The following example draws heavily from one used by F. A. Hayek on page 526 of "The Use of Knowledge in Society,"The American Economic Review, Volume XXXV (September 1945).
Prices are arguably the most fundamental variables in economics. They enter into virtually every economic analysis, and predictions about their values are made in all manner of economic research, from highly esoteric theoretic models to street-level forecasting of business trends. Each day, we all make scores of decisions in which one of the very first questions we ask is, "How much does that cost?"
Prices have this central place in economics because prices contain information, and as we saw in the last Teacher's Corner, information is a crucial input in the decision-making process. In this column, we will raise two points about how prices convey information. Because they reflect choices made by suppliers and demanders, market prices tell us a lot—although not everything—about the preferences of those suppliers and demanders. Then, we will examine the role that the connections among information, prices, and decision-making played in the debate over socialism versus capitalism, or centralized versus decentralized economic planning.
Prices Convey Relative Information
Notice that I have been referring to prices, not a price. This is deliberate. Even though prices do convey a great deal of information, a single price by itself is virtually useless. A price is only informative if there are other prices against which you can compare it, because prices are a source of relative, not absolute, information about different goods and services.
Suppose that I tell you that in the fictional country of Allred, the price of a pound of sugar is fifteen Allredian dollars. Does that tell you anything? Can you draw any conclusions about whether you think sugar is cheap or expensive? No, not unless I give you information about the prices of other goods and services, including wages. For instance, if I also told you that the average Allredian worker makes one hundred Allredian dollars a year, then a price of fifteen Allredian dollars for a pound of sugar conveys that sugar is pretty expensive in Allred and probably very few people by sugar often. If, on the other hand, the average salary is ten million Allredian dollars, then sugar seems fairly cheap and accessible.
With just that one additional price—the price of one year's worth of an average Allredian's labor—the information conveyed by the price of sugar increases. Now you can grasp the purchasing power of an Allredian relative to the purchasing power he must give up to get a pound of sugar. If you were to learn more prices, you could make more comparisons and understand more about the economic environment in which Allredians make their decisions.
Prices Convey Relevant Information
Prices not only convey information about goods and services, they also condense that information so that it is more useful to decision-makers. Imagine that there is a baker in Allred named Tom, who likes cake and pie recipes that use a lot of sugar.1 The price of sugar is therefore important to Tom. Now let's suppose that for some reason, a reason unknown to Tom, either the supply of sugar in Allred drops, or new sources of demand for sugar arise. Maybe a hurricane wipes out most of Allred's sugar crop, or as part of a sudden fad, Allredian children all open lemonade stands and use sugar to make their lemonade—the reason does not matter. (As we will see, the fact that it does not matter is really quite important.)
Basic supply and demand analysis tells us that in any of these situations, the price of sugar will rise. When it rises, Tom the baker is informed that sugar has become more scarce than it used to be. Tom will then adjust his behavior, maybe by baking fewer pies and cakes or using recipes requiring less sugar. The change in price does not inform him as to why sugar is more scarce, but Tom doesn't have to know why in order to make the necessary adjustments. He doesn't want to spend time learning about weather patterns or what Allredian children are doing, because those details are not relevant to his decisions about what to bake and how. All that is important to him in this scenario is whether sugar has become more or less scarce, and the price of sugar tells him that without any extraneous clutter through which Tom must sift.
The Austrian economist F. A. Hayek, whose views on information in regard to centralized planning will be discussed below, emphasized the importance of how prices convey only the most relevant information to interested parties. He described this aspect of the price system in a 1945 article, "The Use of Knowledge in Society,":
The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated from, by a kind of symbol, only the most essential information is passed on, and passed on only to those concerned. It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.2
These characteristics of prices, that they convey information necessary to make relative comparisons among goods and services, and that they do so while conveying only the information relevant to making those comparisons, have led many economists to prefer decentralized market transactions over centralized planning. There are two closely related arguments behind this stance. The first states that information conveyed by market prices is necessary to determine how best to use scarce resources in production. The second states that a centralized planner can never acquire all of the information that is in the hands of decentralized economic actors, and that prices allow that information to be harnessed by individual decision-makers.
