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Comparing J M Keynes’s and F von Hayek’s Differing Definitions of Uncertainty as It Relates to

Knowledge: Keynes’s Unavailable or Missing Knowledge concept versus Hayek’s Dispersal of Knowledge

concept

Michael Emmett Brady

Lecturer

School of Business Administration

Department of Operations Management

California State University, Dominguez Hills

Carson, California

USA

Abstract: J M Keynes and F von Hayek had completely different views about the meaning of the term

“uncertainty” as it was related to the concept of knowledge. Keynes viewed uncertainty through his

concept of the weight of the argument, V,(a logical operator) and weight of the evidence, w(a

mathematical variable).Uncertainty ,U, is an inverse function of w so that one can write U=f(w).The

existence of complete ,relevant knowledge requires that w = 1 ,where w is defined on the closed unit

interval [0,1].A degree of uncertainty occurs if w < 1.A w < 1 means that the relevant knowledge is not

just incomplete but is missing and/or not available to any decision maker. A w=0 means that there is no

relevant knowledge. Keynes viewed the case of 0<w<1 as, in general, being the relevant one. However,

there is one extremely important case where w either equals 0 or is very close to 0.This concerns

investment in long lived, fixed, durable, capital ,producer goods subject to technological change,

advance and innovation over time . Prices are part of the relevant knowledge available to

entrepreneurs. However, market prices do not concentrate the unavailable information so that

w<1.w=1 is a limiting case that will occur or approach close to w=1 in some of the physical, life and

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natural sciences. However, this is not the case in economics, business, finance or social sciences, in

general.

Hayek’s definition of uncertainty is that relevant knowledge is completely dispersed into small or tiny

bits and pieces. All of the total information /knowledge is divided up among the set of decision makers.

However, this dispersed knowledge, while scattered, is complete. Market prices concentrate this

dispersed knowledge into a form that alert, savvy, knowledgeable entrepreneurs can understand and

act on efficiently. Market prices concentrate the relevant knowledge so that uncertainty is eliminated

for savvy, smart, alert entrepreneurs. This is equivalent to arguing that w =1 for alert entrepreneurs.

Keynes’s and Hayek’s definitions of uncertainty directly conflict with each other. Keynes argues that

,especially in the case of producer goods, w ,while w is not equal to 0,is little, flimsy, vague, ambiguous

,small , fluctuating ,and tiny. The prices of producer good DO NOT concentrate the knowledge so that

savvy, alert entrepreneurs can act on it efficiently. Hayek argues that they do. The conflict over the

meaning of uncertainty is insurmountable. The Hayekian outcome is not possible in a world of Keynesian

or Knightian uncertainty.

Section 1.Introduction

The meaning of the term “uncertainty” is extremely important in the debate between Keynes and Hayek

concerning the operational capability of a capitalist economy to provide a macroscopic full employment

level of employment for all available resources. Keynes gave a formal mathematical definition to the

term weight ( uncertainty in his General Theory (GT,1936)) in his A Treatise on Probability (TP,1921)in

chapter 26 on p.315 in the course of specifying his conventional coefficient ,c, of weight and risk that

summarized Keynes’s interval estimate approach to probability as presented in chapters 15,17,20 and

22 of the TP. Keynes also gave a clear verbal definition of weight in the first paragraph of chapter 6 on

p.71.Both definitions are identical. This leads to the following definiGon: 0 <̄ w < ̄1, where

w=K/(K+I),where K is the total relevant knowledge and I is the total relevant Ignorance. Like probability

,K+I equals 1,since it is normalized on the closed unit interval [0,1].I-w= I/(K+I).

Keynes specifically links his GT concept of uncertainty to the TP’s weight of the evidence on p.148 and

240 of the GT. His reference is to chapter 6,which is a prerequisite to understand chapter 26. A footnote

in chapter 6 directs the alert reader to chapter 26.

Hayek provide no such formal analysis of his concept uncertainty as being the dispersion of knowledge

into bits of tiny pieces among the large number of competing decision makers in a complex economic

environment. The rest of this paper examines Hayek’s and Keynes’s arguments .it is demonstrated that

there is no overlapping areas of either Keynes’s or Hayek’s approaches.

