18 June 2008

Hayek, Knowledge and Prices

gormk says:
I still think .... that you rely too much on your Hayekian pragmatism. And this is reflected in the diversity of "challenges" that you have received recently on your popular blog!
First, it's great to have all the comments and debates on these topics. Water touches people in many ways, and opinions and experiences are bound to vary.

Let me elaborate on Hayek, who is famous for knowledge problem and spontaneous order.

My idea of the knowledge problem (I am no Hayek scholar) is: I know what I know but not what you (or many others) know. For me to organize society (i.e., as a government) to some "optimal" level, I need to know what you know, but that information is hard for you to convey to me credibly ("yes, I need money for my babies") and hard for me to assemble/reconcile ("baby subsidy here versus there"). Hayek said that planned economies would collapse under the weight of the knowledge problem, and he expressed his ideas in one of the most important papers ever published in economics (many economists would agree), The Use of Knowledge in Society [PDF].

After expressing the knowledge problem, Hayek gave a solution: Prices act as a means of coordinating behavior such that no central authority need know or direct action. Thus, a market system will deliver a "spontaneous order" wherein the bread is in the shop when you want it and your salary will reflect the value of your skills and knowledge to everyone around you. (Adam Smith pointed out this result in the 18th century.) Contrast this order with "government order" that people often find frustrating.

Hayek gave us an excellent description of how the world works and how to improve it through more decentralization, markets, price signals, etc. That's why I recommend markets (under private or public management) to "solve" many water problems.

Bottom Line: Hayek tells us to be humble about what we know, to trust in the decisions of others, and facilitate the negotiation and cooperation of many through voluntary mechanisms. What's not to like?

26 comments:

Anonymous said...

What's not to like?

Now only if we could get folks to be humble about what they know, to trust in the decisions of others, and to facilitate the negotiation and cooperation of many through voluntary mechanisms.

Especially in a country that privileges this hyperindividualism found here.

In my view, prices are a way to keep track, to focus - a signal - not to impel behaviors that we should be doing anyway. Prices aren't handed down on stone tablets. We make them. Other than that, we agree, mostly.

DS

lkkinetic said...

Not only is it that "I know what I know, but not what you know"; it's also that I *don't* know what I do and don't know in a lot of dimensions. Most decision-making relies on tacit knowledge, on knowledge that we possess without even consciously knowing what it is or that we possess it.

That's one reason why prices are such valuable and powerful signals and transmitters of information; we respond to them from our own private knowledge, both conscious and tacit. Everyone else does too. Prices reflect those responses. And that's how prices help us achieve decentralized coordination.

Fixed Carbon said...

David and gentle correspondents: I learn so much here! Now, pray tell, how, what, where subverts a Hayek economy?

Anonymous said...

Does anyone have any examples - at a societal level - where mere pricing signals were the galvanizing moment that allowed coordination, then action at the societal scale?

DS

David Zetland said...

@DS: "where mere pricing signals were the galvanizing moment that allowed coordination, then action at the societal scale?"

You must be referring to something different than a market economy, i.e., an economy in which price signals convey wheat to the baker to the store to the coffee shop to my mouth -- in the form of a bagel.

Do you mean something like the provision of a PUBLIC good (bagels are private)? These examples are tougher -- mostly because they are defined to have weak property rights. Do you consider the "market" for higher education to be such a good?

@FC: A Hayekian economy (i.e., an economy coordinated on prices) can be subverted by market failure (e.g., failing to price pollution -- a public bad) or government failure (e.g., subsidizing or regulating "target" activities). I often worry more about the latter, since governments are more frail at making decisions.

Anonymous said...

David,

I'm asking about times in history when everyone got together and did something. Were pricing signals the galvanizing event, the motivating factor, the organizing principle? Or were there other things at work as well: mores, ethics, etc?

Point being: money helps us keep track. Let's not devalue societal norms and mores developed over centuries, even millenia.

So. Events on a large scale such as what is implicit in this post? Anyone?

DS

David Zetland said...

@DS: "money helps us keep track. Let's not devalue societal norms and mores developed over centuries, even millenia."

