Free Markets and Highest Valued Use
Knowledge Is Never Perfect
MAY 01, 2000 by ROY CORDATO
Do free markets allocate resources to their highest valued use? It would seem that for the readers of Ideas on Liberty, the answer is a “no-brainer.” Indeed, the idea that voluntary exchange channels resources to where the value of output will be greatest has traditionally been one of the foundational arguments for a free-market economy. It is the core reason why free markets are said to be “more efficient” than socialism or interventionism.
But although free markets are clearly superior to any other social or economic arrangement, it cannot be for this reason. The claim that markets channel resources to their highest valued use is inconsistent with the nature of value and of voluntary exchange. Ultimately, the question I posed cannot even be meaningfully asked.
The argument behind what I will call the “highest valued use” hypothesis is quite simple. If in a market setting, person A and person B each bid for resource X, that resource will go to the person whose bid is the highest. If A is the high bidder, it is then assumed that he valued the resource more than B and that this implies his use of the resource will be more “productive” than B’s. “Productive” here means that A’s use of the resource will lead to the production of those goods and services that will fetch the highest price and therefore that consumers will value most. Hence, free markets will channel resources to their highest valued use. When this process is interfered with, either through intervention in the exchange process or through direct government allocation of resources, the result is “misallocation”; resources are diverted to lesser valued uses or at least to uses whose value is not as high as it otherwise could be.
Embedded in this argument are three assumptions that cannot be logically sustained. The first assumption is that value is objective, which implies that it is measurable in money terms and therefore comparable person to person. The second assumption, involving perfect knowledge, is that A’s and B’s entrepreneurial insights about uses of resource X are accurate; that is, their perceptions of what others are willing to pay for goods are correct. The third is that there is an overarching hierarchy of social value on which the importance of resource use can be ranked.
As for the first, a pillar of Austrian economics is “radical subjectivism.” This is the idea that people’s preferences are determined within their individual contexts. Value is subjective in the sense of its being an internal state that is immeasurable and not amenable to comparison (in the way that people’s heights can be compared). It is inconsistent with this insight to say that A values resource X more highly than B does because he is willing to pay more for it. In reality, all that can be said is that resources will flow to those who are willing to pay the most money.
To go beyond this is to believe that value can be compared among persons and that money can be used for such comparisons. It is often assumed that all people value money equally, permitting money to be used as a stable measuring rod for everyone. In the example above, it would imply that the marginal utility of a dollar (the value placed on the last or next dollar obtained) is the same for both A and B. So if A bids two dollars and B bids one dollar, we can say A values resource X more than B. It’s not that the statement is wrong, or that the marginal utility of a dollar is not equal for A and B, but that all such conclusions are meaningless: they compare the incomparable.
The second unsustainable assumption is that market participants have perfect information. This is implied by the neoclassical premise that all exchanges are based on “perfectly competitive” prices. That premise allows the analyst to skirt the subjective value problem, because in the world of perfect competition all market prices are accurate measurements of not only the (marginal) costs and benefits to the trading parties but also to society. As Israel Kirzner has noted, in neoclassical economics, supply-and-demand analysis assumes perfect knowledge for all market participants. Under these circumstances, people bidding on resources know with certainty the value that others place on alternative uses of those resources. By definition, then, resources will flow to their highest valued use. In an error-free world, no other outcome is possible.
In the real world, though, there are no such assurances. As Austrian school economists are quick to point out, knowledge is never perfect. Considering that perfect information in a market would necessarily involve having knowledge of what actually exists and potentially exists in the minds of others, it should be clear that errors in bidding for resources are inevitable. But beyond this, all market activity takes place through time. Resources are bid for today based on expectations about the state of the world tomorrow. Knowledge, therefore, can never be perfect, and market prices are never “competitive” prices. When prices are not based on perfect knowledge, they do not measure the “social value” of the resources being exchanged, even within an approach to economics that accepts such a concept as meaningful.
Ultimately though, the concept of “social value” is not meaningful in the context of voluntary market exchange. The “highest valued use” hypothesis misconstrues the nature of the free market. This point goes to the heart of a distinction, made first by Ludwig von Mises and then F. A. Hayek, between an economy and a catallaxy. The hypothesis makes sense only for a unified hierarchy of ends; namely, an “economy.” In an economy, Hayek wrote, “a given set of means is allocated in accordance with a unitary plan among competing ends according to their importance.” This is what happens in a firm, a household, a civic organization, or a socialist economic system, where priorities are established by a centralized decision-maker.
In contrast, as Hayek points out, “the market order serves no such single order of ends . . . . it serves the multiplicity of separate and incommensurable ends of all its separate members.” A catallaxy is thus characterized by the lack of a common hierarchy of ends, and so in the context of a free market, the concept of social value is meaningless, as is any talk of resources flowing to their highest valued use. A catallaxy cannot assure “that the more important comes before the less important,” Hayek wrote, “for the simple reason that there can exist in such a system no single ordering of needs.”
Defending the Market
Fortunately, the case for liberty does not hinge on markets’ being perfectly competitive or satisfying the efficiency criterion of neoclassical economics. While it is beyond the scope of this article to detail alternative defenses of free enterprise, it should be noted that Hayek’s and Mises’s advocacy of the market stem in large part from their observation that knowledge is never perfect and that free exchange is the best way to overcome that imperfection. As Kirzner noted, far from being necessary for the defense of capitalism, the assumption of perfect knowledge implies that markets are unnecessary.
Can we say anything about the virtue of market allocation? Indeed we can. As Hayek emphasized, nothing prompts people to economize scarce resources as well as the market. The profit motive encourages people to produce more with less. Moreover, nothing tops market exchange in tending to reconcile people’s disparate plans. That’s saying a lot.
In the final analysis, our advocacy of the free market has to be based on an overriding defense of liberty per se. Free enterprise is desirable because it is just, and it is just because it is the economic arrangement people tend to choose when they are free.
- This assumption is made by Ronald Coase in his famous 1960 article, “The Problem of Social Cost,” Journal of Law and Economics, vol. 3, pp. 1-44, where he argues that voluntary exchanges that are made in the context of zero transactions costs and clearly defined property rights will ultimately lead to the maximization of the “social value of output.”
- For an excellent discussion of the problems associated with price formulation under assumptions of perfect competition, see Israel Kirzner, “The Law of Supply and Demand,” Ideas on Liberty, January 2000, pp. 19-21.
- F. A. Hayek, Law, Legislation and Liberty, vol. 2 (Chicago: University of Chicago Press, 1976), p. 107.
- Ibid., pp. 107-108. See also James Buchanan, “What Should Economists Do?” in What Should Economists Do? (Indianapolis: Liberty Press) 1979, pp. 17-38.
- Hayek, p. 113.
- For discussions of market efficiency in the context of imperfect knowledge and subjective value, see Israel Kirzner, Market Theory and the Price System (Princeton, N.J.: D. Van Nostrand Co., 1963); Murray Rothbard, A Reconstruction of Utility and Welfare Economics (New York: Center for Libertarian Studies, 1977); and Roy E. Cordato, Welfare Economics and Externalities in an Open Ended Universe (Boston: Kluwer Academic Publishers, 1992).
- Hayek, p. 113.