Section 2.Hayek’s view of Knowledge and uncertainty-1937

“I think that the field in which, as one would expect, the discussion of the assumptions concerning

foresight first attracted wider attention was the theory of risk] . The stimulus which was exercised in this

connection by the work of Frank H. Knight may yet prove to have a profound influence far beyond its

special field. “(Hayek,p.34)

“ In the light of our analysis of the meaning of a state of equilibrium it should be easy to say what is the

real content of the assertion that a tendency toward equilibrium exists. It can hardly mean anything but

that, under certain conditions, the knowledge and intentions of the different members of society are

supposed to come more and more into agreement or, to put the same thing in less general and less

exact but more concrete terms, that the expectations of the people and particularly of the

entrepreneurs will become more and more correct. “(Hayek,p.41)

“The significant point here is that it is these apparently subsidiary hypotheses or assumptions that

people do learn from experience, and about how they acquire knowledge, which constitute the

empirical content of our propositions about what happens in the real world. They usually appear

disguised and incomplete as a description of the type of market to which our proposition refers; but this

is only one, though perhaps the most important, aspect of the more general problem of how knowledge

is acquired and communicated”(Hayek,p.43)

“ The questions I have just discussed concerning the conditions under which people are likely to acquire

the necessary knowledge, and the process by which they will acquire it, have at least received some

attention in past discussions. But there is a further question which seems to me to be at least equally

important but which appears to have received no attention at all, and that is how much knowledge and

what sort of knowledge the different individuals must possess in order that we may be able to speak of

equilibrium. It is clear that, if the concept is to have any empirical significance, it cannot presuppose that

everybody knows everything. I have already had to use the undefined term "relevant knowledge," that

is, the knowledge which is relevant to a particular person. But what is this relevant knowledge? It can

hardly mean simply the knowledge which actually influenced his actions, because his decisions might

have been different not only if, for instance, the knowledge he possessed had been correct instead of

incorrect but also if he had possessed knowledge about altogether different fields.”(Hayek,p.45)

“ The problem which we pretend to solve is how the spontaneous interaction of a number of people,

each possessing only bits of knowledge, brings about a state of affairs in which prices correspond to

costs, etc., and which could be brought about by deliberate direction only by somebody who possessed

the combined knowledge of all those individuals. “(Hayek,p.46)

“How can the combination of fragments of knowledge existing in different minds bring about results

which, if they were to be brought about deliberately, would require a knowledge on the part of the

directing mind which no single person can possess ? To show that in this sense the spontaneous actions

of individuals will, under conditions which we can define, bring about a distribution of resources which

can be understood as if it were made according to a single plan, although nobody has planned it, seems

to me indeed an answer to the problem which has sometimes been metaphorically described as that of

the "social mind." But we must not be surprised that such claims have usually been rejected, since we

have not based them on the right grounds.”(Hayek,p.48)

It is interesting to note that Hayek provides no citations to works that explicitly deal with uncertainty as

used in the standard sense as lack of relevant knowledge in his 1937 article. Hayek fails to deal with

the term, “ uncertainty “, as it is used in Schumpeter’s 1912 work, Knight’s Risk, Uncertainty and Profit,

and Keynes’s GT. Hayek refers to risk only and cites Irving Fisher ,for whom there was no difference

between the terms risk and uncertainty. Nor does Hayek use similar words that are substitutes for

uncertainty ,such as vagueness, unclearness, ambiguity.etc.

Hayek failure to discuss the concept of unavailable knowledge or the lack of knowledge leads to the

following question . Did Hayek have a concept of “ uncertainty” that had a completely different meaning

from the use of the term by Schumpeter, Knight or Keynes ? Hayek does repeat his idea of bits of

information dispersed throughout the decision making population. Obviously ,this means that for any

individual decision maker information will be incomplete since each decision maker only has a small

piece o f the entire puzzle. However, all of the pieces of the puzzle are available to the set of all decision

makers. The problem is not that there are pieces of the puzzle that are missing or unavailable to the

decision maker. This is precisely the problem as viewed by Keynes, Schumpeter and Knight .Only Keynes

gave a precise and exact ,formal analysis. Unless the weight of the evidence, w,=1,there is missing or

unavailable evidence or evidence that is lacking and can’t be attained from some source. The set of all

decision makers do not have all of the pieces of the puzzle. One can only conclude that ,for Hayek, the

problem is not information that is not available or lacking which is the problem, but bringing together

all of the dispersed pieces of available knowledge which ,if concentrated ,would be complete. Market

prices do this. Therefore, the problem of uncertainty is solved by the market’s ability to concentrate the

dispersed knowledge in the form of price vectors which only alert and savvy entrepreneurs are able to

decipher as long as market prices are not interfered with by government. Hayek

‘s position creates a giant abyss/chasm between himself and Keynes, Schumpeter and Knight:

“In the light of our analysis of the meaning of a state of equilibrium it should be easy to say what is the

real content of the assertion that a tendency toward equilibrium exists. It can hardly mean anything but

that, under certain conditions, the knowledge and intentions of the different members of society are

supposed to come more and more into agreement or, to put the same thing in less general and less

exact but more concrete terms, that the expectations of the people and particularly of the

entrepreneurs will become more and more correct. “(Hayek,p.41)

This statement by Hayek is expressed in Keynes’s analysis by the statement that, eventually, the

process of concentration of knowledge by market prices will result in a w=1.There is no uncertainty in

this case.

