ighty years ago, one of the most important contributions to economic theory and policy appeared as the lead article in the September 1945 issue of the American Economic Review, under the title, “The Use of Knowledge in Society.” Its author, Friedrich A. Hayek, had been one of the most well-known economists in the 1930s and 1940s as an opponent of socialism and a critic of the new Keynesian economics.I am convinced that if it [the price system] were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind.
[Click to Tweet]
The year before, in 1944, he had published The Road to Serfdom, which became a best seller in both Great Britain and the United States. He challenged the popular assumption that a fairly comprehensive system of socialist central planning was compatible with a wide degree of personal freedom and civil liberty. Once the government had the responsibility and authority to plan the economic affairs of a nation, nothing was outside of the decision-making of those in political power, whether they were democratically elected or not.
Why socialism can lead to tyranny
The very notion of a central plan for all of society meant that the millions of individual plans of the citizens of the country had to be subordinated to the overarching society-wide plan. The government would have to decide what got produced and in what quantities, varieties, and qualities. The government would have to be responsible for determining the allocation of all that centrally planned output in terms of how much would be supplied and distributed to the citizenry.
Everyone’s civil liberties would be threatened, since the government would be the monopoly provider of entertainment and information. The government would determine to whom paper and print would be provided for the publishing of books, magazines, and newspapers.
Even under “democratic,” as opposed to totalitarian, socialism, once the plan had been decided upon and was being implemented, would the political authorities be indifferent to those arguing for dismantlement of the plan or radically changing it in some way? Would not the central planners be more likely to foster only information and opinions concerning socialism in general, and the plan in particular, that would be in tune with premises of central planning? However well-intentioned may be many of those who advocate and implement socialist planning, the success of the plan would inevitably lead to a ruthless determination to reduce and even eliminate all criticisms and resistance to its fulfillment.
The thrust of Hayek’s argument in The Road to Serfdom, therefore, was that if freedom and prosperity were to be achieved, it was necessary to rely instead upon the liberal social institutions of private property, individual liberty, decentralized decision-making, and the competitive market economy. Along with this, there was a need for a limited government under an impartial rule of law, with the political and the coercive powers kept to the minimum necessary to preserve a peaceful social order conducive to the market incentives that fostered savings, investment, innovation, and production guided by consumer demand.
Socialist planning and economic calculation
But there was another question that, while not ignored in The Road to Serfdom, was not its center of analysis: Can a centrally planned economy effectively produce and supply goods and services wanted by consumers better than a market economy guided by self-interest and the profit motive? The first one to effectively challenge the workability of socialist central planning was the Austrian economist Ludwig von Mises (1881–1973). In the aftermath of the Russian Revolution and the end of the First World War, socialists in Europe were certain that the time had come for the overthrow of the capitalist system with its social injustice and exploitation of “the workers.” Socialism and central planning were considered to be on the horizon.
In this heated political environment, particularly in Germany and Austria, Mises penned his famous essay “Economic Calculation in the Socialist Commonwealth” (1920), which he expanded into a full and comprehensive critique of all its aspects in his 1922 book Socialism. The heart of Mises’s analysis was that a socialist planned economy would be inherently unworkable as an alternative to a functioning market economy. Socialism would do away with all the social institutions that had produced an extended system of division of labor, which had successfully facilitated a wide latitude of personal freedom of choice in consumption and production, while bringing about a coordination of supplies and demands that enabled economic efficiency and rising standards of living.
Key to the market economy was a competitively established price system for consumer goods and the means of production (land, resources, capital, and labor services). On the one hand, in the market economy, consumers are able to express what goods they desire to buy and the value they place on them in the form of the prices they might pay to purchase them. On the other hand, with private ownership of the means of production, entrepreneurs and private enterprisers are able to express their judgments about the value of those factors of production in the form of the prices they might pay to buy, rent, or hire them in competing lines of production.
