Reprinted from the American Economic Review,
XXXV, No. 4; September, 1945, 519-30.
What is the problem we wish to solve when we try to construct
a rational economic order? On certain familiar assumptions
the answer is simple enough. If we possess all the relevant
information, if we can start out from a given system of preferences,
and if we command complete knowledge of available means, the
problem which remains is purely one of logic. That is, the
answer to the question of what is the best use of the available
means is implicit in our assumptions. The conditions which
the solution of this optimum problem must satisfy have been
fully worked out and can be stated best in mathematical form:
put at their briefest, they are that the marginal rates of
substitution between any two commodities or factors must be
the same in all their different uses.
This, however, is emphatically not the economic
problem which society faces. And the economic calculus which
we have developed to solve this logical problem, though an
important step toward the solution of the economic problem
of society, does not yet provide an answer to it. The reason
for this is that the "data" from which the economic calculus
starts are.never for the whole society "given" to a single
mind which could work out the implications and can never be
so given.
The peculiar character of the problem of a rational economic
order is determined precisely by the fact that the knowledge
of the circumstances of which we must make use never exists
in concentrated or integrated form but solely as the dispersed
bits of incomplete and frequently contradictory knowledge
which all the separate individuals possess. The economic problem
of society is thus not merely a problem of how to allocate
"given" resources--if "given" is taken to mean given to a
single mind which deliberately solves the problem set by these
"data." It is rather a problem of 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. Or,
to put it briefly, it is a problem of the utilization of knowledge
which is not given to anyone in its totality.
This character of the fundamental problem has, I am afraid,
been obscured rather than illuminated by many of the recent
refinements of economic theory, particularly by many of the
uses made of mathematics. Though the problem with which I
want primarily to deal in this paper is the problem of a rational
economic organization, I shall in its course be led again
and again to point to its close connections with certain methodological
questions. Many of the points I wish to make are indeed conclusions
toward which diverse paths of reasoning have unexpectedly
converged. But, as I now see these problems, this is no accident.
It seems to me that many of the current disputes with regard
to both economic theory and economic policy have their common
origin in a misconception about the nature of the economic
problem of society. This misconception in turn is due to an
erroneous transfer to social phenomena of the habits of thought
we have developed in dealing with the phenomena of nature.
In ordinary language we describe by the word "planning" the
complex of interrelated decisions about the allocation of
our available resources. All economic activity is in this
sense planning; and in any society in which many people collaborate,
this planning, whoever does it, will in some measure have
to be based on knowledge which, in the first instance, is
not given to the planner but to somebody else, which somehow
will have to be conveyed to the planner. The various ways
in which the knowledge on which people base their plans is
communicated to them is the crucial problem for any theory
explaining the economic process, and the problem of what is
the best way of utilizing knowledge initially dispersed among
all the people is at least one of the main problems of economic
policy-or of designing an efficient economic system.
The answer to this question is closely connected with that
other question which arises here, that of who is to do the
;planning. It is about this question that all the dispute
about "economic planning" centers. This is not a dispute about
whether planning is to be done or not. It is a dispute as
to whether planning is to be done centrally, by one authority
for the whole economic system, or is to be divided among many
individuals. Planning in the specific sense in which the term
is used in contemporary controversy necessarily means central
planning--direction of the whole economic system according
to one unified plan. Competition, on the other hand, means
decentralized planning by many separate persons. The halfway
house between the two, about which many people talk but which
few like when they see it, is the delegation of planning to
organized industries, or, in other words, monopolies.
Which of these systems is likely to be more efficient depends
mainly on the question under which of them we can expect that
fuller use will be made of the existing knowledge. This, in
turn, depends on whether we are more likely to succeeding
putting at the disposal of a single central authority all
the knowledge which ought to be used but which is initially
dispersed among many different individuals, or in conveying
to the individuals such additional knowledge as they need
in order to enable them to dovetail their plans with those
of others.
It will at once be evident that on this point the position
will be different with respect to different kinds of knowledge.
The answer to our question will therefore largely turn on
the relative importance of the different kinds of knowledge:
those more likely to be at the disposal of particular individuals
and those which we should with greater confidence expect to
find in the possession of an authority made up of suitably
chosen experts. If it is today so widely assumed that the
latter will be in a better position, this is because one kind
of knowledge, namely, scientific knowledge, occupies now so
prominent a place in public imagination that we tend to forget
that it is not the only kind that is relevant. It may be admitted
that, as far as scientific knowledge is concerned, a body
of suitably chosen experts may be in the best position to
command all the best knowledge available--though this is of
course merely shifting the difficulty to the problem of selecting
the experts. What I wish to point out is that, even assuming
that this problem can be readily solved, it is only a small
part of the wider problem.
