Tuesday, May 13, 2008

Markets and Resource Allocation

The economic problem of society is more than just achieving an optimal or just allocation of resources. It is easy to formulate a ‘positive’ solution mathematically, where P = marginal rate of substitution between any two goods or factors of production, balancing the costs and benefits of some activity. It is easy to state a ‘normative’ solution of what we believe to be a ‘just’ or ‘fair’ distribution of resources.

However, according to Hayek, the information necessary for any solution for allocating resources in society is seldom sufficient for effective government or bureaucratic decision making:

“the knowledge and 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.”

The economic problem of society becomes “ the problem of the utilization of knowledge not given to anyone in its totality” but held by individuals.

Hayek proposes two methods for allocating resources 1) market prices and competition ( decentralized) 2) Planning ( total control by government or socialism)

The best system will be the one that is most effective at “putting at the disposal of a single authority (government) all the knowledge which ought to be used but which is initially dispersed among many different individuals, or in conveying to the individuals (free markets) such additional knowledge as they need in order to enable them to fit their plans in with those of others”

How does Government Obtain its Information

Government obtains much of its decision making information through the gathering of data and statistical analysis. However, this data is aggregated and very static compared to the knowledge held by individuals, or the “knowledge of the particular circumstances of time and place.”

Because individuals are involved in ‘the rapid adaption to changes in the particular circumstances of time and place, and it would seem to follow that the ultimate decisions must be left to people who are familiar with these circumstances, who know directly of the relevant changes and the resources immediately available to meet them.” Only individuals have knowledge of “the relative importance of the particular things with which he is concerned.”

This sort of knowledge by its very nature according to Hayek “cannot enter into statistics and therefore cannot be conveyed to any central authority in statistical form.” There fore government decisions are inherently doomed to be made with poor information and error, measured in terms of costs to individual well being and preferences.

How can markets be used to make the best use of information critical for the use of resources?

Hayek has an answer in that “in a system where the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate the separate actions of individuals.”

Unlike with government, by making use of the price system, individuals do not have to directly possess all of the relevant knowledge in society to make decisions regarding the use of the resources at their disposal. Hayek states that is “because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated through all” This is due to the fact that everyone faces prices which reflect the relative tradeoffs between all of the possible alternative uses of resources.

Reference: F.A. Hayek. “The Use of Knowledge in Society.” The American Economic Review. Vol 35, No. 4 Sept 1945, p. 519-530.

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