prior probability

A previous post of mine identified four possible problems with F. A. Hayek’s classic defense of the price system; in this post, I will proceed to the second critique: Hayek does not define “knowledge” in his knowledge paper. Although Hayek does refer to “different kinds of knowledge” in part 3 of his paper, including “scientific knowledge” and “knowledge of the particular circumstances of time and place” (i.e. “local knowledge”), at no point does he provide an overarching definition of what “knowledge” is. (The closest he comes to doing so is when he writes on pp. 521-522 of his paper: “practically every individual … 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 cooperation.”)

Why is this glaring omission a problem? Because a lot of so-called knowledge might be “socially constructed” or radically indeterminate. Why? Because knowledge, at a minimum, implies the existence of truth, but the truth of a given proposition, in turn, is often subjective or contested, or both. That is, truth is rarely, if ever, an absolute value; the truth is always up for grabs. (Compare the notion, which is popular today, of “my truth.” By way of example, see my 25 March 2021 blog post on “the social construction of conspiracy theories“. For further reading, you may want to check out “The Social Construction of Reality” by Peter L. Berger and Thomas Luckmann.)

In defense of Hayek, however, one could always reply to a social constructionist by simply asking, So what? Even if knowledge is somehow socially constructed, even if truth is a subjective or contested concept, some propositions are more likely to be more true or more coherent than others by most measures of truth. (As an aside, this is one reason why I prefer to the term “probabilistic truth” and why I favor subjective or personalist methods of probability; see here, for example.) Nevertheless, that said, there are two further points we must address: (1) property rights in ideas or the “commodification of knowledge” problem, and (2) knowledge as belief or the “Keynesian beauty contest” problem. I will address these points in my next two posts.

In a previous post, I identified four possible problems with Hayek’s defense of the price system; here, I will focus on the first critique: the absence of law in Hayek’s analysis. As it happens, I am not the first law professor to notice this omission. See, for example, this blog post from 10 October 2015, where I shout out Richard A. Epstein. Among other things, I wrote: “Markets do not exist in a vacuum. Markets require some kind of legal framework, one that respects people’s property rights and enforces their contracts. But where do we get these legal frameworks and rules from? In the case of the United States, we have a Constitution, which is the supreme law of our land. But isn’t a constitution (and law generally, for that matter) a textbook example of human design and not of spontaneous order?”

More specifically, consider the issue of money (pun intended). At no point does Professor Hayek discuss the indispensable role of money or currency in his 1945 knowledge paper. But doesn’t a “marvelous” price system (his term, not mine) imply the existence of some form of medium of exchange, such as the British Pound, the Japanese Yen, or the Mexican Peso? And unless you think Bitcoin or other cryptocurrencies have any real value, doesn’t a stable monetary currency require some kind of central bank or government agency, whether the currency is backed by a precious metal, like the gold standard of yore, or is government-issued, like today’s so-called fiat money?

In fairness to Hayek, volume two of his three-volume magnum opus on The Constitution of Liberty (available here) contains an extended discussion of the role of law in promoting liberty, while his fellow Austrian economist, the great Ludwig von Mises, explains the private origins of money in his classic treatise on The Theory of Money and Credit. In fact, scholars continue to debate to this day whether indispensable elements like money and law are classic “public goods” (i.e. something that requires government intervention and thus some amount of central planning) or whether these things can be organically and voluntarily supplied by private firms. (For a small sample of this masturbatory intellectual back-and-forth, check out Tyler Cowen’s public-good view here versus David Friedman’s “law as a private good” here.)

Rather than try to adjudicate this decades-long debate (an impossible, Quixotic task, in any case), I will refer to Robert Nozick’s influential defense of the night-watchman state in Anarchy, State, and Utopia, one of my favorite fiction books of all time. Even if government is neither necessary nor sufficient for the price system to work at scale (a proposition I find as fanciful as Peter Pan’s “Neverland”), a good government–one that at the very least identifies and punishes aggressors, enforces contracts, and defines and protects property rights–would be nice. Either way, I will identify another important omission in Hayek’s analysis of the price system in my next post: what does he mean by “knowledge”?