Today it is almost heresy to suggest that scientific knowledge
is not the sum of all knowledge. But a little reflection will
show that there is beyond question a body of very important
but unorganized knowledge which cannot possibly be called
scientific in the sense of knowledge of general rules: the
knowledge of the particular circumstances of time and place.
It is with respect to this that practically every individual
has some advantage over all others because he possesses unique
information of which beneficial use might be made, but of
which use can be made only if the decisions depending on it
are left to him or are made with his active co-operation.
We need to remember only how much we have to learn in any
occupation after we have completed our theoretical training,
how big a part of our working life we spend learning particular
jobs, and how valuable an asset in all walks of life is knowledge
of people, of local conditions, and of special circumstances.
To know of and put to use a machine not fully employed, or
somebody's skill which could be better utilized, or to be
aware of a surplus stock which can be drawn upon during an
interruption of supplies, is socially quite as useful as the
knowledge of better alternative techniques. The shipper who
earns his living from using otherwise empty or half-filled
journeys of tramp-steamers, or the estate agent whose whole
knowledge is almost exclusively one of temporary opportunities,
or the arbitrageur who gains from local differences of commodity
prices-- are all performing eminently useful functions based
on special knowledge of circumstances of the fleeting moment
not known to others.
It is a curious fact that this sort of knowledge should today
be generally regarded with a kind of contempt and that anyone
who by such knowledge gains an advantage over somebody better
equipped with theoretical or technical knowledge is thought
to have acted almost disreputably. To gain an advantage from
better knowledge of facilities of communication or transport
is sometimes regarded as almost dishonest, although it is
quite as important that society make use of the best opportunities
in this respect as in using the latest scientific discoveries.
This prejudice has in a considerable measure affected the
attitude toward commerce in general compared with that toward
production. Even economists who regard themselves as definitely
immune to the crud ematerialist fallacies of the past constantly
commit the same mistake where activities directed toward the
acquisition of such practical knowledge are concerned--apparently
because in their scheme of things all such knowledge is supposed
to be "given." The common idea now seems to be that all such
knowledge should as a matter of course be readily at the command
of everybody, and the reproach of irrationality leveled against
the existing economic order is frequently based on the fact
that it is not so available. This view disregards the fact
that the method by which such knowledge can be made as widely
available as possible is precisely the problem to which we
have to find an answer.
If it is fashionable today to minimize the importance of
the knowledge of the particular circumstances of time and
place, this is closely connected with the smaller importance
which is now attached to change as such. Indeed, there are
few points on which the assumptions made (usually only implicitly)
by the "planners" differ from those of their opponents as
much as with regard to the significance and frequency of changes
which will make substantial alterations of production plans
necessary. Of course, if detailed economic plans could be
laid down for fairly long periods in advance and then closely
adhered to, so that no further economic decisions of importance
would be required, the task of drawing up a comprehensive
plan governing all economic activity would be much less formidable.
It is, perhaps, worth stressing that economic problems arise
always and only in consequence of change. As long as things
continue as before, or at least as they were expected to,
there arise no new problems requiring a decision, no n ed
to form a new plan. The belief that changes, or at least*-day
adjustments* have become less important in modern times implies
the contention- that economic problems also have become less
important. This belief in the decreasing importance of change
is, for that reason, usually held by the same people who argue
that the importance of economic considerations has been driven
into the background by the growing importance of technological
knowledge.
Is it true that, with the elaborate apparatus of modern production,
economic decisions are required only at long intervals, as
whcn a new factory is to be erected or a new process to be
introduced ? Is it true that, once a plant has been built,
the rest is all more or less mechanical, determined by the
character of the plant, and leaving little to be changed in
adapting to the ever changing circumstances of the moment
?
The fairly widespread klief in the affirmative is not, as
far as I can ascertain, borne out by the practical experience
of the businessman. In a competitive industry at any rate--and
such an industry alone can serve as a test--the task of keeping
cost from rising requires constant struggle, absorbing a great
part of the energy of the manager. How easy it is for an ineflicient
manager to dissipate the differentials on which profitability
rests and that it is possible, with the same technical facilities,
to produce with a great variety of costs are among the commonplaces
of business experience which do not seem to be equally familiar
in the study of the economist. The very strength of the desire,
constantly voiced by producers and engineers, to be allowed
to proceed untrammeled by considerations of money costs, is
eloquent testimony to the extent to which these factors enter
into their daily work.