Hayek’s 1937 view of uncertainty is completely different from Keynes’s. We will examine in our next

section whether Hayek changes his position in any appreciable manner in 1945.

Section 3.Hayek’s view on knowledge and uncertainty-1945

Did Hayek’s views on knowledge change in 1945 from their earlier expression in 1937 ? Did Hayek ever

link his view of the problem of dispersed, incomplete, individual knowledge in economic decision

making versus his position in 1937 that market prices concentrate knowledge for society as a whole ?

Did Hayek attempt to move toward the Schumpeter, Keynes and Knight view that uncertainty meant

flimsy, tiny, little, vague, uncertain, unreliable, ambiguous or unclear knowledge that was unavailable,

lacking or missing ?. The answer is no. Hayek reaffirms in his 1945 article his view that the problem of

the use of economic knowledge is not that it is missing ,lacking or not available. The problem is that the

knowledge is dispersed among many decision makers. Again, free market prices will concentrate the

knowledge so that alert or savvy entrepreneurs can use it efficiently to always move the economy

toward equilibrium inter temporally. Market prices are the solution to uncertainty. Uncertainty can’t

exist in the form understood by Schumpeter, Keynes, and Knight because then it would be impossible

for market prices to concentrate the unavailable, missing or lack of information needed for possible

equilibrium:

Consider Hayek’s 1945 article on “The Use of Knowledge in Society” :

“If we possess all the relevant information, if we can start out from a given system of preferences, and if

we command complete knowledge of available means, the problem which remains is purely one of

logic.”(Hayek,p.519)

.

.

.

“The reason for this is that the "data" from which the economic calculus starts are never for the whole

society "given" to a single mind which could work out the implications and can never be so given. The

peculiar character of the problem of a rational economic order is determined precisely by the fact that

the knowledge of the circumstances of which we must make use never exists in concentrated or

integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge

which all the separate individuals possess.”(Hayek,p.519)

.

.

“ The various ways in which the knowledge on which people base their plans is communicated to them

is the crucial problem for any theory explaining the economic process, and the problem of what is the

best way of utilizing knowledge initially dispersed among all the people is at least one of the main

problems of economic policy-or of designing an efficient economic system” (Hayek,p.520)

.

.

.

“ This, in turn, depends on whether we are more likely to succeeding putting at the disposal of a single

central authority all the knowledge which ought to be used but which is initially dispersed among many

different individuals, or in conveying to the individuals such additional knowledge as they need in order

to enable them to dovetail their plans with those of others.”(Hayek,p.521)

.

.

.

“ The answer to our question will therefore largely turn on the relative importance of the different kinds

of knowledge: those more likely to be at the disposal of particular individuals and those which we should

with greater confidence expect to find in the possession of an authority made up of suitably chosen

experts”.(Hayek,p.521)

. .

. “Today it is almost heresy to suggest that scientific knowledge is not the sum of all knowledge. But a

little reflection will show that there is beyond question a body of very important but unorganized

knowledge which cannot possibly be called scientific in the sense of knowledge of general rules: the

knowledge of the particular circumstances of time and place. It is with respect to this that practically

every individual has some advantage over all others because he possesses unique information of which

beneficial use might be made, but of which use can be made only if the decisions depending on it are

left to him or are made with his active co-operation”(Hayek,pp.521-522)

.

.

.

“This is, perhaps, also the point where I should briefly mention the fact that the sort of knowledge with

which I have been concerned is knowledge of the kind which by its nature cannot enter into statistics

and therefore cannot be conveyed to any central authority in statistical form. The statistics which such a

central authority would have to use would have to be arrived at precisely by abstracting from minor

differences between the things, by lumping together, as resources of one kind, items which differ as

regards location, quality, and other particulars, in a way which may be very significant for the specific

decision. “(Hayek,p.524)

.

.

“ We need decentralization because only thus can we insure that the knowledge of the particular

circumstances of time and place will be promptly used. But the "man on the spot" cannot decide solely

on the basis of his limited but intimate knowledge of the facts of his immediate surroundings. There still

remains the problem of communicating to him such further information as he needs to fit his decisions

into the whole pattern of changes of the larger economic system.”(pp.524-525)

.