Prices and Economic Calculation
In Part II, Chapter 6 of Socialism (1981, first pub. 1922), Austrian economist Ludwig von Mises concentrated his critique of centralized planning on how a system so organized can determine how best to produce what it wants. In a society in which economic decision-making is decentralized, producers can examine the prices of all of the inputs relevant to their production processes, then choose the input mix that produces the output at the lowest cost. In this way, market prices allow producers to respond to consumer preferences and put resources to their best use. As Mises described in paragraph 37, once the decision of what to produce has been made,
there still remains the problem of ascertaining how the existing means of production can be used most effectively to produce these goods in question. In order to solve this problem it is necessary that there should be economic calculation. And economic calculation can only take place by means of money prices established in the market for production goods in a society resting on private property in the means of production.
Private ownership, according to Mises, is essential for market forces to determine the prices for production inputs that will lead to those inputs' most productive use. Individuals pursuing their own self-interest generate something that is in the interest of the entire society, a system of prices that accurately reflects the relative usefulness of the society's resources in satisfying the society's desires. From paragraph 27,
Without the striving of the entrepreneurs (including the shareholders) for profit, of the landlords for rent, of the capitalists for interest and the labourers for wages, the successful functioning of the whole mechanism is not to be thought of. It is only the prospect of profit which directs production into those channels in which the demands of the consumer are best satisfied at least cost. If the prospect of profit disappears the mechanism of the market loses its mainspring, for it is only this prospect which sets it in motion and maintains it in operation. The market is thus the focal point of the capitalist order of society; it is the essence of Capitalism. Only under Capitalism, therefore, is it possible; it cannot be "artificially" imitated under Socialism.
To describe the fact that individuals acting in pursuit of their own self-interest in market transactions inadvertently act in the interest of society, in Book IV, Chapter 2, paragraph 9 of the An Inquiry into the Nature and Causes of the Wealth of Nations (1904, first pub. 1776) Adam Smith famously wrote that such individuals act as though "led by an invisible hand to promote an end which was no part of his intention."
Therefore, according to Mises, where the means of production are out of the hands of individuals and production decisions are made not with an eye on profits but by central planners with authority to use publicly owned resources as they see fit, there will be no market prices to serve as an "invisible hand," guiding production to the best interests of society. Regardless of the central planners' best intentions, they will be unable to do as well as private producers that have access to market prices because the planners will lack the information that market prices convey. Mises summed up this argument in paragraph 211 of the Epilogue of Socialism.
The fundamental objection advanced against the practicability of socialism refers to the impossibility of economic calculation. It has been demonstrated in an irrefutable way that a socialist commonwealth would not be in a position to apply economic calculation. Where there are no market prices for the factors of production because they are neither bought nor sold, it is impossible to resort to calculation in planning future action and in determining the result of past action. A socialist management of production would simply not know whether or not what it plans and executes is the most appropriate means to attain the ends sought. It will operate in the dark, as it were. It will squander the scarce factors of production both material and human (labour). Chaos and poverty for all will unavoidably result.
Information of Time and Place
Hayek, a student of Mises at the University of Vienna in the early 1920s, took up a related point about limitations on the amount of information that central planners can acquire. Hayek's emphasis, however, was less on the manner in which information is conveyed, and more on the amount and types of information it is possible to convey.
Hayek began his 1945 paper, "The Use of Knowledge in Society," by characterizing the problem of constructing a rational economic order of the sort advocated by socialists as largely one of information aggregation:
On certain familiar assumptions the answer is simple enough. If we possess all the relevant information, if we can start out from a given system of preferences, and if we command complete knowledge of available means, the problem which remains is purely one of logic.... The peculiar character of the problem of a rational economic order is determined by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form, but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess.3
The crucial puzzle to be solved in establishing an economic system, then, is how to make the best use of information that is initially spread out among diverse individuals. Should a society try to convey all of that information to a centralized planning body, which could then assimilate it all such that the planners could make the optimal decisions for the entire society, or should individuals make the best decisions they can for their own self-interest using their own personal bits of information?
