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The Economics of Hayek

hayek_portraitAs I mentioned in my first post, Hayek has had a large influence on the way I think about economics. But despite being one of the most cited authors of all time and winning the 1974 Nobel prize, the bulk of Hayek’s ideas have either been ignored or mischaracterized by modern economic research (see Pete Boettke’s paper on how Hayek is used by modern economics). Looking at the methodology of modern economics (especially macro – more on this in future posts), I doubt there is much of anything that would have appealed to Hayek. Obviously, I think Hayek’s economics deserve a larger role in the theories of modern economists. So what is Hayekian economics? I have broken it into four pieces. If you are not familiar with formal economics, some of the comparisons I make might be a bit confusing, but I hope it is interesting regardless.

The Economic Problem

If we possess all the relevant information, if we can start out from a given system of preferences, and if we command complete knowledge of available means, the problem which remains is purely one of logic…This, however, is emphatically not the economic problem which society faces…It is rather a problem of how to secure the best use of resources known to any of the member of society, for ends whose relative importance only these individuals know
F.A. Hayek, The Use of Knowledge in Society, 1945

Most economics papers begin by doing precisely what Hayek warned against in the quote above. They define a set of preferences for consumers and a production function for firms. They then assume that consumers maximize utility and firms maximize profits and solve for an equilibrium. From Hayek’s perspective, starting from this point assumes away the most interesting questions of economics. The economic problem cannot be solved by taking derivatives of known maximization problems. Instead, it is a question of how resources can be allocated efficiently when this information is not known. It is about the process of discovery, of individuals competing and cooperating attempting to find better ways to achieve their own ends.

The Price System

I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind
F.A. Hayek, The Use of Knowledge in Society, 1945

Hayek’s answer to the economic problem he proposed above and the mechanism that allows a decentralized economy to allocate resources is the price system. It is important to note here that Hayek’s prices are not equilibrium prices. They are not set to ensure that all markets clear or that there are no profit opportunities remaining. He is far more interested in the process by which an economy moves toward its equilibrium than he is in the equilibrium itself. Prices, then, are simply guides, providing the information that incentivizes individuals to make decisions that result in goods being allocated efficiently, even though it wasn’t anybody’s direct intention to do so. When a resource becomes relatively scarce, entrepreneurs recognize a profit opportunity, raise the price, and ensure that only those who will make the best use of the resource actually receive it. Through the price system, knowledge that is known only to a few individuals can be communicated indirectly throughout an economy.

The Meaning of Competition

[C]ompetition is by its nature a dynamic process whose essential characteristics are assumed away by the assumptions underlying static analysis
F.A. Hayek, The Meaning of Competition, 1946

The way that prices are formed in Hayek’s theory is through the competitive process. Entrepreneurs, who are usually given little to do in standard economic theory, are central to Hayek’s story. Rather than assume firms to be price takers, aware of their own cost structure and production function, their actions are instead “a voyage of exploration into the unknown, an attempt to discover new ways of doing things better than they have been done before.” In standard economic theories, “perfect competition” is a state where nothing changes as firms decisions are largely made for them. In contrast, Hayek imagines competition as a constantly moving dynamic system. Even if the economy looks stable, “the task of keeping cost from rising requires constant struggle.”

Spontaneous Order

[M]any of the ‘mere habits’ and ‘meaningless institutions’ that we use and presuppose in our actions are essential conditions for what we achieve; they are successful adaptations of society that are constantly improved on and on which depends the range of what we can achieve. While it is important to discover their defects, we could not for a moment go on without them
F.A. Hayek, The Constitution of Liberty, 1960

In the end, the actions of individuals acting on their preferences and knowledge create a “spontaneous order,” an organization of society that is  the “result of human action, but not of human design” (a quote used by Hayek, but which was originally written by Adam Ferguson in 1767). In other words, even without top down planning, there is an order to society that arises naturally. This idea applies not only to a market economy and the price system, but also to political systems, the rule of law, and more informal orders like societal norms and customs. The institutions that society develops are continuously evolving as people explore new ways to accomplish their goals. These institutions provide the basis for the market system, providing incentives for entrepreneurs to develop new products and methods of production as well as accurately set prices. They are essential to tie together the three pieces explained above.

