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.
Thus, price is accepted as the necessary and sufficient determinant of distribution of resources. This is how it performs the idealistic function of the central planner, namely to have command over all knowledge.
Role of Price System
Hayek observes the pricing system offered as unsurpassed by any other proposed theory as far as allocation of resources is concerned. If information flows freely as it does in a democratic society, access to knowledge is free, and it is equally divided among people, then interactions should be carried out without any concerns for command and stipulation of knowledge that could result in market inefficiency. This proposition postulates the naturally evolved pricing system as a facilitator of the Pareto optimal coordination of use of resources in society. To reinforce this argument, Hayek even denies the importance of mathematical economics in reaching the efficiency-maximized outcomes. Known for his anti-scientism, he abnegates even the credibility of the simultaneous equations by challenging the model’s basic assumption, namely that market agents possess objective knowledge corresponding to the economic conditions in society at any given point of time. Thus, Hayek even opposes the conventional rules of equilibrium and marginal rate of technical substitution as they contradict his explanation of behavior in market processes. The “unavoidable imperfection of man’s knowledge” is a persistent problem that only the pricing system can overcome by transmitting static and dynamic knowledge through numerical values. It is uniquely through combining partial knowledge that the puzzle of total knowledge can be solved and efficient prices established.
Bowles and Gintis : Contested Exchange
The alternative theory, which Bowles and Gintis use to explain the efficient formation of prices in the capitalist market, is the model of contested exchange. It shifts the emphasis of efficiency from independent individual inducements to deliberate conscious planning. Consequently, contested exchange is in drastic contrast with Hayek’s hypothesis that “Civilization advances by extending the number of important operations which we can perform without thinking about them.” Therefore, a comparison between contested (Bowles and Gintis) and uncontested (Hayek) theory of exchange should base its core on fundamental differences not only on rationale but also on philosophy and political beliefs.
For Hayek, just as for Abba Lerner, economics is a science of “solved political problems” while for Bowles and Gintis, it is a dynamic arena of contested exchange. Markets’ functions outreach the reallocation purpose they have in the pricing system, and serve as disciplinary environments with numerous demand and supply shifting variables, including institutions. Power distribution is no longer equal; the vertical dimension of capitalism- command- is manifested. Furthermore, we observe non- neutrality of assets, namely initial distribution of capital is of definitive significance. Credit rationing and involuntary unemployment emerge as phenomena characterizing the equilibrium in the capitalist economy, though labor and credit market do not clear. Thus, price is determined by whoever exercises command, a term unknown in the pricing system of Hayek. The participants in the exchange do not agree on the “property rights relevant to them” (Buchanan), and this is how the “contested”, unsolved political problem arises in the market of labor. Monitoring, stick and carrot methods join in the market, to initiate the enforcement of incomplete effort contracts. In contested exchange, the price indicates information about the distribution of power, rather than scarcity of the resource. Agents on the short side of the market hold the power over allocation of resources and formation of prices. Bowles and Gintis further suggest that the theory of contested exchange does actually lead to more efficient allocation of resources in the society. The Amherst economists claim that the organizational structure and the existence of command inevitably define the Pareto efficiency in the competitive market. This might be generated by redistribution of ownership rights, change of residual claimants, and other variances aimed at decreasing the inequality of the capitalist market, and simultaneously lessening its non-democratic character. Thus, the theory of contested exchange takes into account imperfect contractibility, enforcement costs, and the steadfast presence of command in the relationship employer- laborer. These assumptions prevent natural pricing system from evolving but Bowles and Gintis claim that contested exchange is much more realistic and relevant to our economic environment
Walrasian Economics in Retrospect
- Walrasian Foundation**
The Walrasian Model is based on:
---A) Preferences are self interested and exogenously given ---B) Contractibility is complete and costless
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