I surveyed F. A. Hayek’s “The use of knowledge in society” during the Thanksgiving break. (See here, here, and here.) Below, I identify four possible objections to Hayek’s defense of the price system:

1. What about law? First off, for markets (i.e. the price system) to work, there must be rules, and rules by definition require some form of coercion, but Hayek doesn’t talk about about the role of institutions (i.e. courts, custom, law, etc.) in his knowledge paper.
2. What is “knowledge”? Alas, Hayek never defines the term “knowledge”; why not? Also, according to the post-modern school, knowledge is “socially-constructed”. If so, how does post-modernism affect Hayek’s analysis of the price system?
3. What about the self-reference problem? Hayek’s argument is that market-determined prices reflect the fragmentary bits of local knowledge held by many dispersed individuals and firms, but what happens when some forms of knowledge are themselves a privately-owned commodity (like tin to borrow Hayek’s own example)? Think of trade secrets, for example.
4. Lastly (for now), what about beliefs and emotions? If knowledge refers to facts about the world or to reliable theories about how the world works, beliefs by comparison are subjectively-held or probabilistic states of mind about those same facts or theories. Could beliefs play an important role in market systems? Also, what role do emotions (or what John Maynard Keynes called “animal spirits“) play?

Can you think of any other potential objections to Hayek’s analysis; e.g. wealth effects, “market failures”, public goods, etc.? In the meantime, I will address each of the above points in my next few blog posts.

Thus far, I have reviewed the first six parts of F. A. Hayek’s “The use of knowledge in society.” This leaves the last part (Part 7) of Hayek’s knowledge paper, where Hayek responds to Joseph Schumpeter’s defense of central planning in Schumpeter’s influential work Capitalism, Socialism, and Democracy (CSD), the cover of which is pictured below.

In summary, although Schumpeter concludes CSD by stating “I do not advocate socialism” and “do not ‘prophesy’ or predict it” (Schumpeter 1942, p. 422), Schumpeter devotes an entire chapter of his book (Ch. 16) explaining how central planning could, in principle, work just as efficiently as capitalist systems in practice. In that chapter, Schumpeter acknowledges the argument against socialist planning: “our central board would be confronted with a task of unmanageable complication.” (See Schumpeter 1942, p. 185. Here, Schumpeter also refers to Hayek by name. See ibid., n.11.)

Nevertheless, Schumpeter explains why central planning “is eminently operational.” (Ibid., p. 185.) According to Schumpeter, socialist central planners would face less uncertainty than capitalism managers:

“… solution of the problems confronting the socialist management would be not only just as possible as is the practical solution of the problems confronting commercial managements: it would be easier. Of this we can readily convince ourselves by observing that one of the most important difficulties of running a business—the difficulty which absorbs most of the energy of a successful business leader—consists in the uncertainties surrounding every decision. A very important class of these consists in turn in the uncertainties about the reaction of one’s actual and potential competitors and about how general business situations are going to shape. Although other classes of uncertainties would no doubt persist in a socialist commonwealth, these two can reasonably be expected to vanish almost completely.” (Schumpeter 1942, p. 186, emphasis added.)

Do you find this “Knightian uncertainty” argument persuasive? I don’t. It is true that in a socialist system, central planners don’t have to worry about competitors, but in a free market system, the level of uncertainty about the future will already be reflected in the prices of goods and services. For Hayek, however, the main flaw of this defense of the socialist planning was that Schumpeter has assumed away the knowledge problem altogether:

“The problem is thus in no way solved if we can show that all the facts, if they were known to a single mind (as we hypothetically assume them to be given to the observing economist), would uniquely determine the solution; instead we must show how a solution is produced by the interactions of people each of whom possesses only partial knowledge. To assume all the knowledge to be given to a single mind in the same manner in which we assume it to be given to us as the explaining economists is to assume the problem away and to disregard everything that is important and significant in the real world.” (Hayek 1945, p. 530.)

Hayek further adds: “The practical problem [of the production and distribution of knowledge] … arises precisely because these facts are never so given to a single mind, and because, in consequence, it is necessary that in the solution of the problem knowledge should be used that is dispersed among many people.” (Ibid.)

In closing, even if Hayek’s critique of Schumpeter is right, and it is, I still have my work cut out for me. To begin with, I must address several salient objections to Hayek’s defense of the price system, and after that, I must also show how Hayek’s analysis of prices supports my modest “truth markets” proposal. After all, it is one thing to buy and sell futures in a raw material like tin (to borrow Hayek’s own example), but what about “fake news futures” or “belief contracts”? Stay tuned: I will identify several possible problems with the price system (and respond to these objections), and I will then make a Hayekian defense of truth markets in several future posts.

