Hayek: The coordination problem, prices and information
Phuah Eng Chye (10 October 2020)
“The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate given resources – if given is taken to mean given to a single mind which deliberately solves the problem set by these data. It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality…This is not a dispute about whether planning is to be done or not. It is a dispute as to whether planning is to be done centrally, by one authority for the whole economic system, or is to be divided among many individuals”. Friedrich A. Hayek (1945) “The use of knowledge in society”.
“Hayek argued that the central question of economics is the coordination problem: How does the spontaneous interaction of many purposeful individuals, each having dispersed bits of subjective knowledge, generate an order in which the actors’ subjective data are coordinated in a way that enables them to successfully dovetail their plans and activities?”. Peter J. Boettke and Kyle W. O’Donnell notes this suggest the price system acts as a mechanism for communicating information and is crucial in a world of dispersed, imperfect knowledge for ensuring the best use of resources. “The most important characteristic of the price system, Hayek argued, is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action”.
In this context, “market competition plays a crucial role in Hayek’s economic thought as a coordination mechanism that reconciles people’s different goals and knowledge, allowing the fullest practicable utilization of the dispersed knowledge in society – and thus guiding individuals to dovetail their plans and actions with those of others, to adjust them when they are incompatible with others, and to discover and correct errors in the market order”. Hence, as Hayek explains, competition is essentially a process of the formation of opinion: By spreading information, it creates that unity and coherence of the economic system which we presuppose when we think of it as one market. “What the Hayekian framework ultimately attempts to offer, then, is a theory in which social-economic order emerges from exchange processes operating between individuals who are fundamentally incapable of ever coming to complete agreement. It would be difficult to overstate the significance of this effort, since it suggests that social order emerges directly from the differences in knowledge, perspectives, and interpretations of individuals, not in spite of them”.
The coordination problem: Role of prices and information
Hayek’s thesis on economic coordination is widely accepted; even by regimes that used to practice central planning. But advances in information capabilities have clearly affected the role of prices in facilitating coordination. In this regard, there is a need to examine the changing context arising from the transition from an industrial to an information society.
In the 1950s and 1960s, information systems were primitive in a largely physical environment. Central planning failed because data was manually captured and unreliable. The system was driven by political decisions and gamed by bureaucrats. Coordination broke down because the system was production-driven and generally unresponsive to demand. In a rudimentary information system of an industrial society, prices are superior to central planning in facilitating coordination.
But information systems have evolved. The role of prices has altered as the environment transits from physical scarcity to information abundance. When information is scarce, transactions and resource allocation are dependent on prices to convey information. When information is abundant, price becomes one among many variables to consider.
In the information society, the real-time speed of coordination blurs the distinctions between central planning and spontaneous markets. Resource allocation and coordination is data- and demand-driven. Autonomous exchange takes place on distributed networks supported by machine data, AI and a knowledge ecosystem of standards, disclosures, rules and dispute mechanisms. Human administrators are relegated to support, oversight and strategic roles. The availability of detailed information and transaction speed assists in overcoming information asymmetry and facilitating transactions among strangers.
Jason Smith thinks Friedrich Hayek was “writing in a time before information theory”. “Information theory lets us re-think the price mechanism’s relationship with information” where “prices represent information about the differences (or changes) in the distributions. And differences in distributions mean differences in information”. An example is to picture “a functioning market as an algorithm matching distributions by raising and lowering a price until it reaches a stable price”. This gives rise to “an argument for why planned economies will likely fail, but the same argument implies we cannot check the optimality of the market allocation of resources, therefore claims of markets as optimal are entirely faith-based”.
It has also proven difficult to formally quantify Hayek’s precepts. Peter J. Boettke and Kyle W. O’Donnell note “mainstream economists constructed a formal, mathematical apparatus that attempted to grapple with Hayek’s ideas about knowledge in economics (or rather, their interpretations of these ideas) in a rigorous manner”. One major stumbling block is that “equilibrium analysis is incapable of explaining how coordination is achieved, or of shedding light upon the necessary conditions and processes for there to arise a tendency towards equilibrium, since it begins with the assumption that the problem has already been solved through the pre-reconciliation of knowledge”. In addition, “in the Grossman-Stiglitz framework…the market can never reach equilibrium in a world of costly information where the price system perfectly summarizes private information…the notion that the price system is an efficient mechanism for communicating dispersed, private information is false. In turn, it is questionable if the competitive market system is informationally decentralized and economically efficient and even whether it outperforms central planning”.