.

.

“Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many

people, prices can act to co-ordinate the separate actions of different people in the same way as

subjective values help the individual to co-ordinate the parts of his plan. It is worth contemplating for a

moment a very simple and commonplace instance”.(Hayek,p.526)

. . .

“The most significant fact about this system is the economy of knowledge with which it operates, or

how little the individual participants need to know in order to be able to take the right action. In

abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on

only to those concerned. It is more than a metaphor to describe the price system as a kind of machinery

for registering change…”(Hayek,p.527)

.

. .

“The price system is just one of those formations which man has learned to use (though he is still very

far from having learned to make the best use of it) after he had stumbled upon it without understanding

it. Through it not only a division of labor but also a co-ordinated utilization of resources based on an

equally divided knowledge has become possible. “(Hayek,p.528)

.

. .

“The practical problem, however, arises precisely because these facts are never so given to a single

mind, and because, in consequence, it is necessary that in the solution of the problem knowledge should

be used that is dispersed among many people.”(Hayek,p.529)

.

.

.

“… instead we must show how a solution is produced by the interactions of people each of whom

possesses only partial knowledge. To assume all the knowledge to be given to a single mind in the same

manner in which we assume it to be given to us as the explaining economists is to assume the problem

away and to disregard everything that is important and significant in the real world.”(Hayek,p.530)

Hayek has not changed any of his views from the time of the publication of the 1937 article to the time

of the publication of the 1945 article. Uncertainty ,or synonyms for uncertainty, appear nowhere in his

presentation. His view is still that all of the available evidence is dispersed among many decision makers.

Market prices concentrate this information in such a manner that knowledgeable entrepreneurs are

able to efficiently use this concentrated knowledge to constantly move an economy toward an optimal

allocation of resources inter temporally. This concentration of knowledge by price vectors ,discernable

to alert entrepreneurs, solves the problem of uncertainty in the same way that Milton Friedman’s

assumption that all changes in all market prices are distributed normally(log normally) so that the

mean, a measure of concentration and central tendency, and the standard deviation, a measure of

dispersion, could be used by decision makers to eliminate all uncertainties in the area of decision

making ,eliminates the problem of uncertainty.

Section 4. Summary of Hayek’s view

Hayek was well aware of how Keynes, Schumpeter and Knight used the term “uncertainty “ in relation

to knowledge when he wrote his articles in 1937 and 1945 , respectively. He does not refer to any such

word or alternative word, such as vagueness ,unclearness or ambiguity, in his 1937 and 1945 articles on

knowledge because the existence of uncertainty in the sense of Keynes, Schumpeter and Knight is

completely different from the situation where all of the information is available, but dispersed among

the different economic decision makers. Knowledge is missing for Keynes, Knight and Schumpeter, not

just dispersed. Technological advance, innovation and discovery generates/creates knowledge that was

missing. Businessmen and women know for certain that they do not know where, when and how

technological innovations will either hurt or help their firms. The weight of evidence is greater than 0

but not by much when it comes to new kinds of capital goods that follow upon the waves of

technological breakthroughs .This has nothing to do with knowledge that is dispersed. This has to do

with knowledge that is missing, small ,tiny, little and flimsy. The market prices of capital goods can ‘t

concentrate what is not there. The existing market prices cannot concentrate knowledge about the

new technological breakthroughs that will occur in the near or distant future.

It is well known that GLS Shackle was one of four graduate students who broke with Hayek intellectually

to follow Keynes after the publication of the General Theory in 1936. What was the primary reason for

Shackle’s intellectual break with Hayek ? Shackle was very clear .Shackle realized that Hayek’s

discussion of uncertainty excluded by definition the existence of knowledge that would be unavailable

to the entrepreneur. Hayek’s capital theory, upon which he founded his business cycle theory,

concentrated only on time preference and excluded uncertainty as defined by Keynes, Knight and

Schumpeter. Hayek’s theories were based on an “ …abstraction from

uncertainty”.(Shackle,1988,p.176).Hayek’s theories of capital and the business cycle does not use the

term uncertainty to mean unavailable information .Hayek uses the term that all knowledge is highly

dispersed. Hayek’s Austrian theories claimed that market prices, if not interfered with by government,

concentrate the dispersed pieces of knowledge so that a special class of humans, successful

entrepreneurs, can correctly analyze the concentrated price signals and always move a market

economy toward an optimal allocation of resources inter temporally .Market prices so concentrated

eliminate any and all uncertainties.

