Chapter 12 - Introduction to Information and Economic Structure



Chapter 12

Introduction to Information and Economic Structure: Professor Hayek and Economic Information

INTRODUCTION

This post was inspired by rereading Professor Hayek’s influential paper on the flexible price system being an economic information system, although the focus and conclusions are different than those of Hayek.  (Friedrich Hayek, “The Use of Knowledge in Society,” American Economic Review, XXXV, No. 4, (September, 1945), 519-30)  Reprinted in Hayek, Individualism and Economic Order.

Professor Hayek’s paper was a critique of central planning and a defense of a decentralized capitalist system with flexible prices.  His position was argued at greater length in a best-selling book The Road to Serfdom.

Professor Hayek begins by eliminating any consideration of alternatives to the polar models of central planning and, implicitly, the perfect competition of small firms.  He says that the “halfway house…is the delegation of planning to organized industries, or, in other words, monopoly.”  He continues with “Few like it when they see it.”

But monopoly is rare.  The real “halfway house” is imperfect competition, most visibly, oligopoly. They are not "organized," that is, they are not cartels, trusts or collusive.  Many industries or markets, and the economy as a whole, are dominated by a small number of large competitive corporations.

Professor Hayek emphasizes “unique information” held at the individual or local level.  But in a modern economy much of the information is held at the corporate level.

 What "local" or "unique" information does a company in a perfectly-competitive industry possess? None. Price is set by total industry supply and demand. A company knows nothing about its customers. It doesn't have to learn anything about its competitors since all firms are alike. They use the same technology and predictably react the same way to a change in the competitive environment.

 Once a company or a few companies start to innovate - improve production efficiency, improve quality, improve service, produce variations of the product for different segments of customers - the industry is on its way to changing its structure from perfect competition to imperfect competition. And pricing is on its way from one unique price to price discrimination (different prices for different segments of customers). It is companies in the "halfway house" of imperfect competition that generate "unique" or local information.


PRELIMINARY COMMENTS ABOUT INFORMATION

Following Hayek, we can think of information as an input.  We can also expand the concept of information by thinking of a hierarchy of information, knowledge and technology.

Information is defined as “useful data.”
Knowledge is defined as “useful information.”
Technology is defined as “useful knowledge.”

The word “useful” is defined narrowly, in an economic sense.  Corporations buy information, knowledge and technology if they expect to profitably add value to the input.  Also, companies create these inputs and use them as internal innovations to further growth and earnings.

Similar to Hayek, we can divide information, knowledge and technology into public and private.  Examples of public information are census data and published scientific research.  Private information, knowledge and technology can be public information that has been modified to make it more valuable to the company. It is the company's proprietary information.  In economic jargon, information has become “firm-specific.”

Professor Hayek’s “general” information could be public information or, in economic theory, “complete” information, that is, information known by all economic agents.  Private information is internal or proprietary to companies.  It can be “local” or value-added “general” information.

INFORMATION AND ECONOMIC THEORY AND BEHAVIOR

Economic theory, and Hayek’s article, emphasize that decision-makers are influenced by factors they are not aware of.  This is the subject of economics, summarized as “market forces.”  Most decision-makers might not know why the price of a key input or a consumer product has changed.  But observing the (relative) price change is all the information that is needed to decide to change production or consumption.  This makes the pricing system a very efficient information system.

While the reasons for price changes may be irrelevant in a world of perfect competition, except to economists, they are relevant to decision-makers working for large corporations in an economic structure with other large corporations. 

Managers have to adapt quickly in the short run and plan investment in the long run.  For large corporations, there is no dividing line between “general” and “local” information. In fact, a large corporation has to consider more information that a ministry in a centrally-planned economy. The large corporation has to know about  national and international competitors, the behavior of customers, macroeconomic variables such as changes in total income and interest rates, and international factors such as import competition and exchange rates.

INFORMATION AND INDUSTRY STRUCTURE

The introduction of corporations changes the nature and value of information. The corporate form makes the gathering and integration of information useful and efficient.  Information now becomes a competitive weapon, a source of “economic profit” (profit above the opportunity cost of capital).

“Local” information can also be private or proprietary information, a major source of economic profit.  Some examples are patents, trademarks, brand names, proprietary software, firm-specific knowledge of employees and market research data. 

These types of knowledge give a company an advantage in the areas of market power and bargaining power, the ability to influence transaction prices.

As Professor Hayek implies, not all competitors have the same information, knowledge and technology.  Some companies use private and proprietary information and knowledge as a source of competitive advantage.  When a company knows something its customers or competitors do not know, economists call this “asymmetric information.”  Economists have won Noble Prizes defining and analyzing this concept.

Professor Hayek carefully excludes the combination of large corporations and information.  With reason. This combination leads to a very different picture of a capitalist economy and undermines the perfect competition model of industry structure.  Most important for theory, it leads to indeterminate prices and disequilibrium.  Proprietary information can also be a reason why there is not an optimal use of resources.  All of this will be explored in a future post, Bilateral Oligopoly and Asymmetric Information.


INFORMATION AND LARGE CORPORATIONS

Decentralized (local) knowledge and general knowledge and planning are combined in a large corporation.  A large corporation can be adaptive to local conditions because it can process and analyze a large amount of “local” information, combine it and make company-wide production, pricing and marketing decisions.  The company can also combine detailed information with general information to develop long-range plans.  (I was a corporate economist and corporate planning manager for three large corporations.)

Different combinations of information are relevant at different levels of the corporation.  Following Hayek, the corporation can be viewed as an information hierarchy.  At the level of sales reps or plant production managers, very detailed “localized” information dominates.  Much of this information is about other corporations, companies from which the corporation buys inputs or to which it supplies inputs. 

For top management, financial managers, and strategic planners, general macroeconomic, demographic and technological data and forecasts are important inputs.  Top executives and planners have to understand why economic variables change and if the changes in price and other variables are temporary, cyclical or secular.  They do not need all the detailed knowledge that “front-line” employees have to do their jobs.

A large corporation combines the planning techniques of a centrally planned economy with the flexibility of reacting to local changes.  Historically, information technology has removed the information bottlenecks to operational and financial control of larger, more diverse and geographically dispersed corporations.  This is one reason why large corporations exist and grow.

This view of information is more dynamic than the usual discussion of the role of information in a modern economy.  Corporate employees analyze internal and external data, use programs and algorithms to analyze it, and create proprietary information, knowledge and technology.  This knowledge is the basis for value-added products, superior quality or service, lower costs and future innovation.  

This innovative internal activity can be a source of competitive advantage when negotiating with other corporations and necessary for continual growth and increased profit.

===================================================

CONJECTURES (AKA IDLE SPECULATIONS)

The structure of the American economy is not a combination of small companies and monopolies but an exponential distribution of company sizes.  This size distribution might be a function of an exponential distribution of practical or useful information.

An American economic structure of a hierarchy of size seems to be similar to the American federal political structure.  There is a similar distribution of functions (and interactions) that depends on the importance of “local” knowledge.  There is also a tendency towards larger local units and consolidation if economies of scale exist.  As in the economy, there is some overlap (and competition) between local and larger governmental units.



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