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Thursday, February 27, 2014

The Knowledge Problem

MISES’S STUDENT, F.A. Hayek, brought into relief an aspect of the problem facing socialist planners that was only implicit in the work of his mentor. In his famous essay, “The Use of Knowledge in Society,” Hayek noted the importance of “the particular circumstances of time and place” in making sensible economic decisions:
Today it is almost heresy to suggest that scientific knowledge is not the sum of all knowledge. But a little reflection will show that there is beyond question a body of very important but unorganized knowledge which cannot possibly be called scientific in the sense of knowledge of general rules: the knowledge of the particular circumstances of time and place. It is with respect to this that practically every individual has some advantage over all others because he possesses unique information of which beneficial use might be made, but of which use can be made only if the decisions depending on it are left to him or are made with his active co-operation. We need to remember only how much we have to learn in any occupation after we have completed our theoretical training, how big a part of our working life we spend learning particular jobs, and how valuable an asset in all walks of life is knowledge of people, of local conditions, and of special circumstances. To know of and put to use a machine not fully employed, or somebody’s skill which could be better utilized, or to be aware of a surplus stock which can be drawn upon during an interruption of supplies, is socially quite as useful as the knowledge of better alternative techniques. The shipper who earns his living from using otherwise empty or half-filled journeys of tramp-steamers, or the estate agent whose whole knowledge is almost exclusively one of temporary opportunities, or the arbitrageur who gains from local differences of commodity prices-are all performing eminently useful functions based on special knowledge of circumstances of the fleeting moment not known to others.
In the same essay, Hayek offers an example of how the price system enables the changing circumstances of a market participant to potentially influence the choices of other actors throughout the entire economy, thereby adjusting supply and demand to new conditions:
Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate the separate actions of different people in the same way as subjective values help the individual to coordinate the parts of his plan. It is worth contemplating for a moment a very simple and commonplace instance of the action of the price system to see what precisely it accomplishes. Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter for our purpose—and it is very significant that it does not matter—which of these two causes has made tin more scarce. 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 economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand, and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, 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; and all his without the great majority of those instrumental in bringing about these substitutions knowing anything at all about the original cause of these changes.
Have you ever read the list of ingredients on a package of, say, “Puffy, Deep-Fried Cheese Thingies,” and found something along the lines of: “This product contains one or more of the following: coconut oil, palm oil, soybean oil, corn oil, canola oil, peanut oil, motor oil, snake oil.” When I first did so, I was puzzled as to how a manufacturer could be uncertain about just which oils were in its product. Of course, I was mistaken as to what the list meant. For any particular batch of Puffy, Deep-Fried Cheese Thingies, the manufacturer certainly knows which oil it is using.
In fact, the vague nature of the list is an illustration of Hayek’s point. The producer of Cheese Thingies believes (rightly or wrongly) that its customers don’t care too much about exactly which sort of oil was used to fry the Thingies in the bag they just bought, so long as the taste is pretty much the same as the ones they previously have eaten. Therefore, whenever the manufacturer must buy cooking oil, it purchases whatever one is cheapest at that time.
The goal of the manufacturer is simply to increase its profits. However, because it responds to price signals in its efforts to do so, it also, as an unintended consequence of pursuing its own end, helps to allocate resources to their most urgent use. Users who have a greater need for a currently more expensive variety of oil, for example, a producer of West African foods who can only achieve an authentic taste with palm oil, will acquire that oil in the Cheese-Thingies manufacturer’s stead. It is as Adam Smith noted long ago: “It is not from benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.”
Of course, market prices do not “measure” consumer demand; they only paint a rough picture of it. Prices must always be interpreted by the entrepreneurs, who are eager to profit from any perceived discrepancy between current market conditions and the true desires of the consumers. The market process is driven by the continuing efforts of entrepreneurs to better understand what consumers really want, given the currently available resources. Such knowledge is certainly not available to any person in the absence of the market process, just as the knowledge of how to swim cannot be acquired without getting in the water.
Only in the imaginary state of an evenly rotating economy would prices precisely reflect consumer demand. In the real world, where the conditions presented to humans by nature continually change and human learning is an ongoing process, we will never reach a state of complete and final equilibrium. In the world in which we live, no price is ever perfectly adjusted to the true state of the consumers’ desires. Nevertheless, market prices are the best possible means for making those desires known and for motivating entrepreneurs to fulfill them.

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