My previous post surveyed the first half Hayek’s classic paper “The use of knowledge in society”, where Hayek explores the economics of knowledge and economic organization more generally. To summarize: Hayek identifies three methods of knowledge-production and distribution–central planning, markets, and monopoly–and asks, which method is the best one? The answer to this question finally comes into focus in Part 5 of Hayek’s knowledge-in-society paper. To the point, Hayek’s answer is prices via decentralized markets, i.e. “the price system“. For Hayek, prices reflect hidden information–information that is widely dispersed among many actors and that is too costly for any one individual or firm to assemble in a timely fashion. To illustrate this key point, Hayek gives the following “simple and commonplace” example involving the price of tin. I will quote Hayek’s example in full below:

“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 this without the great majority of those instrumental in bringing about these substitutions knowing anything at all about the original cause of these changes. The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all.” (Hayek 1945, p. 526.)

In brief, Hayek’s most original insight is that prices are signals, or in Hayek’s own words: “Fundamentally, in a system where the knowledge of the relevant facts is dispersed among many people, prices can act to coördinate the separate actions of different people in the same way as subjective values help the individual to coördinate the parts of his plan.” (Ibid., p. 526, emphasis added.) In other words, the price mechanism aggregates disperse information and thus allows people–regardless of how much or how little they know about the overall economy–to quickly and cheaply decide which goods and services to trade and in what quantities.

Next, in Part 6 of his paper, Hayek identifies two additional advantages the price system has over other methods of knowledge production and knowledge distribution: prices not only aggregate dispersed information into a single metric; the price mechanism doesn’t require a panel of experts and prices are user-friendly:

1. The price system is user-friendly. People don’t have to be super-smart or spend a lot of time and money to acquire sufficient information to make good decisions. Here is how Hayek makes this key point:

“The most significant fact about this system [the price system] is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol, only the most essential information is passed on, and passed on only to those concerned. It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications 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.” (Hayek 1945, pp. 526-527, emphasis added.)

2. The price system doesn’t need experts to work well. When market prices are determined by supply and demand, there is no need for a philosopher-king or a central committee of so-called “experts” to give orders, or in Hayek’s own words: “The marvel is that in a case like that of a scarcity of one raw material [such as tin, to borrow Hayek’s own example], 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; i.e., they move in the right direction.” (Hayek 1945, p. 527, emphasis added. Hayek adds: “I have deliberately used the word ‘marvel’ to shock the reader out of the complacency with which we often take the working of this mechanism for granted.” Ibid.)

Hayek concludes his 1945 knowledge paper by responding to a point made by his intellectual nemesis Joseph Schumpeter in his influential book Capitalism, Socialism, and Democracy, the third most cited work in the social sciences published before 1950, behind Karl Marx’s Capital and Adam Smith’s Wealth of Nations. I will discuss Hayek and Schumpeter’s competing theories of markets–and their relevance to my “truth market” proposal–in my next post.

Hello, fellow nerds! I posed the following key question in my previous blog post: How likely is it that the price of any given belief contract on my truth market will eventually converge on the truth value of the conspiracy theory or fake news story being bet on? I will respond to this query by reviewing an influential paper titled “The use of knowledge in society” by F. A. Hayek (pictured below), the classic work that inspired me to propose “truth markets” to begin with.

Hayek’s paper, which was published in the September 1945 issue of the American Economic Review (AER), has seven parts. In Part 1, Hayek poses the following research question: “What is the problem we wish to solve when we try to construct a rational economic order?” (Hayek 1945, p. 519.) But why is constructing a “rational economic order” a problem in the first place? Because our knowledge about supply and demand is often fragmentary and dispersed among many different economic actors, or in the immortal works of Hayek:

“The peculiar character of the problem of 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 **** 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 not given to anyone in its totality.” (Ibid., pp. 519-520.)

Hayek then identifies three major methods of knowledge organization in Part 2 of his paper: 1. central planning, e.g. a board consisting of experts; 2. markets or decentralized decision-making, and 3. monopoly, e.g. planning by a mega-firm like Google or Facebook. (Ibid., p. 521.) Which of these methods is the best? According to Hayek, the answer “depends on whether we are more likely to succeed in putting at the disposal of a single central authority all the knowledge which ought to be used but which is initially dispersed among many different individuals, or in conveying to the individuals such additional knowledge as they need in order to enable them to fit their plans in with those of others.” (Ibid.)