One reason why economists are increasingly apt to forget
about the constant small changes which make up the whole economic
picture is probably their growing preoccupation with statistical
aggregates, which show a very much greater stability than
the movements of the detail. The comparative stability of
the aggregates cannot, however, be accounted for--as the statisticians
occasionally seem to be inclined to do--by the "law of large
numbers" or the mutual compensation of random changes. The
number of elements with which we have to deal is not large
enough for such accidental forces to produce stability. The
continuous flow of goods and services is maintained by constant
deliberate adjustments, by new dispositions made every day
in the light of circumstances not known the day before, by
B stepping in at once when A fails to deliver. Even the large
and highly mechanized plant keeps going largely because of
an environment upon which it can draw for all sorts of unexpected
needs: tiles for its roof, stationery or its forms, and all
the thousand and one kinds of equipment in which it cannot
be self-contained and which the plans for the operation of
the plant require to be readily available in the market.
This is, perhaps, also the point where I should briefly mention
the fact that the sort of knowledge with which I have been
concerned is knowledge of the kind which by its nature cannot
enter into statistics and therefore cannot be conveyed to
any central authority in statistical form. The statistics
which such a central authority would have to use would have
to be arrived at precisely by abstracting from minor differences
between the things, by lumping togcther, as resources of one
kind, items which differ as regards location, quality, and
other particulars, in a way which may be very significant
for the specific decision. It follows from this that central
planning based on statistical information by its nature cannot
take direct account of these circumstances of time and place
and that the central planner will have to find some way or
other in which the decisions depending on them can be left
to the "man on the spot."
If we can agree that the economic problem of society is mainly
one of rapid adaptation to changes in the particular circumstances
of time and place, it would seem to follow that 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. But this answers only part of our
problem. We need decentralization because only thus can we
insure 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.
How much knowledge does he need to do so successfully ? Which
of the events which happen beyond the horizon of his immediate
knowledge are of relevance to his immediate decision, and
how much of them need he know ?
There is hardly anything that happens anywhere in the world
that might not have an effect on the decision he
ought to make. But he need not know of these events as such,
nor of all their effects. It does not matter for
him why at the particular moment more screws of one
size than of another are wanted, why paper bags are
more readily available than canvas bags, or why skilled
labor, or particular machine tools, have for the moment become
more difficult to obtain. All that is significant for him
is how much more or less difficult to procure they
have become compared with other things with which he is also
concerned, or how much more or less urgently wanted are the
alternative things he produces or uses. It is always a question
of the relative importance of the particular things with which
he is concerned, and the causes which alter their relative
importance are of no interest to him beyond the effect on
those concrete things of his own environment.
It is in this connection that what I have called the "economic
calculus" (or the Pure Logic of (Choice) helps us, at least
by analogy, to see how this problem can be solved, and in
fact is being solved, by the price system. Even the single
controlling mind, in possession of all the data for some small,
self-contained economic system, would not-- every time some
small adjustment in the allocation of resources had to be
made--go explicitly through all the relations between ends
and means which might possibly be affected. It is indeed the
great contribution of the Pure Logic of Choice that it has
demonstrated conclusively that even such a single mind could
solve this kind of problem only by constructing and constantly
using rates of equivalence (or "values," or "marginal rates
of substitution"), that is, by attaching to each kind of scarce
resource a numerical index which cannot be derived from any
property possessed by that particular thing, but which reflects,
or in which is condensed, its significance in view of the
whole means-end structure. In any small change he will have
to consider only these quantitative indices (or "values")
in which all the relevant information is concentrated; and,
by adjusting the quantities one by one, he can appropriately
rearrange his dispositions without having to solve the whole
puzzle ab initio or without needing at any stage
to survey it at once in all its ramifications.
Fundamentally, in a system in which the knowledge of the
relevant facts is dispersed among many people, prices can
act to co-ordinate the separate actions of different people
in the same way as subjective values help the.individual to
co-ordinate the parts of his plan. It is worth contemplating
for a moment a very simple and commonplace instance of the
action of the price system to see what precisely it accomplishes.
Assume that somewhere in the world a new opportunity for the
use of some raw material, say, tin, has arisen, or that one
of the sources of supply of tin has been eliminated. It does
not matter for our purpose--and it is significant that it
does not matter--which of these two causes has made tin more
scarce. All that the users of tin need to know is that some
of the tin they used to consume is now more profitably employed
elsewhere and that, in consequence, they must economize tin.