Agreed that social norms and rules matter (don't kill), but money incentives can help and hinder. I'd say that money's more important with private good, and morals are more important with public/club/common-pool goods...

Francis said...

David:

As post-doc economist, you really should know better than to oversimplify water pricing in this way.

Let's look at some of the problems:

1. The Monopoly Problem. Retail water delivery is a natural monopoly. Unlike the nice people at DirecTV, no one is going to put a dish on your roof as a perfect substitute for the water main in the street.

The natural monopolist has no market to compete against. Retail water pricing is not set in a competitive environment.

2. The Democracy Problem. Those pesky voters have decided that giving unregulated power to the water monopolist was a little too dangerous. So either the retailer is regulated by a public utilities commission, or the retailer is itself the government. The policy statement of just about every government retailer states more or less as follows: it is the mission of [name of agency] to provide safe, affordable and reliable water to everyone now and in the long-term.

That affordability language is key -- voters insist that rates be kept low. (See Prop. 218 in California.)

While many agencies are moving to a block rate (aka tiered rate) structure that does impose increased costs for increased usage, the voters can decide not to have that structure if they so choose.

Also, last I checked, my government was not a profit-making enterprise. A city should set its rates to deliver water at its fully-laden cost, no more.

3. The Rights Problem. It's more than a little ironic for someone who purports to be libertarian to support the idea of gutting the existing system of rights and moving to an auction-based system. In California, water law literally pre-dates the state constitution and statehood. Many farmers own the right to receive the water they get. Just because the City of San Diego finds it cheaper to outbid a rice farmer for water rather than fix the leaks in its system doesn't mean that an auction system is a good idea. Besides the fact that it's a gross offense to 200+ years of property rights law, you'll never get the idea past the voters.

4. The Infrastructure Problem. Billions of dollars of investment has been made in California based on the current system. MWD may be able to outbid the Kern County Water Agency for another 0.5 MAF annually of SWP water, but how's it going to get that water over the Tehachapis? What kind of investment will water agencies make in their infrastructure if they risk losing the rights upon which the infrastructure design was based?

David Zetland said...

Welcome back Francis.

1. I never said it was.

2. There is a conflict between low cost and reliability. Read my dissertation, chapter 3.

3. I never said that farmers would lose their rights. I have said MANY TIMES that farmers should be able to monetize their rights.

4. Infrastructure constraints are NOT important when below capacity.

Please check your opinions on what I say against the facts of what I say.

Bob said...

DS said:

I'm asking about times in history when everyone got together and did something. Were pricing signals the galvanizing event, the motivating factor, the organizing principle? Or were there other things at work as well: mores, ethics, etc?

OK, the New York stock exchange on June 17, 2008. There's a good example.

Everything that happens in a market economy involves reliance on prices to help coordinate people's plans. Of course other factors are relevant; even a simplistic economic model doesn't just have prices; there are technological constraints, resources, preferences, etc.

If I said the Internet has been really useful in fostering communication between people, would you say, "Can you name one event where email alone led to concerted action, without being influenced by social customs, mores, etc.?"

Hayek's point is that economists were misconstruing what the "economic problem" was. It wasn't simply the problem of determining which combination of consumption goods to make out of the available factors of production. Rather, it also included the task of getting people to act based on the knowledge contained in billions of different minds.

The beauty of market prices is that they convey very relevant aspects of that knowledge to others. In his famous example, if a tin mine collapses, the price of tin goes up and people around the world economize on tin. They don't have to know why they are doing this; that is superfluous.

Silas said...

phew! I thought francis was saying something that DID incorporate your previous remarks, which worried me, because I want to hold on to the position of "most insightful mysterious poster on david_zetland's blog".

Anonymous said...

OK.

I don't think the NYSE counts as a societal scale action.

So. We're getting closer:

Agreed that social norms and rules matter (don't kill), but money incentives can help and hinder.

I'd say that money's more important with private good, and morals are more important with public/club/common-pool goods...
[line break added]

So societal action can be influenced by pricing (I'm a planner, I see it every day). But what large-scale societal action was impelled by markets and pricing mechanisms in this Hayekian manner so described? E.g. I'm looking for proactive examples, not reaction.

