Wednesday, March 14, 2012

An Introduction to Austrian Economics - The Problem of Coordination and Knowledge

An Introduction to Austrian Economics
Thomas C. Taylor

2. Social Cooperation and Resource Allocation

The Problem of Coordination and Knowledge

The overriding difference between self-sufficient production and production on the basis of social cooperation is that only under the latter arrangement are people able to realize the overwhelming benefits of specialization and the division of labor. In addition, while a self-sufficient producer generates goods solely for his own satisfaction, an arrangement of social cooperation necessarily means that producers create products to satisfy other people. Virtually every person in a modern economy devotes his skills and energies to a highly specialized activity that provides a product or service to be used by someone else. We would all be in a sad state if each of us were suddenly compelled to produce only for himself.
The reliance on the elements of specialization and division of labor complicates the problem of efficient resource allocation because it makes necessary some means of unifying or coordinating the separate plans and efforts of many actors. Underlying the problem of the division of labor, then, is the problem of what Hayek calls the "division of knowledge," which is "the really central problem of economics as a social science." Hayek has stated the central question as follows:
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? 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." [4]
The seriousness of this problem of knowledge must not be underrated. Clearly a system of division of labor harbors the potential for chaos and confusion. If it is to work, there must be some means of synchronizing individual decisions and actions throughout the economy. For example, if the majority wants more timber to be used for the production of houses than for the production of paper products, then signals must be effectively communicated to induce this shift in resource usage. Otherwise a scarce resource will not be employed in the most desirable way; it will be employed for the satisfaction of less urgently felt human wants.
Yet the conventional model of so-called perfect competition, with its assumption of perfect knowledge, completely avoids treatment of the task of synchronizing decisions. The model assumes that knowledge concerning technology, tastes, etc., is given, and all individual plans are imagined as meshing consistently with one another. Knowledge is depicted as data similar to the facts used in the physical sciences. But this view of knowledge misconstrues the nature of knowledge in the social sciences. The knowledge that underlies human decisions and actions is grossly imperfect simply because a significant part of the "knowledge" in the mind of each individual consists of suppositions about the future decisions and actions of other individuals. These suppositions are subjective perceptions that are devoid of the certainty possessed by the facts used in the physical sciences.
And since a person's decisions and actions are likely to be modified as he gains additional experience of both external objective facts and other persons' decisions and actions, the notion that all separate plans and actions will eventually interlock and that the result will be a static, long-run equilibrium is totally unrealistic. By assuming perfect knowledge, the model fails to focus on the problem of the "division of knowledge." The model is a useful analytical construct in assisting the theorist's understanding of the logical result of an atomistic economic process in which unforeseeable changes were to disappear. But it is a construct that must be used carefully if the element of uncertainty is not to be erroneously omitted from the study of the real world.
Thus the task of rational allocation is not a simple matter of utilizing "given perfect knowledge" in the process of making economic decisions and actions. The knowledge that exists is "given" only in innumerable, scattered pieces and not in one single mind. Each individual has unique information regarding his particular circumstances of time and place, and others benefit from the actions taken by each individual because of his being particularly informed about his limited situation. However, because his particular information relates only to his limited situation, he may use his knowledge in a manner that is inconsistent with the plans of others. Social cooperation requires some method that will enable that part of each person's particular knowledge that is relevant to the plans of others to be disseminated as widely as possible. And this method must provide for the continuous dissemination of knowledge in the midst of relentless change. For as Hayek states,"...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 need to form a new plan." [5]
The coordination problem is inextricably connected to the fact that all data relevant to economic action are never simply given, as conventional price theory, dwelling upon the conditions of equilibrium, would have you believe. Market forces, the culmination of decisions by market participants--the consumers, entrepreneur-producers, and resource owners--are continuously effecting change in the market. What should be examined is not a static condition of equilibrium but the dynamic nature of the market process, striving unceasingly toward equilibrium.Decisions are made without perfect knowledge, which means the underlying data, far from being a given for all to use, are elusive and tenuous and available only by discovery and perception. Thus the market process is in essence a continuum of trial and error as new perceptions on the part of participants result in changes in plans and actions.
The driving forces in the market process are the producer-entrepreneurs who see profit opportunities arising from potential improvements in market activities. The process of the market is ongoing because of the relentless search for profit and the resultant alterations in the market effected by competitive producer-entrepreneurs. While other market participants are more or less passive, unaware of or perhaps uninterested in profit-related opportunities, entrepreneur-producers search out and exploit profit potentials. The data they detect and act upon may be erroneous, and the subsequent realization of errors, manifested in monetary losses, provokes further alterations in the market. Once the condition of imperfect knowledge is introduced, price theory and the picture drawn of the market are vastly changed from that of orthodox discussion. The role of entrepreneurial profits and losses will be explored in greater depth in a later section. [6]

Suggested Readings

Hayek, Friedrich A., ed. Collectivist Economic Planning. Clifton: N.J.: Kelley, 1975.
The Counter-Revolution of Science: Studies on the Abuse of Reason. New York: Free Press, 1952.
Individualism and Economic Order. Chicago: The University of Chicago Press, 1948. Particularly the essays "Economics and Knowledge," "The Facts of the Social Sciences," and "The Use of Knowledge in Society."
Kirzner, Israel M. Market Theory and the Price System. New York: Van Nostrand, 1963, pp. 33-44.
Mises, Ludwig von. Human Action: A Treatise on Economics. 3rd rev. ed. Chicago: Henry Regnery Company, 1966, pp. 143-76 and 698-710.
[1] Ludwig von Mises, "Economic Calculation in the Socialist Commonwealth," paper republished in English in Collectivist Economic Planning, ed. F. A. Hayek (London: G. Routledge & Sons, Ltd., 1935), pp. 87-130.
[2] Fred M. Taylor, "The Guidance of Production in a Socialist State," American Economic Review, no. 1 (March 1929): 1-8; also Oskar Lange, "On the Economic Theory of Socialism," Review of Economic Studies, IV, nos. 1 and 2 (October 1936): 53-71 and (February 1937): 123-42.
[3] Austrian theory nonetheless remains steadfast in its contention that economic calculation is impossible in a purely socialist society. Without actual market prices, edicts by central authorities become abysmally inept attempts to simulate market forces and are to no avail. See Ludwig von Mises,Human Action: A Treatise on Economics (Chicago: Henry Regnery Company, 1966), pp. 698-715. The fact that socialist societies today are able to utilize price information emanating from market societies must not be overlooked. Socialist decisions concerning resource allocations do not arise from within a purely and isolated socialist environment.
[4] F. A. Hayek, "Economics and Knowledge," Individualism and Economic Order (Chicago: University of Chicago Press, 1948), p. 54.
[5] Hayek, "The Use of Knowledge in Society," p. 82.
[6] 6. For a penetrating analysis of the market process and its corollary, competitive entrepreneurial activity, see Israel M. Kirzner, Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973).

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