Hayekian Knowledge Arguments: An Epistemic Fallacy?

14 March 2008 at 7:52 am 7 comments

| Nicolai Foss |

A small handful of papers have become highly influential in economics as well as in management and organization research. One such paper is Friedrich Hayek’s 1945 essay, “The Use of Knowledge in Society,” a paper that emerged in the context of the debate on the viability and efficiency of planned resource allocation on the societal level (i.e., socialism) that raged among academic economists in (particularly) the inter-war period. Hayek famously argued that planning confronts inherent knowledge-based constraints, and these constraints are certainly binding at a scale of activity that makes comprehensive overall management/planning of economy-wide resource allocation deeply inefficient. Many modern management thinkers have echoed this argument, arguing that “traditional” authority relations are increasingly challenged by the (increasingly) dispersed nature of knowledge.

However, at least when applied to authority in firms the Hayekian knowledge argument arguably misconstrues the nature of managerial authority, because it is based on an epistemic fallacy.

The fallacy lies in the argument that making rational decisions as a principal or employer concerning agents or employees presupposes full knowledge of their available action repertoire. As Simon argues authority can be understood as a command that takes the form of a result to be produced, a principle to be applied, or goal constraints, so that while the end result may be described, the methods of reaching it are not. In actuality, this is no different from how most agents interact with specialized other agents in the market place. Thus, most of us non-plumbers usually don’t know the full action set of the plumber, or what exactly to do in response to some calamity involving the plumbing of our house. Still, we do rely on our judgment of the plumber, possibly supplemented with reputational mechanisms. Market transactions do not break down when there is only partial knowledge overlap. By the same token, hierarchical mechanisms, involving authority, do not break down when there is only partial knowledge overlap. Exchange, whether in the market or inside firms, is perfectly possible in the face of ignorance.

Frank Knight in Risk, Uncertainty and Profit very clearly recognized this. The arguably key concept in Knight is that of “judgment,” that is, the ability to make decisions concerning resource uses in situations involving genuine uncertainty, that is, situations in which the range of outcomes and the probabilities of outcomes are unknown. More compactly, judgment is the human faculty that makes it possible for us to make decisions, even under severe ignorance. While Knight’s (1921) main interest in judgment lies in its role as a basis for a theory of profit and the firm, he understood very clearly that the effective exercise of authority does not require full knowledge of an employee’s action set and precise knowledge of exactly which action should be picked in response to contingencies: “What we call ‘control’ consists mainly of selecting someone else to do the ‘controlling.’ Business judgment is chiefly judgment of men. We know things by knowledge of men who know them and control things in the same indirect way” (Knight 1921: 291). Delegation, Knight argues, rests on judgment. Again, such judgment does not require that that the principal knows the employee’s entire action set. Hierarchical organization is conceptualized by Knight as a layer of agents exercising judgment of subordinates’ judgment, that is, nested judgment. Although a manager may still be ignorant in an important sense about the knowledge controlled by his employees he does not suffer from complete ignorance; there is some, possibly very modest, knowledge overlap. He may therefore be able to pass judgment on the overall abilities of those employees, and, in particular, about how actions based on their knowledge may be coordinated. In other words, it is possible to have knowledge of types of interdependencies between actions based on different knowledge elements without possessing much knowledge of the actual interdependencies or the actions themselves. (Whether this has implications for the theory of socialism is an open issue).

The above issues are treated in a recent paper, “Hayekian Knowledge Arguments in Organizational Theory” by Kirsten Foss and yours truly. Mail me at njf.smg@cbs.dk if you want to receive a copy.

Entry filed under: - Foss -, Austrian Economics.

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7 Comments Add your own

  • […] Hayek understand management? Not as well as Frank Knight, at least according to Nicolai Foss: Hayek famously argued that planning confronts inherent knowledge-based constraints, and these […]

  • 2. JC  |  15 March 2008 at 5:51 pm

    There are two separate notions here; (a) judgment and (b) control. It is easy to get them tangled up. The most immediate source of Knight’s view is John Locke’s – as those familiar with my treatment (in Industry Recipes p,45) of what Nicolai is calling ‘genuine uncertainty’ will recognize. Locke, while adopting a characterization of ‘mind’ as combining both reason (logicality) and ‘judgment’ – to be used when ‘clear and certain knowledge is not to be had’ – is really engaged in subordinating judgment to rationality – for various reasons not relevant here. But in this sense Knight is being more aggressive, epistemologically, for he makes judgment the core of his theory, almost subordinating, perhaps, rationality to judgment.

