On Economic Planning

In what follows I will argue that economic planning should be decentralized. I will do so by arguing that efficient economic planning requires “the knowledge of the particular circumstances of time and place” (Hayek, The Use of Knowledge in Society), that this knowledge is dispersed among all the economic participants in the society, and that it cannot be accurately communicated through statistical aggregates. If the required knowledge for efficient economic planning is dispersed among all economic participants in the society and cannot be accurately communicated through statistical aggregates, then in order for economic planning to be efficient it needs to be decentralized.

Before arguing that economic planning should be decentralized, it is important to clarify what exactly we mean by economic planning and what it means for this planning to be decentralized. As pointed out by Friedrich Hayek in his 1945 essay The Use of Knowledge in Society, when we speak of economic planning we mean economic decision making about questions such as what to produce, what to purchase, whom to produce for, whom to purchase from, how to produce, how much to purchase, and how much to produce. Decentralizing these decisions means that there is no single entity such as a government, dictator, or king making all these intertwined and crucial decisions but rather leaving these decisions to the economic participants in the society.

A classroom setting may serve as an extremely simplified example. If the decision to be made is what color of shirt every student will wear, centralizing the decision would mean having the teacher decide what color of shirt each individual student will wear. Decentralizing the decision on the other hand would be letting each individual student decide what color of shirt she or he will wear. Assuming strong personal preferences about the color of shirt, in order for this decision to be efficient in the economic sense, to satisfy a set of preferences at the lowest possible cost that is, it would require the decision-making entity (or entities) to know the personal preference of each individual student. While a mechanism for communicating this simple information is certainly possible in this example, it quickly becomes very inefficient and quickly impossible as the decisions to be made increase in number, the number of economic participants increases, and the number of choices increases.

What we can already discover in this very simplified example, is that the knowledge each individual has about her or his preference, which was most likely influenced by a range of factors such as time of year, color of hair, and mood, is certainly to be distinguished from the kind of knowledge we refer to as scientific knowledge. In contrast to scientific knowledge, which is the same everywhere at any time, this kind of knowledge differs on basis of circumstances of place and time. It is precisely this kind of knowledge whose economic importance Hayek stresses in The Use of Knowledge in Society. 

The reason why this “knowledge of the particular circumstances of time and place”, as Hayek put it, is important to efficient economic decision making is quite simple. Because the economic environment constantly undergoes change, knowledge of the particular circumstances of time and place is needed to make efficient on the spot economic decisions. It is precisely the kind of knowledge that 21st century university students label as “real world experience”. This knowledge is never static, but rather constantly changes in agreement with the changes of the economic context. The sum total of the knowledge of the particular time and place in the society is of unimaginably large volume and comes in various forms. For example, a business man might have specialized knowledge of how to the make an old machine in his production work more productively. Without his knowledge of how to make this machine work more productively there would be a loss of efficiency. While this is a very simplified example, the point is that the little comparative advantages that all economic participants derive from their specific experience and knowledge adds up to create a tremendous increase in efficiency.

Now, after having understood that the knowledge required for efficient economic decision making is knowledge of the particular circumstances of time and place, we must ask ourselves where this knowledge may be found. The answer to this question is simple: everywhere. As pointed out in the above example, each economic participant in the society holds a fraction of the sum-total of knowledge and experience that through the aggregate of small comparative advantages leads to the most efficient allocation of resources.

The phenomenon which Hayek points out can be thought of as a derivative of Adam Smith’s division of labor – the division of knowledge. This division of knowledge allows each economic participant of the society to specialize in a sub-field of knowledge and thus creates the above mentioned small comparative advantages. Even though examples of the division of knowledge are all around us, let us look at one example in particular: a university. Rather than having one large department of the study of the world and everything in it, it is significantly more efficient to allow groups of professors to specialize in specific areas of study. The division of knowledge should be understood as the division of cognitive labor and thus leads to an exponential increase in productivity, just like Adam Smith’s division of labor. If the professors divide the knowledge between each other, they will be able to do much more research and a much higher quality of research than if they all attempted to study and research everything by themselves.

After having observed that knowledge of the particular circumstances of time and place is required for efficient economic decision making and that this knowledge is dispersed among all economic participants of the society, the question of why this would imply that economic decision making should be decentralized arises. The answer to this question is also quite simple. If the knowledge required for efficient economic decision-making is dispersed among all the participants of the society, as we have discovered above, then a central economic planner needs to be communicated this knowledge accurately and in its entirety to make efficient economic decisions.

Accurate communication of this knowledge in its entirety, however, is not possible. Due to the nature of the knowledge of the particular time and place, it cannot be accurately communicated through statistical aggregates. Lumping the data together would result in the loss of small differences, and it is these small differences that are particularly crucial. After all, it is these tiny differences in practical knowledge and experience that cause the small comparative advantages, the sum-total of which leads to the massive increase in overall economic efficiency. It then follows that a central planner cannot hold all the knowledge required for efficient economic planning. Therefore, economic planning should be decentralized. Decentralized economic planning is able to harness the sum-total of comparative advantages derived from the specialized practical knowledge and experience among all economic participants to allocate resources efficiently.