Economics and Knowledge
by Freidrich Hayek; Presidential address delivered before the London Economic Club;
November 10 1936;
Reprinted from Economica IV (new ser., 1937), 33-54.
THE ambiguity of the title of this paper is not accidental. Its main subject is, of course, the
role which assumptions and propositions about the knowledge possessed by the different
members of society play in economic analysis. But this is by no means unconnected with
the other question which might be discussed under the same title--the question to what
extent formal economic analysis conveys any knowledge about what happens in the real
world. Indeed, my main contention will be that the tautologies, of which formal
equilibrium analysis in economics essentially consists, can be turned into propositions
which tell us anything about causation in the real world only in so far as we are able to fill
those formal propositions with definite statements about how knowledge is acquired and
communicated. In short, I shall contend that the empirical element in economic theory--the
only part which is concerned not merely with implications but with causes and effects and
which leads therefore to conclusions which, at any rate in principle, are capable of
verification -- consists of propositions about the acquisition of knowledge[1] .
Perhaps I should begin by reminding you of the interesting fact that in quite a number of
the more recent attempts made in different fields to push theoretical investigation beyond
the limits of traditional equilibrium analysis, the answer has soon proved to turn on the
assumptions which we make with regard to a point which, if not identical with mine, is at
least part of it, namely, with regard to foresight. I think that the field in which, as one
would expect, the discussion of the assumptions concerning foresight first attracted wider
attention was the theory of risk[2] . The stimulus which was exercised in this connection
by the work of Frank H. Knight may yet prove to have a profound influence far beyond its
special field. Not much later the assumptions to be made concerning foresight proved to
be of fundamental importance for the solution of the puzzles of the theory of imperfect
competition, the questions of duopoly and oligopoly. Since then, it has become more and
more obvious that, in the treatment of the more "dynamic" questions of money and
industrial fluctuations, the assumptions to be made about foresight and "anticipations"
play an equally central role and that in particular the concepts which were taken over into
these fields from pure equilibrium analysis, like those of an equilibrium rate of interest,
could be properly defined only in terms of assumptions concerning foresight. The
situation seems here to be that, before we can explain why people commit mistakes, we
must first explain why they should ever be right.
In general, It seems that we have come to a point where we all realize that the concept of
equilibrium itself can be made definite and clear only in terms of assumptions concerning
foresight, although we may not yet all agree what exactly these essential assumptions are.
This question will occupy me later in this essay. At the moment I am concerned only to
show that at the present juncture, whether we want to define the boundaries of economic
statics or whether we want to go beyond it, we cannot escape the vexed problem of the
exact position which assumptions about foresight are to have in our reasoning. Can this be
merely an accident ?
As I have already suggested, the reason for this seems to me to be that we have to deal
here only with a special aspect of a much wider question which we ought to have faced at
a much earlier stage. Questions essentially similar to those mentioned arise in fact as soon
as we try to apply the system of tautologies--those series of propositions which are
necessarily true because they are merely transformations of the assumptions from which
we start and which constitute the main content of equilibrium analysis--to the situation of
a society consisting of several independent persons. I have long felt that the concept of
equilibrium itself and the methods which we employ in pure analysis have a clear
meaning only when confined to the analysis of the action of a single person and that we
are really passing into a different sphere and silently introducing a new element of
altogether different character when we apply it to the explanation of the interactions of a
number of different individuals.
I am certain that 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 priori, 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 emphasize 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.
But before I can prove my contention that the tautological propositions of pure
equilibrium analysis as such are not directly applicable to the explanation of social
relations, I must first show that the concept of equilibrium has a meaning if applied to the
actions of a single individual and what this meaning is. Against my contention it might be
argued that it is precisely here that the concept of equilibrium is of no significance,
because, if one wanted to apply it, all one could say would be that an isolated person was
always in equilibrium. But this last statement, although a truism, shows nothing but the
way in which the concept of equilibrium is typically misused. What is relevant is not
whether a person as such is or is not in equilibrium but which or his actions stand in
equilibrium relationships to each other. All propositions of equilibrium analysis, such as
the proposition that relative values will correspond to relative costs, or that a person will
equalize the marginal returns of any one factor in its different uses, are propositions about
the relations between actions. Actions of a person can be said to be in equilibrium in so far
as they can be understood as part of one plan. Only if this is the case, only if all these
actions have been decided upon at one and the same moment, and in consideration of the
same set of circumstances, have our statements about their interconnections, which we
deduce from our assumptions about the knowledge and the preferences of the person, any
application. It is important to remember that the so-called "data," from which we set out in
this sort of analysis, are (apart from his tastes) all facts given to the person in question, the
things as they are known to (or believed by) him to exist, and not, strictly speaking,
objective facts. It is only because of this that the propositions we deduce are necessarily a
priori valid and that we preserve the consistency of the argument[3] .