There is no need for the great majority of them even to know
where the more urgent need has arisen, or in favor of what
other needs they ought to husband the supply. If only some
of them know directly of the new demand, and switch resources
over to it, and if the people who are aware of the new gap
thus created in turn fill it from still other sources, the
effect will rapidly spread throughout the whole economic system
and influence not only all the uses of tin but also those
of its substitutes and the substitutes of these substitutes,
the supply of all the things made of tin, and their substitutes,
and so on; and all his without the great majority of those
instrumental in bringing about these substitutions knowing
anything at all about the original cause of these changes.
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. 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.
We must look at the price system as such a mechanism for
communicating information if we want to understand its real
function-- a function which, of course, it fulfils less perfectly
as prices grow more rigid. (Even when quoted prices have become
quite rigid, however, the forces which would operate through
changes in price still operate to a considerable extent through
changes in the other terms of the contract.) The most significant
fact about this system is the economy of knowledge with which
it operates, or how little the individual participants need
to know in order to be able to take the right action. In abbreviated
form, by a kind of symbol, only the most essential information
is passed on and passed on only to those concerned. It is
more than a metaphor to describe the price system as a kind
of machinery for registering change, or a system of telecommunications
which enables individual producers to watch merely the movement
of a few pointers, as an engineer might watch the hands of
a few dials, in order to adjust their activities to changes
of which they may never know more than is reflected in the
price movement.
Of course, these adjustments are probably never "perfect"
in the sense in which the economist conceives of them in his
equilibrium analysis. But I fear that our theoretical habits
of approaching the problem with the assumption of more or
less perfect knowledge on the part of almost everyone has
made us somewhat blind to the true function of the price mechanism
and led us to apply rather misleading standards in judging
its efficiency. The marvel is that in a case like that of
a scarcity of one raw material, without an order being issued,
without more than perhaps a handful of people knowing the
cause, tens of thousands of people whose identity could not
be ascertained by months of investigation, are made to use
the material or its products more sparingly; that is, they
move in the right direction. This is enough of a marvel even
if, in a constantly changing world, not all will hit it off
so perfectly that their profit rates will always be maintained
at the same even or "normal" level.
I have deliberately used the word"marvel" to shock the reader
out of the complacency with which we often take the working
of this mechanism for granted. I am convinced that if it were
the result of deliberate human design, and if the people guided
by the price changes understood that their decisions have
significance far beyond their immediate aim, this mechanism
would have been acclaimed as one of the greatest triumphs
of the human mind. 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. But those who clamor for "conscious direction"--and who
cannot believe that anything which has evolved without design
(and even without our understanding it) should solve problems
which we should not be able to solve consciously--should remember
this: The problem is precisely how to extend the span of out
utilization of resources beyond the span of the control of
any one mind; and therefore, how to dispense with the need
of conscious control, and how to provide inducements which
will make the individuals do the desirable things without
anyone having to tell them what to do.
The problem which we meet here is by no means peculiar to
economics but arises in connection with nearly all truly social
phenomena, with language and with most of our cultural inheritance,
and constitutes really the central theoretical problem of
all social science. As Alfred Whitehead has said in another
connection, "It is a profoundly erroneous truism, repeated
by all copy-books and by eminent people when they are making
speeches, that we should cultivate the habit of thinking what
we are doing. The precise opposite is the case.
Civilization advances by extending the number of important
operations which we can perform without thinking about them.."
This is of profound significance in the social field. We make
constant use of formulas, symbols, and rules whose meaning
we do not understand and through the use of which we avail
ourselves of the assistance of knowledge which individually
we do not possess. We have developed these practices and institutions
by building upon habits and institutions which have proved
successful in their own sphere and which have in turn become
the foundation of the civilization we have built up.
The price system is just one of those formations which man
has learned to use (though he is still very far from having
learned to make the best use of it) after he had stumbled
upon it without understanding it. Through it not only a division
of labor but also a co-ordinated utilization of resources
based on an equally divided knowledge has become possible.
The people who like to deride any suggestion that this may
be so usually distort the argument by insinuating that it
asserts that by some miracle just that sort of system has
spontaneously grown up which is best suited to modern civilization.
It is the other way round: man has been able to develop that
division of labor on which our civilization is based because
he happened to stumble upon a method which made it possible.
Had he not done so, he might still have developed some other,
altogether different, type of civilization, something like
the "state" of the termite ants, or some other altogether
unimaginable type. All that we can say is that nobody has
yet succeeded in designing an alternative system in which
certain features of the existing one can be preserved which
are dear even to those who most violently assail it--such
as particularly the extent to which the individual can choose
his pursuits and consequently freely use his own knowledge
and skill.
