The Division of Knowledge

In the 1930‘s and 1940‘s, F. A. Hayek wrote a pioneering series of essays describing how free market prices communicate knowledge.‘ More recently, Israel M. Kirzner reinforced and extended Hayek’s arguments.2 If Hayek and Kirzner are correct-and I believe they are-the free market is the most efficient economic system because it most fully utilizes the knowledge dispersed among the individual members of society. 

Every individual possesses a wealth of knowledge known to him alone. A complete list would include personal memories, innermost beliefs, and unspoken ambitions. However, only two types of such private knowledge will concern us here. One type is preferences, particularly consumer preferences. A consumer’s preferences are generally unknown to others until he discloses them by choosing one product over another. Similarly, a worker’s occupational preferences are revealed when he pursues a particular job. An individual’s preferences are his private knowledge until his actions reveal them.

The second type of private knowledge we will consider is that which comes from being in a unique situation-the knowledge of the "man on the spot." For instance, a gas station operator knows his workers‘ skills, their personalities, how well various workers get along with one another, where to hire part-time help, which equipment is in good condition and which is likely to need repair, where to get spare parts, where to get stock if supplies are interrupted, when business is likely to be busy and when it is likely to be slow, his customers‘ particular needs, and the like. Such information is known to the operator plus perhaps a few immediate acquaintances.

The gas station operator possesses essentially private knowledge because he is in a unique situation, at a unique location, dealing with unique individuals and equipment. Clearly, efficient production requires that production decisions somehow take into account the operator’s knowledge of particular circumstances as well as the unique knowledge of other such "men on the spot."

But, efficiency requires more than that production decisions be based on private knowledge. There must exist a means by which each producer’s decisions tend to coordinate with the decisions of all the other producers and consumers in society.

The Role of the Market

On the face of it, this appears impossible. How is an individual to coordinate his decisions with the decisions of millions of other people when their decisions are at least partly based on private knowledge which he doesn’t possess?

This cannot be achieved by central planning-socialism-because the knowledge of millions of individuals cannot be concentrated at a single point. In fact, the private knowledge we have been considering is knowledge which by its very nature cannot enter into statistics and thus cannot be conveyed to a government planner in statistical form. What government statistics do convey are aggregates and averages which lump together, as resources of the same kind, items which differ in quality, age, location, and other particulars. Such statistics are of little use to someone who may, for instance, need a certain kind of ball bearing, and have no need for data on the nation’s yearly output of ball bearings.

To fully appreciate these problems, we need to consider how production and consumption decisions are coordinated in a free market. 

Suppose we are in a free market in which a new use is discovered for copper. Almost immediately, the market begins to adjust. Copper miners start producing more copper, current users of copper begin to substitute other resources, producers of substitute resources adjust their outputs, producers of substitutes for the substitute resources change their production plans, and on and on throughout the market.

Prices Tell the Story

In a free market all these changes occur, not because everyone is informed about the new use for copper, but because the price of copper tends to rise. Most people do not know why there is an increased demand for copper; they do not know where or for what use the copper is needed; they do not know who is buying the copper; nor do they know his race, sex, politics, or religion-factors a socialist allocator of resources might take into account. Free market prices are an impersonal means of communicating knowledge. They provide the individual with all he needs to know to coordinate his production and consumption decisions with those of his fellow men-without knowing anything about their particular decisions!

For example, if a scarce commodity is in great demand, its price is high. The high price encourages people to make careful use of the commodity-which is precisely what potential users would want them to do-without being aware of who is demanding the commodity or what the total supply happens to be. In fact, for many commodities, such as natural resources, no one knows the total supply or the identities of all the potential users.

If a commodity’s price is low because of low demand and large supply, people will make freer use of the commodity-without being ordered by a central authority and without knowing why demand is low and supply is high. 

Free market prices give each individual at least some idea of what others are likely to offer for his products. The "going market price" is an invaluable aid in planning production and consumption. For commodities traded by speculators, futures prices are a further aid. In most cases, the manufacturer can plan production without performing extensive marketing research, i.e., without canvassing the public, finding his potential customers, and asking them what they would be willing to offer for this or that product.

Free market prices also tell a businessman the relative importance others place on the factors of production (natural resources, labor, and capital goods) which he can use in supplying other people’s needs. The businessman is spared the monumental task of locating all those who are interested in using each factor of production, determining the relative importance of each factor to each potential user, and somehow forming an aggregate that expresses-in one number-the "total importance" they place on each particular factor.

In a free market, the contribution of each particular factor of production-each unit of labor, each unit of natural resources, each capital good-is evaluated according to how much the factor adds to production, and the expected selling price of the product. Hence, the contribution of each factor depends on how it is employed. Efficient production requires that each factor be employed where it makes the greatest contribution.

Errors to be Corrected

Because knowledge is divided among millions of individuals, with no one knowing more than a tiny part, factors of production often are employed where they make less than the maximum contribution. A manufacturer may be unaware that a factor could make a greater contribution in another employment. Those who know of other employments may be unaware of the availability of the factor, or even of its existence.

To correct these misallocations of scarce resources, we need a system that (1) provides a means of discovering misallocations, (2) stimulates people to use the means of discovery, (3) encourages people to transfer control of resources to manufacturers who have discovered misallocations, and (4) rewards the correction of misallocations.

All this is accomplished by the free market profit and loss system.

Suppose, for example, copper is being used to make products on which consumers place low values, and/or it is being used where each ton of copper contributes little to physical output. In these cases, each ton of copper makes only a small contribution to the revenues of the manufacturer using it. As a result, manufacturers place low values on copper, and it can be obtained for a low price.

Suppose an entrepreneur surveys this situation and discovers what he believes to be a more profitable way of using copper-by making a product which he hopes consumers will value highly and/or by using a method of production which gets more output per unit input. If he is wrong-and has overestimated the prices consumers will pay and/or underestimated his expenses-he will fare no better than most other manufacturers and have little impact on the market.

If he is right, however, he will earn high profits because each ton of copper will make a large contribution to his revenues. His profits will encourage and enable him to expand production, and he will bid more and more copper away from other manufacturers. Other businessmen will notice his profits, stop using copper in the old and relatively unproductive employments, and start copying his use of copper. In the process, competitive bidding will tend to raise the price of copper to reflect its new, more productive use. At the same time, increased output will tend to reduce the price of the entrepreneur’s product. Competition assures that the entrepreneur has no guarantee of permanent profits.

This, in essence, is how misallocations are discovered and corrected by profit-seeking manufacturers. Production is most efficient when each factor of production is making the greatest possible contribution. By moving factors to more productive uses,