The resulting market prices for consumer goods and the means of production enable the essential process of economic calculation, that is, the determination of profit and loss, and which among the possible ways of producing various goods that consumers want would be the least costly way of doing so given their value in alternative employments of resources. Socialism, by abolishing private ownership over the means of production, would eliminate the only viable and effective way of determining the most economically rational ways of using the scarce means at people’s disposal to achieve the ends for which those means can be applied.
Socialism-in-practice would end in failure
Or as Mises expressed it in 1931:
Inasmuch as money prices of the means of production can be determined only in a social order in which they are privately owned, the proof of the impracticability of socialism necessarily follows. From the standpoint of both politics and history, this proof [of the “impossibility” of socialist planning] is certainly the most important discovery by economic theory. Its practical significance can scarcely be overestimated…. It alone will enable future historians to understand how it came about that the victory of the socialist movement did not lead to the creation of the socialist order of society.
The reason was simple, as Mises had said a few years earlier in his book Liberalism (1927): socialist planning does away with “the intellectual division of labor that consists in the cooperation of all entrepreneurs, landowners, and workers as producers and consumers in the formation of market prices. But without it, rationality, i.e., the possibility of economic calculation, is unthinkable.” Only in the market economy was a decentralized use of all the knowledge in society possible for an effective formation of the price system, without which socialism-in-practice becomes “planned chaos.”
Mises’s critique of socialist central planning resulted in a storm of controversy among economists, first in the German-speaking world and then in Great Britain and the United States. The socialist dreams of a capitalist-free world seemed to be shattered. They twisted and turned, trying to “refute” Mises’s argument about the impossibly of economic calculation under socialism without a price system.
Central planning and market socialism
But in the 1930s, a series of articles and books began to appear that made the claim that socialism with a price system was not only “possible” but could bring about all the benefits of rational planning without the baggage of all the social injustice and exploitation inherent in the capitalist system. Oskar Lange (1904–1965), a Polish economist who came to the United States in 1937 and became a professor of economics at the University of Chicago in 1938, was the most well-known of such socialists. In a two-part article published in 1936–1937, “On the Economic Theory of Socialism” in The Review of Economic Studies, Lange argued for a system of “market socialism.”
With satirical irony, Lange began his article by thanking Mises for bringing the problem of economic calculation to the attention of socialist economists, and said: “Both as an expression of recognition for the great service rendered by him and as a memento of the prime importance of sound economic accounting, a statue of Professor Mises ought to occupy an honorable place in the great hall of the Ministry of Socialization or of the Central Planning Board of the socialist state.”
(It may be noted that Lange became a stooge of Stalin, renouncing his acquired American citizenship, serving as communist Poland’s first postwar ambassador to the United States, was active in the central planning discussions in Poland, and rhetorically groveled with effusive hero-worshipping praise for Stalin in some of his published papers on economic planning up to the Soviet tyrant’s death in 1953.)
Lange applied the microeconomic theory of “perfect competition” to argue that rational economic planning and resource use could be applied in a socialist state with the same efficacy as in a private market economy. All that was needed was knowledge of the preferences of consumers for various finished goods and services; knowledge of the available quantities of factors of production (land, labor, resources, capital) and their technological possibilities; and the “terms-of-trade” at which they might be acquired in exchange for each other.
He asserted that knowledge of consumer preferences and production input availabilities could be known by socialist planners as easily as it was presumed to be known by private enterprisers in a market economy. Statistical collection of all such “data” was readily obtained, Lange stated. In the model of perfect competition, it was assumed that each demander and supplier in each market was too small as a buyer or seller to individually influence the market prices for all they bought and sold. They took the prices found on the market as “given” and simply decided what quantities to acquire as consumers and what products seemed to be profitable, or not, as producers, along with which combination of inputs would minimize their costs in producing any chosen product.
In markets, if supplies and demands were not balanced (in “equilibrium”), with either a surplus or a shortage, then market prices are simply adjusted in the appropriate direction — either a lower price to eliminate a surplus or a higher price to overcome a shortage — to restore or establish balance in and between markets. It was simply all a mathematical exercise of “solving” a series of supply and demand equations.
