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.