In Part III his paper, Hayek identifies two different kinds of knowledge: local knowledge (i.e. information that is “more likely to be at the disposal of particular individuals”) and scientific or technical knowledge (i.e. information “which we should with greater confidence expect to find in the possession of an authority made up of suitably chosen experts”). (Both quotes are in Hayek 1945, p. 521.) After making this distinction, Hayek emphasizes the importance of local knowledge:

“… 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 in that 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 coöperation.” (Ibid., pp. 521-522)

Hayek makes two further points about local knowledge in Parts 4 and 5 of his paper. First off, he emphasizes the temporal problem of change–how conditions can change rapidly or slowly over time, or in Hayek’s own words: “… the economic problem of society is mainly one of rapid adaptation to changes in the particular circumstances of time and place …” (Ibid., p. 524.) Next (in Part 5), Hayek identifies a second-order problem about local knowledge: how is this knowledge transferred among the members of society. As Hayek notes, “… the ‘man on the spot’ cannot decide solely on the basis of his limited but intimate knowledge of the facts of his immediate surroundings. There still remains the problem of communicating to him such further information as he needs to fit his decisions into the whole pattern of changes of the larger economic system.” (Ibid., pp. 524-525, emphasis added. In addition, Hayek identifies a third-order problem: “How much knowledge does he [the ‘man on the spot’] need to [make decisions] successfully?” Ibid., p. 525, emphasis added.)

Hayek then devotes the last half of his paper answering these key questions. According to Hayek, the movement of prices determined via decentralized markets–what Hayek calls “the price system”–conveys the optimal amount of knowledge to the right people at the right time. Because Hayek’s explanation of the price mechanism is so crucial–not just to our understanding of economics but to other domains of life as well–I will review the second half of Hayek’s 1945 paper in my next post.

I recently proposed the creation of a “truth market” to allow people to buy and sell “belief contracts“; i.e. to place bets on conspiracy theories and fake news. One practical problem a new market must overcome, however, is “transaction costs” or liquidity, i.e. how easy or difficult is it to make trades on that market? (See here or the chart below.) At a minimum, a market must have a sufficient number of willing buyers and sellers in order to work properly. Why? Because without enough traders, the prices of the assets being traded on the market won’t reflect the underlying value of those assets.

So, how could we increase the liquidity of my proposed truth market That is, how could we attract a sufficient number of people to participate in the market? Here, I will offer two possible methods for generating truth market liquidity. One is to simply extend the purview of an existing prediction market like Kalshi or PredictIt. Although my proposed truth market would involve “retrodiction” as opposed to prediction, there is no reason in principle why we couldn’t extend the scope of an existing prediction market to include conspiracy theories and fake news.

The other possible solution is pay-to-play: just pay people to participate on the truth market. Specifically, a pro-market charitable organization, such as the Charles Koch Foundation or a think tank like the Mercatus Center, might consider putting skin in the game by creating and subsidizing its own truth market. To attract bettors, instead of funding yet another ad hoc study or wasteful conference on fake news, democracy, and social media, etc., the sponsor organization could allocate a fixed number of fully-transferable cash-value tokens to people in exchange for participating in the market. Market participants could include students, academics, pundits, and members of the public–people from all walks of life. The more the merrier!

Whichever method is tested (why not try both?), another serious problem that my proposed truth market would have to overcome is what I call the “Keynesian beauty contest” objection. To the point: What guarantee do we have that the price of any given belief contract on my truth market will eventually converge on the truth value of the conspiracy theory or fake news story being bet on? I will address this objection in my next post.

Fifty-nine years ago (22 November 1963), President John F. Kennedy was assassinated in Dallas, Texas. Ten months later (September 1964), the Warren Commission concluded that President Kennedy was shot by Lee Harvey Oswald and that the assassin had acted entirely alone.

Do you believe the official lone gunman theory, or was there a conspiracy? What if there were a truth market in which people could place bets on this question? (For what it’s worth, I propose just such a solution here and here, and I will address some possible problems with my proposed truth market during the Thanksgiving break.)