Hayek's Price Fan Simile: The Seeds of the Economy of Knowledge?

Author:McClure, James

"Adam Smith famously argued that the greatest improvements in the productive capacity of mankind were due to the expansion and ever-greater refinements in the division of labor. Hayek simply pointed out that the division of labor implies also a division of knowledge.... Hayek never abandoned economics." --Peter Boettke (2017) I. Introduction

From the early 1930s to 1945, Friedrich Hayek's research on capital structure and market equilibrium gave way to an investigation of the economy of knowledge that market prices marvelously deliver--harmonizing the diverse individual plans of market participants. Of this period, Hayek later said that he left "pure and narrow" theory, or "technical economics," to pursue an explanation of "how an overall order of economic activity is achieved which utilized a large amount of knowledge which was not concentrated in any one mind but existed only as the separate knowledge of thousands or millions of different individuals" Hayek (1967, pp. 91-92). These excerpts are part of a lengthy Hayek quotation that Bruce Caldwell highlighted as the epigraph of his seminal article in 1988, "Hayek's Transformation." Caldwell (1988, p. 538) aptly concludes: "Because he felt that the coordination problem was so crucial, Hayek ultimately turned away from technical economic theory to search for solutions" (emphasis added). Only incautious readings of Caldwell--that omit the qualifier "technical"--have led to the false, unqualified conclusion that "Hayek abandoned economics." (1) For example, Skidelsky (2006, 2018, p. 87), perhaps after misreading Caldwell, maintains that Hayek "eventually abandoned economics for political philosophy."

Boettke's disagreement with Skidelsky, and with all who say "Hayek abandoned economics," is that economics is defined so narrowly as to exclude the institutional tradition within which Adam Smith ([1776] 1976) theorized that "the division of labor is limited by the extent of the market." Smith's discovery, Boettke explains, inspired Hayek's (1937) work on the "division of knowledge," leading him straightforwardly into investigations of law, legislation, and liberty: "Hayek's epistemic institutionalism, as articulated in the 1930s and 1940s, provided the foundation for his own reconstruction and restatement of liberal political economy as evidenced in The Constitution of Liberty and Law, Legislation and Liberty" (Boettke 2017).

This paper presents other, complementary reasons to think that Hayek's transition from the 1930s through the 1940s was anything but an abandonment of economics. Our reasons trace to a price fan simile that Hayek used in 1931 to draw attention to the important role played by input prices as a free market economy's production becomes "more capitalistic." Leveraging Hayek's (1937, 1945) work on the division and economy of knowledge, we revisit his 1931 discussion of the price fan. With the benefit of hindsight, the price fan simile suggests itself as a precursor to Hayek's economy of knowledge thesis. The price fan simile is not only valuable for deepening understanding of Hayek's change in focus, but also for its own sake, as a way to illustrate the interconnectedness of the division of knowledge, the economy of knowledge, and the division of labor.

The remainder of the paper is organized as follows: section 2 traces Hayek's (1945) economy of knowledge thesis to his 1937 critique of the formal economic analysis of the era for its failure to account for the problem of the division of knowledge. Section 3 revisits Hayek's (1931) price fan simile, to explain its connection to Hayek's subsequent work and to "expand upon" the simile in order to overcome the trepidation he expressed in 1931 (long before his research focus shifted to the economy of knowledge in 1945). (2) Section 4 explores the broader implications of the price fan simile--the division and economy of knowledge that have been achieved by our extensive market system, making it obvious that socialist calculation is impossible. Section 5 concludes.

  1. From the Division of Knowledge to the Economy of Knowledge

    In 1937, in "Economics and Knowledge," Hayek begins to discuss two questions about the assumptions and operationalism of formal equilibrium economics, setting set up his work on the economy of knowledge nearly a decade later. First, "to what extent," Hayek (1937, p. 33) asked, is it true that "formal economic analysis conveys any knowledge about what happens in the real world"? He contended it is "only in so far as we are able to fill those formal propositions with definite statements about how knowledge is acquired and communicated" that "formal equilibrium analysis... can be turned into propositions which tell us anything about causation in the real world" (1937, p. 33).

    Second, Hayek (1937, p. 43) wonders: What could be the reason for concern with a "fictitious state of equilibrium"? The "only justification," he reasons, is to bring forth verifiable pattern predictions regarding an empirical "tendency towards equilibrium" (p. 44). Here, Hayek puts forward a challenge to create operational hypotheses about the conditions under which the "knowledge and intentions of purposes of the different members of society" will "come more and more into agreement," or, alternatively stated, the conditions under which "the expectations of the people and particularly the entrepreneurs will become more and more correct." Putting it in the negative, Hayek (1937, p. 43) criticized the formal economics of the era because it had "simply assumed that the subjective data," the divided knowledge dispersed across the many individual minds of those in society, "coincide with the objective facts." In this way, economics had "jumped over an essential link" (1937, p. 52), overlooking the problem of the division of knowledge--a problem "at least as important as the problem of the division of labour" (1937, p. 49).

    Hayek highlighted two avenues by which the problem of the division of knowledge had been "jumped over." One was via the assumption that "everybody knows everything" to "evade any real solution of the problem" that they "pretend to solve," namely, "how the spontaneous interaction of a number of people, each possessing only bits of knowledge, brings about a state of affairs in which prices correspond to costs, etc., and which could be brought about by deliberate direction only by somebody who possessed the combined knowledge of all those individuals" (1937, p. 49). The second avenue, by which the division of knowledge problem was jumped over, was by the "insidious" leap in applying the equilibrium analysis of an isolated individual to the "analysis of the situation in a society" (1937, p. 39).

    By 1945, Hayek had abandoned technical equilibrium economic modeling entirely. His last attempt, published in 1941 as The Pure Theory of Capital, was in fact only the first half of a great book that he intended to assuage the critics of his 1931 book Prices and Production. Asked, "What message do you want to convey in that book [The Pure Theory of Capital]?" he responded:

    To put it briefly, I think it's that while Bohm-Bawerk was fundamentally right, his exposition in terms of an average period of production was so oversimplified as to mislead in the application. And that if we want to think the Bohm-Bawerk idea through, we have to introduce much more complex assumptions. Once you...

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