Information and the Economic Problem


Mr, Johnstone graduated from the University of Texas at Austin in May of this year with a major in economics, He was editor-in-chief of The Texas Review, a conservative student journal of opinion.

      This essay was a runner-up in The Foundation for Economic Education’s 1985-1986 Freedom Essay Contest.

Information is an invaluable tool in promoting social cooperation.

Information is the most precious good in the economy. Scarcer than platinum, more valuable than gold, it is one item of value to all participants in the marketplace. Buyers, conscious of limited budgets, search for information about low prices and high quality. Workers, wanting to support themselves and their families, search for information about jobs where their productivity, and thus their income, will be the highest. Entrepreneurs, in pursuit of profits, look for market opportunities where they can best satisfy people’s needs and wants: Firms, seeking to maximize profits, search for the cheapest inputs of production and the most efficient production techniques.

Information, it will be seen, is the key to solving the economic problem. That problem is this: How do you get people to cooperate in the production of goods and services necessary to society? No one person or family can, beyond a bare subsistence level, produce everything it needs. People must rely on outsiders to help them get what they want: individuals who may very well live in different lands, worship different gods, speak different languages, and who may have very different goals, values, needs, and desires. These different people may very well even hate each other. How, then, can we get them to cooperate?

The obvious solution springs to mind: you command them to cooperate. A central board is set up to determine the needs of society and the best way to achieve them. Orders are given out and enforced; production is planned from the top down. It is, after all, the most obviously logical and efficient way to organize the efforts of individ- uals-is it not?—much as you might organize an army to conquer a city or ants organize themselves in the mound.

The economy of the Soviet Union is the best example of such a centralized state. All capital and all natural resources are owned by the state. The government plans all production as if the economy were one big firm. Through a plethora of plans, regulations, and directives, the state specifies how much will be produced—how many tons of steel, how many yards of cloth—and how much will be used in production: quantities of capital and labor to be deployed when, where, and how.

There is little need to repeat the dismal record of the Soviet economy. The stories of chronic shortages of meat, dairy products, fruits, and many vegetables; of bribery, black markets, and corruption; of low productivity and slipshod labor have been well-reported. Soviet productivity is only 40 per cent of that in the United States. The typical worker in Moscow must work 53.5 hours a week just to provide a family of four with basic groceries—as opposed to 18.6 hours in a week in Washington or 24.7 hours in London. The Soviet press itself abounds with stories of new buildings which rapidly deteriorate or actually fall apart due to substandard construction.[1] The Soviets, living in one of the richest and potentially most productive agricultural areas in the world, must import grain from the West simply to feed themselves. As one student of the Soviet economy concluded, “Soviet planning has not proved seductive. No electorate has freely chosen a system like it, and none is likely to do so in the near future.”[2]

There are many reasons for this poor performance. Part of the answer lies in the absence of private property. When a man’s workshop and the fruits of his labor are not his, he is not likely to care about the quality of his work, or whether his job even gets done at all. But, if we stop our search there, we overlook another aspect: the information problem.

Very simply, it is beyond the capacity of one man, or even a board of men, to specify how much firms should produce or what they need in order to do so—to determine how many pigs are to be raised, how many buses to be run, how many mines to be dug, how many pairs of shoes to be sold. The amount of information needed to answer these questions—much less the foresight and logic to rationally reconcile competing interests and goals—is simply staggering. True, our board may, after much deliberation, devise an answer. But there is no guarantee (witness the Soviet example) that their plan will assemble the inputs of production in the most efficient way possible, or that the plan will provide the most efficient combination of outputs to satisfy consumers. If the Soviet model is any example, the result is likely to be very inefficient. The breadth and complexity of data are so great that no computer can successfully tackle it.

Solving the Problem

Yet the economic problem does get solved—efficiently, productively—every day without active government guidance and regulation. Pause for a moment and consider, as French economist Frederic Bastiat did a century ago, the enormous range of commodities that a major metropolitan city consumes in a single day—many of which, like food, are not produced in the city itself. The city’s survival literally depends on the uninterrupted flow of such goods into the city. And yet no man or agency gives orders or even consciously plans to insure that enough food or clothes or gasoline will make it to the city that day. Nonetheless, these goods arrive daily in the approximately correct quantities—and the city survives.

