Lesson 4 of 7
From calculation to knowledge
Answering the competitive solution moved Hayek from arithmetic to information: who knows what, how fast a decreed price moves, and which goods have no price.
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
- Hayek accepted that the formal conditions of efficient allocation apply to any economy. He said that was never the question, and that nobody had denied it.
- His objection to the competitive solution is about speed and detail: a decreed price changes after a report, and it has to be one price for a class of goods.
- Whole industries produce to individual order rather than for a market, and for those there is no standing price to post at all.
By 1940 the argument had moved twice. Hayek's answer to the competitive solution appeared in Economica in May 1940 and was reprinted in Individualism and Economic Order in 1948, and it is where the calculation question turns into a knowledge question.
Three stages of one argument
- 1920Calculation in kindThe claim that a plan could be run in physical magnitudes, which Mises argued fails for goods of a higher order.
- 1930sSolve the equationsThe proposal that the values could be computed. Hayek quotes Pareto's own denial that the system is numerically solvable.
- 1936 to 1940Restore competitionLange and Dickinson propose a board that posts prices and adjusts them. Hayek's 1940 essay answers this stage.
What Hayek conceded, and why it mattered
He opens by clearing away a misreading. That the formal principles of economic theory apply to a socialist economy had never been denied by anyone except some socialists, he writes; the question Mises raised was whether those values could in practice be found in the absence of a market.
That concession is the reason Lange could claim the critics had retreated. It is also why the argument stopped being about logic. From 1940 the dispute is about what a real institution can do at real speed with the information real people have.
Prices that arrive late, and prices that are too coarse
Two of the objections are practical in a way that is easy to check against any working business.
The first is timing. A market price changes when the parties who know something act on it. A decreed price changes only after the parties report, the reports are checked, the discrepancies are resolved and a new list is published. Hayek argues that practicability forces the board to fix prices for definite periods, and that whether an economy ever approaches equilibrium depends entirely on the speed of adjustment, not on whether a hypothetical equilibrium exists.
The second is grain. To publish prices at all, the board must set them generically, for classes of goods, because otherwise the list is endless. A uniform price for a class cannot reflect quality, place or the circumstances of the moment, so a manager has no reason and no means to exploit a local advantage or to pay extra to fix a temporary shortage quickly. Hayek's reading of Lange is that this is exactly what the parametric treatment of prices requires, and that it costs precisely the information a price was supposed to carry.
The goods with no standing price
The third objection is the one a practitioner recognises immediately. Large parts of heavy industry do not sell standard products into a market at all. Machinery, ships, buildings and major components are produced on individual contract, often after tenders, and the set of possible suppliers and customers differs case by case.
There is no recurring price to post for those. Hayek's conclusion is that the board would have to approve the estimate in each individual case, examining the calculations of every potential supplier and purchaser, which either becomes full central direction of production or becomes a formality that approves whatever the parties already agreed.
Where the 1945 paper came from
The through line is that a price is not only a number to calculate with. It is a signal generated by people who know particular things, and the value of the signal depends on how quickly and how finely it responds to what they know.
That is the argument of the 1945 paper on knowledge, and it was written five years after the essay in this lesson, for an audience that had just watched the calculation debate. The most influential thing this tradition produced came out of losing an argument about arithmetic and finding a different one underneath.
Check yourself
What did Hayek concede in the 1940 essay?
- That a planning board could adjust prices as fast as a market
- That the formal principles of economic theory apply to a socialist economy, which he said was never in dispute
- That calculation in physical units was workable after all
Show the answer
Answer: B.
He argues the question raised in 1920 was whether those values could be found in practice without a market, not whether the formal conditions hold.Why does the board have to publish prices for classes of goods?
- Because quality differences do not matter in practice
- Because pricing every distinguishable good separately would produce an unmanageable list
- Because managers prefer simple lists
Show the answer
Answer: B.
Hayek's point is that the simplification is forced, and that it removes the differences of time, place and quality that a market price would have carried.Which industries does Hayek say the method cannot reach at all?
- Retailing and agriculture
- Those producing to individual order after tenders, such as machinery, ships and buildings
- Industries with many small firms
Show the answer
Answer: B.
For goods produced on contract there is no standing price to post, so each case would have to be approved individually by the authority.Sources
- Hayek, 'Socialist Calculation III: The Competitive Solution', first published in Economica in May 1940 and reprinted in Hayek, Individualism and Economic Order, 1948, chapter nine: the concession about formal principles, the three stages of the debate, the speed of adjustment objection, the argument that prices must be fixed generically and for periods, and the case of goods produced on individual contract.
- Hayek, Individualism and Economic Order, 1948, chapter eight, first published in 1935, for the state of the debate before the competitive solution was set out in print.
- Hayek, 'The Use of Knowledge in Society', American Economic Review, 1945, reprinted as chapter four of the same volume, for where the argument went next.
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 shipyard example is invented to show the shape of a contract price. It describes no company.
- These are objections of practice rather than proofs. Whether they are decisive is what the last three lessons of this course are about.