Economics and Knowledge by F.A. Hayek

This is a presidential address to the London Economic Club by F.A. Hayek on the 10^th November 1936 and first published in Economica February 1937, available in full from the Library of Economics and Liberty.

The topic up for discussion is the concept of economic equilibrium. Hayek’s argument is that in order for the concept to be meaningful it must be dynamic, it must exist in time. This is to say that equilibrium is a state which does not change over time unless there is an external shock or change. Quite an obvious statement really, but integral to his later argument. His second condition for equilibrium is that, as an economic state is the outcome of various individuals actions based on their plans a predictions about the future, equilibrium happens when over time peoples expectations are accurate and therefore there is no need to adjust their planning. In essence as these plans are about production and consumption the overall definition of economic equilibrium is that supply equals demand over time. What is different about this definition when compared to the neoclassical account is the causal link of predictions about the future state of the market being either correct and therefore fulfilled or incorrect and therefore unfulfilled (or over-fulfilled).

This is central to the second part of the address where Hayek argues that because of this link the study of equlibria is of no use in studying the actual functioning of the economy. This argument goes as follows. (Here I’m drawing on an explanation of atomistic planning given by John O’Neil in his 1998 book The Market – Ethics, Knowledge and Politics where he also discusses Hayek’s concept of planning). Plans are made at time t­­­­₀ by all economic agents (anybody who is participating in the market) which are then acted upon at time t­₁ resulting in the prices at which the produced and desired goods are traded at and the ability of each individual to fulfil their goals. The problem is that the state t­₁ is unknown at t₀ and therefore each individual makes predictions on what future prices will be based on their own subjective data sets and beliefs about other agents’ plans.  These predictions are then used to form plans that are enacted in t₁ . At t₁ the predictions are either verified or nullified causing the review of future predictions and plans. All that is required then is for the beliefs and data sets to result in accurate predictions. They themselves do not need to be accurate about the state of the world. For example I could base my plans on how much of good X I will produce based on the belief that due to inferior technology other producers will only produce aX. When in fact my competitors possess for superior technology but die to a series of shortages further up their supply chains they only have access to sufficient resources to produce aX. Regardless of this false belief my predictions are accurate and therefore could result in equilibrium in the market for X.

Equilibrium therefore does not imply the best possible allocation of resources or that the economy is pareto optimal. As in the example above if I was aware of my competitors higher levels of technology I may have chosen to increase my investment, reducing waste and increasing output. Also this implies that studying changes in equilibrium tells us nothing about the objective facts of the economy as the shift in my plans from producing, let’s say, bX to cX (to use the example above) could be a result of changes in objective facts about the economy (such as changes in consumer demand) or it could be that I suddenly become aware of the true state of my competitors and so change my output to increase chances for investment.

Also the above implies that equilibrium has been achieved in the first place. Given the complexity of modern economies and the number of plans made at every moment based on beliefs and “knowledge” that may or may not be true the chances of achieving a state where all expectations are satisfied and therefore no change in the “data” that is used in planning by any individual is highly unlikely.

Therefore any study based on the concept of market equlibria is pointless. As not only are equlibria empirically unlikely, changes in them reveal nothing about the objective state of the economy and when achieved they are not necessarily the desirable state that neoclassical economics makes them out to be. Hayek then argues that because of this th emphasis of economic study should shift towards studying the dissemination of knowledge in the economy and the dynamics of planning in catallaxy in order to develop a better empirical understanding of economics. 

The Market Order or Catallaxy by F.A.Hayek

This chapter comes from the second volume of Hayek’s Law, Legislation and Liberty published in 1976. The chapter is a good summary of Hayek’s argument for markets as the way of organising economic production and distribution.

I’ll try to sketch out his argument alongside my thoughts on it here.

