Wednesday, March 27, 2019

The economic problem of society is the utilization of knowledge which is not given to anyone in its totality

From Doing Bad by Doing Good: Why Humanitarian Action Fails by Christopher J. Coyne. Page 66.
One of the crucial contributions of Nobel Laureate economist F. A. Hayek was his clarification of the exact nature of the economic problem laid out in the preceding section. He noted, “The economic problem of society is . . . 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 . . . the utilization of knowledge which is not given to anyone in its totality.” Hayek’s point is that economic interactions rely on dispersed knowledge, some of which exists for all to grasp but much of which is inarticulate, tacit knowledge that is difficult to make explicit and is not available to everyone. Such knowledge must be discovered through experience and experimentation. Because tacit knowledge cannot be expressed in an objective manner, it is not “out there” for others to obtain as they could articulated knowledge written in the books lining library shelves. We now have the beginnings of an understanding of why markets are so adaptable—they allow dispersed individuals to take advantage of the knowledge possessed by others to discover a solution to the economic problem. But how do markets do this?

At the core of the adaptability of markets is the notion of “economic calculation,” which refers to the decision-making process of how to best allocate scarce resources among the array of feasible alternatives. Economic calculation refers to the determination of the expected value-added of a potential course of action. By comparing the relative expected value added across feasible alternatives, decision makers are able to choose the course of action with the highest expected social return. Crucial to this decision-making process are money prices and profit-and-loss accounting.

Money prices, which serve as a common unit of calculation, capture the relative scarcity of different goods based on context-specific conditions and communicate this information to others in the economy. This is powerful precisely because people are able to act on the context-specific knowledge reflected in prices without needing to actually possess any specific insight into the actual local conditions. The economist Thomas Sowell effectively makes this point when he writes, “Prices are important not because money is considered paramount but because prices are a fast and effective conveyor of information through a vast society in which fragmented knowledge must be coordinated.” This information is crucial because it allows people to compare the prices of inputs, which reflect underlying scarcity conditions, to the expected profitability of numerous alternatives, all of which are technologically feasible. The resulting profit or loss provides feedback as to whether this estimate was accurate or not. A profit indicates that resources have been combined in a manner that generates value to others while a loss signals the opposite—that resources could have been allocated to a higher-valued use that would increase welfare.

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