This is an abridged version of Friedrich Hayek’s The Use of Knowledge in Society.
The Ultimate Economic Problem
If we have the complete and accurate data on everyone’s preferences, then we can allocate resources in an optimal way.
However, the input data for this calculation have never and can never for the whole of society be obtained by a single mind.
Knowledge is Decentralized
That’s because knowledge do not exist in a concentrated form. Knowledge are dispersed bits of incomplete and frequently contradictory data living in separate individuals.
There is a body of very important but unorganized knowledge: the knowledge of the particular circumstances of time and place. For example, businessmen know their business best. Craftsmen deeply understand their craft. Consumers have the best sense of how they should use their money. Practically every individual has some advantage over all others because they possesses unique information, but which can only be used only if the decisions depending on it are left to him or are made with his active cooperation.
How do we properly utilize this totality of knowledge that is unknowable to any single person?
The Problem of Economic Coordination
Finding the best way of utilizing knowledge dispersed among people is a major challenge in designing an efficient economic system.
Who should do the ‘economic planning’? Should it be done centrally by one authority for the whole economic system, or is to be divided among many individuals?
We cannot expect that this problem will be solved by communicating all this knowledge to a central board which, after integrating all knowledge, issues its orders. We must solve it by some form of decentralization.
A decentralized approach means that the ultimate decisions must be left to the people who are familiar with these circumstances, who know directly of the relevant changes and of the resources immediately available to meet them.
But can a solution be produced by the interactions of people each of whom have only partial knowledge?
Decentralized Decision Making
As a single person you can’t make decisions just with the limited knowledge about your immediate surroundings. You also need to somehow be aware the whole other pattern of changes in the rest of the economic system.
How much external knowledge do you need to make a decision? Which of the events which happen beyond the horizon of your immediate knowledge are relevant? How much do you need to know?
There is hardly anything that happens anywhere in the world that might not have an effect on your decision-making. But you don’t need to know about every event, nor of all their effects. It doesn’t matter for you why at the particular moment more screws of one size than of another are wanted, why paper bags are more readily available than canvas bags, or why skilled labor, or particular machine tools, have for the moment become more difficult to obtain.
What’s relevant is how much more or less difficult to acquire they have become compared with other things you also care about. The causes which alter their relative importance are of no interest to you beyond the effect on those concrete things of your own environment.
Prices are Signals
In a free market economic system, the price system is solving this distributed knowledge problem. Prices are signals that bundle both information and incentives. With prices, you can construct and use rates of equivalence (or “values,” or “marginal rates of substitution”) by attaching to each kind of scarce resource a numerical index which reflects its significance in view of the whole economic structure.
In any small change you only have to consider these indices (or “values”) in which all the relevant information is concentrated; and, by adjusting the quantities one by one, you can adjust your preferences without having to know everything about the world.
In a world where knowledge is dispersed among many people, prices can act to coordinate the separate actions of different people in the same way as subjective values help you to coordinate your life.
For example, let’s say a new opportunity for the use of tin has emerged, or that one of the sources of supply of tin has been exhausted. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must conserve tin. The users doesn’t even need to know what the more urgent need is, or in favor of what other needs they should conserve the supply.
If even a handful of people know about the increased demand, and switch resources over to it, the effect will rapidly spread throughout the whole economic system and influence not only all the uses of tin but also those of its substitutes and the substitutes of these substitutes, the supply of all the things made of tin, and their substitutes, and so on. All this happens without the actors knowing anything at all about the original cause of these changes.
Prices Coordinate Economic Actors
The whole acts as one, not because any of its actors survey the whole field, but because their limited individual fields of vision sufficiently overlap so that the relevant information is communicated to all. The mere fact that there is one price for any commodity — or rather that local prices are connected in a manner determined by the cost of transport, etc. — brings about the solution to our distributed knowledge problem.
The marvel is that without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly.
The price system solves the problem of how to extend the span of our utilization of resources beyond the span of the control of any one mind; and therefore, how to dispense with the need of conscious control, and how to provide incentives that make individuals do desirable things without anyone having to tell them what to do.
The price system is a kind of machinery for registering change, which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.
Prices are the information system of economic production, communicating knowledge across the world and coordinating the complex processes of production. Through it not only a division of labor but also a coordinated utilization of resources based on dispersed knowledge has become possible.
The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual actors need to know in order to be able to take the right action. By a kind of symbol, only the most essential information is passed on.
You can read the original version of Friedrich Hayek’s The Use of Knowledge in Society here.
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