DS

Karin said...

Can someone please tell about this monitizing? How do we monetize war and the military? It seems that this war will cost my kids lots, lots more than water as they go through their lives. While I find this discussion of the value to society of charging for water with the rules of Dr. Zetland very promising, how do we get billed for war in a similarly promising fashion. What did we get for this 3 trillion dollars?

Bob said...

DS,

I'm not trying to be a jerk; I really don't understand what you're asking. Can you elaborate a bit on what your problem with David's position is? (I haven't seen if you argued elsewhere about this with him; I'm just seeing this thread.)

I taught Hayekian economics for several years (undergrad level) so I am sure I can give you a decent answer, but at this point I honestly don't even know what you want to see.

Dano said...

Bob:

I can see I'm being a little too Dan-like here*. Apologies.

Briefly, as the pillow calls, using the language of this post, the postulate is:

Prices act as a means of coordinating behavior such that no central authority need know or direct action. Thus, a market system will deliver a "spontaneous order" wherein the bread is in the shop when you want it and your salary will reflect the value of your skills and knowledge to everyone around you.

Good enough for the segment of society where short-term signals direct reactions to such signals.

But what about temporal scales longer than short-term and anticipatory behavior? How can reactive behaviors impel action in different (longer) time scales?

That is: again, using the language of this post, Hayek only gave us an excellent description of how the world works in short time scales and for certain narrow frames of reference.

Now, I'm all for price signals. And I have boxes and a hard drive full of micro papers that have low r^2s that show us they don't always work, and not on everyone.

My point: multiple strategies to impel action at societal scales are necessary - no one method will work.

So using this premise, I'm expecting few if any examples of situations where price signals were used to galvanize, motivate and impel action at societal scales.

Which is why we are starting to see bumper stickers that say "change the light bulbs and the laws", because more people get it.

HTH.

DS

* I call it 'point by circumspection', others call it 'get to the d*mn point!' ;o)

David Zetland said...

@ Karin: "Can someone please tell about this monitizing? How do we monetize war and the military? .... What did we get for this 3 trillion dollars?"

Good question. First, you did not get any kind of market exchange (i.e., labor for bread), since the gov't used taxes (now and future) to launch the war. Second, there was no competition to provide value for war spending, hence much of the money was lost. Basically, spontaneous order and the knowledge problem BOTH require the independent actions of many people seeking their own interests (which can include the interests of others, as a matter of opinion).

DS: On you time scale question, I have to disagree. It's quite possible for private parties to efficiently transact over long time periods (30-50 years), while governments not only have little incentive to do so (election cycles), but also will tend to make great calibration mistakes (i.e., the wisdom of crowds versus the wisdom of a bureaucrat).

As with Bob, I am still a little mystified about the example you seek... Perhaps you can think of a non-market example that solved a social problem?

ADAM S. said...

Well, yes David. How did we get to the point where the average years of education is 14 (half-way to college bachelor degree) in the US, and where you can cris-cross throughout the country on federal/state highways? Would that have happened in a Hayekian world? I think not.

Hayek's ideas are not original and way overrated. He did nothing but re-state Adam Smith after 200 years of hind-sight. To even coin a phrase like "Hayekian Pragmatism" (as gormk does) is a joke.

David Zetland said...

Adam S. -- as a counter-example to your education/transport and "Hayek was nothing special", I offer you the Soviet Union. They, like you, thought that the knowledge problem would not be an issue in deciding the provision of public goods.

Bob said...

Adam and DS,

This won't satisfy you, I'm sure, but I still don't quite "get it" so I'll flounder some more...

The production of a pencil requires a "concerted effort" from thousands of people all over the globe. None of that would be possible without price signals.

Opening a mall is fantastically complicated. Can you imagine if you had to sit down from scratch, and write out every single person in society who needed to help you in some way, just to build a mall and get it up and running by opening day? There's no way in #$)#$ you could even come close to getting the list complete. And even if you were allowed to constantly update it, it would probably take you at least a decade to get the mall finished--and that estimate assumes that the rest of society is still running on market prices.

