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
