CAPITALISM

1
The Price System As A Mechanism For Using
Knowledge

• Friedrick Hayek, AER, 1945
• What is the problem we wish to solve when we try
  to construct a rational economic order? On
  certain familiar assumptions the answer is simple
  enough. If we possess all the relevant
  information, if we start out from a given system
  of preferences, and if we command complete
  knowledge of available means, the problem is
  purely one of logic. That is, the answer to the
  question of what is the best use of available
  means is implicit in our assumptions.

2

• The conditions which the solution of this
  optimization problem must satisfy have been
  fully worked out and can be stated best in
  mathematical form put at their briefest, they
  are that the marginal rates of substitution
  between any two commodities or factors must be
  the same in all their different uses.
• By rational economic order Hayek means Pareto
  efficient
• Marginal rate of substitution is a technical
  condition that must hold for an efficient state
  of the world

3
Back To Hayek

• So if we possess all the relevant information,
  if we start out from a given system of
  preferences, and if we command complete knowledge
  of available means, then all we have to do is
  make sure that everyone is consuming where his or
  her marginal rate of substitution between any two
  goods is the same as everyone elses
• But...

4

• This ... is emphatically not the economic
  problem which society faces. And the economic
  calculus which we have developed to solve this
  logical problem, though an important first step
  ..., does not yet provide an answer to it. The
  reason for this is that the data from which the
  economic calculus starts are never for the whole
  society given to a single mind, and can never be
  so given.

5
What Does Hayek Mean?

• Pareto efficiency/equality of MRS is merely a
  state of being
• Is there an institutional arrangement, an
  economic framework, which would bring about a
  state of efficiency?
• If perfect information holds, then a central
  planner, using his or her perfect knowledge,
  could simply organize production and consumption
  so as to achieve efficiency
• But perfect information does not exist

6
Capitalism Uses Available Information To Reach
Efficiency

• The market-based capitalist system (when it works
  right) does not require perfect information
• All any one person needs to know is information
  about his or her own preferences and
  circumstances
• Price signals provide the rest

7
Final Comments on Hayek

• Similar mechanisms occur on the production side
• intuition simple say you are a producer who uses
  tin as an input. Something happens to tin
  production making it more scarce. Tin users must
  somehow be induced to use less tin. Markets
  automatically respond to the greater scarcity by
  making tin prices go up. How will tin users
  respond?
• No such mechanism exists under planned socialism
• someone would have to tell tin users to cut back

8

• The conclusion is that there is a mechanism in
  capitalism that automatically brings about an
  efficient outcome
• at least under ideal conditions
• There is no such mechanism in planned socialism
• Thus, we conclude that capitalism is, in
  principle, a more efficient system