How Expectations Coordinate Markets
Open, competitive markets have a resilient capacity to successfully coordinate the actions of, now, billions of people around the world. With an amazing adaptability to changing circumstances, the actions and reactions of multitudes of suppliers and demanders are brought into balance with each other. Yet, none of this requires government planning, regulation or directing control. But how does this all come about?
The key to this coordinating process is often assigned to the pricing system of the market economy. All the minimal information that anyone needs to bring his own actions as supplier or demander into balance with multitudes of others with whom he is interdependent is provided by the changing pattern of relative prices for finished consumer goods and the factors of production (labor, land, raw materials and capital).
Types and Uses of Knowledge in Society
Austrian economist Friedrich A. Hayek explained how this came about almost 75 years ago in his famous article, “The Use of Knowledge in Society,” first published in the American Economic Review in September 1945. He emphasized that matching the division of labor is an inescapable division of knowledge. Specialization necessarily means that each of us knows things that others do not.
Each of us possesses different types of knowledge in different complementary combinations. For instance, all of us, to one degree or another, have acquired what Hayek referred to as scientific or “textbook” knowledge. This is the type of knowledge we learned in school, and while we all learned many of the same things in our classroom experiences, especially in college or university we focused on and acquired far more specific and detailed knowledge about some subject in which we majored than many others who selected different majors at the same and different institutions of higher learning. The medical doctor knows many things that the criminal lawyer does not, just as the lawyer has a detailed knowledge of his area of the law that the biologist or the architect do not possess based on their classroom and assigned textbook learning, and so on.
Localized Knowledge of Time and Place
But Hayek pointed out that there is also another type of knowledge that we each possess in different ways, what he called “the localized knowledge of time and place.” This is the particular knowledge that is only learned, appreciated, and useable based on an individual working and interacting with others in a specific corner of the society and the marketplace.
The recently graduated entry-level young employee shows up for his first day of work in the enterprise that has hired him. There is a period of getting oriented: Meeting the other employees and finding out what, exactly, they do; the nature of the way “things are done” within the firm in terms of rules and procedures; learning who are the individuals and groups of buyers and sellers that company sells to or buys from that may be relevant to that new employee doing his own job properly; finding out how the production processes or service activities undertaken and performed may be distinctly different from how things are done in competing firms in the same industry or from those in other markets.
Little or none of this knowledge could be learned in the classroom or read about in any readings assigned to pass and master a course taken. Yet, such “intimate” knowledge in all these “mundane” matters are crucial for everything in each corner of the market system of division of labor to run smoothly and effectively.
The entrepreneur, in particular, needs to know all of these and many other details about his specialized area of the market in which he operates if profits are to be earned and losses avoided. And, in addition, all of these localized circumstances and situations are subject to continual change in a dynamic market setting in which things today may be different from yesterday, just as tomorrow may vary from the situation today.
Inarticulate Knowledge of Knowing How, What and When
Hayek later highlighted a third type of knowledge, what the chemist and philosopher of science, Michael Polanyi, called “tacit” or “inarticulate” knowledge. This is knowledge that each of us possesses in various forms and ways that concern how to do something, when and what to do, but which we often find it difficult or “impossible” to easily put into a written or spoken form to convey or share with others.
Think of the auto mechanic who can “just tell” from listening to and looking at an engine that is not functioning properly what is wrong with it, based on years of experience, but which he cannot easily put into words to the car owner. Or the master sculptor who knows just the right amount of hand pressure to place upon the watered piece of clay on the wheel whose speed he is controlling with a foot pedal, but which he could never precisely put down on paper so others could readily copy the technique that he uses to produce a pleasing piece of art. Or the successful businessman who has never taken an economics class or a marketing course, but has a tacit knack for “reading the market signals” about when consumer demands might be likely to change or a new advertising message might just do the trick to attract more customers.
Using All the Knowledge No Planner Can Master
These diverse and varying types of knowledge, which are possessed in different combinations and forms in the individual minds of all the interconnected and interdependent people in a modern complex market system and social order can never be known or mastered, Hayek argued, by any one mind or group of minds, no matter how wise and determined they may seem or try to be.