“Imagination is baffled,” wrote Bastiat, contemplating the Paris of his day, “when it tries to appreciate the vast multiplicity of commodities which must enter tomorrow in order to preserve the inhabitants from falling prey to the convulsions of famine, rebellion, and pillage. Yet all sleep, and their slumbers are not disturbed for a single minute by the prospect of such a frightful catastrophe.”[3]

No one plans; no one calculates; no one consciously tries to solve the economic problem for society—and yet the problem is solved. The relevant information is transmitted to the essential parties, and the necessary goods are produced and distributed. How can this happen?

Forty years ago Nobel laureate economist F. A. Hayek considered the problem. His insights are crucial to understanding how society may best solve the information problem.[4]

Hayek began by redefining the economic problem. If we possessed all the relevant information; if we had a given set of priorities and preferences; if we knew the full range of options before us, the economic problem would simply be one of logic. Given these facts, the answers would flow out inevitably and ineluctably: Who says A must say B.

The difficulty is, of course, that this is not the economic problem—at least as we face it in the real world. We do not have perfect information about our options or the means to achieve them. The knowledge which we need does not exist in a single mind; it is not even found in a single coherent and integrated form. It is only found in the dispersed bits of incomplete (and often contradictory) knowledge possessed by all the participants in the economy.

So, Hayek writes, “The economic problem of society is thus not merely a problem of how to allocate ‘given’ resources . . . . It is rather the problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge not given to anyone in its totality.”[5]

The question is not whether there will be planning in an economy. The question is who will do it. Should it be done centrally by one agency for the whole economy, or by the individuals themselves by the processes of a free market? That question turns, from our perspective, on who is more likely to have the necessary and relevant knowledge (and who thus is better able to act on it): the state or the individual.

Time, Place, and Change

Classical liberalism argues that man is a rational and competent decision-maker, and that as such, in Adam Smith’s words, “every individual, it is evident, can, in his local situation, judge much better than any statesman or lawgiver can do for him.”[6] Each individual has his own set of priorities; each knows, better than anyone else, his individual capacities and talents. He knows what he is and is not capable of. He alone knows the particular circumstances of his time and place.

Then there is the problem of change. To think of the economic problem in terms of allocating “given” resources is to assume that the world is static and unchanging. The cardinal fallacy implied in statist schemes of control, regulation, and planning, wrote Austrian economist Ludwig von Mises,

is that they look at the economic problem from the perspective of the subaltern clerk whose intellectual horizon does not extend beyond subordinate tasks. They consider the structure of industrial production and the allocation of capital to the various branches and production aggregates as rigid, and do not take into account the necessity of altering this structure in order to adjust it to changes in conditions. What they have in mind is a world in which no further changes occur and economic history has reached its final stage.[7]

Technology, the availability of natural resources, consumer tastes and preferences: all these things are constantly in flux. Change—intangible as it is—cannot be captured in statistical aggregates and computed. It cannot be predicted, and thus we cannot make accurate and reliable forecasts. No one knows when the next technological breakthrough, the next scientific discovery, the next consumer fad will strike. But just because we cannot predict such events does not mean that we can simply disregard them. On the contrary, the ability of the economy to generate new scientific and technological advances is crucial to economic progress. The ability of entrepreneurs to take advantage of new opportunities as they emerge, quickly and efficiently, is crucial.

A World of Change

The economic problem, then, takes on another dimension. Its solution requires rapid adaptation to change. The world is not static. The reports which greet the central planning committee in the morning may be obsolete by noon. In a world of change, it only follows that the ultimate decisions are best left to those familiar with the particular circumstances of time and place: those who know of the changes and of the resources available to meet them. Such problems by their nature cannot be solved by a central board which ponders for weeks and makes a decision. The answer is decentralization: decisions made not by the state but by individuals themselves.

But the decentralization of decision-making, Hayek points out, only solves part of the problem. It means only that the knowledge of the particular circumstances of time and place will be used. But our “man on the spot” has only his own limited but intimate knowledge of the facts of his immediate surroundings. How can information about other changes in other areas be communicated to him?[8]

One answer is the price system. In a free economy the price system serves as a means of communicating information to all parties in the marketplace about opportunity costs and the relative scarcity of goods and services. Prices are easy to understand and readily available. Buyers can efficiently use them to adjust to complex events a continent away.[9] Hayek explains:

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 the 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. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand, and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the effect will rapidly spread throughout the whole economic system and influence not only the uses of tin, but also those of its substitutes and the substitutes of these substitutes, the supply of the things made of tin, and their substitutes, and so on, and all this without the great majority of those instrumental in bringing about these substitutes knowing anything at all about the original cause of these changes. The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all.[10]

