When our students are faced outside of class with yet another proposal for government intervention in the economy, how do they assess that intervention? What they learn from us about the virtues of markets may make them suspicious of a proposed intervention, but can they think through its particular pros and cons and predict its likely unintended consequences?
The following describes a simple but I hope robust and easy-to-remember approach for such analysis. It is a distillation of the main questions I observe my favorite economists from the Austrian and Public Choice schools raising about a wide variety of policies. Four terms provide an outline of the approach: knowledge, discovery, incentives, and institutions. For each I present the basic insights and give students a related question to ask that applies those insights to policy.
The whole comprises three to five lectures that take between three and six class periods to present, depending on the course and student questions. I use a short version in principles of economics and a longer version in comparative economic systems and public policy courses.
The first crucial insight for students to know and apply comes from Hayek's (1948 ) "The Use of Knowledge in Society": Ever-changing relative prices are essential for communicating throughout society the local "knowledge of the particular circumstances of time and place" (p. 80) on which well-coordinated and efficient production depends. Students must understand that, "We must look at the price system as ... a mechanism for communicating information if we want to understand its real function" (1948 , p. 86). While I emphasize this point regularly, two particular exercises make it especially well.
First, to make sure that students appreciate the immense dispersion of local knowledge on which production depends, I have them read aloud most of Leonard Read's "I, Pencil" and note the remarkable variety of knowledge involved. Read emphasizes that there is "no mastermind" directing the process. I exclaim that the process "is out of control!" then ask students what provides the coordination. With some coaching they begin to see that prices do.
Second, I emphasize the necessity of market prices for informing decision-makers with a fifteen-minute thought experiment based on Mises's (1920, p. 108) railroad example. I ask students to imagine themselves the commissar of railroads in the old Soviet Union, with no markets and no prices, facing a choice of railroad routes between two cities on opposite sides of a mountain range. They may build through the mountains, a shorter route requiring relatively little steel rail, but a great deal of engineering; or they may build around the end of the mountain range, using much more steel rail, but much less engineering. I assume away all costs other than those of engineering and steel, and any greater benefits from one route or the other, but call their attention at length to the many alternative uses of both engineering and steel. I ask them to suppose they are conscientious commissars, aiming only at what is best for the Soviet Union--if steel is more urgently needed for other uses than engineering, they should build across the mountains; if engineering is more urgently needed than steel, they should build around.
"Which way would you go," I ask, "and why?" When the exercise works well, there is a long silence, for which I congratulate them as the correct answer. What they would need to know to make the correct decision, I ask, and how might they find it out? We sample some of the myriad bits of detailed, dispersed, often inarticulate knowledge about the needs for and supplies of engineering and steel. They see that there is no conceivable way for the commissar of railroads to find out all he would need to know to make the best decision.
Then it is quick work to conclude the exercise by asking them to change the thought experiment slightly so that they are the CFO of a for-profit railroad company in the capitalist West. When someone answers that she would choose the cheapest route, I point out that this is the typical capitalist answer, aiming solely at profit with no concern for the overall well-being of the country. But the magic of the market is that in...