L.S.E. Essays on Cost

I

3

Economics and knowledge

by F. A. VON HAYEK

The ambiguity of the title of this paper is not accidental. Its main subject is of course the role which assumptions and propositions about the knowledge possessed by the different members of society play in economic analysis. But this is by no means unconnected with the other question which might be discussed under the same title, the question to what extent formal economic analysis conveys any knowledge about what happens in the real world. Indeed my main contention will be that the tautologies, of which formal equilibrium analysis in economics essentially consists, can be turned into propositions which tell us anything about causation in the real world only in so far as we are able to fill those formal propositions with definite statements about how knowledge is acquired and communicated. In short I shall contend that the empirical element in economic theory—the only part which is concerned, not merely with implications but with causes and effects, and which leads therefore to conclusions which, at any rate in principle, are capable of verification
*31—consists of propositions about the acquisition of knowledge.

Perhaps I should begin by reminding you of the interesting fact that in quite a number of the more recent attempts made in different fields to push theoretical investigation beyond the limits of traditional equilibrium analysis, the answer has soon proved to turn on one question which, if not identical with mine, is at least part of it, namely the question of foresight. I think the field where,
as one would expect, the discussion of the assumptions concerning foresight first attracted wider attention was the theory of risk.
*32 The stimulus which was exercised in this connection by the work of Professor F. H. Knight may yet prove to have a profound influence far beyond its special field. Not much later the assumptions to be made concerning foresight proved to be of fundamental importance for the solution of the puzzles of the theory of imperfect competition, the questions of duopoly and oligopoly. And since then it has become more and more obvious that in the treatment of the more ‘dynamic’ questions of money and industrial fluctuations the assumptions to be made about foresight and ‘anticipations’ play an equally central role, and that in particular the concepts which were taken over into these fields from pure-equilibrium analysis, like those of an equilibrium rate of interest, could be properly defined only in terms of assumptions concerning foresight. The situation seems here to be that before we can explain why people commit mistakes, we must first explain why they should ever be right.

In general it seems that we have come to a point where we all realize that the concept of equilibrium itself can be made definite and clear only in terms of assumptions concerning foresight, although we may not yet all agree what exactly these essential assumptions are. This question will occupy me later in this paper. At the moment I am only concerned to show that at the present juncture, whether we want to define the boundaries of economic statics or whether we want to go beyond it, we cannot escape the vexed problem of the exact position which assumptions about foresight are to have in our reasoning. Can this be merely an accident?

As I have already suggested, the reason for this seems to me to be that we have to deal here only with a special aspect of a much wider question which we ought to have faced at a much earlier point. Questions essentially similar to those mentioned arise in fact as soon as we try to apply the system of tautologies – those series of
propositions which are necessarily true because they are merely transformations of the assumptions from which we start, and which constitute the main content of equilibrium analysis
*33 – to the situation of a society consisting of several independent persons. I have long felt that the concept of equilibrium itself and the methods which we employ in pure analysis, have a clear meaning only when confined to the analysis of the action of a single person, and that we are really passing into a different sphere and silently introducing a new element of altogether different character when we apply it to the explanation of the interactions of a number of different individuals.

I am certain there are many who regard with impatience and distrust the whole tendency, which is inherent in all modern equilibrium analysis, to turn economics into a branch of pure logic, a set of self-evident propositions which, like mathematics or geometry, are subject to no other test but internal consistency. But it seems that if only this process is carried far enough it carries its own remedy with it. In distilling from our reasoning about the facts of economic life those parts which are truly
a priori, we not only isolate one element of our reasoning as a sort of pure logic of choice in all its purity, but we also isolate, and emphasize the importance of, another element which has been too much neglected. My criticism of the recent tendencies to make economic theory more and more formal is not that they have gone too far, but that they have not yet been carried far enough to complete the isolation of this branch of logic and to restore to its rightful place the
investigation of causal processes, using formal economic theory as a tool in the same way as mathematics.