Hayek’s point was that if we are all to benefit from what others know that we, personally, do not, but which when brought to bear in different ways for different things can improve our own circumstances in ways we cannot fully imagine ahead of time, then the individuals possessing all this decentralized and diffused knowledge must have the liberty and market-based latitude to utilize it in ways that they understand and see best. Otherwise, much that is known and potentially used by many others that could improve our own circumstances will not be taken advantage of or never even discovered.
But if not under the commanding instructions of a central planner or government regulator, how shall people know how, when and for what to apply their unique and distinct bits of knowledge, which cumulatively adds up to all “the knowledge in the world,” but resides in no one mind or group of minds?
Worldwide Knowledge and the Price System
Hayek’s answer was the competitive pricing system of a free market. It is not necessary for everyone to know what all the others in society possess as their unique knowledge. It is sufficient if there is an institutional mechanism through which people can convey a minimum required amount of information to others, so producers and suppliers may know what products consumers want and how intensely they desire them, and that consumers can find out what are the terms under which suppliers may find it profitably advantageous to apply what they know to satisfy the market demands of others.
And, likewise, it is not necessary for every private enterpriser thinking about undertaking a production process to know all the other businessmen who have a competing use and demand for all the different types of means of production (land, labor, raw materials, and capital), to make up their minds about how best to manufacture a product that minimizes the cost outlays to hopefully maximize the profits that might be earnable.
Consumers and producers “speak” to each other through the prices that are bid and offered on the market. This tells multitudes of suppliers what products are wanted by consumers and what price might be paid for them, just as the prices offered by rival enterprisers and accepted by labor and resource owners looking for employment tell each businessman the relative costs to be paid to hire or purchase various combinations of inputs relative to the anticipated selling price to be earned by producing and marketing a particular output to potentially willing buyers.
Thus, businessmen and workers and resource owners thousands of miles away from each other on other sides of the world can make reasonable and informed decisions about how to apply their own specialized and local forms and types of knowledge in ways that they hope profitably improves their own circumstances by satisfying the wants and desires of many others; others who they will never meet or personally know and who may live far away or around the corner; nor do they need to fully understand why and for what purposes that which they produced was wanted by any particular consumer following his own goals, purposes and plans in his buying choices in the part of the world in which he lives.
Knowledge Needed for Forming Expectations
But there is, in fact, a fourth type of knowledge that is equally essential for social and market participants to successfully coordinate all they do that is interdependent with the actions of many others. Hayek insightfully explained the central role of market-based prices for bringing together the dispersed and decentralized knowledge of the world to help bring into balance all that is done by those buying and selling in the social system of division of labor.
But when prices change, that is, when a price or group of prices rise or fall, or even stay the same “today” as they were “yesterday,” what are they telling the various and relevant market participants about what it suggests will be the situation “tomorrow”?
In other words, prices need to be interpreted to successfully form expectations about the actions and reactions of others in the marketplace in deciding how best to use one’s own specialized knowledge in effective and profitable ways for the achievement of one’s own ends.
An understanding of how people actually form many of the expectations that guide and direct their interactions with others was developed in the writings of the famous German sociologist, Max Weber (1864-1920), in his monumental work, Economy and Society (1921), in the works of the Austrian sociologist, Alfred Schutz (1899-1959), especially in The Phenomenology of the Social World (1932) and in a variety of his essays written in the 1950s, and in the works of the Austrian economist, Ludwig von Mises, most particularly in Human Action: A Treatise on Economics (1949) and Theory and History (1957).
Max Weber on Meaningful Action and Ideal Types
Weber argued that what makes “human action” distinct is that it is conscious conduct to which an individual assigns a “subjective” (a personal) meaning or purpose, and that the meaning or purpose defines what kind of action the individual is undertaking and with what end in mind. But no man is an island; he interacts and associates with others. As a result, Weber said, “social action” is conscious human conduct in which individuals “orient” their actions intentionally toward one another.
For instance, Weber argued that what makes the physical transfer of two objects between two individuals an act of “free exchange,” as opposed to being, say, some compulsory transfer, is how the transactors conceive of and view their own intentions and that of the other with whom they are interacting. Weber’s primary focus was developing various interpretive tools of analysis for the study of history.
Thus, he argued that a central tool of history and sociology is the “ideal type.” This was meant to be a composite image of a “type” of an historical person or activity. Thus, one might construct an image, or “mental picture,” of the “typical” characteristics of a Latin American military dictator, or the qualities and characteristics of the “typical” Medieval “lord of the manor.” Or it might reflect the “typical” aspects and forms of development of the “typical” Western European city in the modern era.
