The Answer Is Transaction Costs

FA Hayek: Price Whisperer

• Michael Munger

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The price system solves a profound coordination problem by communicating dispersed knowledge that no central planner could ever fully access or comprehend. We explore Hayek's insight about how prices serve as both information and incentives, allowing self-interested actions to inadvertently benefit society.

• The "knowledge problem" – why information needed for economic decisions is dispersed among millions of individuals
• Tale of two farmers – how profit-seeking Mo unknowingly serves society better than altruistic Al
• Markets generate information through commercial processes that otherwise wouldn't exist
• Goodhart's Law – when measures become targets, they cease to be good measures
• Soviet planning failures – absurd outcomes like factories producing single giant nails to meet weight quotas
• Recycling pennies – potential approaches as the US phases out penny production

Mentioned in the podcast:

Ross Kaminsky, of KOA:

My Duke colleague Bruce Caldwell, on the intellectual history of Hayek's 1945 AER paper

Book'o'da'week! Three suggestions (but mostly Red Plenty!)



If you have questions or comments, or want to suggest a future topic, email the show at taitc.email@gmail.com !


You can follow Mike Munger on Twitter at @mungowitz


Speaker 1:

Before we start this week, a brief technical note. I recorded the episode, had it almost edited and ready and then saved it to Dropbox from our house in Kings Grant in Wilmington. But the Audacity project file was huge and apparently I didn't wait to let it upload completely, so when I got home I had no file and no microphone to re-record. I do once again want to acknowledge the help of David and Jack Boyd of Burlington, north Carolina, for the donation of a Shure MV7 microphone to the cause, and that's what I have at our house down in Kings Grant. This week I'll be using the mic on my Logitech camera, which is not very good. Figured, it's better to be on time than miss the week, or anyway, that's what I claim. In any case, apologies in advance for the sound quality.

Speaker 1:

What do you want for nothing? This is Mike Munger, the knower of important things from Duke University, who knows enough to make decisions about what people should produce in a society. Where does that information come from? Now, the problem would be hard even for Robinson Crusoe making decisions by himself about how to allocate his effort, but it's really hard when you're trying to decide what and how much one person should produce for someone else, someone they've never met, and then scale that up to a society of millions of people who don't know each other and have no low transaction cost way of communicating or coordinating. To start answer the question, we'll lean on a classic insight from Nobel laureate Friedrich Hayek, a practical story that I made up about two farmers, al Truis and Mo Cash for me, and an old debate that still matters today why central planning keeps running into a wall. There's a new twedge this month's letter plus book in a month and more. There's a new twedge this month's letter plus book in a month and more, straight out of Creedmoor. This is Tidy C. I thought they'd talk about a system where there were no transaction costs, but it's an imaginary system. There always are transaction costs when it is costly to transact, institutions matter and it is costly to transact.

Speaker 1:

We'll start with a simple but profound question from Hayek's 1945 essay in the American Economic Review, the Use of Knowledge in Society. Hayek asks who knows enough to run the economy Now? At first glance you might think well, surely governmentsek asks who knows enough to run the economy Now? At first glance you might think well, surely governments, experts or powerful planners can gather enough data to steer the ship. But Hayek flips that idea on its head. He points out that knowledge, the knowledge needed to coordinate an economy, is not centralized. It's dispersed. It lives in the minds of millions of people Consumers deciding what to buy, workers choosing where to apply, entrepreneurs sensing opportunities. No central authority, no matter how brilliant or well-intentioned, can possibly collect and process all that information in real time. Hayek wrote.

Speaker 1:

The economic problem of society is thus not merely a problem of how to allocate given resources, but a problem of the utilization of knowledge, which is not given to anyone in its totality. Well, to understand that, we're going to have to have an example. So let's cue the dream sequence music. In your dream you see two farmers, altruus and Mocash for me. They each have 500 acres of land and both need to decide what to plant. Let's suppose it's simple corn or soybeans. When asked what they plan to do, they both just shrug and they say well, I don't know because they have no way of knowing. But here's where they differ.

Speaker 1:

Altruist believes deeply in doing good for society. He's skeptical of markets because he thinks they involve greed or prices are manipulated. So he sets out to research the question himself Nutrition reports, global trends, you name it to figure out which crop will do the most good for humanity. What about Mo Cash for me? He doesn't care about grand ideals, he cares about profits. Mo watches market prices and notices that for commodities, market prices are a pretty good indication of how you can make profits where there are shortages. He notices that soy futures are climbing and corn prices are dropping. He doesn't know why. And remember, he only cares about mo cash for me, so he doesn't care why soy futures are climbing and why corn prices are dropping. We, the outside observers, have borrowed a crystal ball. We know that halfway across the world, droughts have devastated Brazil's soybean crop and we know that within the next six months, new uses for soy are going to be booming in Asia, and some people have predicted that. Now maybe you can say that couldn't be true, but it's a dream sequence. You heard the music. At the same time, there's a global surplus of corn thanks to record harvests and countries phasing out corn-based ethanol.