II

But before I can prove my contention that the tautological propositions of pure-equilibrium analysis as such are not directly applicable to the explanation of social relations, I must first show that the concept of equilibrium
has a clear meaning if applied to the actions of a single individual, and what this meaning is. Against my contention it might be argued that it is precisely here that the concept of equilibrium is of no significance, because, if one wanted to apply it, all one could say would be that an isolated person was always in equilibrium. But this last statement, although a truism, shows nothing but the way in which the concept of equilibrium is typically misused. What is relevant is not whether a person as such is or is not in equilibrium, but which of his actions stand in equilibrium relationships to each other. All propositions of equilibrium analysis, such as the proposition that relative values will correspond to relative costs, or that a person will equalize the marginal returns of any one factor in its different uses, are propositions about the relations between actions. Actions of a person can be said to be in equilibrium in so far as they can be understood as part of one plan. Only if this is the case, only if all these actions have been decided upon at one and the same moment, and in consideration of the same set of circumstances, have our statements about their interconnections, which we deduce from our assumptions about the knowledge and the preferences of the person, any application. It is important to remember that the so-called ‘data’, from which we set out in this sort of analysis, are (apart from his tastes) all facts given to the person in question, the things as they are known to (or believed by) him to exist, and not in any sense objective facts. It is only because of this that the propositions we deduce are necessarily
a priori valid, and that we preserve the consistency of the argument.
*34

III

The first answer which would seem to follow from our approach is that equilibrium in this connection exists if the actions of all members of the society over a period are all executions of their respective individual plans on which each decided at the beginning of the period. But when we inquire further what
exactly this implies, it appears that this answer raises more difficulties than it solves. There is no special difficulty about the concept of an isolated person (or a group of persons directed by one of them) acting over a period according to a preconceived plan. In this case the execution of the plan need not satisfy any special criteria in order to be conceivable. It may of course be based on wrong assumptions concerning the external facts and on this account may have to be changed. But there will always be a conceivable set of external events which would make it possible for the plan to be executed as originally conceived.

The situation is, however, different with the plans determined upon simultaneously but independently by a number of persons. In the first instance, in 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.
*35 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.

IV

The confusion about the concept of a datum is at the bottom of so many of our difficulties in this field that it is necessary to consider it in somewhat more detail. Datum means of course something given, but the question which is left open, and which in the social sciences is capable of two different answers, is to whom the facts are supposed to be given. Economists appear subconsciously always to have been somewhat uneasy about this point, and to have reassured themselves against the feeling that they did not
quite know to whom the facts were given by underlining the fact that they
were given – even by using such pleonastic expressions as ‘given data’. But this does not solve the question whether the facts referred to are supposed to be given to the observing economist, or to the persons whose actions he wants to explain, and if to the latter, whether it is assumed that the same facts are known to all the different persons in the system, or whether the ‘data’ for the different persons may be different.

There is, however, still the other question of whether the individual subjective sets of data correspond to the objective data, and whether in consequence the expectations on which plans were
based are borne out by the facts. If correspondence between data in this sense were required for equilibrium it would never be possible to decide otherwise than
ex post, at the end of the period for which people have planned, whether at the beginning the society has been in equilibrium. It seems to be more in conformity with established usage to say in such a case that the equilibrium, as defined in the first sense, may be disturbed by an unforeseen development of the (objective) data, and to describe this as an exogenous disturbance. In fact it seems hardly possible to attach any definite meaning to the much-used concept of a change in the (objective) data unless we distinguish between external developments in conformity with, and those different from, general expectations, and define as a ‘change’ any divergence of the actual from the expected development, irrespective of whether it means a ‘change’ in some absolute sense. Surely if the alternations of the seasons suddenly ceased and the weather remained constant from a certain day onward, this would represent a change of data in our sense, that is a change relative to expectations, although in an absolute sense it would not represent a change but rather an absence of change. But all this means that we can speak of a change in data only if equilibrium in the first sense exists, that is, if expectations coincide. If they conflicted, any development of the external facts might bear out somebody’s expectations and disappoint those of others, and there would be no possibility of deciding what was a change in the objective data.
*36

V

For a society then we
can speak of a
state of equilibrium at a point of time – but it means only that compatibility exists between the different plans which the individuals composing it have made for action in time. And equilibrium will continue, once it exists, so long as the external data correspond to the common expectations of all the members of the society. The continuance of a state of equilibrium in this sense is then not dependent on the objective data being constant in an absolute sense, and is not necessarily
confined to a stationary process. Equilibrium analysis becomes in principle applicable to a progressive society and to those intertemporal price relationships which have given us so much trouble in recent times.
*37