Hayek explicitly denied that statistical evidence could be used ,in general, in the social sciences because

much unique information content would be lost, with respect to specific time and place knowledge, in

the process of using statistical data. Hayek is correct. Keynes arrived at a very similar conclusion at the

end of chapter 26 of the TP. Information is lost in the statistical computations. The problem for Hayek

is that market prices ignore such unique information also. The weight of the evidence is < 1.Information

is lost or ignored in the process of concentrating the bits of dispersed knowledge into market prices just

as it is lost or ignored in statistical computations of averages. One Austrian has realized this-Stefan

Schmitz.

5.Schmitt’s Critique of Hayekian and Austrian Economics

Let us start with certain points made by Austrian economist Stefan W Schmitz in his 2004

article in the journal , Review of Austrian Economics :

"Furthermore, problems of dispersed knowledge in society are hardly mentioned in

ACT(insert-Austrian Capital Theory).That seems to imply that complete information is

assumed throughout any capital theoretic argument in Austrian economics...neither

uncertainty nor incomplete knowledge receive much attention in the arguments. The

decomposition has to be based on two dimensions: time and uncertainty...Over the past

100 years, ACT has centered solely on the time dimension..."(Schmitz,2004,p.72).

"The following sections stress the importance of uncertainty in the Austrian School of

Economics and attempt to introduce the dimension of uncertainty into ACT by systematically

relating uncertainty to the structure of goods". (Schmitz,p.72)

Schmitz points out that in his Principles book Menger assigns four essential functions to

entrepreneurial activities but that " ... he excludes risk(or uncertainty) bearing from that

list".(p.73).Schmitz argues that "..another explanation (insert-for excluding uncertainty

from the list of essential entrepreneurial functions) is that Austrians implicitly assume

perfect information in ACT. Due to the fact that the importance of information, knowledge

and its dispersion in society are stressed by Menger and Hayek,this argument does not

seem particularly appealing "(pp.73-74).

Schmitz states that Hayek ,on p.330 of the Pure Theory of Capital(1941) ,does briefly talk

about the relationship between the stock of capital, correct entrepreneurial forecasts of

future profits and uncertainty. However,"... Hayek (1941),does not pay attention to the

relationship between uncertainty and the structure of capital." (p.74)Furthermore, "...also

Kirzner (1996-insert "Essays on Capital and Interest ")fails to develop the systematic

relationship between uncertainty and the order of goods". (p.74)

Schmitz's conclusion explains why J M Keynes rejected Austrian Business Cycle theory

,which rests precariously on Austrian Capital Theory :

"The complete neglect of the structural relation between uncertainty and the order of goods

as well as the dispersion of knowledge in ACT is inconsistent with the emphasis on these

concepts which characterize the Austrian School of Economics".(p.81).

In other words, Austrian use of the term about uncertainty actually means dispersed

knowledge .Unfortunately, they are incapable of analyzing and/or evaluating the

relationships specified verbally in a technical , formal ,logical, or mathematical, analytic

manner, in order to show how uncertainty impacts the stock of capital goods over time.

Now Keynes had already discovered the answer in 1908.Practically all decision makers are

averse to uncertainty even if they are risk takers. There is no role here for Kirzner's alert or

knowledgeable Austrian entrepreneurs because such alert entrepreneurs are especially

uncertainty averse because they know that they do not know. They are all unwilling to

commit resources in the face of ignorance(no knowledge) or uncertainty(little

knowledge)Market prices do not concentrate the uncertainties of the present and/ot future.

They will do so only under conditions of Keynesian nonlinear risk

Unfortunately, Schmitz was ignorant of J M Keynes's nonlinear, non additive, inexact,

interval estimate, upper-lower bound, Boolean approach to probability and decision making

that Keynes published in 1921 as the A Treatise on Probability(TP;1921).The exact same

material is contained in Keynes’s December,1908 Cambridge Fellowship thesis.

Keynes's conventional coefficient, c, of risk and weight is a very simplified decision rule that

incorporates in another way the material covered by Keynes in Parts II and III of the TP.I

will append a summary of Keynes's c coefficient below .It was first available as a Cambridge

Fellowship Thesis in 1908 when Hayek was nine years old. Parts II and III of both books are

identical. Keynes's theory of decision making under risk, uncertainty and ignorance is

presented in technical language that Austrians are not able to follow in Parts II and III of

the TP. The case based approach of Gilboa and Schmiedler , based on memory-resemblance

-similarity concepts, is practically identical to Keynes's analysis except for their mistaken

view that the resemblance functions need to give precise numerical answers. Schmitz

suggests the non additive, capacities approach of Gilboa and Schmiedler as a foundation

upon which Austrians could incorporate uncertainty into Austrian Capital Theory and

Business Cycle Theory. However, it has already been proven that the capacities approach is

just a form of Boole's 1854 approach. Schmitz could have suggested Shackle's potential

surprise, non additive analysis. However, Shackle was completely unaware that Keynes had

already successfully mastered such a non additive approach when Shackle was eight years

old. Keynes's capital theory is simply an application of his general theory of decision making

to the decision to obtain and use long run capital goods to make short run consumption

goods. Keynes correctly rejected Hayek's capital theory and his business cycle theory

because Hayek failed to incorporate an analysis of uncertainty into either of his theories.