It is in many ways fortunate that the dispute about the indispensability
of the price system for any rational calculation in a complex
society is now no longer conducted entirely between camps
holding different political views. The thesis that without
the price system we could not preserve a society based on
such extensive division of labor as ours was greeted with
a howl of derision when it was first advanced by Von Mises
twenty-five years ago. Today the difficulties which some still
find in accepting it are no longer mainly political, and this
makes for an atmosphere much more conducive to reasonable
discussion. When we find Leon Trotsky arguing that "economic
accounting is unthinkable without market relations"; when
Professor Oscar Lange promises Professor von Mises a statue
in the marble halls of the future Central Planning Board;
and when Professor Abba P. Lerner rediscovers Adam Smith and
emphasizes that the essential utility of the price system
consists in inducing the individual, while seeking his own
interest, to do what is in the general interest, the differences
can indeed no longer be ascribed to political prejudice. The
remaining dissent seems clearly to be due to purely intellectual,
and more particularly methodological, differences.
A recent statement by Joseph Schumpeter in his Capitalism,
Socialism, and Democracy provides a clear illustration
of one of the methodological differences which I have in mind.
Its author is pre-eminent among those economists who approach
economic phenomena in the light of a certain branch of positivism.
To him these phenomena accordingly appear as objectively given
quantities of commodities impinging directly upon each other,
almost, it would seem, without any intervention of human minds.
Only against this background can I account for the following
(to me startling) pronouncement. Professor Schumpeter argues
that the possibility of a rational calculation in the absence
of markets for the factors of production follows for the theorist
"from the elementary proposition that consumers in evaluating
('demanding') consumers' goods ipso facto also evaluate
the means of production which enter into the production of
these goods." [1]
Taken literally, this statement is simply untrue. The consumers
do nothing of the kind. What Professor Schumpeter's "ipso
facto" presumably means is that the valuation of the
factors of production is implied in, or follows necessarily
from, the valuation of consumers' goods. But this, too, is
not correct. Implication is a logical relationship which can
be meaningfully asserted only of propositions simultaneously
present to one and the same mind. It is evident, however,
that the values of the factors of production do not depend
solely on the valuation of the consumers' 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.
The problem is thus in no way solved if we can show that
all the facts, if they were known to a single mind
(as we hypothetically assume them to be given to the observing
economist), would uniquely determine the solution; instead
we must show how a solution is produced by the interactions
of people each of whom possesses only partial knowledge. To
assume all the knowledge to be given to a single mind in the
same manner in which we assume it to be given to us as the
explaining economists is to assume the problem away and to
disregard everything that is important and significant in
the real world.
That an economist of Professor Schumpeter's standing should
thus have fallen into a trap which the ambiguity of the term
"datum" sets to the unwary can hardly be explained as a simple
error. It suggests rather that there is something fundamentally
wrong with an approach which habitually disregards an essential
part of the phenomena with which we have to deal: the unavoidable
imperfection of man's knowledge and the consequent need for
a process by which knowledge is constantly communicated and
acquired. Any approach, such as that of much of mathematical
economics with its simultaneous equations, which in effect
starts from the assumption that people's knowledge corresponds
with the objective facts of the situation, systematically
leaves out what is our main task to explain. I am far from
denying that in our system equilibrium analysis has a useful
function to perform. But when it comes to the point where
it misleads some of our leading thinkers into believing that
the situation which it describes has direct relevance to the
solution of practical problems, it is high time that we remember
that it does not deal with the social process at all and that
it is no more than a useful preliminary to the study of the
main problem.
[1] Capitalism,
Socialism, and Democracy (New York; Harper & Bros.,
1942), p. 175. Professor Schumpeter is, l believe, also the
original author of the myth that Pareto and Barone have "solved--
the problem of socialist calculation. What they, and many others
dld was merely to state the conditions which a rational allocation
of resources would have to satisfy and to point out that these
were essentially the same as the conditions of equilibrium of
a competitive market. This is something altogether different
from s owing how the allocation of resources satisfying these
conditions can be found in practice. Pareto himself (from whom
Barone has taken practically everything he has to say), far
from claiming to have solved the practical problem, in fact
explicitly denies that it can be solved without the help of
the market. See his Manuel d'economie pure (2d ed.,
1927), pp. 233-34. The relevant passage is quoted in
an English translation at the beginning of my article on "Socialist
Calculation: The Competitive 'Solution,' " in Economica,
VIII, No. 26 (new ser., 1940), 125; reprinted below as
chapter viii.
Original Location: http://www.virtualschool.edu/mon/Economics/HayekUseOfKnowledge.html