These considerations seem to throw considerable light on the relationship between equilibrium and foresight, which has been somewhat hotly debated in recent times.
*38 It appears that the concept of equilibrium merely means that the foresight of the different members of the society is in a special sense correct. It must be correct in the sense that every person’s plan is based on the expectation of just those actions of other people which those other people intend to perform, and that all these plans are based on the expectation of the same set of external facts, so that under certain conditions nobody will have any reason to change his plans. Correct foresight is then not, as it has sometimes been understood, a precondition which must exist in order that equilibrium may be arrived at. It is rather the defining characteristic of a state of equilibrium. Nor need foresight for this purpose be perfect in the sense that it need extend into the indefinite future, or that everybody must foresee everything correctly. We should
rather say that equilibrium will last so long as the anticipations prove correct, and that they need to be correct only on those points which are relevant for the decisions of the individuals. But on this question of what relevant foresight or knowledge more later.

Before I proceed further I should probably stop for a moment to illustrate by a concrete example what I have just said about the meaning of a state of equilibrium and how it can be disturbed. Consider the preparations which will be going on at any moment for the production of houses. Brickmakers, plumbers and others will all be producing materials which in each case will correspond to a certain quantity of houses for which just this quantity of the particular material will be required. Similarly we may conceive of prospective buyers as accumulating savings which will enable them at certain dates to buy definite quantities of houses. If all these activities represent preparations for the production (and acquisition) of the same amount of houses we can say that there is equilibrium between them in the sense that all the people engaged in them may find that they can carry out their plans.
*39 This need not be so, because other circumstances which are not part of their plan of action may turn out to be different from what they expected. Part of the materials may be destroyed by an accident, weather conditions may make building impossible, or an invention may alter the proportions in which the different factors are wanted. This is what we call a change in the (objective) data,
which disturbs the equilibrium which has existed. But if the different plans were from the beginning incompatible, it is inevitable that somebody’s plans will be upset and have to be altered, and that in consequence the whole complex of actions over the period will not show those characteristics which apply if all the actions of each individual can be understood as part of a single individual plan he has made at the beginning.
*40

VI

When in all this I emphasize the distinction between mere intercompatibility of the individual plans
*41 and the correspondence between them and the actual external facts or objective data, I do not of course mean to suggest that the subjective inter-agreement is not in some way brought about by the external facts. There would of course be no reason why the subjective data of different people should ever correspond unless they were due to the experience of the same objective facts. But the point is that pure-equilibrium analysis is not concerned with the way in which this correspondence is brought about. In the description of an existing state of equilibrium which it provides, it is simply assumed that the subjective data coincide with the objective facts. The equilibrium relationships cannot be deduced merely from the objective facts, since the analysis of what people will do can only start from what is known to them. Nor can equilibrium analysis start merely
from a given set of subjective data, since the subjective data of different people would be either compatible or incompatible, that is, they would already determine whether equilibrium did or did not exist.

VII

In the usual presentations of equilibrium analysis it is generally made to appear as if these questions of how the equilibrium comes about were solved. But if we look closer it soon becomes evident that these apparent demonstrations amount to no more than the
apparent proof of what is already assumed.
*42 The device generally adopted for this purpose is the assumption of a perfect market where every event becomes known instantaneously to every member. It is necessary to remember here that the perfect market which is required to satisfy the assumptions of equilibrium analysis must not be confined to the markets of all the individual commodities; the whole economic system must be assumed to be one perfect market in which everybody knows everything. The assumption of a perfect market then means nothing less than that all the members of the community, even if they are not supposed to be strictly omniscient, are at least supposed to know automatically all that is relevant for their decisions. It seems that that skeleton in our cupboard, the ‘economic man’, whom we have exorcised with prayer and fasting, has returned through the back door in the form of a quasi-omniscient individual.

The statement that, if people know everything, they are in equilibrium is true simply because that is how we define equilibrium. The assumption of a perfect market in this sense is just another way of saying that equilibrium exists, but does not get us any nearer an explanation of when and how such a state will come about. It is clear that if we want to make the assertion that under certain conditions people will approach that state we must explain by what process they will acquire the necessary knowledge. Of course any assumption about the actual acquisition of knowledge in the course of this process will also be of a hypothetical character. But this does not mean that all such assumptions are equally justified. We have to deal here with assumptions about causation, so that what we assume must not only be regarded as possible (which is certainly not the case if we just regard people as omniscient) but must also be regarded as likely to be true, and it must be possible, at least in principle, to demonstrate that it is true in particular cases.