While this brief post can only give a taste of Hayek’s work (look here for some videos and a free ebook that go into more detail), I think it highlights the main differences between his approach and that of mainstream economic theory. Disequilibrium, fundamental uncertainty, and the discovery process of entrepreneurs are all essential pieces of Hayek’s analysis that are challenging to model using the most commonly used methods of modern economic analysis. But rather than throw these concepts aside because they do not conform to these methods, I believe the right path forward is to change the methods themselves.

More on this in future posts.


2 thoughts on “The Economics of Hayek”

  1. I am not so sure that “the bulk of Hayek’s ideas have either been ignored or mischaracterized by modern economic research”, or maybe this is just my distant from macro view.

    My key thesis is that: first, they are not ignored, they are deeply integrated in how we think about economics; second, it might seem like what modern econ is doing is far away, but thats just because we are doing easy stuff to maybe do hard later; and third, modern research tries to get at those things, albeit imperfectly.

    1. The Economics problem

    I might be misreading Hayek, but the problem defined in quote is what I was told in my first class in economics ever. Everyone understands that if we know everything, this is just a question of computing. However, reality is different, not everyone has a cloud to run. Thats why each individual takes as inputs only prices. Through his actions, individual communicates relevant part of his information to the market, and that exactly why markets are better than Gosplan (thanks to first welfare theorem and historic results). I do not think your interpretation of the quote is entirely correct, it is not about individuals not knowing their own preferences or endowments, it is abou them not knowing those of others.

    2. The Price system.

    Cool quote, totally agree. You explanation here reflects that there is not much of a wedge between two problems in first section. As for transition is being more interesting than endpoint, I think many agree with that, and it is just so much harder to do. I mean, we have even done transition paths in Ohanian’s class, there are experiments on price convergence over time game theory settings, or papers in dynamic IO (though very rare), like WP “Just Startring Out”.

    3. The Meaning of competition.

    Not sure about macro, but IO is all about imperfect competition and firm decisions. For dynamics, again, see “Just Starting Out”. Dynamics in IO is very tough, but many agree thats where we should be moving, and we slowly are. Again, let economists first do easy steps, and then build on.

    4. The Spontaneous order.

    Again, I do not think this is contrarian to modern economics, but deeply embeded in it. Just think back to the Sugar paper I’ve discussed in Trade – it tells you how institutions were formed and why! Again, I think first we study what people do given instituions (like budget constraints), then start thinking about institutions adjusting (adding labour supply decision to move budget constraint). Economics is very young, give us time 🙂

    Let me know where I am wrong.

    1. Good comment and you’re right I’m coming at this from a more macro point of view so maybe IO is better on these points.

      On the first point, I don’t think I implied that individuals don’t know their own preferences (at least I didn’t intend to). You’re absolutely correct that determining the preferences and the local knowledge of others is exactly the relevant problem. But I don’t know of many theoretical macro papers written in the last 30 years that don’t begin by defining consumers’ preferences and a production function and then assuming that these are known to all agents.

      As for the transition paths some macroeconomic papers study, the economy is still in equilibrium along the path as it converges to its steady state so there isn’t really any role for entrepreneurs to convey information through the price system. Leijonhufvud has a good quote where he says “In rational expectations models, people do not learn about changing relative scarcities from price movements; price movements merely reflect what they have already learned more directly.” If prices conveyed any relevant information to agents, they would not be equilibrium prices (in most models). Even in imperfect competition models, there is little room for the discovery process that is so important for Hayek. The “Just Starting Out” paper is more promising and is exactly the kind of analysis I hope we move towards, but it’s brand new and I wouldn’t say it reflects what most of the profession is doing.

      Easy steps are fine as long as they’re going the right direction. I hope you’re right that economics is moving towards Hayek, but I think the last 40 or so years have been more of a detour.

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