Hayek Explained Why the Smartest Planner in the Room Always Loses

Somewhere on this planet, at a moment you will never know about, a tin mine floods. Or a manufacturer discovers that a cheaper metal works just as well in a gadget, and quietly stops buying tin. Or a new use for tin turns up in a laboratory. You do not hear about it. Nobody calls you. There is no memo.

And yet, within days, the people who use tin start using a little less of it, or a little more, and the people who sell it start looking for new sources. Strangers on four continents change their behaviour, each for reasons of his own, and not one of them has to understand what happened at the mine.

That little story is the heart of one of the most important essays an economist ever wrote, and I would like you to leave this post able to explain it to your brother-in-law. The essay is "The Use of Knowledge in Society," by Friedrich Hayek, published in the American Economic Review in September 1945. The tin example is Hayek's own. It is short, it is plain, and it takes apart the central idea of every central planner who ever lived. Let me show you how.

The question, defined

Hayek begins by asking what the economic problem of society actually is. The textbook answer is that it is a problem of allocation: you have a given set of resources, a given set of wants, and you work out the best use of the first for the second. If that were the problem, Hayek says, it would be a problem of arithmetic, and a sufficiently clever person with a sufficiently complete list could solve it.

But the list does not exist. The knowledge needed to run an economy is never given to anyone in concentrated, integrated form. It exists only as scattered bits of incomplete and often contradictory knowledge possessed by separate individuals. The real problem, Hayek argues, is how to use knowledge that nobody possesses in total.

Two kinds of knowledge matter here, and it helps to keep them straight.

• Scientific knowledge. The laws of physics, the properties of steel, the known techniques of production. It can be written down, taught, and gathered into the files of an expert agency.
• Knowledge of particular circumstances of time and place. Which truck is half empty this afternoon. Which tenant is about to leave. Which machine in the back of the shop is running a little rough. Which supplier is two days late and which is always early. Hayek's argument is that this second kind is enormously valuable, can almost never be reported up a chain of command in usable form, and is held by the people on the spot.

A factory manager who knows that a lathe is sitting idle on Thursday has an advantage over every expert in the capital, and it is an advantage no expert can take from him by asking nicely.

Why the tin story matters

Now go back to the mine. In a market, the news arrives as a price. Tin gets dearer. That is all anyone needs to know. A buyer who could switch to aluminium has a reason to do so, a buyer who cannot has a reason to use it more sparingly, and a prospector somewhere has a reason to look for a new deposit. Hayek's picture is of the price system as a kind of machine for registering change, a telecommunications system in which only the most essential information is passed on, and passed on only to those concerned.

Notice what the price does not do. It does not explain. It does not say why tin is scarce, and it does not need to. The man who economizes does not need to know whether a mine flooded or demand rose. He needs to know that tin has become more costly relative to the alternatives, and that is exactly what the price tells him. Hayek called this a marvel. I will keep it simpler: it is a message that fits on a price tag and reaches everybody who can act on it, and it costs the taxpayer nothing.

A hypothetical to make it concrete

Picture a diner owner in a small Ohio town. This is a hypothetical, but you can find its twin in any town in America. One Monday the wholesale price of eggs jumps. Nobody tells her why. She does not need to know whether it is weather, disease, trucking or a change in demand overseas. She sees the number on the invoice.

What does she do? She might raise the price of the two-egg special by a few cents. She might push the pancake platter on the menu board and quietly drop the omelette. She might switch to a different supplier. Each of those choices ripples outward. Her customers, seeing the new prices, shift a little. Her supplier's competitors, seeing that her old supplier has lost an account, adjust. A farmer three states away is nudged toward expanding his flock.

No agency issued a directive. No committee studied the egg situation. Millions of small, informed choices did, in an afternoon, what no planning bureau could do in a year, because each choice was made by the one person who had the relevant facts.

The planner's problem, in numbered premises

Here is the argument laid out the way I like it. Take the premises one at a time.

1. The knowledge an economy needs is dispersed. It lives in the heads, shops, farms and ledgers of millions of people, and much of it is tacit. The foreman cannot fully explain how he knows the machine is about to fail. He just knows.
2. A planner can collect only a thin, stale summary of it. Statistics are averages. Averages flatten exactly the particular differences that matter. By the time a report reaches the capital and a decision comes back, the circumstances have changed.
3. Prices compress this knowledge and carry it to everyone who needs it. A price reflects the choices of everybody who has bid for the good, and tells the next person how much to economize.
4. Therefore a planned economy has to make decisions without the one signal that carries the knowledge. It can make them, of course, but it will make them blind, and the errors will pile up.

That is the knowledge problem. Notice that it is an objection to planning that has nothing to do with the planners' motives. You can staff the planning ministry with saints and give them the best computers money can buy, and the problem remains. It is about information, not about character.

What actually happened in Moscow

This is not a seminar-room puzzle. The Soviet Union ran the experiment for seventy years. Its central planning agency, Gosplan, was created in 1921 and for decades drew up the targets that the factories and farms were told to hit. The Soviet Union dissolved in December 1991.

Without market prices for capital, land, or most goods, planners had no honest way to tell whether a factory was creating value or destroying it. Targets had to be set in physical quantities, tons of nails, metres of cloth, and managers answered to the target. You can guess the result. A manager told to produce a quota of nails by weight has every reason to make fewer, heavier nails. The target was met. The need was not.

Ludwig von Mises had made the underlying point in 1920, in an essay on economic calculation in the socialist commonwealth: without prices for the means of production there is no rational way to compare the cost of alternatives. Hayek's 1945 contribution was to widen it from calculation to knowledge, from the arithmetic to the people.