Speaker 1:

Altruist, he's still tangled up in research trying to connect the dots, but there's simply too much to know Global supply chains, weather patterns, consumer trends, nutrition. It's overwhelming. He plants corn, thinking it's a noble choice, but he doesn't get much planted because he spent a lot of his time doing research. In any case, the corn market is flooded and prices collapse. Al's farm struggles because he has only a small amount of a commodity corn that no one actually wants, because there's a surplus Mo Cash for me, remember. He planted soybeans and he planted on every available bit of land and maybe even rented some.

Speaker 1:

He doesn't need perfect knowledge, he just needs information in prices. And remember, the reason he cares about prices is not that he thinks prices tell him about what's good for the world. He's chasing profits, but he inadvertently produces exactly what society needs more of soybeans. So who did more good for the world? The selfless idealist or the profit-chasing farmer? It turns out prices condensed vast, dispersed knowledge into one signal, a signal Moe followed without even understanding the details. This gets to Hayek's genius insight Prices are not just numbers, they're information and they come in the form of an incentive. In Hayek's words, prices are a mechanism for communicating information, a way to coordinate the use of knowledge dispersed among many people. End quote.

Speaker 1:

The price of soy rising, told farmers everywhere. Hey, society needs more soy. The falling price of corn whispered we have enough corn, don't grow corn. No committee decided that. No bureaucrat needed perfect data or some way of aggregating all the information. It came together just by prices, naturally.

Speaker 1:

So this brings us to an age-old debate central planning versus markets, and why attempts at top-down control keep failing. The socialist calculation debate, as it's known, revolves around a deceptively simple question If markets disappear or suppressed by government policy because we don't want to have private property, how do we decide what to do? I had a post a while back in AIER's Daily Economy that talks about what I call the socialist generation debate Socialist thinkers especially a new generation now that are advocating planned economies, and I think it's just because they have no experience with how poorly planned economies perform. But in any case, socialism is now popular. Even cool Advocates underestimate the scale of the information problem.

Speaker 1:

They believe that with modern computing, ai or big data planners can replace markets. But, as Hayek argued and as history has confirmed, this is a fantasy. In a centrally planned system, authorities might know some facts how many factories exist, how many tons of steel are produced but they lack the micro level, constantly shifting knowledge of millions of individuals Factory worker who notices a supply chain glitch, the entrepreneur sensing changing consumer tastes, the farmer observing soil conditions after a surprisingly rainy season or when weather conditions change Without prices. Planners grope in the dark, often trying and I admit they try to do the right thing based on incomplete, outdated or biased information. It's the illusion of control. In fact, it may even be worse than that the information doesn't actually exist. If all you know is the resources that you have, you're not sure about what use they should be put to. That information about what people want is generated by the commercial process itself. It doesn't exist until commerce gives the information in the form of price. So you're not actually calculating because you don't have enough information to perform the calculations in the first place. Markets generate the information which previously never existed. It's not available to calculate.

Speaker 1:

Let's think back to Al and Moe. Al tried to know everything before acting a noble goal, but literally impossible. Moe followed prices which distilled the best available knowledge from countless others making decisions globally. And that's the paradox. Markets allow selfish individuals to unknowingly advance the public good, while planners who intend good often misallocate resources, creating shortages, surpluses or worse. So what's the takeaway? Certainly not that markets are perfect. Prices can be distorted by monopolies, government interference or misinformation, but compared to the alternative, central planning, they remain humanity's most reliable tool for coordinating action in a complex, uncertain world. Prices whisper what no planner, no expert, no genius can shout with certainty what's scarce, what's abundant and where resources should flow. That information is generated by the commercial process. It's not otherwise available to calculate. In the first place, hayek saw this whole process as a triumph of humility. Remember, we can't know everything. We build systems like markets that let each person act on their own small piece of knowledge, producing outcomes that no one could have designed from the top down. Whoa? That sound means it's time for the twedge.

Speaker 1:

Goodhart's Law states when a measure becomes a target, it ceases to be a good measure. Now, charles Goodhart originally formulated this to describe how performance metrics, once they were turned into rigid targets, distort behavior and lead to unintended consequences, maybe worse than having no quota at all and certainly worse than using prices. So in centrally planned economies like the Soviet Union, goodhart's Law operated on an enormous scale because the quotas were imposed across entire industries, and so the distorting effects of using these simple performance metrics distorted every part of the production process. With no functioning market to allocate resources or convey information through prices, central planners relied on production targets output by weight, by quantity, by area, and so on. These targets were supposed to ensure productivity and meet consumer needs, but once they were set as goals they led to perverse incentives, waste and absurd outcomes. And so here are some outcomes that you actually get when you understand Goodhart's Law.

Speaker 1:

A nail factory you have a quota by weight. Factory produces a single enormous nail weighing several tons, completely useless. You obviously can't drive it into anything, in fact you can't even move it. But it meets the weight requirement and so the quota is satisfied. So you change you have a quota by quantity. The next year they produce millions of tiny little pins Technically they're nails, but too small to be a practical value. Again, you've produced nothing that is worthwhile. You've just confirmed Goodhart's law.