The two main conclusions from these considerations are, first, that, since equilibrium
relations exist between the successive actions of a person only in so far as they are part of
the execution of the same plan, any change in the relevant knowledge of the person, that
is, any change which leads him to alter his plan, disrupts the equilibrium relation between
his actions taken before and those taken after the change in his knowledge. In other words,
the equilibrium relationship comprises only his actions during the period in which his
anticipations prove correct. Second, that, since equilibrium is a relationship between
actions, and since the actions of one person must necessarily take place successively in
time, it is obvious that the passage of time is essential to give the concept of equilibrium
any meaning. This deserves mention, since many economists appear to have been unable
to find a place for time in equilibrium analysis and consequently have suggested that
equilibrium must be conceived as timeless. This seems to me to be a meaningless
statement.
Now, in spite of what I have said before about the doubtful meaning of equilibrium
analysis in this sense if applied to the conditions of a competitive society, I do not, of
course, want to deny that the concept was originally introduced precisely to describe the
idea of some sort of balance between the actions of different individuals. All I have argued
so far is that the sense in which we use the concept of equilibrium to describe the
interdependence of the different actions of one person does not immediately admit of
application to the relations between actions of different people. The question really is what
use we make of it when we speak of equilibrium with reference to a competitive system.
The first answer which would seem to follow from our approach is that equilibrium in this
connection exists if the actions of all members of the society over a period are all
executions of their respective individual plans on which each decided at the beginning of
the period. But, when we inquire further what exactly this implies, it appears that this
answer raises more difficulities than it solves. There is no special difficulty about the
concept of an isolated person (or a group of persons directed by one of them) acting over a
period according to a preconceived plan. In this case, the plan need not satisfy any special
criteria in order that its execution be conceivable. It may, of course, be based on wrong
assumptions concerning the external facts and on this account may have to be changed.
But there will always be a conceivable set of external events which would make it possible
to execute the plan as originally conceived. Individualism and Economic Order The situation
is, however, different with plans determined upon simultaneously but independently by a
number of persons. In the first instance, in order that all these plans can be carried out, it is
necessary for them to be based on the expectation of the same set of external events, since,
if different people were to base their plans on conflicting expectations, no set of external
events could make the execution of all these plans possible. And, second, in a society
based on exchange their plans will to a considerable extent provide for actions which
require corresponding actions on the part of other individuals. This means that the plans
of different individuals must in a special sense be compatible if it is to be even conceivable
that they should be able to carry all of them out[4] . Or, to put the same thing in different
words, since some of the data on which any one person will base his plans will be the
expectation that other people will act in a particular way, it is essential for the
compatibility of the different plans that the plans of the one contain exactly those actions
which form the data for the plans of the other.
In the traditional treatment of equilibrium analysis part of this difficulty is apparently
avoided by the assumption that the data, in the form of demand schedules representing
individual tastes and technical facts, are equally given to all individuals and that their
acting on the same premises will somehow lead to their plans becoming adapted to each
other. That this does not really overcome the difficulty created by the fact that one person's
actions are the other person's data, and that it involves to some degree circular reasoning,
has often been pointed out. What, however, seems so far to have escaped notice is that this
whole procedure involves a confusion of a much more general character, of which the
point just mentioned is merely a special instance, and which is due to an equivocation of
the term "datum." The data which here are supposed to be objective facts and the same for
all people are evidently no longer the same thing as the data which formed the starting-
point for the tautological transformations of the Pure Logic of Choice. There "data" meant
those facts, and only those facts, which were present in the mind of the acting person, and
only this subjective interpretation of the term "datum" made those propositions necessary
truths. "Datum" meant given, known, to the person under consideration. But in the
transition from the analysis of the action of an individual to the analysis of the situation in
a society the concept has undergone an insidious change of meaning.
The confusion about the concept of a datum is at the bottom of so many of our difficulties
in this field that it is necessary to consider it in somewhat more detail. Datum means, of
course, something given, but the question which is left open, and which in the social
sciences is capable of two different answers, is to whom the facts are supposed to be given.