    But if we admit judgment into the analysis the question then arises, how is the judgment of others to be ‘controlled’? Knight’s suggestion, that one depends on others who have better knowledge and therefore do not need to apply the same kind of ‘judgment’ is hiding the contradiction – how do you know who to delegate to? This implies a different kind of certain knowledge – the overlap to which Nicolai refers, thereby invoking what Hayek points out is simply NOT available.

    Notwithstanding, Knight is one of a handful of people – Simon being another – who ever asked this question in the context of theorizing firms, and is deservedly honored for the impact he made in so doing.

    What is needed, of course, are some viable answers. They seem likely to fall into two groups (a) theoretical and (b) matters of practice. By theoretical I mean answers that follow from a more substantial theory of mind than that, or those, which currently dominate our literature. In this sense behavioral economics is clearly a small but significant step forward. Other theories of mind, some based on recent neurological work, are floating around and have encourage some to think the answer is at hand. By practice I imply something closer to ‘situated logics’, and there is an expanding neo-Vygotskian literature here.

    I would be exceptionally interested in others’ views of what might be done at this stage.

  • 3. srp  |  15 March 2008 at 6:52 pm

    According to Paul Graham, software essayist and Silicon Valley promoter, it is almost impossible for a non-programmer to assess whether a given programmer is good or not. He claims it’s also very difficult even for a skilled programmer to assess another person with whom he hasn’t worked directly.

    The problem with this as a critique of Hayek is that Hayek doesn’t make the knowledge problem strictly about action sets. It’s also about preferences and behavior. There is a very good question about how big the size, scope, and diversity of an enterprise has to become before this particular Hayek critique sets in. (But you also have to bear in mind the difference between an organization and an order in terms of shared purpose, which is a separate issue.)

  • 4. JC Spender  |  15 March 2008 at 10:10 pm

    Thanks for this comment.

    SRP provides an excellent illustration of ‘situated logic’. Then adds that even when this is allowed there is surely some point at which ‘the situation’ becomes so large/complex/multifaceted (?) that the individual’s practice-based logic/judgment is stretched beyond the limits of its ‘bounded-ness’ – to use Simon’s term.

    I’m interested in the increasing number of executives who try, in their various ways – sometimes in court, sometimes as they attempt to justify their pay-packets – to explain the modern corporation has reached this critical degree of complexity. No human mind can any longer grasp its globalized multi-cultural multi-technology inter-relations – which likewise reminds me of Perrow’s early work on systems failures. It is not so much that the anti-missile system is bound to fail – along the lines of a column exceeding its Euler buckling height – as the firm, as an anti-poverty system, also fails at a certain point. Which then reminds me of Rumelt’s classic PhD work on related and unrelated diversification.

  • 5. stevphel  |  17 March 2008 at 1:34 am

    Remebering, of course, that this critical inflexion point is not fixed but evolves according to institutional and organizational innovation (e.g. the invention of the M-form organization to manage multidivisional firms). Accordingly, complexity should be a rich topic for organizational scholars.

  • 6. srp  |  17 March 2008 at 4:48 am

    I just read the Fortune issue (March 17) with the Most Admired company survey and they had a couple of articles about Apple (give a round of applause for our new Voted Most Popular student!).

    One point it makes is that upon Jobs’s return to the helm the company drastically cut down its product portfolio so as to get management focused on making a few great products rather than a host of mediocre ones. (They contrast this with what they incorrectly allege is a tendency of business schools to preach diversification, but what the heck.)

    When you read in an interview with Jobs that he a) wants his managers to have a lot of autonomy (with “kibitzing” from him), b) he wants each manager to know all about the entire Apple business so that they internalize tradeoffs properly, and that c) every Monday the top management team spends hours reviewing the entire business from top to bottom, you can see that reducing complexity may be a necessity for Apple to carry on its current style.

    According to Jobs, every Monday the management team reviews the previous week’s sales, every single product under development, every product they sell, goes over development snags, capacity problems, and so on. You can see how that style of management would not work if the product portfolio were really diverse and big–the complexity would overwhelm the process. (You can also see how product-oriented Jobs and the whole company is.) So it’s a pretty stark example of complexity limits on managerial oversight.

  • 7. JC  |  17 March 2008 at 12:32 pm

    In Industry Recipes I suggested the limits to the firm’s size arise from the ‘amount’ of uncertainty embraced. This is not merely the result of the management’s strategic decisions about what activities to draw into the firm – the Coasian make or buy notion – but also to do with the institutional context in which these decisions are implemented.

    I feel this suggestion is more or less the same as that of Penrose when she notes the limits to the growth of the firm are set by the management team’s ability to learn how to negotiate the disjunction between resources and the services they provide.

    So I’m agreeing with Steve. But his use of the term ‘complexity’ may throw a lot of people off. Complexity may have little to do with ‘genuine’ Knightian uncertainty.

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