Prices, Profits and Planning – the teaching of Hayek. By Murray Sanderson- November 02, 2011

The insights of Frederick Hayek concerning the development of modern human society h a v e c o n t r i b u t e d g r e a t l y t o o u r understanding of the relationship between law, economics and politics.

They are contained in his two major works, 'The Constitution of Liberty' and 'Law, Legislation and Liberty'. But this Nobel Prize winner also wrote for ordinary people. That is how Hayek's best known book, 'The Road to Serfdom', which explained the dangers of socialism, was the one and only abbreviated book ever published by the Readers Digest at the front, instead of the back, of the magazine. Hayek’s study of economic freedom covered many years.
Despite this, it was very straightforward. In his own words, 'In 1936 I suddenly saw, as I prepared my Presidential Address to the London Economic Club, that my previous work in different branches of economics had a common root.' His great insight was that 'the price system was really an instrument that enabled millions of people to adjust their efforts to events, demands and conditions of which they had no direct knowledge, and that the whole coordination of the world economy was due to certain practices and usages which had grown up unconsciously.' 'I gradually found,' he wrote, 'that the basic function of economics was to explain the process of how human activity adapted itself to data about which it had no information.
Thus the whole economic order rested on the fact that, by using prices as a guide or as signals, we were led to serve the demands and enlist the powers and capacities of people of whom we knew nothing. It was because we had relied on a system which we had never understood and which we had never designed that we had been able to produce the wealth to s u s t a i n a n e n o r m o u s increase in the world's population, and to begin to realize our new ambitions of distributing this wealth more justly. ‘This insight, he said, 'has extraordinarily important consequences once its truth has been accepted. Either you must confine yourself to creating an inst i tut ional framework within which the price system will operate as efficiently as possible, or you are driven to upsetting its function. If it is true that prices are signals which enable us to adapt our activities to unknown events and demands, it is obviously nonsense to believe that we can control prices'.Hayek explains in detail how the price system communicates the results of very sophisticated information throughout the
Suppose, for example, that a new use for some resource such as tin has been discovered, or that an existing source of tin has become exhausted. Significantly it does not matter to the trader which of these two causes has occurred. All he needs to know is that he must economise on tin because it now commands a higher price; the change in market conditions has enabled tin producers to obtain more for their product. Some users of tin will no doubt economise, perhaps switching to substitute materials that are now cheaper.
Thus the scarce tin will continue to be employed only where alternatives are unavailable or are more expensive. The new demand for substitutes will prompt their further supply or switching from less profitable employments, which will in turn affect the things which can be substituted for the substitutes, and so on.
The entire market order adjusts to the scarcity or new demand for tin, and acts as one market, even though few people know the original cause of the changes. Users and producers do not need to scan the whole field, or to be aware of the various uses for tin and its substitutes, for this adjustment to occur and for the relevant information to be communicated to all. The prices of these goods are all they need to know in order for a complete adjustment to be made.
The most remarkable fact about prices, Hayek explains, is that in this way they match the purposes of many unknown people by summarizing a great deal of information very simply. Any central planner would need to know all of the various uses and end purposes for tin and its substitutes before he could even begin to work out what switching should occur, but the market provides the adjustments rapidly and without any need to find out all this detailed information. Of the price system Hayek says: 'In abbreviated form, by a kind of symbol, only
the most essential information is passed on, and passed on only to those concerned.' The result of this is that the price system ensures that goods are produced in the most efficient and least costly way possible.What does all this mean for the 'P' words of economics – prices, profits and planning?
To control signals involves distorting them, with harmful results. If the price for a product (cooking oil, for example,) is set below its economic level, demand will be boosted but production discouraged, resulting in a shortage. Conversely, if the price of a service (labour, for example) is set above its economic level, supply will be encouraged but demand reduced, resulting in a surplus, i.e. unemployment.
How about profits, a business objective which has often been denounced as evil? The prospect of high profits encourages entrepreneurs to concentrate on products which are in high demand, whereas losses or low profits encourage moves to improve efficiency or to switch to other products which are in greater demand.
Both actions are economically beneficial. Another major role of profit is to stimulate individuals to discover new and untapped opportunities.
A n d p l a n n i n g ? C e n t r a l p l a n n i n g b y governments is appropriate for national finances and major infrastructure. But otherwise it should be left to businesses to respond to the signals provided by price and profit. In short, the appropriate guides for virtually all economic activity are the signals provided by prices, for which economic freedom is the right environment. Having died in 1991, Hayek was not alive to comment on the current world recession.
We can be sure, however, that he would not have agreed with those who blame it on excessive economic liberty.
He would doubtless have attributed it mainly to the actions of those 'government sponsored enterprises', Freddie Mac and Fannie Mae, which, encouraged by the government, supported the excessive promotion of 'subprime' mortgages.
Murray Sanderson is Executive Secretary of Zambia Institute for Public Policy Analysis. This article is syndicated by
Friedrich Hayek

Friedrich  Hayek's enduring insights