Alfred Schutz and the World of Intersubjective Meanings
But it was the Austrian sociologist, Alfred Schutz, who had studied at the University and Vienna and who was part of Ludwig von Mises’s circle of scholars in the Vienna of the 1920s and early 1930s, who took Weber’s ideas and combined them with aspects of Austrian Economics to develop a theory of how expectations are formed and used by human actors in society.
While we may reasonably speak about the general qualities and characteristics discoverable in any and all human conduct – what Mises named, “praxeology,” the logic of human action – Schutz emphasized that filling in the actual “content” of that general logic of action comes from the social setting into which people are born and within which they interact with others.
We are born into an existing social world, and we learn a language, customs, traditions, rules of conduct of “good” and “bad” behavior, etc., by growing up in a family, around friends, within a society of other human actors from whom we absorb the intersubjective (interpersonal) structures of meaning that define and “objectify” the meaning of actions and objects.
For instance, this object is a “book” and this other object is a “Halloween mask.” This object is a “knife” for carving meat, while another sharp object is a “surgeon’s scalpel” for performing a “medical operation.” This person’s “kneeling” before a woman is a “proposal of marriage,” while this other person’s “kneeling” before a “royal queen” is being “knighted” for acts of “valor” or “heroism.”
The division of labor brings about not only a specialization of tasks, but particular forms of standardized conduct in performing them in various social and market settings, Schutz explained. Thus, we come to “expect” that anyone understood as performing a certain task in a certain way, and, perhaps, dressed in a specific manner is a “policeman,” or “fireman,” or airplane “steward,” or “bank manager,” or “server” at a restaurant, or “mailman” on their delivery rounds, or . . .
Regardless of which concrete, specific, individual is “playing this role” in society we anticipate each will act toward any others with whom they interact in a generally prescribed way. And, likewise, that person expects anyone interacting with them to act and interact in expected ways. The “mailman” does not expect any of us to ask him what may be the cause of a heart palpitation. Nor will the “fireman” expect that a person whose house is on fire is going to ask him what is on the menu for lunch in “business class” on a plane flight they are scheduled to be on later in the week. These “ideal typifications” of tasks and routinized conduct in various specialized roles in the division of labor provide essential everyday points of interpersonal orientation and expectations for planning one’s own actions.
Thus, if I go into a bank I know that if I sit down with a “bank manager” he will be able (and is expecting to) to offer information to me for applying for a home or car loan, or opening a new account. If I make an appointment with a “dermatologist,” I know he will be able (and he expects) to do an examination and offer a diagnosis of a skin problem I may have.
Our Personal “Ideal Types” of Each Other
Alfred Schutz also highlighted that such “ideal types” of people are along a spectrum. At one extreme are those most general and wide characteristics of any and all human action, which is the basis for Ludwig von Mises’s formulation of a general logic of choice and action, “praxeology.” In the middle of this spectrum of ideal types are those just explained of “typical” roles and specialized activities often routinized in the division of labor.
And at the other end of this spectrum is what Schutz called the “personal ideal type.” This is not the general characteristics discoverable in any and all human action or the specialized “types” of actions expected from any individual performing a particular role in the division of labor. Instead, these are the qualities or characteristics “typifying” a particular, distinct individual. This is our “mental image” not of all men, or some men performing specialized tasks, but of this specific human being.
I explain to my students that when they entered one of my classrooms for the first time, what could they anticipate about me? Certainly, that I am a human being and they could expect that I would demonstrate those qualities known to be true about any other person. But they also had an image in their mind, an “ideal type,” of a “college professor,” and a college professor who (hopefully!) knows what he is talking about in an introductory economics class.
But as they sit in the class and watch, listen, and interact with me they come to formulate in their minds an image, an “ideal type,” not of all men, or some men in the division of labor, but of this particular person with his specific mannerism, behavioral characteristics, ways of expressing himself and moving about.
We all develop and use these “personal ideal types” of others, and on the basis of which we form expectations of what to expect when we interact with these specific individuals. If you laugh at Joe’s jokes, his is likely to buy you a round of drinks. If you mention sex to Bob, he usually acts embarrassed and becomes quiet. If you mention to Sally that “a woman’s place is in the kitchen,” you’re going to get a “lecture” on the place of women in modern society. If you criticize socialized medicine in Europe, George is likely to go into a rant on the “evils” of the profit motive.
