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Saturday, December 1, 2001

Imperfect Knowledge

From the Very Beginning, the Austrian School Put Uncertainty and Error at the Center of Economic Theory

Three economists have won the Nobel Prize in economics for studying the “asymmetric” (uneven) distribution of information in markets. The winners are Joseph Stiglitz of Columbia University, George A. Akerlof of the University of California at Berkeley, and A. Michael Spence of Stanford University.

As the prize committee and various commentators see it, Stiglitz, Akerlof, and Spence deserve the honor for recognizing that markets, contrary to the textbooks, do not consist of people possessing perfect knowledge about the future and one another. Some people know more than others. A used-car seller likely knows more about a car than a prospective buyer does. Someone buying medical insurance likely knows more about his health than the company does. As the New York Times put it, “Their theories incorporated ‘imperfect information’ into economics—a concept at odds with the mainstream view that markets are all-knowing and self-correcting.”

But that’s not all they did, according to the commentators. Alan Krueger of Princeton University said, “The three of them really pioneered the view that markets, when confronted with imperfections, may not be the best way to allocate resources.”

And what might be a better way? The government, presumably. And since imperfect information is ubiquitous, the role for government is comprehensive. Professor Stiglitz has taken just such a position with only occasional qualifications.

There are a few problems with all this. The trio did their separate work in the 1960s and ’70s. Yet neoclassical economics has been under attack for its assumption of perfect knowledge for a lot longer than that. From the very beginning, the Austrian school put uncertainty and error at the very center of economic theory. After all, if one is trying to describe how real people grapple with the real world, one must take ignorance into account as thoroughly as one does scarcity.

Carl Menger’s path-breaking Principles of Economics (1871) did so. The same goes for Ludwig von Mises, who wrote in Human Action (1949, but based on earlier work), “The uncertainty of the future is already implied in the very notion of action.” And for F. A. Hayek, who in the 1930s and ’40s published articles titled “Economics and Knowledge” and “The Use of Knowledge in Society,” it is precisely the absence of the “given data” of which neoclassical economics is so fond that is the key to understanding markets as we actually encounter them. The “knowledge problem” was central to Hayek’s elaboration of Mises’s critique of socialism in the 1930s and to Hayek’s own pioneering work on markets in the 1940s. (Hayek’s Nobel prize in 1974 was partly in recognition of his work on the knowledge problem.)

Stiglitz, Akerlof, and Spence are indeed neoclassicals-come-lately.
Moreover, the neoclassical attempt to catch up to the Austrians has been half-hearted. For those who wish to see why, read Esteban Thompson’s Prices and Knowledge: A Market-Process Perspective (Routledge, 1992), based on his dissertation written under Israel Kirzner, whose own work on entrepreneurship has always incorporated the phenomenon he calls “utter ignorance” and the profit-driven effort to dispel it.

Finally, there are the policy implications of the work of Stiglitz et al. We are asked to believe that since the economy is riddled with ignorance, government can be better at allocating resources than markets. But markets are people (with an incentive to seek out the information they need). Just who will be staffing those government bureaus?

* * *

It’s well known that Henry Ford overcame large odds to launch a great automobile company that catered to the average consumer. What is less well known is that he had to overcome a formidable legal obstacle as well. Melvin Barger tells the story.

Virtually all government policy directed at health care is premised on the notion that the law of economics doesn’t operate in that realm. Walter Block, a part-time resident of Canada, knows better.

The concept of “feedback” is critical both in the micro and macro sense—that is, from the factory floor to the economy at large. William Conerly tells us why.

The recent hard times for Web-related high-tech firms have prompted comparisons of that industry to the nineteenth-century railroads, which were said to have been “built ahead of demand.” Those comparisons miss the mark, according to Larry Schweikart.

In response to the atrocities in New York and Washington last September 11, the U.S. government is prosecuting a war in Afghanistan and promises long-term operations against perpetrators and enablers of terrorism elsewhere. The demand for justice, however, should be tempered by a realization that any war is costly in terms of liberty at home. To that end, we reprint an article that Robert Higgs wrote for Ideas on Liberty (then known as The Freeman: Ideas on Liberty) in 1999 during the war in Serbia.

When a corporation announces a shareholder protection plan that causes the stock price to drop, something is awry. Gary Galles looks at the case of Yahoo! and how the courts compromise the rights of owners.

This month marks the 150th anniversary of the birth of the great Swedish economist Knut Wicksell, who influenced the Austrian school’s view of the business cycle. Richard Ebeling contributes an appreciation of this seminal thinker.

Have we got columns this month! Mark Skousen praises religious diversity. Lawrence Reed says we shouldn’t expect much from politics. Doug Bandow reevaluates American security guarantees to Australia. Dwight Lee ponders how much energy to conserve. Donald Boudreaux examines an overlooked externality. Russell Roberts can’t find signs of American piggishness. And Roy Cordato, seeing commenators proclaiming a bright side to terrorist destruction, protests, “It Just Ain’t So!”

In the book department, our reviewers report on new offerings dealing with why socialism as a movement failed in the United States, Austrian macroeconomics, education, the Civil War, and critiques of capitalism and liberalism.

Sheldon Richman

  • Sheldon Richman is the former editor of The Freeman and a contributor to The Concise Encyclopedia of Economics. He is the author of Separating School and State: How to Liberate America's Families and thousands of articles.