Great Economical Thinkers: Hayek
Friedrich Hayek [1] (1899 - 1992) was an Austrian-Hungarian economist and philosopher, Nobel Prize in Economics Award (1974) for his work on booms and busts economic cycles. He is known for his defense of classical liberalism. Hayek served in World War I and said that his experience in the war and his desire to help avoid the mistakes that had followed to the war led him to his career. One of Hayek’s main observations was that when governments interfere in the economy it results in people acting in ways that are not sustainable, which ultimately leads to booms and then inevitably, busts. An example would be a politician that thinks he has a great idea for creating jobs and prosperity. With the best intentions he convinces the government to support companies so that they can develop and build factories to produce candy. If there really was demand for candy, factories would appear without the government’s assistance. What if there is no real demand? The resources provided by the government, whether in the form of direct support like subsidies, or indirect support like loan guarantees, distorts the economy by encouraging people to make bad decisions. In this case, to use resources to make candy. As the lack of demand for candy becomes apparent, businesses must adjust by retooling or making cuts in factories adjusting their production lines, changing their distribution networks, etc. All of these things mean idle resources in the short term (unemployment) as businesses adjust to the reality of the market. The challenge is to ensure that producers have the knowledge and the incentives to produce goods and services that people want. Government interference, such as subsidies or manipulation of the money supply obscures that knowledge by distorting prices. This interference, by initially causing producers to accelerate to produce things that consumers don’t really want, inevitably results in producers having to downsize and/or readjust in order to better meet true consumer demand. The core in Hayek’s theory is that government interference even when done with the best intentions changes people behaviour by changing incentives, and changing signals in the market. These changes result in investments that are not sustainable and which ultimately lead to recessions or busts. Another of his most known ideas was the role of prices and information. All economists understand that people make decisions based on the cost they face and the benefit they receive. In most cases, the key cost of a decision is the price the person faces to purchase a good or service. Let’s take an example of a consumer that likes Colombian coffee, which she buys at the local shop. The local usually sells their coffee to her for 10 USD. She does not know the details or cost of how the coffee beans are grown, the irrigation at the coffee farm, how the beans are roasted, or how the coffee beans are transported to her store. All she knows is that her favourite coffee costs 10 USD and that it is worth it for her. What happens if bad weather severely damages the coffee plantation in Colombia? Bad weather and plant damage will mean fewer coffee beans from Colombia and that results in the price of coffee going UP. When the customer goes to her local store, the price of coffee is now 20 USD. The customer does not know why the price has gone up, nor does she need to know. The increase price means that she will have to give up something else to buy that same coffee (her budget remains of course, fixed). She might even buy another coffee now, like Indonesian, for only 9 USD. Her decision is purely based on the price she saw on the grocery store, regardless of the cost composition of the product. Customers simply know what the price IS – and that is sufficient to prompt each of us to act as if we know vast quantities of facts about economic reality that we can’t possibly really know. Interestingly enough, and tying this article to my experience in entrepreneurship and the business world, most entrepreneurs and business people do NOT understand that there is NO relationship between PRICE and COST. The price is given by supply and demand and defined by the market. The cost is given by the production or service cycle the company has to go through. The difference between the price and final cost will be the profit margin. If the cost is higher than the price, there will be no profit, and there is no business. Many entrepreneurs do a strange calculation where they mark-up the cost, let’s say a 20%, and that is the price. If the new pricing is accepted by the consumer, that is ok. However, if it becomes too expensive the volume of sales will diminish, the final amount of sales remaining the same but at a higher cost, liquating the profit.
In my next article, I’ll discuss my favourite economist of all times: Lord John Maynard Keynes, the founder of modern Macroeconomics. Check out this funny video of the eternal battle between Hayek and Keynes:
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