Knowledge and markets... or Fred meets Mike

Rereading Friedrich Hayek’s classic 1945 article “The Use of Knowledge in Society,” I find its message surprisingly relevant, and worthy of assigning to yet another generation of microeconomics students. This in spite of the dated references to the socialist calculation debate, which long ago was won by Hayek’s side.

Hayek’s point is that the distinctive virtue of the market is not the efficiency of competitive equilibrium per se, although that is what we teach cohort upon cohort of micro students. Rather, it is that this efficiency is achieved through a decentralized process, whereby individuals make decisions based on local, idiosyncratic knowledge, and prices summarize and convey all the information that other participants need to know:

“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 very 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 (p. 526).”

Nowadays any attentive student of freshman micro should be able to recite the limitations of this claim. Prices do not necessarily convey the correct information under a variety of real-world conditions–notably, in the presence of externalities (spillover effects like pollution), market power (monopolies), or asymmetric information (used cars). But Hayek’s point is still powerful: the best policy prescription to correct such problems usually involves government regulations that would help the market “get the prices right,” while still taking advantage of the price system’s ability to coordinate decentralized agents: a carbon tax to reduce greenhouse gas emissions is an important current example.

One can think of Hayek’s essay as a tribute to both local knowledge and global ignorance. Our user of tin need know nothing more about the conditions of tin production than what is summarized in the price. Indeed the beauty of the price system is that it would be a waste of his time and resources to try to learn more. And here we see a head-on collision with the increasingly influential view that consumers should make it their business to learn as much as possible about where their purchases came from and under what conditions they were produced. This perspective informs the fair-trade and anti-sweatshop movements, as well as the ethical food movement, exemplified in the writings of Michael Pollan, whose wonderful book The Omnivore’s Dilemma I recommend to everyone who eats.

One of the many strengths of Pollan’s writing is that he does justice to the tension between impersonal global markets, on which modern affluence depends, and a “small is beautiful” ethos that, were it practical, might make humans and their planet a lot healthier. In a recent article in the New York Times Magazine, he writes, “As Adam Smith and many others have pointed out, this division of labor has given us many of the blessings of civilization.... Yet this same division of labor obscures the lines of connection--and responsibility--linking our everyday acts to their real-world consequences...”

As a comfortable professional living in the Bay Area, I wish everyone could shop for vegetables at their local farmers’ market and get to know the lettuce guy and the tomato lady. But I suspect that for most inhabitants of the planet, the best hope for the future rests with Hayek, augmented by thoughtful government regulation to mitigate the market’s many serious imperfections.