The Impact of Hayek's 1945 Paper

Summarizing Key Points of Hayek's 1945 Paper

Even those most prominent for their critiques of Hayek's work, point to Hayek's paper entitled, "The Use of Knowledge in Society" (1945) as a substantial contribution to the study of economics, worthy in an of itself of the Nobel Prize. At the time, the notion of intergrating numbers, calculus and practices of the other sciences into economics was widely received. However, in the process, economists began to make simplifying assumptions, including: possessing all the relevant information, starting out from a system of preferences (given endogenously), and commanding complete knowledge of available means. This gave rise to the Walrasian Model, which implemented calculus to determine the best use of the available means and resources. In short, efficient allocation occurred when the "the marginal rates of substitution between any two commodities or factors must be the same in all their different uses." (1945).

Problems With Walrasian Model

This self contrived economic problem is not real in society. The simplifying assumptions that lay the foundation for the mathematical calculations, are never "given" for the entire society, nor is that knowledge static and equally dispersed amongst all individuals. In sum, it fails to capture the most important and relevant knowledge: the knowledge of circumstance. In short, Hayek argues that the true goal of economics is not mathematically calculating how to reach Pareto optimal points and allocate "given' resources with given information to produce a static equilibrium from the Walrasian model. Rather, the real problem of economics is "how to secure the best use of resources know to any members of society" (1945). In layman's terms, economic success and efficiency is dependent upon the utilization of dispersed information.

The Knowledge of Circumstance

The knowledge of circumstance does not exist in a concentrated or integrated form. In fact, the economic relevance and potential economic benefit of possessing said knowledge is that the knowledge of circumstance is incomplete and often contradictory between multiple economic actors. Hayek recognizes the acceptance of scientific knowledge and its compatibility with economic aggregates and statistical formulas. However, only the knowledge of circumstance or temporary, dynamic knowledge of a present circumstance can explain the evolution of shippers, real estate agents, and the arbitrageur (who gains from knowing temporary differences in commodity prices). It is there knowledge in a fleeting moment, unbeknown to others that makes them profitable. A recent application of this scenario was the short lived success of the Connecticut based hedge fund Long Term Capital Management (LTCM). Founded by John Meriwether (the former vice-chairman and head of bond trading at Salomon Brothers) and including on its board Nobel Prize winners Myron Scholes and Robert C. Merton, LTCM initially produced annualized returns of over 40% in its first years. Their success was hindered on possession of a temporary, non-integrated peice of information in the bond market. But much like the January effect, as the knowledge becomes widespread, the economic benefits of possessing that knowledge fade.

All Economies Are Planned

Of interesting note, and often quickly admonished, is Hayek's determination that all economies are "planned," what determines an economy's efficiency is who does the planning. At one extreme is the theory of central planning (the common connotation of "economic planning), which is conducted by some authority or limited experts. On the other end of the spectrum is competition, in which the whole economic system engages in planning the economy through their pursuit of self interest, armed with incomplete information. Half way in between is the delegation of planning by organized industries, which Hayek terms monopoly. All economic decisions are planned, in that the decision entails a cost-benefit assessment over the employment of scare resources. Since economic relations require the collaboration of numerous parties, this activity must be guided by knowledge. Here is where Hayek finds fault with the socialists state; since most information is that of circumstance and dispersed in a incomplete form to many individuals, this knowledge can only be best utilized when each individual shares his knowledge through the spontaneous order of market interactions. Efficient transmission of this information through economic relations is dependent upon the spontaneous rise of the pricing system.

The solution to what Hayek sees as the really challenge of economics: the utilization of dispersed and incomplete arises from the pricing system. The price system synthesizes knowledge in a most comprehensive manner. A prominent representative of the Austrian school of thought, Hayek argues that efficiency is contingent on the way information is encompassed and utilized. A fervent liberalist, he sharply denies the feasibility of central planning since knowledge cannot be concentrated in a single authority. He perceives the absurdity of the above proposition in the inability to obtain the total knowledge, as well as in the limited capacity of a single human mind to accumulate information. However, Hayek does not accept decentralization as a solution of the problem. He analyzes it as an alternative source of inefficiency due to the fact that a separate person cannot obtain the necessary savoir without actively communicating within societal entities. The author suggests though that “the man on the spot” does not need to acquire all the explanatory information in the markets and knowing the prices suffices for him to judge about relative scarcity of goods and services.

Walrasian Economics in Retrospect

Friedrich A. Hayek || Ludwig Von Mises || What is Socialist Calculation Debate? || Critiques of the Socialist Calculation Debate || Advocates for the Socialist Calculation Debate || Knowledge Problem || The Impact of Hayek's 1945 Paper || Questions to Ask