Sunday, March 27, 2011

The Austrian Theory of Prices

Most Austrians consider Tomas Sowell's Knowledge and Decisions book an excellent statement of the Austrian (Hayekian) theory of prices and knowledge. In fact, Kirzner spoke of this book as "the most extensive and wide-ranging development of the implications of the Hayekian insights." In this book, Sowell described prices as "knowledge surrogates," because "nobody needs to know the whole story in order for the economy to convey the relevant information through prices and secure the same adjustments as if everyone had known." The Austrians have seized on this idea of prices as "knowledge surrogates" or summaries of information, and have used this to re-interpret the market process as a system that responds to conditions of disequilibrium by attempting to realize profit.

This recapitulation of the Austrian theory of prices will strike many readers as familiar and old-hat. But this theory was subtly, yet savagely, attacked by a great scholar who wrote a book in 1992 that tried to rescue the Austrian theory of the market process from this misleading interpretation of prices and knowledge. I am referring, of course, to Esteban Thomsen's Prices and Knowledge, a short book that accomplishes many great things. I will limit this post to Thomsen's critique of Sowell's account of the Austrian theory of the market process because I think it is important in view of how this interpretation has captured the minds of nearly every working Austrian.

The author is quite clear that it is wrong to interpret prices as summaries or "surrogates" of knowledge and information. He does this by distinguishing between the "discovery" of knowledge and its subsequent summarization. The Austrians, according to Mr. Thomsen, are making a mistake by eliding the discovery role in their emphasis on the role prices play in conserving information. The author makes this point clearly when he writes,

"Kirzner's emphasis is more on the discovery of knowledge than on its summarization or its transmission. ... The difference appears to stem from the dissimilar views held of ignorance and discovery, and from the difference between interpreting prices as only 'information-saving' devices and interpreting them as part of an entrepreneurial discovery procedure."

The author proceeds in the next chapter to a discussion of Herbert Simon's concept of bounded rationality. The author finds common ground between Herbert Simon's account of "satificing" and the Austrian theory of prices as "knowledge surrogates." In Simon's model, for example, prices work for individuals because they are a simplifying device in a complex world. Individuals, according to Simon, can infer market conditions from prices without having to know all the details of every event. But this is exactly what Austrians have been arguing! The author concludes by stressing the "discovery" role of prices, and not its "information-saving" role.

This is an important distinction because the author correctly points out that reliance on the "information-saving" role of prices defeats the purpose the market process. Thus Mr. Thomsen writes,

"This enables him [Simon] to imply that with the aid of computers man gets (even if only slightly) closer to (neoclassical) optimizing and that he may achieve objective rationality in 'simple problem situations,' in which case the neoclassical agent may be appropriate. In the market-process approach, on the other hand, facts, even if they were few and simple [and thus no longer need to be 'summarized'], have to be noticed, discovered, by alert, active agents."

I think this interpretation is very good. Austrians should be mindful of the implications of their analysis. By arguing that prices are "knowledge surrogates," other economists are likely to respond by arguing that advances in technology can aid the market in translating prices into "knowledge surrogates." In other words, if all prices do is "save" on the information individuals need to know in their decision-making, then the market should be arranged in a way that maximizes this "knowledge surrogate" function. However, this attention to prices as "knowledge surrogates," in Mr. Thomsen's view, ignores the more entrepreneurial role of "discovery."

Now if Austrians do not see this as a problem worth correcting, it is at least one that deserves further clarification. I also understand this to be one of the more important themes in Mr. Thomsen's book, so I would encourage every student to give this book a close and careful reading.

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