The Function of Prices

Prices inform people about the relative value and scarcity of literally hundreds of thousands of products and, in so doing, reduce decision-making down to the level of the syllogism. By observing market prices and adding to them their personal knowledge of circumstances and events, individuals can make competent decisions about the costs and benefits of alternative actions.[11]

The remarkable thing about this process is that people need to know very little—just the relative changes in the prices of the commodities themselves—in order to make the correct choice. A good becomes scarce and its price increases. Without any directives or regulations being passed—indeed, without any need for people to know the reason for the scarcity—people, because of the higher price, will take the right action: they will consume less of the good. And yet the solution is not produced by the judgment of one man with perfect knowledge of all the facts, but by the natural interaction of many individuals, each of whom has only partial knowledge. The price system, writes Hayek, “brings about the solution which . . . might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process.”[12]

The misfortune of this system is that it works so subtly and so well that people forget its existence, if they were aware of it at all. Thus, they are quick to replace the invisible hand of the marketplace with the visible hand of government trying to redirect the actions of people via regulation, tax policy, directives, plans, and orders: trying, as it were, to reinvent the wheel. Some of the best economic minds of this century—Oskar Lange and Abba Lerner, among others—have spent years trying to solve the economic problem with the visible hand of central planning, unaware that the problem already has been solved by the market. Indeed, the advocates of government planning are not only trying to solve a problem whose answer is already known, but their “solution” is necessarily an inferior one. As Hayek writes: “The problem is precisely how to extend the span of our utilization of resources beyond the span of the control of any one mind; and, therefore, how to dispense with the need of conscious control and how to provide inducements which will make the individual do the desirable things without anyone having to tell him what to do.”[13]

The late G. Warren Nutter told this story: Suppose you have a sack of potatoes and want to make that sack as compact as possible. One way is to examine the size and shape of each potato, measure its dimensions, put those measurements into a computer, and try to determine mathematically how to fit the potatoes together in the smallest possible space. Anyone familiar with higher mathematics will realize the enormous complexity of this problem.

Another way to solve the problem is to give the sack a couple of shakes and let the potatoes settle in by themselves.[14]

There are many lessons in this parable. But the most important is probably this: Information is costly, and economic efficiency requires that we, as a society, economize on our use of knowledge. The great virtue of a market economy, as Nutter reminds us, is that “it mobilizes knowledge for the benefit of society far more cheaply and effectively than any conscious effort can.”[15]

Perhaps in the static and ideal world of the economic theorist, government coercion can effectively organize the activities of society. But in the real world—a world in which we do not have perfect knowledge and where change is our only guarantee—government planning necessarily leads to failure. Only in an economy where individuals are free to make their own choices and where markets, and not governments, organize and coordinate the production of goods and services can the economic problem be successfully solved. In contrast to the airy dreams of the central planners, the marketplace really works, really helps live people with real-life problems. []

1.   John Barron, KGB Today: The Hidden Hand (New York: Reader’s Digest Press), 1983, pp. 1012.

2.   G. Warren Nutter, Political Economy and Freedom (Indianapolis: Liberty Press), 1983, p. 112.

3.   Quoted by J. P. Gould and C. E. Ferguson, Microeconomic Theory (Illinois: Richard D. Irwin, Inc,), 5th ed., 1980, p. 409.

4.   E A. Hayek, “The Use of Knowledge in Society,” The American Economic Review 35, September 1945, pp, 519-530.

5.   Hayek, op cit,, pp 519-520.

6.   Adam Smith, The Wealth of Nations (New York: Modern Library), 1937, p. 423.

7.   Ludwig von Mises, Human Action (Chicago: Contemporary Books), 3rd ed., 1963, p. 707.

8.   Hayek, op cit., pp. 524-525.

9.   A helpful discussion of the role of prices can be found in Edwin G. Dolan, Basic’ Economics (Illinois: Dryden Press), 2nd ed., 1980, Chapter 2, pp. 27-35.

10.   Hayek, op cit., p. 526.

11.   Dolan, op cit., p, 29.

12.   Hayek, op cit., p. 526.

13.   Hayek, op cit., p. 527.

14.   Nutter, op cit., p. 115.

15.   Nutter, op cit., pp. 115-116.


August 1986

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