In contrast, if you are allowed to use markets, you just buy the relevant semi-finished goods from their respective sellers, and you can delegate to them how they actually produce those things. So you only have to worry about hiring a few construction crews, etc.

In terms of filling the mall up with stores, here too you don't need to do too much planning. You can just set a price and rent out the locations to whichever company bids the most, so long as it meets certain qualifications (a legal business, etc.).

Anyway, market prices are crucial in coordinating this tremendously complex web of interactions between human beings. If you think the market is just achieving simple linear adjustments on a foundation designed by some other mechanism, then I think you're misconstruing what the market is.

Bob said...

Another example fresh on my mind: Offshore oil exploration and drilling. Incredibly expensive and "bold." Totally driven by market prices.

Anonymous said...

Bob, I appreciate your efforts.

I'm asserting that pricing in markets is a necessary but not sole condition to move societies in a direction.

Not a direction that it is already moving, but, say a course change from 240º to 270º or even 300º. Leadership and cogent and coherent policy are also needed.

Prices are one of the best feedbacks/indicators/signals for analysis, but motivators for big change? Eh.

I'm looking for examples to show I'm wrong.

DS

Francis said...

David: I apologize for the obnoxious tone of my comment. I should not have been so rude.

I respectfully disagree on the importance of markets in water. Alternatively, I think we disagree on what the word "market" means in this context.

The characteristics of a "market" that seem to me to be important in developing useful price signals include:

multiple buyers
multiple sellers
ease of entry/exit
substitutability of product
[there's probably a few more, but I need to get back to work]

On one end of the scale, we have supermarket flour. On the other, interstate highways.

Water, I believe, is way off in the direction of highways for the following reasons:

water buyers are govt agencies or highly regulated corporations

transportation costs are staggeringly high

infrastructure costs are also staggeringly high

it's difficult to store. Dams and reservoirs can only be built by agencies with the power to condemn land; underground storage is difficult and carries substantial energy costs. And since most dams in California are also flood control facilities, if you guess wrong on the rains you have to dump the stored water in order to have the storage space for storm flows (which have already been appropriated by someone else).

It's a life necessity; voters insist on heavy regulation of the entire industry.

As a result of these factors, it is difficult to create a clearinghouse in which the "true" market price of water can be established. (Google Azurix, frex.)

David Zetland said...

Francis,

We agree on most of this, but I am one who thinks that markets WITHIN these massive bureaucracies can accomplish something. If you want to see a detailed proposal for a market within Metropolitan Water District of SoCal, see C7 of my diss.

I am "talking" to ag and enviro people now to try to bring markets to watersheds (incl. the Sac Delta) as a means of reconciling diametrically opposed interests.

Your definition of markets has a lot to do with competitive markets and wealth maximization. I am interested in them as a means of redistributing rights among competing, political interests.

Mr.Porteño said...

this post has been dormant for two years, and a recession.
Is there any update on the trust to a hayekian economy when prices end up sending very wrong signals? How is the knowledge problem resolved?
How does Hayek deal with shocks to the system, completely away from equilibrium?
Love the phrase "since governments are more frail at making decisions" after what happened in the financial markets. So idiosyncratic.

David Zetland said...

@Mr.Porteno -- you appear to blame markets for the financial meltdown when most people understand that government policies (low interest rates, guarantees, poor regulations) led to the moral hazard that privatized profits and socialized losses. Read a little deeper into Hayek and the Austrians.

David Zetland said...

M. Porteno emailed: "Blame, I can't blame anybody, I can only say that the actors in the financial markets took very poor decision, as bad as those you are afraid govs would do. Very bad decisions.

If regulation making and enforcement were independent of the actors in the market, I would perhaps understand your moral hazard argument. But pressuring the institutions to change the regulation is part of policy making, so later blaming the institutions for poor regulation, seems a little bit off the reality.
I do have to read more on that Austrian perspective into economics, thanks."

[sorry, I approved it and then deleted it by accident]