F.A. Hayek, Three Essays on Knowledge

For this post, I will be addressing three essays by Friedrich Hayek on knowledge, listed below. Since they naturally relate to each other, it seems like distilling these three essays into one post on knowledge would be extremely useful.

Friedrich Hayek, “Economics and Knowledge” Economica 4, no. 13 (new ser., February 1937): 33-54. [Also, a Presidential address delivered before the London Economics club, November 10, 1936.]

This first essay addresses the role of individual knowledge in economics. He begins by noting that the relevance of knowledge to foresight began being discussed more broadly in and after the work of Frank H. Knight on risk. Hayek said that it is only through proper assumptions concerning foresight that we can answer many important questions, including the equilibrium rate of interest (33-34). It is here that he made his famous admonition that “before we can explain why people commit mistakes, we must first explain why they should ever be right” (34).

Hayek writes that in applying a priori tautologies to society, we begin seeing the problem of foresight and knowledge take shape--and we see the beginnings of the failure of equilibrium analysis (34-35). He stresses the importance of what he calls the Pure Logic of Choice in economic reasoning, whose truths can only be tested according to “internal consistency” (35)-- what we would today call the praxeological method.

Discussing the concept of equilibrium, Hayek says that “Actions of a person can be said to be in equilibrium in so far as they can be understood as part of one plan,” and equilibrium concerns “relations between actions” (36). The equilibrium construct depends on the data, or facts of the world, being given, i.e., known by the actor. Thus, anything disrupting the plan or altering the facts of the world disrupts the equilibrium that had existed when the plans were made and the individual had perfect information. Once the unfolding facts of the world no longer line up with the actor’s anticipations, we are out of equilibrium. Since actions must necessarily take place in time, any equilibrium construct that neglects time (as many did) is utterly unconnected to the real world (36-37).

As we begin moving away from explaining individual actors with equilibrium analysis, we begin experiencing problems. There are certain conditions that must be met for equilibrium to occurs between multiple people:

[I]n order that all these plans can be carried out, it is necessary for them to be based on the expectation of the same set of external events, since, if different people were to base their plans on conflicting expectations, no set of external events could make the execution of all these plans possible. And, secondly, in a society based on exchange their plans will to a considerable extent refer to actions which require corresponding actions on the part of other individuals. 'This means that the plans of different individuals must in a special sense be compatible if it is to be even conceivable that they will be able to carry all of them out.' Or, to put the same thing in different words, since some of the " data " on which any one person will base his plans will be the expectation that other people will act in a particular way, it is essential for the compatibility of the different plans that the plans of the one contain exactly those actions which form the data for the plans of the other (37-38).

Hayek points out that this problem is “solved” by mainstream economists making demand curves “given,” but because each actor’s “decisions are the other person’s data,” it doesn’t answer how this relationship really works (38).

In section IV, Hayek points out the problem of given data, noting that it has often been unclear what it even meant to have given data; was the data “given to the observing economist, or to the persons whose actions he wants to explain”? (39). Nevertheless, we still have to answer what it could mean for a society to be in equilibrium. One option could be that society is in equilibrium as long as there exists a “mutual compatibility of intentions” such that events could bring about a realization of all plans, with no disappointments (39-40). And if there are not mutually compatible intentions, “We have a situation where a revision of the plans on the part of at least some people is inevitable” (40). It might also be that equilibrium concerns whether the data and expectations possessed by each individual align with the objective data, meaning that we would only know whether society was in equilibrium ex post by whether plans were upset. However, we would only be able to determine if there was a change in the objective data if we first had a mutual harmony of interests and then still found plans disappointed (40).