Of course, Hayek, like Menger before him and Kirzner after him, did talk about uncertainty

and did realize that risk and uncertainty were different. However, he never incorporated

uncertainty into any of his theories. On the other hand, the General Theory is built on the A

Treatise on Probability and the A Treatise on Probability is built on Boole's The Laws of

Thought(1854,LT).This means that the Austrians face the insurmountable task of trying to

demonstrate that Boole's approach to logic, which itself generalized the work of Francis

Bacon and John Stuart Mill, is incorrect. Austrians do not have the technical training in

mathematics and logic to even start reading LT, much less criticize it.

This would explain the fact that no Austrian has attempted to implement Schmitz's

suggestions..Any attempt by an Austrian to work with non additivity/nonlinearity leads

directly to Keynes’s work in the TP and the GT. This was partially recognized by Shackle,

although Shackle failed to read beyond chapters 3 and 4 of the TP. Shackle would have

soon discovered that there was no real need for his own non-probabilistic approach because

Keynes had already developed a non additive approach in Parts II and III of the TP.

6.J M Keynes’s non- linear, non -additive approach to uncertainty and risk

Keynes's 1921 A Treatise on Probability (TP) analysis of decision making can be found in

sections 6-8 of chapter 26 and chapters 15,17,20 and 22 of the TP. We will concentrate on

the conventional coefficient of risk and weight in chapter 26,as opposed to the interval

estimate, upper-lower bound approach of the other chapters, because of the greater

explanatory power exhibited by the conventional coefficient. The technical details can be

found on p.315 and in footnote 2 on p.315 .Keynes presented a very precise analysis

demonstrating that an analysis of uncertainty introduced non additivity and non linearity

into the formal representation of decision making. The subjectivist, Bayesian approach

regards decision making as another name for the application of the purely mathematical

laws of the probability calculus that require additivity and linearity. The Subjectivist

approach makes the crucial error of conflating probability theory with decision theory.

Keynes realized that ,due to the impact of a lack of weight of the evidence (confidence)on

decision makers ,as well as because of the optimism-pessimism of the decision maker,

decision theory would have to be able to take into account the importance of non linearity

and non additivity. The concept of expected value or expected utility is crucial to the

Ramsey-De Finetti-Savage-Friedman approach. Keynes demonstrated that expected value

or expected utility can ,at best, only be a special case of a much more general theory .

The Ramsey-De Finetti-Savage-Friedman approach is the mathematical translation of

Jeremy Bentham's original Benthamite Utilitarian approach.

Bentham's approach was that the whole can never be anything more than the sum of the

individual ,atomic parts. However, this requires the assumptions of additivity and linearity.

Bentham assumed also that all decision makers can calculate the odds all the time. Keynes

showed that this was not the case because this requires a w=1. Keynes's demonstration

,taken from chapter 26 of his A Treatise on Probability(1921;TP),of the special case nature

of any expected value(utility) approach ,based on the purely mathematical laws of the

probability calculus, shows this to be a very special case that rarely, if ever, occurs in the

real world. This is why public policy based on utilitarianism fails . Bentham claimed that all

individuals have the capability to calculate the odds and outcomes and act on the expected

utility (the probability times the utility of the outcome) in a rational(optimizing) way. This is

where the rationality postulate comes from. This can be expressed by the following

maximization problem ,where p is the probability of success, q is the probability of failure,

and A is the outcome:

Maximize p A.

The modern version of this is to Maximize pU(A),where p is a subjective probability that is

additive, linear, precise and exact and U(A) is a Von Neumann-Morgenstern Utility function.

The goal is to

Maximize p U(A).

The modern name for Benthamite Utilitarianism in neoclassical economics is SEU

theory(Subjective Expected Utility). Therefore, a microeconomic foundation based on Utility

Maximization is just Benthamite Utilitarianism updated with modern mathematical

probability techniques. Modern macroeconomics is all disguised SEU theory.

