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.