As a result, Hayek concludes that equilibrium only means a mutual compatibility of plans, and continues to exist  “so long as the external data correspond to the common expectations of all the members of society”; in other words, equilibrium exists so long as market participants have correct foresight (41). As long as the activities of housebuilders correspond to the expectations of future home-buyers, for example, such that “preparations for the production (and acquisition) of the same amount of houses” correspond, there is equilibrium. If this harmony is disrupted by an exogenous change, such as the destruction of building materials that leads to a shortage in house production, future equilibrium is disrupted (42). It is when “different plans were from the beginning incompatible, [that] it is inevitable that somebody’s plans will be upset and have to be altered” (42-43).

It is reasonable to assume that the correspondence of individual, subjective plans with the objective facts probably comes about “due to the experience of the same objective facts,” but equilibrium analysis does not account for how this correspondence comes about--instead, it is simply assumed (43). The “fictitious state of equilibrium” only justifies its applicability to the real world through the economists’ empirical proposition that in the real world a tendency towards equilibrium exists; but, yet again, we fail to find under what conditions and through what processes this tendency is cultivated (43-44).

The problem with the equilibrium analysis is that it assumes a perfect market, or one in which every actor is “strictly omniscient, [or they] are at least supposed to know automatically all that is relevant for their decisions” (45). Yet, if this tendency toward equilibrium does exist, it must at least be demonstrable that people acquire all the relevant knowledge they need to exercise accurate foresight, even if the demonstration is only hypothetical in character. Hayek then points out that whatever hypotheses we might advance here, they are not the self-evident, a priori truths from which we deduce the Pure Logic of Choice that is applicable universally, across space and time (45-46).

The first condition equilibrium theorists advance to prove the tendency towards equilibrium is that there is a “constancy of the data.” However, Hayek advances two reasons why this is not sufficient. First, taken to its extreme, constancy of the data would mean no changes whatever--the cessation of all action, that is, purposeful behavior--which divorces it from the real world. Or, it simply means “that there must be some discernible regularity in the world which makes it possible to predict events correctly,”  but this still leaves open why  it would be likely or probable that people have correct foresight; regularity alone is insufficient (47-48).

What is more important to Hayek is to ask “how much knowledge and what sort of knowledge the different individuals must possess in order that we may be able to speak of equilibrium”? (48). This “relevant knowledge”--rather than perfect information--is important because if the individual possessed different knowledge, he might have acted differently. This raises the problem of the Division of Knowledge, or “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. . . .which could be brought about by deliberate direction only by somebody who possessed the combined knowledge of all those individuals” (49). Knowledge of prices, Hayek says, isn’t enough. We need to figure out how “the knowledge of the basic fact of how the different commodities can be obtained and used, and under what conditions they are obtained or used” (50).

When individuals may change their plans due to changing tastes or the collection of new facts, severing the equilibrium connections, we find that new facts can become known in one of two ways. The first way is through accident, whereby the individual learns of new facts outside of the consequence of the pursuance of his plan, and the second way is that in pursuance of his plan, it is inevitable that he or she will “find that the facts are different from what he expected” (51). The conclusion Hayek reaches is that “it is only relative to the knowledge which a person is bound to acquire in the course of the carrying out of his original plan and its successive alterations that an equilibrium is likely to be reached” (52), but that this equilibrium is not a utopian ideal position as the equilibrium construct is usually construed.

F.A. Hayek, “The Use of Knowledge in Society,” American Economic Review 35, no. 4 (September 1945): 519-530.

The knowledge problem which society faces has nothing to do with the set of equilibrium conditions that are given, i.e., assumed in equilibrium analysis. In equilibrium analysis, “the best use of the available means is implicit in our assumptions” (519). In the real world, not so:

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 (519).

The problem is how to integrate all these dispersed bits of knowledge such that resources can be efficiently applied as means to achieve the subjectively valued ends of market actors--ends and valuations that only the individual actor can know. If we want to solve the economic problem of society, we need to divorce ourselves from erroneous habits of method that lead us even to misinterpret the problem itself (520).