Instead of private owners of the means of production, the nationalized enterprises would be overseen by state-appointed managers. The central planning agencies would initially set the prices at which finished goods might be bought or sold and the resource prices at which the managers of the state-owned enterprises could purchase or hire factors of production, including labor. The managers would be directed to choose the combinations of labor, capital, and other resources that would minimize their respective costs of production relative to the set output price for the consumer good being manufactured.
Periodic inventories of available consumer goods and input supplies would indicate if there was a surplus or a shortage. The planning agencies would then simply adjust all the prices in the required directions (higher or lower) to bring everything into balance. Since these were state-owned enterprises, there were no longer private entrepreneurs and businessmen deciding what new investments of capital were to be undertaken for future outputs. Instead, in the name of the “social good,” the central planners would determine the ultimate future directions of economic growth and development rather than any self-interested private profit motive.
Hayek’s criticisms of market socialism
Mises did not directly offer his own reply to the arguments made by Oskar Lange and other market socialists until the publication of his major treatise Human Action in 1949. Instead, the most significant response was offered by Friedrich Hayek in his article “Economic Calculation: The Competitive ‘Solution’,” (Economica, May 1940). Hayek pointed out:
It seems then that … the criticisms of the earlier socialist schemes have been so successful that the defenders, with few exceptions, have felt compelled to appropriate the argument of their critics, and have been forced to construct entirely new schemes of which nobody thought before….
[Lange and others] rely to some extent on the competitive mechanism for the determination of relative prices. But they … refuse to let prices be determined directly in the market and propose instead a system of price-fixing by a central authority, where the state of the market of a particular commodity, i.e., the relation of demand to supply, merely serves as an indication to the authority whether the prescribed prices ought to be raised or lowered.
It is clear, in retrospect, that it was the socialist calculation debate, especially these types of proposals for a form of market socialism, that made both Mises and Hayek aware of how different the “Austrian” perspective on the market process was from the emerging “mainstream” or neoclassical microeconomic approach as reflected in the perfect competition model of the market economy. Indeed, Hayek’s critique of Lange’s proposal is really a criticism of much of what the perfect competition model presumed.
When Lange said that all the necessary knowledge about consumer preferences, resource availabilities, and technological potentials are as readily knowable to a socialist planner as to private enterprisers under capitalism, Hayek asked to whom and how is all this “data” given? Parts of all this knowledge are known to different people doing different things at different times in different places for different purposes. It is not easily collectable in a simple statistical and quantitative form so that the planners can know all of the nuanced circumstances in a changing social environment and simply and periodically move prices up and down accordingly so that all the other members of society will passively adapt and adjust their behavior to ensure centrally planned economic equilibrium.
Furthermore, precisely because the central planners cannot know all that is going on and changing in different corners of the economy, they are dependent upon periodic accounting of the inventory of goods and resources and the imbalance between supply and demand, on the basis of which the planning authorities make their respective price adjustments, to which all other market participants react and then modify what they are doing.
But this requirement shows how much less effective and less efficient such a system of market socialism would be precisely because the needed price adjustments cannot be known and instituted until the planners acquire the necessary “data.” On the other hand, in the private, competitive free market, individuals in their respective corners of the market can decide how best to adapt and quickly modify what they are doing, while Lange’s market socialist system would always be lagging behind any new and changing circumstances.
Furthermore, precisely because private ownership over and use of the means of production would have been abolished, no longer would it be profit-pursuing entrepreneurs directing existing and newly formed capital into different and changed directions based on their estimate of future consumer demands. Instead, it would be the values and preferences of the central planners that would determine how the economy was to develop and in what forms.
