June 18, 2024

Friedrich Hayek’s essay “The Use of Knowledge in Society,” published in 1945 in the prestigious American Economic Review, is often hailed as an important contribution to economics. Rightly so, because it provides important “meat” to the price theory “skeleton.” However, Austrian economists often exaggerate its importance in ways that risk undermining Austrian economic theory.

Primary among the exaggerations is the claim that Hayek showed in his essay that the market system offers the solution to the knowledge problem through prices. Specifically, how prices aggregate and make available relevant information about the particulars of time and space. The role of entrepreneurs is then to adjust their production undertakings to price changes. This, then, constitutes the marvel of the market, as Hayek put it: that entrepreneurial production responds to changes without needing to know the specifics of those changes.

While the essay works well as a critique of the “perfect information” assumption in mainstream economics, which was arguably Hayek’s purpose with writing the essay, a Misesian reading makes clear that the argument is at best incomplete. Hayek’s reasoning greatly oversimplifies the economic calculation argument, downgrades entrepreneurship to responsive action, and misconstrues factor prices as bearers of information about the past. While these are listed here as separate errors, they amount to a single core issue: a misunderstanding or misrepresentation of the market process.

Economic Calculation Is a Process

The Misesian economic calculation argument is often misunderstood as the inability of any economy to rationally allocate resources without prices. Market socialists, like Fred Taylor and Oskar Lange, made this mistake. Therefore, as a solution, the market socialists offered a scheme in which socialism could be saved by having a central list of prices that the central planning board’s bureaucrats would update as shortages and surpluses are observed. There are several practical issues with this attempted solution, but the core problem is theoretical: it fails to recognize that the issue is not an inability to aggregate dispersed knowledge but an inability to deal with the uncertainty of the future.

Ludwig von Mises’s economic calculation problem is not merely a matter of gathering and processing information but the issue of meeting the uncertain future in value terms. Investments in production today are necessarily made without knowing whether and to what extent consumers will value the goods and services produced. The issue is not efficiency in the production of specific goods in the present (which is the role of management) but how to decide which investments should be made given unknown future valuations. In other words, today’s factor prices cannot represent information about the past.

Prices Are Future Prices

Factor prices also cannot represent information about the present state of the market because production underway is not intended to satisfy wants already held but wants that consumers will hold in the future. Factor prices also incorporate entrepreneurial judgments about what productions are possible. We can easily observe this when new regulations are put in place that do not affect present production but will have an effect in the future. For example, a ban on gasoline automobiles many years into the future would cause prices of factors used in gasoline automobile manufacturing to fall while prices of factors used in production of substitute goods would go up. This should not be the case if prices represent the present. Instead, it should be obvious that the prices represent expectations about the future.

The Role of Entrepreneurs

The entrepreneur is at the core of Mises’s economic calculation argument. It is not merely a matter of adjusting production to new information, whether it can easily be aggregated and communicated, but a process of price determination. In markets, entrepreneurs seeking to profit from uncertain future market states determine factor prices. As Mises put it in Human Action: “The entrepreneurs, eager to earn profits, appear as bidders at an auction, as it were, in which the owners of the factors of production put up for sale land, capital goods, and labor.”

What is the basis of the entrepreneurs’ competitive bids for factors? The basis is their appraised value of the goods they intend to make available to consumers (discounted using their rate of time preference). In other words, an entrepreneur expecting to produce goods that they envision will be of high value to many consumers will be able to outbid entrepreneurs who appraise their productions to be of lower value or of value to fewer consumers. The estimated future revenue (adjusted for the entrepreneurs’ required returns and time preference rates) determines the prices they can and will offer for factors in the present.

This bidding process weeds out entrepreneurs whose productions are appraised of insufficiently high value. This process also directs resources into more capable hands. However, it importantly also determines factor prices in the present—based on the entrepreneurs’ collective appraisement of the future value of present production. This issue is missing from Hayek’s discussion. It is also what is missing from the market socialists’ attempted solutions to Mises’s calculation problem.

Hayek’s Incomplete Argument

As Hayek puts it in his famous essay:

A rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate “given” resources—if “given” is taken to mean given to a single mind which deliberately solves the problem set by these “data.” It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality.

Read as a critique of the “perfect information” assumption in mainstream economics, Hayek’s argument points to an important problem with how information is (mis)understood. It is not perfect but both imperfect and asymmetric, always incomplete and dispersed.

Reading the essay from a Misesian perspective, however, Hayek not only directs the reader’s attention to a relatively unimportant issue but, in effect, misrepresents the calculation problem and therefore the market process.