoelaces? How much food should be grown? What types of food? What skills should be taught? Who should teach them? And on and on.

Hayek’s key insight was to suggest that the answer to the distributional problem depends upon the answer to another problem:

Knowledge Problem: To figure out who should get what and when, we need to know certain things: we need to know what people want and need, what resources are available to meet those wants and needs, what the best (most efficient) means of deploying those resources is, how people react to our distributional decisions and so on.

It is also important not to underestimate the difficulty of the knowledge problem. Given the complex and complicated nature of human society, there are many discrete and constantly changing knowledge gaps that need to addressed if we are to figure out who should get what and when.

The essence of Hayek’s knowledge argument is that central planners are not very good at solving the knowledge problem whereas free markets, despite some obvious flaws, are. Those two claims constitute the core of his ‘knowledge argument’. Let’s look at both in more detail.

2. The Case Against Central Planning
The first claim is that central planners fail to solve the knowledge problem. Why not? To answer that we need to understand what central planning is, and it is, in fact, a somewhat complex notion. Roughly, we are talking about a state-run bureaucracy that collects information and makes decisions about what should get made and how it should be distributed. There are many different ways for this play out in practice. You could imagine a single, dictatorial bureaucrat sitting at the centre of an institution deciding what should get done and when in a largely intuitive manner. Or you could imagine something more complex and technocratic, like the cybernetic management system that was used by the Allende government in Chile in the 1970s. There are also ways in which central planners could create market-like structures that replicate some, but not all, features of the free market (itself a highly contested concept). The possible market-like structures that could be adopted featured heavily in the general ‘socialist calculation debate’ in economics (to which Hayek’s argument is a contribution).

So when Hayek says that a centrally planned economy will not solve the knowledge problem what kind of centrally planned economy is he talking about? The general model would be something along the lines of what existed in Soviet Russia: reasonably complex bureaucratic organisations where information is collected and processed by diverse (sometimes politically antagonistic) groups and fed through some decision-making system. The key point is that there is a kind of ‘bottleneck’ within the system. Instead of distributional decisions being made all the time and in parallel, distributional decisions are forced through a single bureaucratic decision-making node. This means that all the information relevant to the distributional decision needs to reach that node. Hayek argues that this is not going to happen.

The argument works like this:

  • (1) If a centrally planned economy is going to work (i.e. going to solve the distribution problem), central planners will need the knowledge relevant to making distributional decisions.
  • (2) Central planners cannot have the relevant knowledge.
  • (3) Therefore, a centrally planned economy is not going to work.

The second premise is key here. Hayek presents four arguments in support of that premise. The first is:

  • (4) Much of the knowledge required for distributional decision-making is tacit, i.e. cannot be easily translated into explicit representations that can then be communicated between relevant decision-makers.

I discussed the phenomenon of tacit knowledge in a previous post about automation and unemployment. The basic idea is that much of the know-how underlying the creation and supply of goods and services is tacit. It is based on practical, oftentimes subconscious, skills that individual workers and manufacturers have acquired over the course of their working lives. Think of the expert surgeon who has performed thousands of hours of complex surgery and intuits when something is going wrong. They act on these intuitions and they often, consequently, improve the quality of the service they provide. There is nothing necessarily mystical or unusual in this ability. The intuitions don’t come from nowhere; they come from practical experience. But they are, nonetheless, very difficult to express and communicate. It is hard to see how a central planner could gain access to this tacit knowledge unless they themselves replicated the experience levels of the individual suppliers of goods and services.

The second argument in support of premise (2) is:

  • (5) The knowledge required is too diverse to be amassed into (and appreciated by) one perspective.

Markets are complex and multi-faceted. The knowledge any one individual has of the market is necessarily partial and incomplete. Hayek argues, and this seems plausible, that no one individual or group is likely able to amass together all those partial perspectives into a unified and complete perspective. Instead, what will happen is that central planners will think they have complete knowledge. They will become over-confident in their ability to understand and predict the behaviour of the people affected by their decisions.

The third argument in support of premise (2) is:

  • (6) Central planners cannot know subjective values and subjective values are part of the knowledge needed to solve the distributional problem.

Hayek defended the subjective theory of value. He held that the value of a good or service was determined by the interaction of the subjective preferences of the agents supplying and demanding that good or service. It was not determined by any intrinsic/objective property of the good or service. Scarce resources are best distributed when the actions of suppliers are responsive to the preferences of demanders. But since it is impossible to really know what is really going on in someone’s mind — i.e. to know what they truly prefer — it follows that it is impossible for a central planner to have access to all the knowledge they need. At best, they will get a partial understanding of subjective value by examining the external behaviour of individuals, but this external behaviour can be misleading.

The fourth and final argument in support of premise (2) is:

  • (7) Central planners cannot rival the knowledge discovery mechanisms of the free market and knowledge discovery is also essential to solving knowledge problem.

This is probably the most complicated aspect of the case against central planning. The idea is that the efficient distribution of goods and services does not just depend on current knowledge but that it also depends on creation and innovation. Suppliers discover more efficient ways of doing things: they innovate in production processes, creating new machinery and new tools, and they innovate in supply chains, creating new ways to get goods and services to consumers. In other words, they create new forms of knowledge that then get fed into the resolution of the distributional problem. Central planners may be able to encourage some experimentation and innovation but they will never, according to Hayek, rival the creative potentialities of the free market. (I should say that this is something hotly contested by defenders of socialist planning like Oskar Lange and there are some historical counterpoints highlighting to role of big government projects in innovation and experimentation).