Economic coordination can also be analysed from a machine perspective. Chris Berg, Sinclair Davidson, Jason Potts and Bill Tulloh point out “machines suffer from knowledge problems too. For example, blockchains and other distributed ledger technologies can be used to “coordinate and govern decentralised human economies (as governments, firms and markets do) but they can coordinate and govern decentralised machine economies (or human-machine economies). This extends what Hayek called catallaxy – the spontaneous order of the market - from the market coordination of human action to the coordination of human-to-machine and machine-to-machine economies”.
Chris Berg, Sinclair Davidson, Jason Potts and Bill Tulloh highlights nanoeconomics as “the study of an economy of software agents, using market institutions and property rights to order computation and bid for computational resources. It is the study of choices and market exchange that occur between computational objects in object-oriented software architectures, and which are economically coordinated through blockchain infrastructure”. Nanoeconomics “is the economics of distributed ledgers and artificial intelligence, of object-capability programming and cybersecurity, of central planning in the machine, and of markets in the machine”.
The role of prices in allocating resources is also affected by information-driven financialisation. Price signals are distorted by an abundance (as opposed to scarcity) of savings in a financialised economy. Abundance creates excess liquidity. Price signals reflects expectations on asset returns, ownership and risks; and financial conditions over-ride demand-supply fundamentals in determining resource allocations. This results in substantial price deviation from demand-supply “equilibrium” for long periods of times and increases financial instability risks. This results in an expansion in financial market regulation with the focus shifting from maintaining orderly prices and markets towards the regulation of information (disclosure) and risks.
It should be recognised the traditional perspective on prices is narrow and imputes an ideological belief that output and profits are all that matters. Expanding the amount of information allows us to broaden the range of objectives. In the example of ride-sharing, commercial operators set objectives to maximise ridership revenues and firm profits. But with greater information, prices could be tweaked to achieve alternative targets such as minimising traffic congestion, improving drivers’ incomes or public safety. Likewise, in a financialised economy, the profit (or asset price returns) motive can be tempered by policies that seek to mitigate widening inequalities.
In the 1950s and 1960s, the coordination problem revolved around knowledge and output. In the information society, knowledge is easily accessible and output is abundant; they no longer represent formidable barriers to coordination. The bigger threat to coordination stems from the features of the information society. Information societies are complex and vulnerable to information and regulatory overload. At the same time, it is polarised, inequitable and fractious. The fractious divide leads to disputes and litigation which can hold up coordination and progress.
The coordination problem of the information society thus differs from that of the industrial economy. Prices are important but are no longer the only variable. Output and profits are important but are no longer the only objectives. Hence, the coordination problem needs to be reframed for the lifting of information constraints. In the information society, economies that don’t use or respond to data will suffer from coordination problems and will be unable to achieve the necessary vibrancy and scale to drive their economic growth.
Chris Berg, Sinclair Davidson, Jason Potts, Bill Tulloh (30 December 2018) “The use of knowledge in computers: Introducing nanoeconomics”. Medium. https://medium.com/@cryptoeconomics/the-use-of-knowledge-in-computers-introducing-nanoeconomics-2a1b7ef5061b
Jason Smith (18 May 2017) “Hayek meets information theory. And fails”. Evonomics. http://evonomics.com/hayek-meets-information-theory-fails/
Friedrich A. Hayek (1944) The road to serfdom. The collected works of Hayek. Volume II. The University of Chicago Press. https://fee.org/resources/the-road-to-serfdom-condensed-edition/?itm_source=parsely-api
Friedrich A. Hayek (1945) “The use of knowledge in society”. The American Economic Review. https://fee.org/articles/the-use-of-knowledge-in-society/
Peter J. Boettke, Kyle W. O’Donnell (18 October 2017) “The failed appropriation of F. A. Hayek by formalist economics”. GMU Working Paper in Economics. SSRN. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2336805&rec=1&srcabs=2503530&alg=1&pos=1
Phuah Eng Chye (2015) Policy paradigms for the anorexic and financialised economy: Managing the transition to an information society.
Phuah Eng Chye (18 July 2020) “Economics of data (Part 1: What is data?)”.
Phuah Eng Chye (1 August 2020) “Economics of data (Part 2: Market approach to valuing data)”. http://economicsofinformationsociety.com/economics-of-data-part-2-market-approach-to-valuing-data/
Phuah Eng Chye (15 August 2020) “Economics of data (Part 3: Relationship between data and value and the monetisation framework)”.
Phuah Eng Chye (29 August 2020) “Economics of data (Part 4: The data economy)”.
Phuah Eng Chye (12 September 2020) “Economics of data (Part 5: Tax policies)”.
Phuah Eng Chye (26 September 2020) “Economics of data (Part 6: Data and poverty eradication)”. http://economicsofinformationsociety.com/economics-of-data-part-6-data-and-poverty-eradication/
 Claude Shannon published his theory in 1948
 See Policy paradigms for the anorexic and financialised economy: Managing the transition to an information society.