Planning, according to Hayek, is “the complex of interrelated decisions about the allocation of our available resources” (520). In all cooperative societies where we find economic activity, we will find planning--and we will find that the planner needs to utilize exogenous knowledge not given to the planner. The better the means of communicating this dispersed information, the better the chance we have “of designing an efficient economic system.” The question then becomes whether planning should be centralized among a single individual or small group, or decentralized with planning “divided among many individuals”  in order to utilize this dispersed knowledge (520-521); it is a question of central planning or competition. To answer this question, we have to examine “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” (521).

The reason why many people today think that planning should be in the hands of experts comes from the prominence of scientific knowledge. Hayek points out that even if we can expect to find reliable knowledge ably commanded in the hands of suitably chosen experts, the question then becomes one of the method of choosing suitable experts (522). In general, we can expect different kinds of knowledge to be put to their best uses by different sorts of organization, processes, and individuals--there is no single optimal process of which we know. Nevertheless, “scientific knowledge is not the sum of all knowledge”; there is still the critical and unique knowledge of time and place that each individual possesses, “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” (522-523). As proof of this, Hayek asks us to consider just how much more we learn in practice, putting our theoretical knowledge into actual use--things which could not be adequately conveyed in a classroom or through training. For example, we need to consider

the shipper who earns his living from using otherwise empty or half-filled journeys of tramp-steamers, or the estate agent whose whole knowledge is almost exclusively one of temporary opportunities, or the arbitrageur who gains from local differences of commodity prices, are all performing eminently useful functions based on special knowledge of circumstances of the fleeting moment not known to others (522).

Could these individuals have been taught these things purely through training, i.e., through the conveyance of knowledge from an “expert” to someone unaccustomed to the industry or field? The person who regards those individuals who secure an advantage through this kind of practical knowledge as “dishonest” because all this knowledge is “given” in the model, or because it is felt that all information “should be readily at the command of everybody,” is failing to truly grasp the economic problem of how to make the best use of the available, dispersed knowledge. They instead engage in a nirvana fallacy by comparing the real world of imperfect or asymmetric information to a utopian ideal of perfect information, which tells us nothing about the economic problem itself (522).

Hayek next addressed the idea that the economic problem has become less important in modern times, that, “with the elaborate apparatus of modern production, economic decisions are required only at long intervals, as when a new factory is to be erected or a new process to be introduced” (523). If this were true, would we see so many managers in competitive industries spending great quantities of expense and effort to keep costs down? If it was so easy to turn a profit, why aren’t these critiquing individuals investing in the productive process to accumulate sure returns? Turning a profit and producing a product that consumers value is not a mere technical problem, but an economic one. The “reason why economists are increasingly apt to forget about the constant small changes which make up the whole economic picture,” Hayek points out, “is probably their growing preoccupation with statistical aggregates, which show a very much greater stability than the movements of the detail” (523-524). These aggregates hide all the businesses who fail each year, and all the fluctuations individual businesses face for year to year between profits, losses, and breaking even. Track individual firms across these same years and you will find a much different, and less stable, picture. These sorts of aggregates, also, are exactly the kind of thing that would not convey the tacit knowledge of individuals in possession of the unique knowledge of time and place, because these aggregates abstract away from this particular information:

It follows from this that central planning based on statistical information by its nature cannot take direct account of these circumstances of time and place, and that the central planner will have to find some way or other in which the decisions depending on them can be left to the "man on the spot” (524).

Therefore, because

the economic problem of society is mainly one of rapid adaptation to changes in the particular circumstances of time and place, it would seem to follow that the ultimate decisions must be left to the people who are familiar with these circumstances, who know directly of the relevant changes and of the resources immediately available to meet them. We cannot expect that this problem will be solved by first communicating all this knowledge to a central board which, after integrating all knowledge, issues its orders (524).