Secondly, while in the field of the Pure Logic of Choice our analysis can be made exhaustive, that is, while we can here develop a formal apparatus which covers all conceivable situations, the supplementary hypotheses must of necessity be selective, that is, we must select from the infinite variety of possible situations such ideal types as for some reason we regard as specially
relevant to conditions in the real world.
*43 Of course we could also develop a separate science, the subject matter of which was
per definitionem confined to a ‘perfect market’ or some similarly defined object, just as the Logic of Choice applies only to persons who have to allot limited means among a variety of ends. And for the field so defined our propositions would again become
a priori true. But for such a procedure we should lack the justification which consists in the assumption that the situation in the real world is similar to what we assume it to be.

VIII

The only condition, about the necessity of which for the establishment of an equilibrium economists seem to be fairly
agreed, is the ‘constancy of the data’. But after what we have seen about the vagueness of the concept of ‘datum’ we shall suspect, and rightly, that this does not get us much further. Even if we assume – as we probably must – that here the term is used in its objective sense (which includes, it will be remembered, the preferences of the different individuals) it is by no means clear that this is either required or sufficient in order that people shall actually acquire the necessary knowledge, or that it was meant as a statement of the conditions under which they will do so. It is rather significant that at any rate some authors
*44 feel it necessary to add ‘perfect knowledge’ as an additional and separate condition. And indeed we shall see that constancy of the objective data is neither a necessary nor a sufficient condition. That it cannot be a necessary condition follows from the facts, firstly, that nobody would want to interpret it in the absolute sense that nothing must ever happen in the world, and, secondly, that, as we have seen, as soon as we want to include changes which occur periodically or perhaps even changes which proceed at a constant rate, the only way in which we can define constancy is with reference to expectations. All that this condition amounts to then is that there must be some discernible regularity in the world which makes it possible to predict events correctly. But while this is clearly not sufficient to prove that people will learn to foresee events correctly, the same is true to a hardly less degree even about constancy of data in an absolute sense. For any one individual, constancy of the data does in no way mean constancy of all the facts independent of himself, since, of course, only the tastes and not the actions of the other people can in this sense be assumed to be constant. And as all those other people will change their decisions as they gain experience about the external facts and other people’s action, there is no reason why these processes of successive changes should ever come to an end. These difficulties are well known
*45 and I only mention them here to remind you how little we actually know about the conditions under which an equilibrium will ever be reached. But
I do not propose to follow this line of approach further, though not because this question of the empirical probability that people will learn (that is, that their subjective data will come to correspond with each other and with the objective facts) is lacking in unsolved and highly interesting problems. The reason is rather that there seems to me to be another and more fruitful way of approach to the central problem.

IX

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.
*46 The problem which we pretend
solve is how the spontaneous interaction of a number of people, each possessing only bits of knowledge, brings about a state of affaris in which prices correspond to costs, etc., and which could be brought about by deliberate direction only by somebody who possessed the combined knowledge of all those individuals. 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 our science. But in our analysis, instead of showing what bits of information the different persons must possess in order to bring about that result, we fall in effect back on the assumption that everybody knows everything and so evade any real solution of the problem.

Before, however, we can proceed further, to consider this division of knowledge among different persons, it is necessary to become more specific about the sort of knowledge which is relevant in this connection. It has become customary among economists to stress only the need of knowledge of prices, apparently because – as a consequence of the confusions between objective and subjective data – the complete knowledge of the objective facts was taken for granted. In recent times even the knowledge of current prices has been taken so much for granted that the only connection in which the question of knowledge has been regarded as problematic has been the anticipation of future prices. But, as I have already indicated at the beginning, price expectations and even the knowledge of current prices are only a very small section of the problem of knowledge as I see it. The wider aspect of the problem of knowledge with which I am concerned is the knowledge of the basic fact of how the different commodities can be obtained and used,
*47 and under what conditions they are actually obtained and used, that is, the general
question of why the subjective data to the different persons correspond to the objective facts. Our problem of knowledge here is just the existence of this correspondence which in much of current equilibrium analysis is simply assumed to exist, but which we have to explain if we want to show why the propositions, which are necessarily true about the attitude of a person towards things which he believes to have certain properties, should come to be true of the actions of society with regard to things which either do posses these properties, or which, for some reason we shall have to explain, are commonly believed by the members of society to possess these properties.
*48

