The Use of Knowledge in Society — Friedrich Hayek on Planning and Economic Organisation

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Friedrich Hayek - The Use of Knowledge in Society

Knowledge, organisation and (de-)centralisation

In his seminal paper, The Use of Knowledge in Society, economist Friedrich Hayek highlights the importance of recognizing information that individuals can and cannot aggregate for decision-making. By extension, he describes the fundamental role that decentralized mechanisms play in the coordination and allocation of scarce resources.

Kenneth Arrow, Robert Solow and other esteemed economists included Hayek’s paper in their list of  the top twenty most “admirable and important articles” in the last hundred years of the American Economic Review. More than seven decades on, Hayek’s paper remains an accessible and illuminating read, even if you disagree with it.

This post will highlight the main ideas I drew from Hayek’s paper, including his views on the nature of economic society and some of his criticisms of mainstream economic thinking, which I think remain relevant to this day.

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Rational economic organisation

How can society determine the best use of its scarce resources? In classical economics, this is a logical and mathematical problem. But their solutions commonly assume that we have complete knowledge of all preferences, available means and relevant information.

We know that such assumptions are not always, if rarely, true for society. In many cases, the knowledge necessary for “economic calculus” doesn’t exist in a single individual or institution. Knowledge is diffused across society. Sometimes, knowledge is incomplete. And sometimes, it is contradictory.

The economic problem of society

Hayek says that the “economic problem of society” isn’t just about the allocation of scarce resources. Instead, it’s “how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know”. Put another way, it’s “a problem of the utilization of knowledge not given to anyone in its totality”.

Hayek believes that mathematical economic theory has to some degree obscured our understanding of the nature of rational economic organisation. That’s not to say that there’s no place for mathematics in economic reasoning. Rather, it’s a criticism of the way we specify and solve for economic problems. The author attributes this obfuscation in part to the “erroneous transfer” of our understanding and methods in the physical sciences to that of social problems.

Centralised and decentralised “planning”

Every form of economic activity requires planning of some sort. Much of economic life involves interdependent interactions and decisions.

Economic theory should then consider how individuals and groups incorporate knowledge into planning. Moreover, good theories should explain how we should use knowledge when it’s dispersed across society. It follows that the design of an “efficient economic system” rests on the assumptions we make about this.

So, when is a centralised authority preferable, to say a decentralised system of competition, for coordination, resource allocation and decision making? Hayek believes that this depends on whether it can make “fuller use… of the existing knowledge”.

“The values of the factors of production do not depend solely on the valuation of the consumer’s goods but also on the conditions of supply of the various factors of production. Only to a mind to which all these facts were simultaneously known would the answer necessarily follow from the facts given to it. The practical problem, however, arises precisely because these facts are never so given to a single mind, and because, in consequence, it is necessary that in the solution of the problem knowledge should be used that is dispersed among many people”.

Friedrich .A. Hayek, “The Use of Knowledge in Society.” The American Economic Review 35.4 (1945)

Knowledge of general rules

It helps then to distinguish between different types of knowledge, its role and its dispersal. For example, there is scientific and technical knowledge – a bedrock of societal progress and productivity. So, where scientific knowledge is necessary for decision making, it seems most wise to have experts involved.

But scientific knowledge, in Hayek’s view, is a small fraction of society’s total knowledge. There remains a large pool of “unorganised knowledge”, or what he refers to as the “knowledge of general rules: the knowledge of the particular circumstances of time and place”. This is a type of localised know-how that people cultivate through experiences unique to them.

Details behind the economic picture

“Economic problems arise always and only in consequence of change”. If nothing has changed, then no new decision is necessary in that moment of time.

In this light, Hayek sees “the economic problem of society [as] mainly one of rapid adaptation to changes in the particular circumstances of time and place”. This in turn implies an important role for the adaptation and incorporation of knowledge of general rules in society.

Hayek laments that economists often neglect the “constant small changes which make up the whole economic picture”, given their “growing preoccupation with statistical aggregates”. I think this observation applies not only to economists, but to business executives and policy makers as well.

What’s more, these aggregates sometimes exhibit “greater stability than the movements of the detail”. From the booms and busts of industry to the rise and fall of empires, much of business, financial and political history is testament to this.

Relatedly, it isn’t easy to isolate the “knowledge of general rules” from aggregate statistics. As such, the central planner or business executive must make decisions without a complete or precise account of knowledge particular to their circumstances of time and place.