Yet, these decentralized individuals also need a way of integrating their own “intimate knowledge of the facts” with “the whole pattern of changes in the larger economic system,” otherwise his forecasts and thus his decisions will be at odds with these larger distributed changes, causing his plans to fail (524-525). The information that will be important to him is quantitative, more so than qualitative, in order to make his decisions fit into the broader world. That is, he need not know why particular changes are occurring, only the magnitude and direction of these changes: “It is always a question of the relative importance of the particular things with which he is concerned, and the causes which alter their relative importance are of no interest to him beyond the effect on those concrete things of his own environment” (525).

It is through the price system that this problem heads toward a solution, of which the central planner does not have the advantage of utilizing, meaning he will be at a decisive disadvantage in planning compared to the decentralized actor. A central planner, even if they could be in possession of all knowledge, would in addition have to “go explicitly through all the relations between ends and means which might possibly be affected” every time a change occurs, which is beyond the ability of the single mind to calculate. The price system tells individuals when they need to economize particular resources due to the relative price of that resource, even to the point of substitution if the resource becomes dear enough, and his use of the resource is of less value to him than to some other producer (526).

While the price mechanism does not yield perfect adaptations to change, it still does a wondrous job of allowing individuals to successfully act on the basis of extremely limited knowledge, while distilling and communicating a vast expanse of knowledge into simple indices.

The marvel is that in a case like that of a scarcity of one raw material, 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 (527).

It is a marvel, Hayek says, because the price mechanism guides people into successful actions and gives individual actors’ decisions “significance far beyond their immediate aim,” yet few people marvel at it because it was not consciously designed by an individual mind and those who utilize the knowledge conveyed by the price system often do not fully understand it (527). Hayek approaches the end of his essay with a plea:

[T]hose who clamor for "conscious direction". . . .should remember this: The problem is precisely how to extend the span of our utilization of resources beyond the span of the control of any one mind; and, therefore, how to dispense with the need of conscious control and how to provide inducements which will make the individuals do the desirable things without anyone having to tell them what to do (527).

It is much more “rational” to try and squeeze as much benefit out of the system that allows us to act on limited knowledge than to hope in vain that a single mind will be collect all knowledge in the world, examine every possible relation between means and ends on the basis of that knowledge, and then be able to consciously direct all of humanity according to a single plan. Quoting Alfred Whitehead, Hayek says that "It is a profoundly erroneous truism, repeated by all copy-books and by eminent people when they are making speeches, that we should cultivate the habit of thinking what we are doing. The precise opposite is the case. Civilization advances by extending the number of important operations which we can perform without thinking about them” (528).

It is an “unavoidable” fact that man has imperfect knowledge, and “ Any approach, such as that of much of mathematical economics with its simultaneous equations, which in effect starts from the assumption that people's knowledge corresponds with the objective facts of the situation, systematically leaves out what is our main task to explain” (530).

F.A. Hayek, “The Pretence of Knowledge,” Speech for The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1974 (December 11, 1974).

In 1974, Friedrich Hayek received The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, sharing the award with Gunnar Myrdal.

In his speech, Hayek blames the then-impending threat of accelerating inflation on the policies recommended by economists. The more closely these economists have imitated the methods of the physical sciences, Hayek says, the greater the propensity for failure in policy recommendations. These economists had adopted a scientistic attitude, whereby economists have uncritically emulated adopted the methods of the physical sciences in economics, producing grave errors in economic policy.

Hayek blames the mistaken monetary and financial policy on the belief that “there exists a simple positive correlation between total employment and the size of the aggregate demand for goods and services,” leading to the corresponding “belief that we can permanently assure full employment by maintaining total money expenditure at an appropriate level”; in essence, the blame lies on Keynesianism.

