Prices, profits and planning - the teaching of Hayek
The insights of Frederick Hayek concerning thedevelopment of modern human society have contributed greatly to our understanding of the relationshipbetween law, economics and politics.
They are contained in his two major works,’The Constitution of Liberty’ and ’Law, Legislation and Liberty’. Butthis Nobel Prize winner also wrote for ordinary people. That ishow Hayek’s best known book, ’The Road to Serfdom’, which explainedthe dangers of socialism, was the one and only abbreviated book everpublished by the Readers Digest at the front, instead of the back, ofthe magazine. Hayek’s study of economic freedom covered many years.
Despite this, it was very straightforward.In his own words, ’In 1936 I suddenly saw, as I prepared my PresidentialAddress to the London Economic Club, that my previous work in differentbranches of economics had a common root.’ His great insight was that’the price system was really an instrument that enabled millionsof people to adjust their efforts to events, demands and conditionsof which they had no direct knowledge, and that thewhole coordination of the world economy was due to certain practicesand usages which had grown up unconsciously.’ ’I gradually found,’ hewrote, ’that the basic function of economics was to explain the process ofhow human activity adapted itself to data about which it had noinformation.
Thus the whole economic order rested on the factthat, by using prices as a guide or as signals, we were led to servethe demands and enlist the powers and capacities of people of whom we knewnothing. It was because we had relied on a system which we had neverunderstood and which we had never designed that we had been able to producethe wealth to sustain an enormous increase in the world’s population, andto begin to realize our new ambitions of distributing this wealthmore justly. ‘This insight, he said, ’has extraordinarily importantconsequences once its truth has been accepted. Either you mustconfine yourself to creating an inst i tut ional framework within which the price system will operate as efficientlyas possible, or you are driven to upsetting its function. If itis true that prices are signals which enable us to adapt ouractivities to unknown events and demands, it is obviously nonsenseto believe that we can control prices’.Hayek explains in detail how theprice system communicates the results of very sophisticatedinformation throughout the
Suppose, for example, that a new usefor some resource such as tin has been discovered, or that anexisting source of tin has become exhausted. Significantly itdoes not matter to the trader which of these two causes has occurred.All he needs to know is that he must economise on tin because it nowcommands a higher price; the change in market conditions has enabledtin producers to obtain more for their product. Some users of tinwill no doubt economise, perhaps switching to substitute materials thatare now cheaper.
Thus the scarce tin will continue to beemployed only where alternatives are unavailable or aremore expensive. The new demand for substitutes will prompt theirfurther supply or switching from less profitable employments, which willin turn affect the things which can be substituted for the substitutes,and so on.
The entire market order adjusts tothe scarcity or new demand for tin, and acts as one market, eventhough few people know the original cause of the changes. Usersand producers do not need to scan the whole field, or to be aware ofthe various uses for tin and its substitutes, for this adjustmentto occur and for the relevant information to be communicated to all.The prices of these goods are all they need to know in order for acomplete adjustment to be made.
The most remarkable fact aboutprices, Hayek explains, is that in this way they match the purposesof many unknown people by summarizing a great deal of informationvery simply. Any central planner would need to know all of the varioususes and end purposes for tin and its substitutes before he could evenbegin to work out what switching should occur, but the marketprovides the adjustments rapidly and without any need to find outall this detailed information. Of the price system Hayek says:’In abbreviated form, by a kind of symbol, only
the most essential information is passedon, and passed on only to those concerned.’ The result of this isthat the price system ensures that goods are produced in themost efficient and least costly way possible.What does all this mean forthe ’P’ words of economics - prices, profits and planning?
To control signals involves distortingthem, with harmful results. If the price for a product (cooking oil,for example,) is set below its economic level, demand will be boosted butproduction discouraged, resulting in a shortage. Conversely, ifthe price of a service (labour, for example) is set above its economiclevel, supply will be encouraged but demand reduced, resulting in asurplus, i.e. unemployment.
How about profits, a business objective which hasoften been denounced as evil? The prospect of high profitsencourages entrepreneurs to concentrate on products which are in highdemand, whereas losses or low profits encourage moves toimprove efficiency or to switch to other products which are ingreater demand.
Both actions are economically beneficial.Another major role of profit is to stimulate individuals to discovernew and untapped opportunities.
And planning? Central planning by governments is appropriate fornational finances and major infrastructure.But otherwise it should be left to businesses to respond to thesignals provided by price and profit. In short, the appropriateguides for virtually all economic activity are the signals providedby prices, for which economic freedom is the right environment. Having died in 1991, Hayek was not aliveto comment on the current world recession.
We can be sure, however, that he wouldnot have agreed with those who blame it on excessive economicliberty.
He would doubtless have attributed it mainlyto the actions of those ’government sponsored enterprises’, FreddieMac and Fannie Mae, which, encouraged by the government, supportedthe excessive promotion of ’subprime’ mortgages.
Murray Sanderson is Executive Secretary of ZambiaInstitute for Public Policy Analysis. This article is syndicated by AfricanLiberty.org
Franklin Cudjoe is head of Ghanaian think tank, IMANI, a non-profit, non-government organization dedicated to fostering public awareness of important policy issues concerning business, government and civil society. He is also editor of AfricanLiberty.org The Foreign Policy Magazine named IMANI, the fifth most influential think tank in Africa in 2009. Franklin was named Young Global Leader 2010 by the World Economic Forum.
** “If I have seen further than other men, it is because I have stood on the shoulders of giants”.-Sir Isaac Newton,