Austrian Economics and Hayek's View of the Market Process

The work of Austrian economist Friedrich Hayek in describing the market as a dynamic process challenges mainstream assumptions about the market as a set of imaginary static equilibria and states of "perfect competition." In three treatises-"Economics and Knowledge" (1937), "The Use of Knowledge in Society" (1945), and "Competition as a Discovery Procedure" (1968)-Hayek shows how the free market successfully addresses the dilemma of dispersed and imperfect knowledge among the participants of an economy. The price system, according to Hayek, is remarkably effective in communicating an immense quantity of practical knowledge through a set of numbers. Furthermore, free-market competition enables producers and consumers to discover what the optimal prices and costs for products ought to be.

The "mainstream" economic view of markets, which Hayek's work challenges, treats the market as a state rather than a process. Mainstream economics focuses overwhelmingly on analyzing states of equilibrium-seldom attained in actual economies-without concerning itself with how the market gets there. Furthermore, the mainstream view-more often than not-assumes that every economic actor possesses perfect information about the entire economy and this his particular value-scale reflects the single value-scale exhibited by all other participants in the economy.

Hayek, however, sees the market as a process, a system that necessarily involves an empirical element to it: the observed fact that all market participants possess imperfect and incomplete knowledge. Rather than analyzing perfect static equilibria, the central question of economics, for Hayek, becomes how the market facilitates the acquisition and dispersal of knowledge. According to Hayek, there is no single value-scale in a market economy; no single goal exists toward which the economy tends and which it achieves in a perfect equilibrium state. No single individual possesses all the facts and different individuals have different realms of skill and expertise. Rather than solely relying on formal mathematical constructions, the economist needs to examine empirical reality and construct from his observations a theory explaining how the market coordinates discrepancies in information, skill, and the individual plans of economic actors. With this vast diversity present, how does the market assist people in matching each other's expectations? Furthermore, how does the market remedy genuinely false and mistaken expectations on the part of certain economic actors?

Mainstream economists often describe the "optimal" function of a market using a simple equation: P=MC, where price for a product is equal to the marginal cost of producing that product. This, under mainstream models, describes a state of "perfect competition." For Hayek, however, such an approach entirely misunderstands the function of competition. Indeed, it evades and assumes away the very question that a theory of competition ought to answer: How does a competitive market tend to bring about a harmonizing of prices and marginal costs, supply and demand? Furthermore, the entire purpose and usefulness of competition consists of determining what the optimal costs and prices for a given set of goods are. There is no way to know what these prices and costs would be in advance and then expect competition to set them at that predicted level. Rather, competitive activities lead to a discovery of optimal prices and costs, a knowledge that cannot be achieved before the exercise of competition brings it to our attention. Competition, by definition, cannot be some optimal end state. It is a constant, continual process to figure out the optimal mode of production in an economy, and it arrives at progressively better answers to this challenge.

In Hayek's view, the price structure of the free market is a potent tool for remedying the problem of imperfect knowledge and economizing on knowledge. Prices give consumers all the information they need to properly adjust their economic decisions-even though most consumers will never know the full details of the market disturbance that made the economic adjustment necessary in the first place. For example, a tin mine might collapse in Africa-unbeknownst to almost everybody in the First World. The decrease in the supply of tin will imply higher prices of tin to be paid by owners of bronze smelters. Most manufacturers of bronze tools and consumers thereof will never have heard of the original collapse, but the new higher prices on bronze and its derivatives informs them of the need to economize on tin and the manufactured goods produced using it. Economic actors will now purchase fewer tin-based products than they would have under the lower price. Furthermore, those willing to purchase the most tin under the new higher price will get all the tin they truly need. They express their comparatively higher valuation for tin through the willingness to trade more money for it in return than other market participants. A single number-the price of a product-allows all the relevant actors on the marketplace to adjust their decisions in such a manner as to benefit them. Even if, on a free market, they had fully known the original cause of the price alteration, they could not have made a better decision than one guided solely by responding to the price shift.

Prices are, furthermore, accurate indicators of the actual supply of and demand for a product because competition makes them so. "Competition" cannot be a model incorporating prior perfect knowledge of economic data, because competition is itself a discovery procedure of that data. The "logical" end result of competition cannot be known until the competition has taken place. Hayek's theory thus rules out the possibility of a monopoly government accurately charging a "competitive" price for a service it provides. Take the example of a "public" utility which charges its consumers on the basis of a "cost-plus" approach. The government determines the price it charges by adding the "cost" of the service itself and the normal rate of return on the capital goods used in furnishing the service. But, because the government is a coercive monopoly, it is immune to competition, having barred all prospective competitors from the utility market via the threat of force. The government cannot know what the true cost of its service is, since it did not allow the competitive process to discover it. Rather, whatever value the government designates to be the "cost" will be a mere arbitrary number. In a competitive market, private businessmen-driven by the profit motive-would have continually discovered better ways to provide utility services. They would have figured out hitherto unknown ways to cut costs, increase productivity, and eliminate waste. The government, by restricting competition, prevents these discoveries from taking place and relegates all the consumers of public utilities to having to pay far more than they otherwise might have.

As Friedrich Hayek's insights illustrate, the free market performs a vital function in coordinating economic actors' dispersed knowledge, plans, and expectations by means of competition and the price system. Hayek provides an eloquent argument for allowing the market to carry out this coordination; any government intervention with the structure of prices and competition will inevitably distort both and impede the discovery process a free market provides.

Note: This essay was approved as an accurate representation of Austrian School economic ideas by Dr. Robert P. Murphy, one of the leading contemporary scholars of Austrian Economics.