But to revert to the special problem I have been discussing, the amount of knowledge different individuals must possess in order that equilibrium may prevail (or the ‘relevent’ knowledge they must possess), we shall get nearer to an answer if we remember how it can become apparent either that equilibrium did not exist or that it is being distrubed. We have seen that the equilibrium connections will be severed if any person changes his plans, either because his tastes change (which does not concern us here) or because new facts become known to him. But there are evidently two different ways in which he may learn of new facts which make him change his plans, which for our purposes are of altogether different significance. He may learn of the new facts as it were by accident, that is in a way which is not a necessary consequence of his attempt to execute his original plan, or it may be inevitable that in the course of his attempt he will find that the fact are
different from what he expected. It is obvious that, in order that he may proceed according to plan, his knowledge needs to be correct only on the points on which it will necessarily be confirmed or corrected in the course of the execution of the plan. But he may have no knowledge of things which, if he possessed it, would certainly affect his plan.

While such a position represents in one sense a position of equilibrium, it is however clear that it is not an equilibrium in the special sense in which equilibrium is regarded as a sort of optimum position. In order that the results of the combination of individual bits of knowledge should be comparable to the results of direction by an omniscient dictator, firther conditions must apparently be introduced.
*49 And while it seems quite clear that it is possible to define the amount of knowledge which individuals must possess in order that this result should be obtained, I know of no real attempt in this direction. One conditions would probably be that each of the alternative use of any sort of resources is known to the owner of some such resources actually used for another purpose and that in this way all the different uses of these resources are
connected, either directly or indirectly.
*50 But I mention this condition only as an instance of how it will in most cases be sufficient that in each field is a certain margin of people who possess among them all the relevant knowledge. To elaborate this further would be an interesting and a very important task, but a task that would far exceed the limits of this paper.

But although what I have said on this point has been largely in the form of a criticism, I do not want to appear unduly despondent about what we have already achieved in this field. Even if we have jumped over an essential link in our argument, I still believe that by what is implicit in its reasoning, economics has come nearer than any other social science to an answer to that central question of all social sciences, how the combination of fragments of knowledge existing in different minds can bring about results which, if they were to be brought about deliberately, would require a knowledge on the part of the directing mind which no single person can possess. To show that in this sense the spontaneous actions of individuals will under conditions which we can define bring about a distribution of resources which can be understood as if it were made according to a single plan, although nobody has planned it, seems to me indeed an answer to the problem which has sometimes been metaphorically described as that of the ‘social mind’. But we must not be surprised that such
claims on our part have usually been rejected by sociologists, since we have not based them on the right grounds.

X

One is that, in stressing the nature of the empirical propositions of which we must make use if the formal apparatus of equilibrium analysis is to serve for an explanation of the real world, and in emphasizing that the propositions about how people will learn, which are relevant in this connection, are of a fundamentally different nature from those of formal analysis, I do not mean to suggest that there opens here and how a wide field for empirical research. I very much doubt whether such investigation would teach us anything new. The important point is rather that we should become clear about what the questions of fact are on which the applicability of our argument to the real world depends, or, to put the same thing in other words, at what point our argument,
when it is applied to phenomena of the real world, becomes subject to verification.

The second point is that I do not want of course to suggest that the sort of problems I have been discussing were foreign to the arguments of the economists of the older generations. The only objection that can be made against them is that they have so mixed up the two sorts of propositions, the
a priori and the empirical, of which every realistic economist makes constant use, that it is frequently quite impossible to see what sort of validity they claimed for a particular statement. More recent work has been freer from this fault – but only at the price of leaving more and more obscure what sort of relevance their arguments had to the phenomena of the real world. All I have tried to do has been to find the way back to the common-sense meaning of our analysis, of which, I am afraid, we are apt to lose sight as our analysis becomes more elaborate. You may even feel that most of what I have said has been commonplace. But from time to time it is probably necessary to detach oneself from the technicalities of the argument and to ask quite naïvely what it is all about. If I have only shown that in some respects the answer to this question is not only not obvious, but that occasionally we do not even quite know what it is, I have succeeded in my purpose.