James A. Dorn
In the history of economic thought, it is often found that what at first appears as a new idea can often be traced back to earlier work, which was lost sight of. Such is the case with Benjamin M. Anderson’s article, “Capitalism versus Socialism in the Light of the Present World Economic and Financial Situation,” published in June 1922, in the Chase Economic Bulletin (Vol. 2, No. 3). A careful reading of that article clearly shows that Anderson was a precursor of F. A. Hayek on the so-called knowledge problem—that is, how to utilize the particular knowledge dispersed among millions of individuals to allocate society’s scarce resources to satisfy human wants.
Hayek on the Knowledge Problem
Friedrich Hayek first discussed the knowledge problem in his presidential address before the London Economic Club, November 10, 1936. His remarks, titled “Economics and Knowledge,” appeared the following year in Economica (Vol. 4, new series, 33–54). In that article, Hayek argues that “economics has come nearer than any other social science to an answer to that central question of all social sciences: How can the combination of fragments of knowledge existing in different minds 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?”
The knowledge problem can be solved, according to Hayek, once it is recognized that under certain conditions “the spontaneous actions of individuals will … 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.” Those conditions include private property rights, a just rule of law, free-market pricing, and knowledge of alternatives.
In 1945, Hayek expanded his discussion of the knowledge problem in his famous article, “The Use of Knowledge in Society,” published in the American Economic Review (Vol. 35, No. 4, 519–30). The key points in that article are:
“The economic problem of society is mainly one of rapid adaptation to changes in the particular circumstances of time and place.”
“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. We must solve it by some form of decentralization.”
“We need decentralization because only thus can we ensure that the knowledge of the particular circumstances of time and place will be promptly used. But the ‘man on the spot’ cannot decide solely on the basis of his limited but intimate knowledge of the facts of his immediate surroundings. There still remains the problem of communicating to him such further information as he needs to fit his decisions into the whole pattern of changes of the larger economic system.”
“Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate the separate actions of different people.”
“The mere fact that there is one price for any commodity—or rather that local prices are connected in a manner determined by the cost of transport, etc.—brings about the solution which (it is just conceptually possible) might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process.”
Hayek’s insights into the institutional infrastructure of a free-market economy, the transmission of relevant information via the price and profit system, and the spontaneous order that arises when people are free to choose, in contrast to central planning, were recognized by the Royal Swedish Academy of Sciences in awarding him the 1974 Prize for Economic Science in Memory of Alfred Nobel.
In his presentation speech, Professor Erik Lundberg of the Royal Academy of Sciences stated:
It is above all the analysis of the viability of different economic systems which is among Professor Hayek’s most important contributions to social science research. From the middle of the 1930s onwards, he devoted increasing attention to the problems of socialist central planning. In this area, as in all others to which Hayek has devoted research, he presented a detailed exposition of ideas and conceptions in this field. He evolved new approaches in his examination of fundamental difficulties in “socialist calculation” and investigated the possibilities of achieving effective results through decentralized “market socialism”. His guiding criterion in assessing the viability of different systems refers to the efficiency with which these systems utilize the knowledge and information spread among the great mass of individuals and enterprises. His conclusion is that it is only through a far-reaching decentralization in a market system with competition and free price formation that it is possible to achieve an efficient use of all this knowledge and information. Hayek shows how prices as such are the carriers of essential information on cost and demand conditions, how the price system is a mechanism for communication of knowledge and information, and how this system can mean an efficient use of highly decentralized resources of knowledge.
Over the last 50 years, Hayek’s pioneering work on the use of knowledge in society has spawned a wide range of research on the importance of understanding the institutional framework for a free-market system, especially the essential role of private property rights and the free flow of information for creating a harmonious social and economic order.
Benjamin M. Anderson: Precursor of Hayek on the Knowledge Problem
When Hayek wrote his landmark articles on the knowledge problem, in 1936 and 1945, he was at the London School of Economics. In those articles, he did not cite the work of American economist Benjamin M. Anderson (1886–1949), whose 1922 article in the Chase Economic Bulletin touched upon many of Hayek’s key insights regarding the use of knowledge in society. Hayek surely would have cited Anderson’s article on “Capitalism versus Socialism” if he had read it.
The following are some of the key passages related to the knowledge problem from Anderson’s 1922 article; the parallels to Hayek are evident.
“Under this system of free, private enterprise with free movement of labor and capital from industry to industry, the tendency is for an automatic balance to be maintained and for goods and services to be supplied in right proportions. A social order is created, a social cooperation is worked out, largely unconscious and largely automatic, under the play of impersonal forces of market prices and wages.”
“The success of this system, however, depends upon its flexibility and the quickness with which readjustments can be made, and this, in turn, depends largely upon the extent to which it is competitive and free from unified conscious control. If a government or a collective system undertakes to regulate the business of a country as a whole and to guide and control production, there is required a central brain of such vast power that no human being who has yet lived, or can be expected to live, can supply it.”
“When millions of people are working, each at his own special problem, studying his own special market, making his readjustment piecemeal, under the guidance of market prices, the problem is manageable. If a central brain must do the thinking for all of them, chaos is inevitable. Great mistakes are made and these mistakes are carried much further than would be possible under the competitive system, controlled by free prices.”
“When the markets are satisfied that prices are free from artificial control and that they really reflect conditions of supply and demand, goods move and production can go on.… Right prices may be defined as prices which will move goods and which, through clearing the markets, permit new goods to be produced. The best way to determine what right prices are is not by a priori calculation, but rather by experimentation in the open, two-sided, competitive markets.”
A Free Market for Ideas
Both Hayek and Anderson recognized the importance of a free market for ideas in generating knowledge of alternatives and, thus, in the formation of market prices that reflect opportunity costs and individual preferences. Both saw the dangers to economic freedom and social coordination from price controls and erosion of private property rights. Their message was “institutions matter,” and that the relevant knowledge of time and place, which is dispersed among millions of individuals, cannot be duplicated by central planning and control. Those lessons are well worth repeating as we celebrate the 50th anniversary of Hayek’s Nobel Prize.