Lesson 2 of 8
A number that carries a message
A price tells a user that something is scarcer without telling them why. That is the economy of the signal, and it is also everything the signal throws away.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A price change tells a user how much more or less urgently to economise on something, without telling them what changed or where.
- That compression is the point. A signal that carried the reasons would be too large to act on and would not reach most of the people who need it.
- The same compression is the limit. A price cannot say whether it moved because of a real scarcity or because of something in the money, and that ambiguity is the whole of the later cycle theory.
Section six of Hayek's 1945 paper contains the argument the paper is remembered for, and it is worth reading slowly, because both halves of it matter and only one half is usually repeated.
What travels, and what does not
- 1A new use for tin appears somewhereOr a source of it is lost. Nobody downstream learns which
- 2Some users economiseThey face a higher price and use less, or switch
- 3Their demand for substitutes risesWhich raises those prices too
- 4The adjustment spreadsThrough people who never learn the original cause
The example, and what it shows
Hayek's illustration is a commodity, tin, that becomes scarcer. He points out that it makes no difference to the response which of many possible causes was responsible: a new use somewhere, or a supply lost somewhere else.
Users of tin need to know one thing, that they should now use less of it and look harder at substitutes. They need not know why, and almost none of them find out. Those who adjust create gaps that others fill, and the adjustment travels outward through people who have no idea what started it.
His description of the result is that a great many people are moved in the right direction without anyone issuing an order and without most of them holding more than a fragment of the relevant knowledge.
Why compression is the mechanism and not a defect
The reason this works is that the signal is small. One number, on a thing a person already deals in, is something they can act on in an afternoon. The full account of what happened in the tin market this month is not.
This is the direct answer to the previous lesson. The knowledge of particular circumstances stays where it is and is never transmitted. What is transmitted is a summary of its consequences, expressed in the one dimension every user already pays attention to.
What the signal cannot say
Here is the half that matters for the rest of this track, and it follows from the same property.
If a price does not carry its cause, then the user cannot tell one cause from another. A price that rose because people genuinely want more of something, and a price that rose because there is more money chasing it, look identical to the person reading it. The signal is exactly as informative in both cases and exactly as silent about which it is.
Everything the later courses say about credit and about production being misdirected is built on that sentence. Nothing in a price says whether the scarcity behind it is real.
Check yourself
What does a user of a scarcer commodity need to know, on Hayek's account?
- What caused the scarcity
- Only that they should economise on it more than before
- How much of it exists in total
Show the answer
Answer: B.
Section VI of the 1945 paper makes the point that the cause is irrelevant to the appropriate response, and that almost no user ever learns it.Why is the compression in a price a feature rather than a defect?
- Because it makes prices easier to publish
- Because a signal small enough to act on reaches people a full account never would
- Because it prevents manipulation
Show the answer
Answer: B.
The knowledge stays where it is used. What travels is a summary of its consequences in the one dimension every user already watches.What can a price not tell the person reading it?
- How much to buy
- Whether the scarcity behind it is real or the result of something in the money
- What the price was last year
Show the answer
Answer: B.
The signal carries the consequence and not the cause. That silence is what the later theory of the cycle is built on.Sources
- Hayek, 'The Use of Knowledge in Society', American Economic Review, 1945, section VI, on the price system as a mechanism for communicating information, the tin illustration, and the claim that users need know only the direction and degree of the change rather than its cause.
- Hayek, 'The Use of Knowledge in Society', section VII, on what equilibrium analysis leaves out of this account.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- The component example is invented to separate two causes of one price move. It describes no market and no company.
- That prices communicate does not mean they communicate accurately or quickly. Hayek's claim is about the mechanism, and how well it performs in any actual market is a separate, empirical question this lesson does not answer.