Economists appear subconsciously always to have been somewhat uneasy about this point
and to have reassured themselves against the feeling that they did not quite know to
whom the facts were given by underlining the fact that they were given, even by using
such pleonastic expressions as "given data." But this does not answer the question whether
the facts referred to are supposed to be given to the observing economist or to the persons
whose actions he wants to explain,.and, if to the latter, whether it is assumed that the same
facts are known to all the different persons in the system or whether the "data" for the
different persons may be different.
There seems to be no possible doubt that these two concepts of "data," on the one hand, in
the sense of the objective real facts, as the observing economist is supposed to know them,
and, on the other, in the subjective sense, as things known to the persons whose behavior
we try to explain, are really fundamentally different and ought to be carefully
distinguished. And, as we shall see, the question why the data in the subjective sense of
the term should ever come to correspond to the objective data is one of the main problems
we have to answer.
The usefulness of the distinction becomes immediately apparent when we apply it to the
question of what we can mean by the concept of a society being at any one moment in a
state of equilibrium. There are evidently two senses in which it can be said that the
subjective data, given to the different* persons, and the individual plans, which
necessarily follow from them, are in agreement. We may mean merely that these plans are
mutually compatible and that there is consequently a conceivable set of external events
which will allow all people to carry out their plans and not cause any disappointments. If
this mutual compatibility of intentions were not given, and if in consequence no set of
external events could satisfy all expectations, we could clearly say that this is not a state of
equilibrium. We have a situation where a revision of the plans on the part of at least some
people is inevitable, or, to use a phrase which in the past has had a rather vague meaning,
but which seems to fit this case perfectly, where "endogenous" disturbances are inevitable.
There still remains, however, the other question of whether the individual sets of
subjective data correspond to the objective data and whether, in consequence, the
expectations on which plans were based are borne out by the facts. If correspondence
between data in this sense were required for equilibrium, it would never be *possible to
decide otherwise than retrospectively, at the end of the period for which people have
planned, whether at the beginning the society has been in equilibrium. It seems to be more
in conformity with established usage to say in such a case that the equilibrium, as defined
in the first sense, may be disturbed by an unforeseen development of the (objective) data
and to describe this as an exogenous disturbance. In fact, it seems hardly possible to attach
any definite meaning to the much used concept of a change in the (objective) data unless
we distinguish between external developments in conformity with, and those different
from, what has been expected, and define as a "change" any divergence of the actual from
the expected development, irrespective of whether it means a "change" in some absolute
sense. If, for example, the alternations of the seasons suddenly ceased and the weather
remained constant from a certain day onward, this would certainly represent a change of
data in our sense, that is, a change relative to expectations, although in an absolute sense it
would not represent a change but rather an absence of change. But all this means that we
can speak of a change in data only if equilibrium in the first sense exists, that is, if
expectations coincide. If they conflicted, any development of the external facts might bear
out somebody's expectations and disappoint those of others, and there would be no
possibility of deciding what was a change in the objective data[5] .
For a society, then, we can speak of a state of equilibrium at a point of time--but it means
only that the different plans which the individuals composing it have made for action in
time are mutually compatible. And equilibrium will continue, once it exists, so long as the
external data correspond to the common expectations of all the members of the society.
The continuance of a state of equilibrium in this sense is then not dependent on the
objective data being constant in an absolute sense and is not necessarily confined to a
stationary process. Equilibrium analysis becomes in principle applicable to a progressive
society and to those intertemporal price relationships which have given us so much
trouble in recent times[6] .
These considerations seem to throw considerable light on the relationship between
equilibrium and foresight, which has been somewhat hotly debated in recent times[7] . It
appears that the concept of equilibrium merely means that the foresight of the different
members of the society is in a special sense correct. It must be correct in the sense that
every person's plan is based on the expectation of just those actions of other people which
those other people intend to perform and that all these plans are based on the expectation
of the same set of external facts, so that under certain conditions nobody will have any
reason to change his plans. Correct foresight is then not, as it has sometimes been
understood, a precondition which must exist in order that equilibrium may be arrived at.
It is rather the defining characteristic of a state of equilibrium. Nor need foresight for this
purpose be perfect in the sense that it need extend into the indefinite future or that
everybody must foresee everything correctly. We should rather say that equilibrium will
last so long as t