San José State University
Department of Economics
Thayer Watkins
Silicon Valley
& Tornado Alley

A Complete Price System
as a Mechanism for
Using Knowledge

Friedrich von Hayek

Friedrich von Hayek in his essay, The Price System as a Mechanism for Using Knowledge provided marvelous insights into the role of the price system in the efficient functioning of an economy. Hayek first makes the point that people possess particular knowledge that is vital for the proper functioning of economic enterprises at the local level. This information is impossible to summarize and transmit to a central administrative unit. Thus the efficient functioning of the economy requires a decentralization of decision making. But these decentralized decisions must be tied together and made compatible. The system of prices established by supply and demand performs this function.

Hayek uses a wonderfully simple case to illustrate the power of the price system. Suppose there is a decrease in the supply of tin or an increased demand for tin. In a centrally administered economy such as operated in Stalinist Soviet Union or in Nazi Germany the change in the tin situation will require several steps for its resolution. First, a survey must be done to find out which enterprises are using tin, how much and for what purpose. Second, this information must be compiled at the central administrative headquarters and a decision made to which uses will be reduced and by how much. Tin is used as the protective coating for the steel in tin cans and there may be no substitute for it. Tin was also used for tubes for such things as toothpaste and it was used for foil, as in tin foil. There are ready substitutes for tin in these uses. The third step in the process is that orders must be sent out to all of the enterprises using tin as to how much they must reduce or increase their use of tin. Fourth, a follow-up survey must be made to determine whether the enterprises are complying with the administrative orders.

In contrast, in a market system all that needs to be done is allow the price of tin to increase. Those enterprises using tin are conscious of the price of tin. They know whether or not it is economical to switch to substitutes for tin when the price rises.

So the price system is a wonderful means of communication within the economy. Are prices the only information needed? Driving around a city one may see housing construction. Is it possible that since all of the builders are operating independently that more houses are being built than can be sold without depressing the price? Of course, it is possible. That suggests that the builders need the government to compile statistics on building intentions to warn the builders that an excess of houses is being built.

Consider this anecdote told to me by my optometrist many years ago. He grew up in the Central Valley of California. In the late 1940's there was one year, 1947, in which the potato harvest outside of California was unusually low. This led to higher prices. My optometrist said that year everyone involved in the potato harvest in the Central Valley did very well financially, the farm workers as well as the farm owners. Because that year was such a bonanza for potatoes the next year people planted every square foot in potatoes. That led to a bumper crop of potatoes and the price was low and the potatoes growers did poorly.

That anecdote suggests that there might be a need for government to guide if not regulate the potato industry. However such is not the case. In the case of some commodities such as wheat there exists a futures market. Farmer contemplating growing wheat do not have to rely upon the current market price of wheat as an estimate of what the price of wheat will be when they harvest the wheat. They can enter into a futures contract and know exactly the price they will sell the wheat for. They could also purchase a put option on the wheat and guarantee a minimum price being able to take advantage of a higher price.

The futures market price is established by market participants who have an incentive to gather, compile and forecast what the market price will be in the future. These are the same activities that a government bureau would have to perform to regulate a particular market, only the bureaucrats would have less of an incentive to get things right.

Thus a complete price system, one involving futures prices as well as spot (current) prices provides all the information needed for a decentralized economy. There is no need for a government bureau to collect information on a market for which a complete price system exists.

There do not exist futures markets for such things as houses. In principle, however such futures markets could exist. All that would need to be done is establish a price index for a cross-section of housing in a particular location. Builders could place bets on what is going to happen to the index. Thus if the price level does go down they would recover any losses on the houses they build from winning on their bets on the housed price index. There are two technical issues concerning the matter of a complete price system. The first is whether an equilibrium set prices exist. The second is the stability of that equilibrium.

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