This is the first post in a new series at AU for this summer. The series will highlight famous papers in economics, typically older papers that have already cemented their names in history. For all of the posts in the series, I encourage everyone to at least skim the accompanying paper and comment with your thoughts, for I cannot guarantee that my own comments will be either unique or insightful.
I begin with a 12 page paper published by Friedrich Hayek in the American Economic Review, 1945, entitled, “The Use of Knowledge in Society.” The thesis of this short paper is that prices convey knowledge:
We must look at the price system as such a mechanism for communicating information if we want to understand its real function. (page 526)
Hayek quickly distinguishes between scientific knowledge and “the knowledge of the particular circumstances of time and place”–which refers to the knowledge of where resources are, how much things cost to produce, etc. Today we usually refer the the latter kind as information, not knowledge.
This idea is now widely accepted by economists, and is certainly not new to UES. I am no historian of thought, but this article’s prominence leads me to believe it was either the first or the most persuasive article to discuss this special role that prices play in the economy.
Reconsidering these ideas, I am most struck by the observation the author of this review: We must be careful when discussing “perfect information” in models of the economy. Hayek’s description:
I fear that our theoretical habits of approaching the problem with the assumption of more or less perfect knowledge on the part of almost everyone has made us somewhat blind to the true function of the price mechanism and led us to apply rather misleading standards in judging its efficiency. (page 527)
It is not the existence of such information which causes the market to be efficient but rather the lack thereof!
Hayek argues that central planning fails because a planner could not possibly gather all of the disseminated knowledge in an economy without prices. Today the so-called economic, or socialist, calculation debate is no longer at the forefront, but the role of prices in conveying information is no less important. In evaluating various policies, we still must consider their effects on prices’ signaling ability.
Here are some thoughts as I go down through the paper:
I know that Hayek does not say this is possible, really, but I wanted to point out how impossible it really is– even for a given market. If you start from the assumption that human actors have free will, then there is too much noise in the system right now to derive a “given system of preferences” that will hold for any deductions. Furthermore, this is the old Godel problem popping up in the context of human actors. Any attempt to pin down human preferences will result in feedback preference changes as well as the necessity for more and more proofs… unless and until, that is, neuroeconomics translates through the barriers of axon sheaths and into the heart of nervous system matter.
You were a few days too late for me on this one, Matt. I could definitely have used it in one or two of my papers this semester! Ahhh, but now, retirement…
Yes, and of course we have Democrats on one side of the issue and Republicans on the other side. Luckily for the Republicans who care about re-election, there is a one-way bridge from their side to the “central planning” side. I find that Republicans cross it far too often. Central to the excuses is the need to “protect of the public interest.” This, I have decided, is one of the most deadly of all ideas yet uttered, at least insofar as it relates to someone’s reasoning behind the implementation of regulations. In any case, these “educated” persons are also seduced into the fallacy of their own superiority *to know*, and I won’t call them elites, yet, but…
ELITES!!!
I won’t paste this, but I love the distinction between scientific knowledge and “other” knowledge. I can’t wait to use that one.
[ Note: we need to have a discussion on whether or not math is a subset of logic, not vice versa, because the wikipedia articles I am reading seem to argue that both of our sides are correct. Though I have read books on the Incompleteness Theorem(s), I think it may yet be beyond me to argue this in depth. Which leads me to my next point… ]
What say you regarding Hayek’s discussion of mathematics? It seems to me that he comes to the same conclusion we did at the soiree — namely, that math has its uses, but they must not be overbroadly applied. Restraint is vital for the true logician.
I LOVE this — and as it is my main subject on my art blog, intend to start wielding it as well. I couldn’t agree more. Marginal Revolution recently had a post on this subject as well, really, relating to how we should deal with antiquities, which are very scarce. Finally, a more persuasive author on the subject than Merryman has spoken up.
And wow, I did not see Hayek’s tour de force assault on Schumpeter coming, along with the conclusion about the imperfection of man’s knowledge, but it seems rather convincing to me!
Another interesting link, I was randomly reading this post about prediction markets over at CIA Studies and lo and behold, there’s a discussion of the very paper you cited!
https://www.cia.gov/library/center-for-the-study-of-intelligence/csi-publications/csi-studies/studies/vol50no4/using-prediction-markets-to-enhance-us-intelligence-capabilities.html
Regarding the possibility of solving the economic problem given perfect information and a “given system of preferences”: Hayek seems to concede that this is possible, if we had perfect information, but then just moves on by saying, ‘well, we don’t have perfect information.’ Admiral claims that the economic problem is not even possible to solve with perfect information.
I think the characteristics of preferences, as Admiral discusses, factor into who is correct. If preferences are very nice looking (as we can easily model using some mathematics), then I believe a solution will exist. Nonetheless, it’s not clear exactly how preferences are structured such that this explicit calculation would be even remotely possible, so I’m not sure who is correct.
Reagan referred to a similar idea of Hayek’s quote “anyone who…gains an advantage over somebody…” in his 1964 speech:
I agree, to an extent, with the Whitehead statement. This statement is the flip-side of the division of labor coin. Each individual doesn’t have to worry about how many, many tasks are achieved in a modern civilization. Nonetheless, when it comes to your specialty, you certainly should think about what you’re doing. The classic example is the modern relationship between the calculator and mathematics.
So back to economics and math: I certainly agree that one must think about the economics behind the math. I think our only disagreement is the extent of which mathematics is useful, which is more difficult to reconcile.
[P.S., Admiral: your wikipedia link is broken.]
::sighs:: Yes, depending on the assumptions, we can either determine it to be provably provable that logic will take hold and determine the most efficient allocation of resources or it will be provably unprovable. I very strongly suspect that the case is latter, due in part to the case I already laid out. What do you suspect?
It seems as though the reasons I have already given are good enough, but if there is an element of randomness as well, that alone would probably be sufficient, it seems, to defeat your “logic” modeling.
In hindsight, I think I am beginning to maybe see your point about “perfect information.” There is only one scenario in which it is possible, however, to have completely perfect information. That is to be an all-knowing entity who has full information on the *past*. This will therefore include all data regarding quantum states and choices made, so as to avoid observer paradoxes and free will infinite regress problems.
Perhaps Hayek meant this and in the prose of his day this was quite a barnburner of a comment. But assuming he didn’t mean this and also that this state of being is impossible for us, then I have another point against Hayek’s claim that we can “solve the economic problem given perfect information” and it should also qualify as a point against you for hedging.
Technology. I don’t believe that perfect information as you and Hayek refer to it would be able to forecast technological developments in any way and that would distort all manner of pricing and allocation issues.
Hmm. Past information may matter, but only insofar as it is used to predict the future. If one knew the future completely, then why would we need to know past information? I’m not too familiar with the paradoxes you cite, so perhaps there is something logically wrong with the idea of “knowing everything”, but I don’t know.
Regarding technology, I think perfect information would include perfect knowledge of the future, and hence knowledge of technology. After all, one of the most basic choices we have to make is how much to consume today and how much to consume tomorrow.
Anyway, for whatever reasons, we agree that having such perfect information is essentially impossible, regardless of whether or not the calculation itself is possible, given the information. Hence it doesn’t really matter if the calculation is possible.
Here is an interview with Ken Arrow (19 minutes), where apparently he bashes this Hayek paper by saying that it’s obvious and Hayek fails to recognize the importance of information issues in market transactions. [HT Economic Investigations]
I haven’t listened to the interview yet (my computer is on the verge of breakdown and my audio no longer works), so I can’t confirm the Hayek bashing yet. Check out some of the comments on Gabriel’s blog.