The division and pursuit of knowledge in society
Hayek’s mulling over these matters culminated in his 1945 article on “The Use of Knowledge in Society.” He said that if all the relevant knowledge needed to ensure a fully efficient coordination of all production and consumption activities were available to a single mind or groups of minds, the problem of rational economic planning would be little more than a logical and mathematical exercise to determine the necessary and continuous general equilibrium conditions within and across all markets for consumer goods and the cost-effective use of the means of production. However, this knowledge is not and cannot be centralized in the way it was often presumed possible in discussions over the possibilities for socialist central planning. Said Hayek:
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 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…. 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 those individuals know. Or do put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality.
Part of the confusion, Hayek suggested, is what people often mean when they refer to “knowledge” in society. Too often, the knowledge thought of was what might be called “scientific knowledge,” the type that can be learned and shared, in principle, by anyone and everyone through study and communication. For example, the knowledge discoverable through a study of physics or chemistry or biology, or in engineering, or in law or medicine. While there is practical learning in all these fields, the core of such knowledge is all collectable and shareable through textbook access and learning.
Hayek highlighted that, of course, all such knowledge was crucial to much that goes on in society. It is part of the division of knowledge that complements the division of labor in society. If one needs the assistance of a lawyer or a brain surgeon, it is useful if they have acquired all the relevant textbook and practical knowledge to properly provide their specialized services. This is no less true with hiring an engineer to plan the building of a bridge or a chemist to prepare a medicinal compound.
But Hayek’s point was that this is not the only or necessarily the most relevant knowledge in much that goes on every day in changing circumstances to ensure effective and efficient adaptation and adjustment to the ever-changing circumstances of economic life.
Equally, if not more, important, Hayek said, was the localized knowledge of time and space. This is the knowledge that a person learns and knows about only in the everyday circumstances of the corners of society in which he lives and works. I have often told my students to imagine that they have graduated with their degree and are now on the first day of their entry-level job. They are handed a document and told to make “x” number of copies for a senior staff meeting in two hours. But where is the photocopying machine, in which room in the office? What if they find it, but when they put the originals in the machine and push the start button, nothing happens? Suppose that another employee sees their difficulty and says the machine has a short somewhere inside, and a repairman is coming to fix it tomorrow. But if you kick the machine in the right place on the side, the contact is made and the copies will be made.
In what textbook would you ever have learned that in this particular business, on this particular day, the photocopy machine would not be working but could still be made to function until the next day, when the repairman will either fix the problem or replace the machine? But everyday life is made up of such seemingly trivial and mundane matters.
Consider another example: You are in a management role in the firm. An employee calls in sick and won’t be back to work for at least two or three days. Who do you substitute him with to do his job while he is out sick? Who knows enough about his job in sufficient detail to cover for him until he returns? And who helps cover for the person who is covering for the individual who is ill? After all, just because an employee is out sick does not change the fact that production has to continue, orders have to be fulfilled, and customers must be kept satisfied so as not to lose their business.
As the businessman or entrepreneur, you need to know what it is that consumers want, how their tastes and preferences may or may not have changed in terms of the qualities and characteristics they are looking for in a particular good, or in the price they may be willing to pay, or in the quantity they might purchase at some price. It is necessary to judge how potential customers might respond to a new or significantly improved commodity. It is equally essential to anticipate how rivals for consumer business will react to your product and pricing changes and what they might be planning to initiate to enhance their own market position relative to yours.
In addition, a good part of this routine, localized knowledge of time and place includes skills and abilities, the full content of which is not easily articulated in either the written or spoken form to explain to others. For instance, your car is experiencing some engine problem. You take it to the mechanic; he listens to the engine and tells you to come back in a couple of hours and it will be running like new. If asked to explain how he knows what the problem is just from listening to the engine, he tells you that he has been working on this type of car for years and just knows what is the problem. What is more important? That he can precisely explain the problem or that he has your car back on the road running like new?
There are forms of inarticulable knowledge that are essential everyday for doing things and solving problems that are either used by those who possess these types of knowledge or are ineffectively used or even lost because they can never fully be expressed in forms transmittable to central planners to know what can be done, by whom, and how.