Anyway, this gives us the first part of Hayek’s argument (the case against central planning). The argument is diagrammed below.

3. The Case in Favour of Free Markets
The second part of Hayek’s argument is an argument in favour of free markets. To some extent, this argument implicit in the critique of central planning: the knowledge gaps faced by central planners would not, it is claimed, arise on the free market. But you cannot get all the way to that conclusion from what has been said thus far. After all, at least some of the knowledge gaps that arise for central planners would seem to arise on the free market too. If knowledge is tacit, diverse and subjective, then surely it is just as difficult for it to be discovered by players on the market too?

This is where Hayek makes his most famous contribution. He argues that the free market has one tool at its disposal that can help to fill in these knowledge gaps: the price mechanism. For him, the free market functions like an information communications system, with prices being the signals that communicate important information (knowledge) to the players on the market.

The argument works a little something like this:

  • (8) If free markets are going to solve the distribution problem, they will have to solve the knowledge problem.
  • (9) A key feature of a free market is the price mechanism: the supply and demand-related decisions of the players on the free market create and respond to prices.
  • (10) The price mechanism can solve the knowledge problem.
  • (11) Therefore, free markets can solve the distribution problem.

There is a lot that needs to be said about this argument. The first premise (8) simply applies the general principle underlying Hayek’s argument (i.e. that the distributional problem depends on the knowledge problem). The second premise (9) is appealing to a key feature of the free market. As we will see below, it is not a unique feature of the free market (prices can exist on ‘unfree’ markets), but prices do function in a particular way on the free market. The third premise (10) follows this up by highlighting the particular way in which prices function, namely to solve the knowledge problem. ‘Solves’ is a bit strong, of course. We are not going to fill every relevant knowledge gap. The idea is, rather, prices do a better job than a central planner ever could.

So premise (10) is then the key to the whole argument. What can be said in its favour? Three things stand out from Hayek’s discussion:

  • (12) Prices collate information about subjective preferences and tacit knowledge from diverse sources.

The subjective knowledge about how much individual consumers and suppliers value a good or service is encapsulated in the market price. This price is the result of diverse, locally-situated actors, coming together and interacting on a marketplace. In other words, it pulls together the diverse perspectives that are difficult to encapsulate in the spreadsheets and statistical data beloved by central planners. We can also argue that the price draws upon the tacit knowledge of the producers and suppliers working on the market. They have the know-how required to produce goods and services and they can communicate the value of that know-how through the price they charge.

  • (13) Prices respond to developments, e.g. changes in preference, new discoveries or innovations in production and so forth.

The individual suppliers and consumers change the prices they are willing to receive and spend in response to local, dynamically updated information. Furthermore, the players on the market are incentivised to do new things in the hope that it will result in higher profits or lower costs. If a new production process is discovered that supplies a good or service at a cheaper cost, this will be fed into the market price, thereby telling people that a new production process is worth taking onboard (and vice versa).

  • (14) Prices communicate relevant information to people, thereby enabling them to know what is and is not worth doing on the market.

One of the big problems facing central planners is that they have to know what needs to be produced and what needs to be supplied, and then communicate this knowledge to the people who make and supply things. This is not easy: you have to somehow draw all the knowledge together and give a quick and easy signal that conveys that knowledges. Prices address this problem with remarkable efficiency. Prices don’t tell you everything you need to know about human wants and needs and how best to meet them. But they do provide a nice, simple, and clear signal of what people want and what methods will best meet those wants. The signal (the price) compresses a lot of information into one place and is readily available to anyone who needs to know it. This helps solve the communication problem that would otherwise arise.

This second portion of the knowledge argument is diagrammed below.

4. Problems and Next Steps
Hayek’s argument is not above criticism. This is to state the obvious. But three criticisms are worth mentioning here by way of conclusion. The first is that market prices will only work their communicative magic if they are undistorted by government interference. For Hayek, prices need to freely respond to changes in local behaviour and to new discoveries if they are going to collate and communicate relevant knowledge. If the government intervenes by setting price floors or price ceilings, this cannot happen. Similarly, if the government imposes additional costs where none should arise, you get further distortions in the knowledge being communicated.

Second, even though Hayek thinks that prices contain a lot of the information needed to solve the knowledge problem, he does not think that they contain all relevant information. This makes his view quite different from modern-day proponents of the efficient market hypothesis (who do think that market prices contain all relevant information). Hayek thinks that the players on the market are constantly trying to achieve some informational advantage over their peers: they are trying to discover new production processes or spot knowledge gaps that others have missed (opportunities for arbitrage). This is both healthy and necessary. It means that markets can encourage innovation and that prices can constantly adapt and update in response to new information. If market prices already contain all the relevant information, it would be difficult to make sense of much market behaviour.

Third, Hayek’s argument overlooks the various ways in which markets can themselves distort prices, either by failing to collate some relevant information or by being hijacked by dominant narratives. Bronk argues that this is more common than we might like to think, particularly in certain markets. This is possibly the most interesting critique of Hayek’s argument and I will look at it in more detail in a future post.

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