This paper analyzes The Use of Knowledge in Society by F. A. Hayek, which was published in the American Economic Review, in 1945. This paper argues that centralized economic planning is inherently less efficient in the allocation of resources than a free market. The problem is that concentrating information among a small group of decision makers means less information is used to govern the economy, compared with a free market.
Economics
Hayek argues against economic planning -- or given the context of 1945 he is probably focusing his target squarely against the planned economies of Communism -- based on some of the fundamental flaws in the execution of a planned economy. His first point is about information. He notes that if one person could have perfect information, a planned economy is feasible, but such an instance is impossible by a wide margin. No one person or even body of people, could possibly possess the knowledge necessary to successfully plan an economy. The "data from which the economic calculus starts are never for the whole society given to a single mind which could work out the implications, and can never be so given." Even today, we do not have a computer powerful enough to run an economy, and we probably never will.
If economic planning is understood as allocation of resources, Hayek argues, then all economic activity is planning. The different resources available, and the needs of all of the businesses, people and governments, can never be accurately understood ahead of time. Those who are planning in a planned economy will therefore plan the economy according to their perceptions of the needs of the nation. These perceptions can never been entirely accurate, and are likely to be considerably far from accurate. Those who are doing the planning necessarily fill in the gaps in their knowledge with guesswork based on imperfect information at best, or no information at worst. Even with adequate systems for gathering information -- which do not really exist and certainly did not at the time -- no body was able to process that information and make efficient decisions to meet demand for all products. Instead, under Communism, the government dictated demand, which is basically ignoring the realities of demand altogether in favor of a new and fictional version of reality convenient to those in power.
2. Hayek argues that "competition…means decentralized planning by many separate persons," wherein economic transactions reflect the best possible information. No one actor has a large amount of information, but none need to when the means exist for all economic actors to conduct their transactions with each other freely. Hence, Hayek argues there relatively little information is needed in a free market economy. The markets themselves provide small pieces of information, and these are used by actors within the market to generate goods and services. Each person within the market is responsible for a relatively small amount of decision-making.
However, because each actor has specific economic interest in making the most efficient decisions, those decisions are going to be more closely reflective of reality. Producers do not want to produce too much, lest there be waste. Consumers do not want to spend too much, because their resources (for most people anyway) are inherently scarce.
Hayek makes the point about there being different types of knowledge. In his free market economy free from centralized planning, he argues that each individual has different knowledge -- each specializes. This allows the millions of people who are making economic decisions to have the ability to gather and process as much information as possible. With more information, better decisions are made. By delegating decision-making to millions of economic actors, each operating within their own specific area of expertise, decisions are going to be better. They will be based on more information and more specialized knowledge to interpret that information.
He argues that economic planning inherently must be based on cycles, such that there is day-to-day adjustments. Such a situation requires stability, therefore, but in the real world that stability does not exist. Conditions in which the economy operates vary, and if economic decision-making is centralized then it is going to be impossible to make the necessary adjustments that will improve economic decision-making. Under a free market, economic actors are free to respond to market signals as frequently as they like, and the result will be more efficient decision-making, and ultimately more efficient allocation of resources.
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