One of the reasons why the scientific method works for the sciences is because it can be “generally assumed. . . .that any important factor which determines the observed events will itself be directly observable and measurable, [while] in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process. . . .will hardly ever be fully known or measurable.” Not only this, but in the social sciences, what is treated as important “happens to be accessible to measurement,” to the neglect of the unmeasurable, but possibly more important causal factors. Too often the social scientists are dismissive of anything that is qualitative and incapable of measurement, suggesting that only that which is measurable could be a causal factor: “It can hardly be denied that such a demand quite arbitrarily limits the facts which are to be admitted as possible causes of the events which occur in the real world,” yet those who use this method “happily proceed on the fiction that the factors which they can measure are the only ones that are relevant.” From this, we may find that “there may thus well exist better ‘scientific’ evidence for a false theory, which will be accepted because it is more ‘scientific’, than for a valid explanation, which is rejected because there is no sufficient quantitative evidence for it.”

We must consider “that the social sciences, like much of biology but unlike most fields of the physical sciences, have to deal with structures of essential complexity, i.e. with structures whose characteristic properties can be exhibited only by models made up of relatively large numbers of variables.” In addition, the social sciences have to deal with “phenomena of organized complexity,” which means that

the character of the structures showing it depends not only on the properties of the individual elements of which they are composed, and the relative frequency with which they occur, but also on the manner in which the individual elements are connected with each other. In the explanation of the working of such structures we can for this reason not replace the information about the individual elements by statistical information, but require full information about each element if from our theory we are to derive specific predictions about individual events.”

In examining the price system, for example, not only can we not know all the facts of the world and their frequency of occurring, we “cannot know at which particular structure of prices and wages demand would everywhere equal supply, we also cannot measure the deviations from that order.” It has been useful to apply mathematics to economics in determining the characteristics of general economic patterns, he says, but the search for “the determination and prediction of the numerical values of those magnitudes....has led to a vain search for quantitative or numerical constants.” Equilibrium theory was never meant “to arrive at a numerical calculation of prices,” and its search has probably yielded no “significant contributions to our theoretical understanding” of the market.

While the kinds of theories Hayek favors are “somewhat limited content because it allows us to make only very general predictions of the kind of events which we must expect in a given situation,” they have not experienced the monumental policy failures the reliance on the more “scientific” theories have precipitated. “I confess that I prefer true but imperfect knowledge,” says Hayek “even if it leaves much indetermined and unpredictable, to a pretence of exact knowledge that is likely to be false,” and a pretence that leads to “grave consequences.” The increase of aggregate demand to counter unemployment, for example, has been a cause of the persistence of the business cycle due to the misallocation of resources it drives, as resources are poured into lines of production that will fail once this artificial demand is halted and the misallocation is revealed.

Hayek concludes by restating his argument and explaining the dangers of acting as if we could transcend the insurmountable obstacles to applying scientism to the social sciences. “The chief point we must remember is that the great and rapid advance of the physical sciences took place in fields where it proved that explanation and prediction could be based on laws which accounted for the observed phenomena as functions of comparatively few variables - either particular facts or relative frequencies of events.” In “essentially complex phenomena,” however, “we must refer to a large number of particular facts; and to derive a prediction from it, or to test it, we have to ascertain all these particular facts [emphasis added,]” and the difficulty “consists in the ascertainment of the particular facts.”

Hayek then gives an example of a ball game, where if we knew everything about the individual players, and every other particular fact affecting the outcome of the game, we could probably predict its outcome. Yet, we cannot know all of these particular facts. But, “If we know the rules of the different games we shall, in watching one, very soon know which game is being played and what kinds of actions we can expect and what kind not. But our capacity to predict will be confined to such general characteristics of the events to be expected and not include the capacity of predicting particular individual events.”

To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm. In the physical sciences there may be little objection to trying to do the impossible; one might even feel that one ought not to discourage the over-confident because their experiments may after all produce some new insights. But in the social field the erroneous belief that the exercise of some power would have beneficial consequences is likely to lead to a new power to coerce other men being conferred on some authority. Even if such power is not in itself bad, its exercise is likely to impede the functioning of those spontaneous ordering forces by which, without understanding them, man is in fact so largely assisted in the pursuit of his aims. . . .The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men's fatal striving to control society - a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.