The starting point of his argument is that there is a common misconception in modern thought by classifying the “economic” activity of a society as an economy. Hayek argues that strictly speaking an economy is a closed unit in which there is a clear continuum of goals and aims that are to be satisfied. This is clearly not the case in society where there are multiple sets of goals and aims possessed by each individual and group which are not commensurable. So therefore cannot be converted into a single continuum of desires. Instead, he argues, we should think of market orders as a catallaxy where multiple agents come together in production and exchange under set rules in order to achieve their goals. This catallaxy does not attempt to create a single continuum or guarantee that each set of goals will be fulfilled but it does maximise the chances of each individual, given her material endowments, of achieving her goals.

This is set against a planned, or partially planned, society where through a political hierarchy a continuum is constructed based on the thoughts and ideas of officials, who cannot know the desires of the individuals, and then dictated to producers. This, Hayek appears to argue, is an economy in the strictest sense but it is based on a false continuum of desires representing not the goals and aims of the citizens but the goals and aims of the elite.

Hence Hayek argues that the freedom of the individual is inseparable from market relations as to intervene from above is to reduce the chances of some of achieving their goals in favour of increasing the chances of a select few.

The second strand of this chapter was the standard argument that markets result in production at the production possibility frontier. However due to the lack of knowledge and the non-commensurability of peoples goals (i.e. the lack of a continuum) the point that is chosen is not pareto optimal. But for the same reasons (non-commensurability and knowledge) the concept is redundant. Personally I don’t fault this statement and it is a much more mature understanding of the issues of knowledge and commensurability problems than that of modern neo-classical economics.

But the first argument that individual freedom is inseparable from market relations I do fault. The problem is the initial distribution of resources. Hayek openly accepts that both the initial resources available to an individual and the results of her actions are in part determined by chance. He also argues that if this were not the case we could not be seen as free as we would have perfect information about the future and the present and therefore would just be machines calculating best outcomes. However this ignores that although the fickle hand of chance may have a role in the outcomes of our decisions the options available to us to pursue are limited by our initial bundle of resources. It is both high conceivable and empirically the case that poverty traps exist and that those who by chance are born into wealth often maintain their position with no effort or work by simply employing somebody else to manage their estate; somebody who, if endowed initial with the same resources, could have made more of them.

A possible rejoinder to this is that the exact opposite may be the case where the ingenious accountant is deprived of resources to invest wisely in order to support the lifestyle of a delinquent.  This would be to slightly misunderstand my argument. What I am arguing is that if all started with the same resources some would succeed and some would fail dependent partly on chance and partly on skill. Therefor the delinquent would have to be incredibly lucky, ala Forest Gump, to achieve the standard of living afforded in the case above; whereas the ingenious accountant would have to be unlucky to not be able to achieve her goals.

However this assumes that in each generation we are able to have a “hard reset” of economic resources. This clearly isn’t possible. So any attempt to achieve this distribution would have to be done by redistribution. Hayek argues that this is not acceptable as it interferes with the working of the catallaxy. This is because redistribution is to interfere with the “rules of the game”. As the “rules of the game” are part of the institutional framework that actors depend on to make their predictions and thus their plans any changes brings chaos and disrupts the outcome of the catallaxy; causing actors to become wary of future action thereby reducing the ability of the catallaxy to function efficiently.

This however, I would posit, depends on the type of intervention. If for example there was a 100% inheritance tax implemented progressively over time and it was explicit that this was the case (say a 1% increase each year for however many years) the catallaxy would accept this as the case and individuals would be able to adjust their plans appropriately. Also if the equalisation of starting points was achieved by free education to all for as long as people achiever a set standard to progress (i.e. achieving a 2:1 to progress to masters) and a “starting fund” accessible at a given age to be spent or invested as the individual wishes would be beneficial to the catallaxy as not only will potential entrepreneurs be able to begin innovation with fewer barriers but the knowledge available in planning will be increased enabling better formulated plans and therefore potentially better results. In effect increasing the “chances of any chosen individual to achieve their goals”.

Therefore although the market order may result in the most efficient way (if considered in opposition to planning) of enabling as many people as possible the chance  of achieving their aims and goals this does not rule out entirely redistribution and in fact redistribution can have a role in improving the functioning of the catallaxy in certain circumstances.

Or at least that’s what I took from it.