Keynes rejected Benthamite Utilitarianism as a very special case that would only hold under

the special assumptions of the subjectivist, Bayesian model-that all probabilities were

additive, linear, precise, single number answers that obeyed the purely mathematical laws

of the probability calculus.

Keynes specifies his conventional coefficient of risk and weight, c, model in chapter 26 of

the TP on p.314 and footnote 2 on p.314,as a counter weight to the Benthamite Utilitarian

approach of Ramsey.

Essentially, Keynes's generalized model is given by

c=2pw/(1+q)(1+w),

where w is Keynes's weight of the evidence variable that measures the completeness of the

relevant, available evidence upon which the probabilities p and q are calculated.(Benthamite

Utilitarians always assume that the value of w is always 1.)w is an index defined on the unit

interval between 0 and 1,p is the probability of success ,and q is the probability of failure

.p+q sum to 1 if they are additive .This requires that w=1.Keynes's c coefficient can be

rewritten as

c=p [1/(1+q)][2w/(1+w)].

Now multiply the above by A or U(A).One obtains c A =p[1/(1+q) ][2w/(1+w)] A or

c U(A)= p[1/(1+q)][2w/(1+w)]U(A).

The goal is to Maximize c U(A) as opposed to the special Ramsey-Savage case of Maximize

p U(A).

If w = 1 and all probability preferences are linear, then one obtains Ramsey's special result

,which was

Max p U(A).

Austrian discussions of risk and uncertainty lead to the same conclusion. Full employment

will arise under either condition. This means that there is no difference between risk and

uncertainty for Austrians .S. Schmidt deserves a good deal of credit for trying to deal with

this gigantic lacuna in Austrian thought.

Section 7.Hayek’s ”Pretence of Knowledge” paper in 1975

In his Nobel Memorial Topic of 1974, Hayek returned to the topic of his 1937 and 1945

papers one more time concerning the dispersed nature of knowledge available to an

economic decision maker.

However , he added a new twist :

“This brings me to the crucial issue. Unlike the position that exists in the physical sciences, in economics

and other disciplines that deal with essentially complex phenomena, the aspects of the events to be

accounted for about which we can get quantitative data are necessarily limited and may not include the

important ones. While in the physical sciences it is generally assumed, probably with good reason, that

any important factor which determines the observed events will itself be directly observable and

measurable, in the study of such complex phenomena as the market, which depend on the actions of

many individuals, all the circumstances which will determine the outcome of a process, for reasons

which I shall explain later, will hardly ever be fully known or measurable”.(Hayek,1975,p.434)

.

.

.

The reason for this state of affairs is the fact, to which I have already briefly referred, that the social

sciences, like much of biology but unlike most fields of the physical sciences, have to deal with

structures of essential complexity, i.e., with structures whose characteristic properties can be exhibited

only by models made up of relatively large numbers of variables. Competition, for instance, is a process

which will produce certain results only if it proceeds among a fairly large number of acting

persons.(Hayek,1975,p.436)

.

.

.

“Organized complexity here means that the character of the structures showing it depends not only on

the properties of the individual elements of which they are composed, and the relative frequency with

which they occur, but also on the manner in which the individual elements are connected with each

other. In the explanation of the working of such structures we can for this reason not replace the

information about the individual elements by statistical information, but require full information about

each element if from our theory we are to derive specific predictions about individual

events”.(Hayek,p.436)

Hayek ‘s argument is very close to Herbert Simon’s distinction between procedural rationality and

substantive rationality .Simon argued that decision makers were faced with very complex situations

that contained too many variables to analyze given the time and cost constraints involved. There was

too much information/knowledge available for a rational decision making process to consider and

analyze in order to arrive at an optimal decision. Instead of maximizing, decision makers would choose

to satisfice .They would substitute short cuts ,rules of thumb and heuristics in such complex situations.

Hayek does not cite Simon .In any case ,his new position, which is not stated in the earlier 1937 and

1945 articles ,is combined with his earlier emphasis on the dispersion of knowledge :

“ This is particularly true of our theories accounting for the determination of the systems of relative

prices and wages that will form themselves on a well-functioning market. Into the determination of

these prices and wages there will enter the effects of particular information possessed by every one of

the participants in the market process — a sum of facts which in their totality cannot be known to the

scientific observer, or to any other single brain. It is indeed the source of the superiority of the market

order, and the reason why, when it is not suppressed by the powers of government, it regularly

displaces other types of order, that in the resulting allocation of resources more of the knowledge of

particular facts will be utilized which exists only dispersed among uncounted persons, than any one

person can possess. “(Hayek,p. 437)

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.

.