All these types of knowledge and experiences of changing circumstances are known and discoverable only by all those in their respective roles and corners of the social system of division of labor in pursuit of positive market opportunities and profit. Much of it depends upon judgments and interpretations of existing and changing situations that cannot be easily reduced to “objective” measurements or completely articulable explanations of how and why the market is changing, which is what the individual actor does in his particular place in the marketplace. Furthermore, great and small changes, potentially occur all the time, to which the individual actor must adapt as immediately and appropriately as possible.
The market price system and economic coordination
Hayek’s argument was that trying to pass along all such information and knowledge to central planning authorities and wait for them to digest and decide what the responses should be would reach the low-level planners too late and too incompletely to ensure the continuous and necessary coordination of all the market supplies and demands that would be needed.
That, Hayek said, was the benefit and usefulness of the market price system. It is not necessary for all the market participants to either know each other in what is now a global, interdependent system of division of labor, or the particular reasons and purposes behind any individual’s desire for any particular good or service. Nor is it necessary for everyone to possess the knowledge of how and why other individuals want to hire or purchase and use specific resources, types of labor, or forms of capital equipment on the supply side of the market.
All the essential and minimal information needed for individuals to attempt to effectively and successfully adapt and coordinate all they are trying to do with the actions of others in the marketplace is made possible through the competitively established price system. It is sufficient, Hayek reasoned, for people to express their demands and their estimated opportunity costs through the prices at which they are willing to buy something and the prices at which they are willing to produce and supply something. Every change in any input or output price sends out a signal to the market as a whole about a change in the actions of someone, somewhere, to which the relevant individuals in other parts of the market need to adapt and respond to in their own actions.
This reinforced the importance of individual and market freedom so that everyone may be at liberty to use their knowledge, which they possess and know about in ways others never can, so that others might benefit from what they know and how best to use it in as timely a fashion as possible. Thus, the cumulative “knowledge of the world” is placed at the disposal and use of everyone, rather than be limited to and dependent on what a handful of central planners can ever know and effectively utilize during any given period of time. Or as Hayek expressed it:
We must look at the price system as such a mechanism for communicating information if we want to understand its real function…. The most significant fact about this system 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….
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; that is they move in the right direction.
I am convinced that if it [the price system] were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind.
Artificial intelligence not a substitute for the human mind
Today, some suggest that Hayek’s arguments are no longer as compelling, given the development and application of “big data” and artificial intelligence (AI). Surely, it is asserted, with the ability to rapidly collect and utilize almost any amount of measurable information with modern computer science, and the capacity of (AI) to digest, integrate, analyze, and interpret all this vast knowledge with a speed beyond any individual or group mind’s capability, a solution has been found to Hayek’s “knowledge problem.”
But if thought through a bit more deeply, AI does not offer the technique to make socialist planning possible. However fast the computational and informational ability of AI, it still lags behind several inescapable human elements upon which AI is dependent. First, any knowledge shared with AI first has to be known by someone who has experienced a discovery of some new circumstance in the market, no matter how profound or seemingly inconsequential, before it can be shared with AI. Hence, AI still lags behind the human discovery of new circumstances.
Even if this lag is not considered of any great significance in terms of AI’s rapid ability to absorb the human-discovered changes of everyday life, there would remain the immeasurable and nonquantifiable aspects to the changing discovery, interpretation, and imagined uses of new knowledge. Thus, AI can never have the same subtle and qualitative dimension to the use of knowledge in society that remains uniquely “human.” And no computer “brain” can know or anticipate the new and original thoughts and ideas that can come only from the human mind and from which all real change emerges. Any supposed new “ideas” AI might come up with from the information in its data banks would be the computer’s supposed “ideas.” These would always be different from those that come from all the billions of human minds in all the corners of the world.
So Hayek’s knowledge problem would remain: People’s freedom to use their own minds in their own ways as they discover and interpret their knowledge of the market versus the central planner’s AI computer “brain” preempting and commanding people instead?
This article was originally published in the September 2025 issue of Future of Freedom.
