1937

Hayek says this:

“The problem which we pretend [to] solve is how the spontaneous interaction of a number of people, each possessing only bits of knowledge, brings about a state of affairs in which prices correspond to costs, etc., and which could be brought about by deliberate direction only by somebody who possesses the combined knowledge of all those individuals … “

This is from his essay ‘Economics and Knowledge’ which was published in 1937.

Hayek’s thrust is, of course, to demolish the notion that an economy can be centrally planned to any degree of efficiency. His argument is simplicity itself: the body of knowledge that exists within an economy is so asymmetrically distributed, so extensive, and so diverse, that it is not possible for anyone sitting at the center to know whether their proposals and policies are the “best” solution to whatever problem is being solved.

The “we” in that first sentence is the economics profession — his essay is based on his 1936 presidential address to the London Economic Club, so he addressing an audience of economists and attacking their assumption that everyone knows everything, which is really an assumption to make modeling more tractable rather than an effort to understand the world.

And I think he’s correct.

Knowledge is scattered about the economic landscape. It is clumpy rather than smoothly available to everyone. People hoard and protect knowledge in order to extract value from it. A pictorial representation of the spread of knowledge would look decidedly granular.

But having made this point, Hayek then goes on to commit an error:

” … And experience shows us that something of this sort does happen, since the empirical observation that prices do tend to correspond to costs was the beginning of the science.”

No, it doesn’t.

Having established the impossibility of knowing everything, Hayek then slips back and appears to assert that we do know something: he is telling us that prices correspond to costs.

But, if certain knowledge is always going to remain inscrutable to us, how would we know that? We cannot. Hayek is contradicting his own argument.

And this, in essence, remains an issue in economics. The asymmetrical distribution of knowledge, which allows the creation of value to those who use their knowledge for that effect, is the driver of economic activity. Economists, in order to build their elegant and rigorous models, have eliminated this asymmetry. Why? Because the clumpiness of knowledge is the telltale sign of fundamental uncertainty, and fundamental uncertainty is a difficult subject to deal with if you want to build models that automatically tend towards equilibrium. In the face of uncertainty you can never tell where the tendency is headed. Or why it is headed there.

Later on, in the same essay, Hayek says this:

“Clearly there is here a problem of the division of knowledge which is quite analogous to, and at least as important as, the problem of the division of labour. But while the latter has been one of the main subjects of investigation ever since the beginning of our science, the former has been as completely neglected, although it seems to me to be the really central problem of economics as a social science.”

Is he correct in this?

I am not so sure. I see the two as being the same thing. To me, the division of labor is an instance of the division of knowledge. Specialization is a consequence of, and a contributor to, learning or skill development. The more components there are, the more opportunity there is to seek value from each.

In any case, this division of knowledge, and the profound asymmetry it speaks to along with the accompanying uncertainty it engenders, is why business firms exist. Firms collect knowledge, they protect it, and they deploy it for profit. They actively seek to make the economic landscape more clumpy rather than the perfectly smooth plane that economists love to postulate.

Which is why, in my opinion, to understand the economy we must understand the business firm. This is not an advocacy of the “micro-foundations” school of thought, it is simply a recognition that business firms prowl around the economic landscape, doing their business — for better or worse — and we thus need to accommodate them centrally in our thinking.

Ironically, also in 1937, another economist was making this point. This was the year that Coase launched the transaction cost view of the firm. His central question was, in short: if markets are as perfect as economists make them out to be, why are some economic activities undertaken within the boundaries of firms? This ought not to happen: there should be no gain from enclosing some activities within firm boundaries. So what’s going on?

Uncertainty, and what Coase calls the “institutional structure of production”.

Production needs structuring within institutions precisely because fundamental uncertainty precludes alternatives. This is especially so in more intensely clumpy knowledge landscapes. Getting control over the entire production process is a method that mitigates the impact of uncertainty. At least you can get the product made reliably, both in terms of consistency of quality and volume. It can be no accident that, as knowledge became more specialized and thus more valuable to concentrate, and as products became more complex through time and space, more control was needed.

The outcome is what we can describe as “localized central planning”.

Which is what Hayek would have concluded too, had he not been hellbent on attacking universal central planning.

In any case I find it fascinating that the two, Hayek and Coase, both in their own way, brought the impact of uncertainty to the fore in the same year.

It’s a shame that economics has never fully embraced, nor realized, the full richness of their ideas. Neither author was willing to step into the world that they clearly understood existed. Hayek was right about universal central planning: it is an impossibility. He was wrong to assert that this implied anything about the market place or prices. By his own argument we simply cannot know whether something is optimal. Uncertainty makes such a thing inscrutable too us. And Coase was equally correct when he saw the need for local central planning: it is the only way we can organize production adequately in the face of uncertainty. But his focus on transactions was a legacy of the classical emphasis on exchange. It ignored the need for active coordination. He missed the requirement for management. He should have talked about “management cost” not “transaction cost”. They’re different animals.

So: an interesting question is this: what happens to Coase’s “institutional structure of production” when information, and by association knowledge, is less clumpy in the economic landscape? Does something like the Internet, which is a vector for information and knowledge, obviate the need for such structure? Does it smooth that landscape out sufficiently for firms not to exist?

We need to think about that.

We need a new version of the discussion that ought to have taken place in 1937.