It should be evident that many if not most of the ideal types discussed by Alfred Schutz also overlap with that category of tacit or inarticulate knowledge. In our interactions with others, we all form these types of mental images of those with whom we associate in various settings. But it is something we do “tacitly,” that is, without consciously thinking about it very much, if at all. And while we often know “how to interact” around someone based on our “ideal type” of them in our mind, it is not always easy to express in written or spoken words to someone else how and why we see these characteristics in that other person, or how and why we “just know” most of the time that if we do or say “X” around that person we are fairly confident that it will being about response “Y” from that individual.
Ludwig von Mises and the “Thymology” of Market Expectations
Ludwig von Mises came to call this method of understanding and interpreting others through ideal types of various sorts as the subject matter of “thymology,” the study of how individuals form images of others in their minds to generate expectations for purposes of interpersonal understanding, planning and the coordinating one’s own actions with those of others.
In Mises’s theory of the market process, a central actor is the entrepreneur, the individual who anticipates possible future consumer demands, conceives of production plans of action to bring forth a product or service to satisfy that prospective demand, and who organizes the activities of the enterprise that he directs to bring that product to market for purposes of earning a profit.
The entrepreneur must make informed judgments in doing all this, and in doing so, Mises said, he must form expectations of individuals and groups on both the demand- and supply-sides of the market. The knowledge on the basis of which he does so, is built up from the experiences he has personally had, or heard about, or learned from others in some manner concerning the likely actions and reactions of those with whom he interacts in the marketplace, and whose future actions he must anticipate the best he can to design his own plans of action.
How might potential buyers respond to a price reduction for the product, or to a new marketing campaign advertising “new and improved” qualities to the product, or why it is better than the one’s offered by rival sellers in the marketplace? He must also, from past experience and other sources of information form expectations about his supply-side competitors. How will they respond to what he is planning, as well as anticipating what they are possibly planning to do to which he must respond effectively in the pursuit of profits and market share?
Ideal types, Mises argued, enable acting man to be what he called “the historian of the future.” Forming composite pictures or images of individuals from their past actions in terms of characteristics, qualities, motives and meanings, “ideal types” enable an individual decision-maker to project himself into the future, imagine that another individual or groups of individuals are confronted or faced with a particular event or change in their circumstance, and then ask the question, “What responses and courses of action would these individuals manifest in this situation?” It enables the formation of expectations concerning patterns or regularity or “types” of response for prediction of a wide variety of circumstances. No matter how imperfect, it introduces an additional source of knowledge for coordination of plans in the complex social setting of the market.
Indeed, it is the “ideal types” of these various forms within the wider social structure of intersubjective meanings (explained earlier), that allows entrepreneurs and other market participants to evaluate and judge the meaning behind competitive prices and changes in them so as to form expectations of what those prices are “saying” in terms of anticipating the actions of other suppliers and demanders when undertaking the economic calculations of potential profits or possible losses.
Mises pointed out that many might consider this a rather unsatisfactory method of anticipating possible social actions in comparison to the claims of more detailed and determinate predictive power in the natural sciences. But he argued that given the uniquely distinct qualities and characteristics of human action in the social world, this in fact might be the best that can be hoped for, given the intentional and choice-based reality of human conduct.
Ideal Types, Expectations and the Free Society
One other aspect of this social institution of “ideal types” for interpersonal plan coordination is that it is part of the wider “spontaneous order” of the social system. That is, the social structures of intersubjective meaning, the “ideal types” of actors and actions in various face-to-face and “role playing” tasks in the division of labor, and the formation of expectations by people in their respective locations of specific time and place within the market order emerge out of the actions and interactions of multitudes of people in various societal settings at a moment in time and over shorter or much longer periods of time.
They are part of the societal “glue” for coherence, cooperation and coordination, with degrees of complexity and adaptability that defies the very notion of intentional planning by political actors asserting the need for and their ability to impose “order” on communities of human beings.
Appreciation for the nature, workings and importance of expectations formation processes in the marketplace of the free society demonstrates once more the superiority of the classical liberal system of individual liberty free markets and limited government, and the absurdity of the pretense of knowledge claimed by political paternalists and social engineers.