Eric Rasmusen’s Weblog

Colin Bird asked what I thought about Hayek’s view of economic methodology, in particular, about his criticism of it in his 1937 Economica article. I might not be understanding it fully, but my impression is that what he doesn’t like about the economic theory of his day is that it:

1. Ignores the fact that people are imperfectly informed and differently informed about prices, products, and methods;

2. Ignores the interesting question of how people become informed;

3. Makes policy conclusions on the basis of theories deficient in their treatment of information (i.e., from points 1 and 2).

This is clearest in his 1945 AER article, the most famous one, which is mostly about the role of prices rather than methodology:

I fear that our theoretical habits of approaching the problem with the assumption of more or less perfect knowledge on the part of almost everyone has made us somewhat blind to the true function of the price mechanism and led us to apply rather misleading standards in judging its efficiency. The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; i.e., they move in the right direction. This is enough of a marvel even if, in a constantly changing world, not all will hit it off so perfectly that their profit rates will always be maintained at the same constant or “normal” level….

…there is something fundamentally wrong with an approach which habitually disregards an essential part of the phenomena with which we have to deal: the unavoidable imperfection of man’s knowledge and the consequent need for a process by which knowledge is constantly communicated and acquired. Any approach, such as that of much of mathematical economics with its simultaneous equations, which in effect starts from the assumption that people’s knowledge corresponds with the objective facts of the situation, systematically leaves out what is our main task to explain. I am far from denying that in our system equilibrium analysis has a useful function to perform. But when it comes to the point where it misleads some of our leading thinkers into believing that the situation which it describes has direct relevance to the solution of practical problems, it is time that we remember that it does not deal with the social process at all and that it is no more than a useful preliminary to the study of the main problem. (The Use of Knowledge in Society F. A. Hayek The American Economic Review, Vol. 35, No. 4. (Sep., 1945), pp. 519-530.)

Hayek’s 1937 article in Economica, also well-known, is mainly about method.

I am certain there are many who regard with impatience and distrust the whole tendency, which is inherent in all modern equilibrium analysis, to turn economics into a branch of pure logic, a set of self-evident propositions which, like mathematics or geometry, are subject to no other test but internal consistency. But it seems that if only this process is carried far enough it carries its own remedy with it. In distilling from our reasoning about the facts of economic life those parts which are truly a prior;, we not only isolate one element of our reasoning as a sort of Pure Logic of Choice in all its purity, but we also isolate, and emphasise the importance of, another element which has been too much neglected. My criticism of the recent tendencies to make economic theory more and more formal is not that they have gone too far, but that they have not yet been carried far enough to complete the isolation of this branch of logic and to restore to its rightful place the investigation of causal processes, using formal economic theory as a tool in the same way as mathematics…. (Economics and Knowledge F. A. von Hayek Economica, New Series, Vol. 4, No. 13. (Feb., 1937), pp. 33-54.)

I see this as saying that he does not object to rigorous theory, but one of its advantages is that a tight, ceteris paribus theory highlights its own flaws, by making it clear if something importan– information, in this case— is omitted.

He says that:

…price expectations and even the knowledge of current prices are only a very small section of the problem of knowledge as I see it. The wider aspect of the problem of knowledge with which I am concerned is the knowledge of the basic fact of how the different commodities can be obtained and used,l and under what conditions they are actually obtained and used,…

…economics has come nearer than any other social science to an answer to that central question of all I social sciences, how the combination of fragments of now- ledge existing in different minds can bring about results which, if they were to be brought about deliberately, would require a knowledge on the part of the directing mind which no single person can possess. To show that in this sense the spontaneous actions of individuals will under conditions which we can define bring about a distribution of resources which can be understood as if it were made according to a single plan, although nobody has planned it, seems to me indeed an answer to the problem which has sometimes been metaphorically described as that of the ” social mind “.

At one point, though, he does seem to be attacking modelling, and attacking it simplistically:

The device generally adopted for this purpose is the assumption of a perfect market where every event becomes known instantaneously to every member. I t is necessary to remember here that the perfect market which is required to satisfy the assumptions of equilibrium analysis must not be confined to the markets of all the individual commodities ; the whole economic system must be assumed to be one perfect market in which everybody knows everything. The assumption of a perfect market then means nothing less than that all the members of the community, even if they are not supposed to be strictly omniscient, are at least supposed to know automatically all that is relevant for their decisions….

I wonder whether he really means that, since surely he knows that perfect information can be made as a simplifying assumption, not as a substantive assumption. If people’s info is a little imperfect, it does not change the conclusions of the perfectly competitive models to any important degree.

I think Hayek would be quite happy with the direction economics has taken. The economics of knowledge is a huge part of the theory by now– both of the effects of imperfect information, and teh process of information acquisition.

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