Hayek ‘s conclusion is that the Free market is able to solve this problem:

“ We are only beginning to understand on how subtle a communication system the functioning of an

advanced industrial society is based — a communications system which we call the market and which

turns out to be a more efficient mechanism for digesting dispersed information than any that man has

deliberately designed.”(Hayek,p.440)

Hayek has simply combined Simon’s perspective with his earlier perspective that the set of all

knowledge is complete for the set of all individual decision makers. Uncertainty for Hayek means that

each individual decision maker only has a small piece of the puzzle. However, as a whole ,the aggregated

set of all decision makers have a complete set of all relevant knowledge. There are no pieces missing,

lacking or unavailable from the puzzle. Market prices organize and synthesize the aggregate amount of

knowledge so that market price signals ,understood only by savvy, knowledgeable entrepreneurs,

eliminates any uncertainty.

Keynes, Knight and Schumpeter deny Hayek’s claim that the market generates price vectors which

concentrate the knowledge so that savvy, knowledgeable entrepreneurs can act on this information

and solve the problem of uncertainty. Uncertainty means vital ,important information is missing .Pieces

from the puzzle are missing and will not turn up in the future. It doesn’t help to fall back on the average

opinion of the market in the hopes that the market will be better informed. One can ,of course, realize

that, like Keynes in chapter 12 of the GT, one can create a convention that the market as a whole is

better informed

Section 8.Conclusions

Hayek knew exactly what Keynes, Knight and Schumpeter meant by uncertainty when he

wrote his 1937,1945 and 1975 articles on knowledge. Keynes, Knight and Schumpeter

meant that important ,relevant information, data, and knowledge was unavailable ,lacking

or missing at the time that a decision had to be made about a future investment decision

dealing with the provision of long run. durable. physical capital. Decision making involving

irreversible and irrevocable investments in fixed capital formation in plant and equipment

,subject to the constant threat of technological innovation, advance, change and

obsolescence ,was carried out under conditions where the totality of available knowledge

was known to be incomplete for all decision makers. Uncertainty was not a condition where

the available knowledge was incomplete and dispersed for the individual decision maker, but

complete for all decision makers considered as a whole.

Hayek’s position ,that the needed information and knowledge available for all decision

makers as a whole is complete, but that this complete amount of knowledge is dispersed

widely among the set of all relevant decision makers, directly conflicts with the views of

Keynes, Knight and Schumpeter. Hayekian uncertainty bears an uncanny resemblance to

Milton Friedman’s view that the time series data on changing prices is distributed normally.

This essentially allows the entrepreneur to take advantage of profitable opportunities

.Hayek, while rejecting the position that the normal probability distribution can be applied in

economics

, makes a very similar claim to that made by Friedman when he claims that knowledge

about market prices is concentrated by price vectors in a form that allows savvy,

knowledgeable entrepreneurs to take advantage of profitable opportunities. This perspective

,of course, has nothing to do with uncertainty. Hayek could not accept the standard concept

of uncertainty as defined by Keynes, Knight and Schumpeter because it would then be

impossible for market prices to concentrate knowledge that did not exist.

In conclusion, nowhere in any of Hayek’s three articles on Knowledge in Economics in 1937 ,1945 and

1947 does Hayek deal with the standard view that uncertainty means knowledge that is not there .

REFERENCES

Schmitz,Stefan,2004.”Uncertaimty in the Austrian Theory of Capital”.The Review of Austrian

Economics, 17:1,,pp.67-85.

Hayek, F.A.1975.”The Pretence of Knowledge ”.Swedish Journal of Economics,77(4),pp433-442

(Reprinted in August, 1989. American Economic Review

American Economic Association, vol. 79(6), pp. 3- 7)

Hayek, F. A. (1937) “Economics and Knowledge.” Economica, 4: 33–54.

Hayek, F. A. (1941) The Pure Theory of Capital. London: Routledge & Kegan Paul.

Hayek, F. A. (1971) “The Use of Knowledge in Society.” In: Townsend, H. (Ed.) Price Theory, pp. 17–31.

Hamondsworth: Penguin Books; reprinted from: American Economic Review, 35: 77–91.

Keynes,J.M. 1921.A Treatise on Probability.London;Macmillan.

Keynes,J M.1936.The General Theory of Employment, Interest and Money. New York ; Harcourt,Brace

and Company,1964.

Knight,Frank.1921.Risk,Uncertainty and Profit.Boston,Ma.Houghton,Mifflin and Com

Schumpeter,Joseph A.1912.The Theory of Economic Development: An inquiry into profits, capital,

credit, interest and the business cycle)