Speaker 1:

Second, the glass factory. You can have a quota by weight. Factories create ultra-thick, heavy, distorted glass sheets. It's impossible to use for windows, but pretty good for meeting a weight target that is imposed by the state. So they changed the quota by area. Square meters of glass Producers change. All right, they start manufacturing ultra-thin, fragile glass that breaks immediately but that boosts their square meter output and satisfies their quota.

Speaker 1:

Third, the shoe factory. If you have a quota by the number of pairs produced, then the factory will either produce children's shoes, or all of the shoes will be exactly one size and they don't actually care whether it's a size anybody wants. This literally happened a number of times in the Soviet Well, you could have a quota by weight, but then producers will make oversized heavy boots that fulfill the weight quota but serve little practical purpose and that no one will want to wear. Finally, the collective farm and grain production. You could have a quota by tonnage, and that was actually fairly common. How many tons of grain are going to be produced? That means that you'll harvest immature crops, because they actually weigh more, before they've dried out, and you can mislabel sandbags or rocks because you don't care if anybody can use it. You just want to be able to say we delivered this amount of weight, we met our quota. Well, meeting the target when it has a simple definition is actually the perfect illustration of Goodhart's Law. You're doing that instead of what you should have done.

Speaker 1:

This week's letter Ross Kaminsky, intellectual shock jock and the king of Rocky Mountain Talk Radio. He's on KOA, which is 850 AM or 94.1 FM, but mostly he's on iHeartRadio. Check him out, he's the man. I will put up the link to his iHeartRadio channel. Here's the letter from Ross. Hi, mike, I was wondering about your make versus buy suggestions concerning pennies. Hi, mike, I was wondering about your make versus buy suggestions concerning pennies.

Speaker 1:

Given how little pennies are used and how little they're valued at least in small, unconcentrated quantities in fact, they're valued so little that you yourself said people wouldn't even bother stealing them or picking them up off the street Is there really any valid purpose for choosing either make or buy? I don't know if pennies can be recycled to claim the metal, but if so, maybe there'd be a purpose that way. Overall, especially given what always happens with government programs, I think the best way to deal with pennies is probably using the existing private sector chain machines. He's referring here to Coinstar or other private change machines. Either just let people sell them for 95 cents to get them out of their drawer, because if they're not motivated to realize almost all the value of the penny, then they're probably also not motivated to realize a tiny bit more than the value of the penny. Maybe, rather than increasing the price, just spend a little money to remind people they can turn their pennies into dollars or quarters from those machines. Alternatively, if you really want to get more pennies, even if it costs a little more than a penny. Tell those private companies to offer anybody who puts pennies in their machine a full penny, or even a tiny bit more than a penny, of credit, and then the government pay the machine owner the fraction of a penny more than that. In other words, the machine can pay 10 cents for every nine pennies, for example, and then the government can pay the machine owner 11 cents. That way, the government doesn't have to create any new program or infrastructure.

Speaker 1:

Best Ross End of letter. Well, that's certainly right, and in my suggestion I had said that we might do this at post offices. I have to admit that when I did the podcast last week, I was thinking of it as a satire. A number of you had written in with points like this, but in thinking about it more, it actually is interesting to think how we might get at least a few years of pennies continued use, even though we have stopped the production of new pennies.

Speaker 1:

It might be worth it to be able to buy some, and, as Ross said, at least before 1984, pennies were 95% copper, so it's quite possible that they are worth something. Probably we don't need the government to do it, though. What we might do instead is just make it legal to melt down pennies. So, since we're not producing or using pennies anymore after May of 2025, when that was announced by the Treasury Department all we need to do is make it legal to purchase and melt down pennies, and then recycling will just operate on its own, because pennies actually are useful, at least before 1984. Since 1984, pennies are 95% zinc and they just have a copper coating. They're probably not worth recycling. In any case, I had thought something along these lines and I have a piece coming out at AIER about how buying pennies might work, and that'll be out later this week For Book of the Week.

Speaker 1:

I have three sources this week, three excellent books, and these are books that illustrate the main point about Goodhart's Law. Now, the examples that I gave were simple and probably overly simplified, but in fact, there are numerous examples of the operation of Goodhart's Law in the Soviet and other socialist economies, and there's three interesting books about it. First is Paul Craig Roberts Alienation and the Soviet Economy, published in 1971. Second, alec Nove, n-o-v-e. He wrote the Economics of Feasible Socialism in 1983.

Speaker 1:

And then, best of all, one of my favorite books by Francis Spufford, read Plenty 2010, published by Faber and Faber, that's Francis Spufford, s-p-u-f-f-o-r-d. It's a great summer read. I recommend that you get it and read it and then read it again, because it is a fantastic story of the problem of what I've been talking about today, which is the difficulty of even the smartest, best generous, well-intending people to solve the problem of what should be produced if they don't have the information that comes from prices. Well, the next episode will be released next week, tuesday July 8th. We'll have a new topic, some letters and, of course, a hilarious new twedge. All that and more next week on Tidy C.