Decentralisation and the price system

Practically, if we’re to incorporate localised but unorganised knowledge into decision making, some amount of decentralisation appears necessary. After all, it seems unreasonable to expect the central planner or business executive to incorporate everything that’s necessary for decision making. They may have to leave some or much of it to the people on the ground and those closest to the economic problem.

The last few statements may seem obvious to you – But it’s worth stressing when you see how hierarchical and bureaucratic some large public and private enterprises have become today. As a former consultant, sometimes I couldn’t get even the smallest of improvements through without the say-so from my client’s senior executives. To me, this is concerning when it’s their middle management and operational staff that are closest to these problems. Not to mention the lengthy process of moving information up and down the pyramid.

Unfortunately, the person on the ground too has limited knowledge. But this problem isn’t insurmountable if mechanisms exist to connect and incorporate unorganised knowledge. If such mechanism exists, then it’s sufficient for people to know only of their immediate wants, ability, resources and opportunity.

One example of this in business is the decentralised ownership model that some conglomerates pursue. Berkshire Hathaway is an obvious one, where its chairmen – Warren Buffett and Charlie Munger – are responsible only for top-level capital allocation, succession planning and the incentive schemes of their managers. They leave the rest to their highly capable staff. This allows all parties involved to focus on problems that they’re best equipped to resolve.

Overlapping visions

Another example of such a mechanism is the price system of society. Hayek says that the economists who assumes perfect knowledge in their analysis should remember the “true function of the price mechanism” – A mechanism “for communicating information” in an “economy of knowledge” in which people do not know everything.

Hayek highlights this with a simple example: Let’s say regional demand somewhere for some class of raw materials rises. The individuals that know about it will allocate resources and new ventures to meet that opportunity. The relative change in demand and supply affects the price of this raw material. This in turn influences the market for its substitutes, complements and inputs. And this in turn affects the substitutes, complements and inputs of these markets, and so on.

In this way, prices adjust to reflect and balance the relative wants of different actors, even though each holds knowledge only of circumstances local to them. As Hayek puts it:

“Fundamentally, in a system where the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate the separate actions of different people in the same way as subjective values help the individual to coordinate the parts of his plan…. 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”.

Friedrich .A. Hayek, “The Use of Knowledge in Society.” The American Economic Review 35.4 (1945)

Silent systems of social order

The price system is one of society’s ingenious solution to the problem of coordination and allocation. It’s a somewhat emergent product of repeated social interactions at ever-increasing scale and complexity.

But, to Hayek’s point, “its misfortune is the double one that it is not the product of human design and that the people guided by it usually do not know why they are made to do what they do”.

From work to leisure, we often forget how silently prices guide our behaviours in many aspects of life. Here, Hayek shares a nice observation from mathematician Alfred Whitehead:

“It is a profoundly erroneous truism, repeated by all copy-books and by eminent people …, that we should cultivate the habit of thinking what we are doing. The precise opposite is the case. Civilisation advances by extending the number of important operations which we can perform without thinking about them”.

Alfred Whitehead

Much of society is based upon shared habits, symbols and rules that give rise to formal institutions and practices. The price system, as imperfect as it may be, is one of these emergent systems that help to coordinate the division of labour and allocation of resources.

Eusocial species, like ants, bees and termites, have developed their own mechanisms for coordination, allocation and specialisation. But for social civilizations, such as ourselves, it’s hard to imagine an alternative order that accounts for our cognitive limitations, and our dual nature between self-interest and altruism.

Final thoughts

A quick reading of this post may give the impression that decentralisation is the way to go. Not quite and not always. Again, the preferred solution depends on its relative ability to incorporate knowledge for useful ends. But ability in this context is a nebulous concept. A large enterprise, for example, must balance the efficiency gains from centralisation against the cost of bureaucracy and knowledge loss. This isn’t easy to quantify.

We know also that an efficient or Pareto optimal allocation of resources is not always socially desirable. Individuals and constituents, left to their own devices, can behave in ways that undermines the collective. Price systems in such contexts, without further intervention, may exist only to facilitate such outcomes.

A lecturer in economics once told me that the correct but unfortunate answer to every problem in economics is “it depends” – Wise words that have stuck with me to this day. The science of social organisation, I think, has a long but fascinating road ahead.

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Further reading