Friedrich von Hayek, the neo-liberal pin-up, wrote this treatise in 1945, published in "The American Economic Reviewâ€ť. It encapsulates well his disagreement with the dominant Neo-Classical school of economics.
The use of knowledge in society was an attack upon the idea of centralised economic planning which was popular amongst economists at the end of the Second World War. The view Hayek takes is a consequence of the methodology he believes economists should adopt when analysing our economic system â€“ before asking why a particular system does not work the way we want it to, he believed we should investigate why we would ever expect it to work at all.
Hayek refers to two kinds of knowledge in the paper: on the one hand scientific knowledge, of which he is dismissive and scathing. Scientific or technical knowledge of production methods can be best judged and organised by a panel of experts, and so should have no special place in a capitalist system.
But the second kind of knowledge is different. This is practical knowledge of available resources, â€śknowledge of the particular circumstances of time and placeâ€ť. This is Hayekâ€™s favourite kind of knowledge. It has the characteristic of being spread around every individual in society, not just the intellectual elite, so that â€śPractically every individual has some advantage over all others in that he possesses unique information of which beneficial use might be made, but of which use can be made only if the decisions depending on it are left to him or are made with his active cooperationâ€ť. Furthermore, because every individual only processes a small piece of the puzzle, no central planner can ever run the economy efficiently.
Hayek gives examples of how entrepreneurs use this second kind of knowledge in a beneficial way for society and themselves; â€śthe shipperâ€¦ using otherwise empty or half filled journeys of tramp-steamers, or the estate agent whose whole knowledge is almost exclusively one of temporal opportunities, or the arbitrageur who gains from the local differences of commodity pricesâ€ť. This shows the productivity gains society can experience from taking advantage of practical knowledge are at least as great as those potentially available from exploiting scientific knowledge.
Hayek believes the economic problem of society is dealing with imperfect information, particularly concerning the â€śknowledge of the particular circumstances of time and placeâ€ť, not one of satisfying a given system of preferences, from a given pool of resources of which there exists perfect knowledge, as neo-classical economics assumes.
Since practical knowledge of economic resources is distributed amongst all individuals in society, and no individual can know more than a tiny portion of the total information concerning this spatial and temporal distribution of societies resources, Hayek concludes that a centralised system of running an economy could never be anywhere near as efficient as the free market. This is because, in the free market, the price system is a means for transmitting information between the numerous individual actors in the economy. â€śThe mere fact that there is one price for any commodityâ€¦brings about the solution whichâ€¦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.â€ť Prices tell individual economic actors about the relative shortage or abundance of resources for the production of goods. Hayek does not assume that the price system is perfect, merely that it is the only manner by which any economic system can come close to working efficiently at all.
The main criticisms that can be levelled at Hayekâ€™s analysis must be the manner in which he ignores transaction costs, the time and trouble of negotiating contracts inherent to the price system, which economists even at his time knew were the cause of large companies growing in the market system, (See Coase, R, â€śThe Nature of the Firmâ€ť, 1936, Economica 4:16, 386-405) and secondly his neglect of the role of institutions in society in both facilitating the operation of the free market, and helping spread knowledge through society. The operation of the market depends upon the rule of law, otherwise contracts would be worthless, and prices would have no meaning.
Furthermore, his distinction between the two kinds of knowledge is very artificial. In reality there is no fine distinction between purely theoretical scientific knowledge on the one hand, knowing in what circumstances this knowledge is useful in abstract, and knowing the conditions on the ground. All forms of knowledge are based upon experience of the real world to some degree. Importantly, by nature all forms of human knowledge share the characteristic of being public goods â€“ they are free to share. Hayek seems to be imagining a world in which everyone jealously guards everything they know â€“ they never tell another person anything useful without demanding some form of payment, and they take every opportunity to ruthlessly exploit gaps in other peoples knowledge. In such a world Everything2 could not exist. Surely that is not a world in which we would want to live.