Hayek argued that the type of society that is able to more fully use all of the existing knowledge is the one that would lead to better outcomes. Further, he argued that there is one important classification of information that cannot be used by a central planner, information that Hayek termed "the knowledge of the particular circumstances of time and place." This is the sort of information that can only be acquired with experience and intimate contact with a specialized industry or locale. According to Hayek, this is
knowledge of the kind which by its nature cannot enter into statistics and therefore cannot be conveyed to any central authority in statistical form. The statistics which such a central authority would have to use would have to be arrived at precisely by abstracting from minor differences between the things, by lumping together, as resources of one kind, items which differ as regards to location, quality, and other particulars, in a way which may be very significant for the specific decision.4
The importance of decentralized information, and the difficulty of conveying certain kinds of it to others, had been commented upon by others before Hayek did so in 1945. Nearly a century before Hayek, English economist John Stuart Mill noted in Principles of Political Economy (1909, first pub. 1848) that no government can attain all of the information known by its constituents.
It must be remembered, besides, that even if a government were superior in intelligence to any single individual in the nation, it must be inferior to all the individuals of the nation taken together. It can neither possess in itself, nor enlist in its service, more than a portion of the acquirements and capacities which the country contains, applicable to any given purpose.
Other economists provided examples of knowledge of time and place as described by Hayek. One of the more important forms of particularized knowledge does not concern the physical characteristics of inputs or local vagaries of supply and demand, but instead relates to the abilities, temperaments, and financial situations of the other people with whom an individual may consider transacting. Frank H. Knight, in Part III, Chapter 9, paragraph 37 of Risk, Uncertainty, and Profit (1921) wrote that
men form judgments of other men on the basis of watching their performances over a period of time, and in addition form impressions having some claim to validity from mere personal appearance, conversation, etc.... It is the most difficult to discuss scientifically of all the data connected with the practical bearings of knowledge and uncertainty.
In Chapter 11, paragraph 2 of Lombard Street: A Description of the Money Market (1915, first pub. 1873), Walter Bagehot described the particular knowledge about other market participants held by securities traders called bill-brokers:
The relative credit of different merchants is a great 'tradition'; it is a large mass of most valuable knowledge which has never been described in books and is probably incapable of being so described. The subject matter of it, too, is shifting and changing daily; an accurate representation of the trustworthiness of houses at the beginning of a year might easily be a most fatal representation at the end of it.... No one can be a good bill-broker who has not learnt the great mercantile tradition of what is called 'the standing of parties" and who does not watch personally and incessantly the inevitable changes which from hour to hour impair the truth of that tradition.
Given the amount of important information about time and place that is outside of the reach of central planners, Hayek asserted that "the central planner will have to find some way or other in which the decisions depending on them can be left to the 'man on the spot,'" in other words, decentralize the decision-making.
Decentralizing the decision-making authority allows information on the particulars of time and place to be more fully utilized, but what about other types of information, information that is beyond most individuals? Many individual producers may not have direct access to information on scientific advances, broad trends in demand or supply of goods and resources, or other distant but economically significant events. If there is no way for the man on the spot to make use of this sort of information, which would be available to a central planner, then there may be no advantage in decentralizing decision-making authority.
This is where the ways in which prices convey information enter the picture. Hayek wrote that "Fundamentally, in a system where the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate the separate actions of different people." Returning to the example of Tom the baker and the sudden increased scarcity of sugar in Allred, we noted that Tom did not need to know what caused the increased scarcity. In fact, very few people having anything to do with sugar need to know what happened. In Hayek's words,
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.... 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.
Tom does not need to go out of his way to find information about the sudden increased scarcity of sugar, and he does not need to receive information gathered and organized by any centralized functionary. Everything that he needs to know is presented to him in the market prices he observes.
Because of the remarkable way in which market prices facilitate communication without conscious effort, it is possible for dispersed individuals to share relevant information among each other. This is so even though it is impossible for a centralized planner to learn the particular information of time and place that dispersed individuals possess. Information is more fully utilized when decision-making is decentralized, and so Hayek concluded that better outcomes are possible where decision-making authority is decentralized rather than in the hands of central planners, a resounding blow to the intellectual support for socialism over capitalism.
The connections between prices and information are fundamental to understanding what a remarkable allocative tool the market is, and how vital market transactions are to using resources effectively. Not only is it impossible for a central planner to successfully aggregate to itself the information accumulated and disseminated by countless individual market transactions, but in attempting to replace the market a central planner eliminates the market prices it needs in order to make decisions effectively.