I will not tell you the Soviet economy produced nothing. It built tanks, rockets and a great many apartment blocks. The point is narrower and harder to answer: it could not tell, from inside the system, what was worth building.

The strongest rebuttal

Now to the other side, and I want to state it at its best, because it deserves that. Here is what a thoughtful defender of planning says.

"Hayek's argument proves too much. The American government planned production during the Second World War, rationed key goods, and out-produced the Axis. Governments plan roads, water systems and power grids all the time, and nobody thinks that is tyranny. Some goods, like clean air or national defense, are public goods that markets underprovide. And modern computers can gather far more data than any 1945 bureaucrat could dream of. The knowledge problem is a problem of the past."

That is a serious argument. Here is the answer, point by point.

1. Wartime planning had one overriding goal. In the Second World War the nation wanted one thing, victory, and the government could rank everything against it. That clarity is exactly what a peacetime economy lacks. In peacetime there are hundreds of millions of people with hundreds of millions of different goals, and there is no way to rank them from above. Even in wartime, rationing and price controls produced shortages, black markets and queues. The wartime economy leaned on private firms for most of the production and on the price system for much of the civilian economy. It was command in a few sectors, running on top of a market, which is not the same thing as replacing the market.
2. Public goods are a real exception, and Hayek never denied them. Roads, courts, national defense and the rule of law are things the government provides. The knowledge problem does not say government has no role. It says that where a market price exists and carries information, overriding it destroys the information. Deciding to provide a public good is one question. Deciding how many left-handed bolts the economy needs is another.
3. More data is not the same as the relevant knowledge. A computer can count what has been recorded. It cannot capture what has not been recorded, including the preferences people have not yet discovered and the offers that would be made if the price allowed it. And data from a planned system is distorted by the plan: people report what the system rewards. A market produces fresh information because people are acting on their own stake, with their own money.
4. The planning mindset also ignores incentives. Even if the planner had the knowledge, the shop-floor worker would have no reason to use it in the planner's interest. A price is not only a signal. It is a reward for acting on the signal.

That last point is why markets and knowledge go together. The price tells you what to do, and the profit or loss makes you want to do it.

Hayek was not an anarchist

Here is something a surprising number of people on both sides get wrong. Hayek did not oppose every government program, and conservatives who quote him as if he did are making a mistake.

In The Road to Serfdom, published in 1944, a year before the knowledge essay, Hayek wrote that there was no reason why a society as wealthy as ours should not guarantee a basic minimum of food, shelter and clothing to everyone. He saw a floor under the poor as consistent with a free economy, provided it was not run through a scheme that suppresses the price system and the competitive market. His enemy was central direction of the economy, not a modest safety net, and he distinguished between the two. If you want to check it, read the relevant chapter of the book yourself. It will take you an evening.

This matters for how conservatives argue. The case is not "government never helps." The case is "government cannot run the whole economy from the top, and it should be humble about what it can know." Those are different claims, and the second is much easier to defend before a skeptical audience. Hayek also shared the Nobel Prize in economics in 1974, which tells you the profession eventually agreed that he was on to something.

Where this lands for your family

I said I would keep this practical, so here is what the knowledge problem looks like at the kitchen table.

• Be suspicious of the phrase "we need a national plan for..." Housing, groceries, gasoline, health care. Ask who will know, on a Tuesday afternoon in your town, what your town needs. Usually the answer is that you do, and your neighbours do.
• Treat a price as information, not an insult. When a price rises, something changed. If a law forbids the price from rising, the information is destroyed and the shortage shows up some other way: empty shelves, long lines, quality cut in secret. You can read more about that in From Diocletian to Nixon, Every Price Control Ends the Same Way and price gouging laws sound fair and then the shelves go empty.
• Notice who is closest to the facts. Local decisions beat distant ones for the same reason. That is the logic behind Subsidiarity Is the Old Idea Behind Keeping Power as Close to Home as Possible and the case for letting states differ.
• Respect the limits of the idea. Markets are not magic, and I will not pretend otherwise. The honest conservative argument, laid out in Yes, Markets Sometimes Fail, and Governments Fail Right Alongside Them, is that governments fail too, and they fail without the discipline of losing their own money.

If you want a second, lighter version of the same insight, there is a famous parable about a humble wooden pencil that no single person knows how to make. It is told well in I, Pencil and the price system, how nobody plans your breakfast, and it pairs well with Thomas Sowell Asks What Happens After the Policy Passes, which takes the same ideas and asks what happens after a policy passes.

The verdict

So, the question. Can the smartest planner in the room beat the millions of people who actually live in the economy?

No. Not because the planner is stupid, but because the thing he needs to know is not in the room. It is spread across a nation, held in pieces by people who each know only their own corner, and the only mechanism that has ever gathered those pieces without taking them away from the people who hold them is a system of free prices, property and the freedom to act on what you know.

I will say it plainly. The next time somebody tells you that a smart enough committee, armed with a big enough spreadsheet, could run the economy better than the people in it, ask him one question: where is the committee going to get the tin?

The bottom line

• No one person or committee can hold the knowledge an economy runs on. It is scattered, local and constantly changing, and a price is the cheapest way to deliver it.
• A price tells you what to do without telling you why. Law that freezes or forbids prices removes the message, and the shortage appears somewhere else.
• Hayek's case is against central direction, not against all government. He accepted a basic floor under the poor. Argue the narrower claim and you will win more minds.
• When you hear a plan for your town, ask who will know what your town needs. Usually it is you, and the case for local choice is the case for using that knowledge.
• Read the originals. The 1945 essay is only about a dozen pages. Look it up and judge it for yourself.