Book review: Knowledge and Decisions by Thomas Sowell

One of the most famous and insightful pieces of economic writing is Friedrich Hayek’s The Use of Knowledge in Society. Most of you have probably read it, if you didn’t I recommend it (only 5-7 pages)!

Economist Thomas Sowell wrote a book Knowledge and decisions, building further on this line of reasoning. Compared to the article, there is not that many new insights. But Sowell expands on Hayek’s worldview and offers some interesting definitions and ways of looking at the world.

His book was written in 1980, and yet many insights about how the government operates ring true today. It is a due reminder that to understand the present and future, it is no wasted effort to understand the past.

The most foundational principle of the book: the core use of information is to make trade-offs. You can distinguish categorical from incremental decisions, Sowell prefers the latter. Or in other words, avoid step functions.

Core principles from the book

Sowell models the world as organizations of different sizes, operating under a diverse set of processes. Whereas Hayek’s original essay is mainly focused on explaining the role of prices in conveying information, Sowell aims to look at other mechanisms which create and correct knowledge. For example, the importance of feedback:

“Given the crucial importance of feedback in using knowledge to make decisions, the transfer of decisions from one kind of institution to another raises serious and even grave questions as to which institution is inherently more open to feedback and which more thoroughly insulated from it. The nature of the feedback process is also important: Is it mere articulation, in which some may have great talents without a corresponding depth of understanding, and in which others may choose to listen to or ignore, or is it inarticulate but powerful mechanisms ranging from money to love?”

Information is not always true. The degree to which authentication of the information has taken place, separates pure beliefs from ever more verified pieces of knowledge:

“Authentication is as important as the raw information itself. [...] This means that the ratio of knowledge to belief may also vary enormously from one aspect of life to another. [...] In short, the degree of authentication of knowledge may be lower in the “higher” intellectual levels and much higher in those areas which intellectuals choose to regard as “lower.”″

Moreover, it is also important to consider who is the Decision Making Unit. Is it a person or an organization? Which incentives govern the different elements of the unit? Only when you can answer these questions, does it make sense to discuss the unit. Therefore, don’t say “society” as it is made up of many smaller conflicting units. The market is also no decision making unit but: “simply the freedom to choose among many existing or still-to-be-created possibilities.”

The bigger the unit, the bigger the potential costs of consensus. In other words: large decision making units have higher more transaction costs. “The net difference between policy x and policy y may be far less than the cost of choosing, or one policy may require far more consensus than the other.” Similarly: “In some cases-an extreme example being a combat unit under enemy fire-the time spent discussing alternatives may be more costly than either alternative itself.”

Proponents of direct democracy may think that consensus between decision making units is an important factor to optimize, but you can also look consensus as a cost to minimize:

“On the contrary, we satisfy our desires at least cost-which is to say, we can satisfy more of our desires-by minimizing the amount of consensus that is necessary. We easily provide ourselves with food and clothing precisely because there is no consensus needed as to what is the best food or the best clothing. If we had to reach a consensus first, we might destroy ourselves in the process of trying to meet simple basic needs.”

And as I wrote about before, beware of notions of ‘efficiency’, they are often simply expressions of preferences:

“People who are convinced that their values are best-not only for themselves but for others-must necessarily be offended by many things that happen in a market economy, whether those people’s values are religious, communistic, white supremacist, or racially integrationist. [...] Looked at another way, the more self-righteous observers there are, the more chaos (and “waste”) will be seen. Although neither value nor efficiency is wholly objective, the idea that they are dies hard. Denunciations of “inefficiency” and “waste” are often nothing more than statements of a different set of preferences.”

On the use of incentives

Every economist is told and taught that financial incentives matter, but the extent to which this is true is remarkable. A morally repugnant example:

“The practical limitations of sheer subordination were repeatedly demonstrated by the various economic incentives which had to be resorted to under slavery, especially for getting higher quality work performed. [...] Concentration camps in both Nazi Germany and the Soviet Union were far less economically efficient than the totalitarian societies of which they were a part,18 but they were maintained despite this, for political purposes. Slave plantations were profit-making enterprises,” inherently limited by that fact in how far they could go in oppressing or destroying the sources of their wealth. Whatever moral equivalence may have existed between the two kinds of institutions, they were neither politically nor economically equivalent.”

Business owners themselves are just as enslaved to their incentives:

“It is not as a retrospective sum that residual claims have a major impact on the economy. It is as a prospective incentive that it profoundly affects behavior and the efficiency of production. If residual claimants were guaranteed in advance the very same sums which they end up earning, the whole economic system would function differently. With everyone in the economic system essentially on guaranteed salaries, the monitoring problems would be massive.”

And with a bit of luck our government officials are as well:

“In an economy coordinated by government decisions, the same economic resolution would be efficient, though it would have to be reached institutionally through a political or administrative process. Whether the same resolution would be reached in fact would depend upon the extent to which the particular institutional arrangements convey the same knowledge of consumer preferences (incremental trade-offs) and production costs (incremental trade-offs), and whether that knowledge was conveyed in a form that was “effective” in the sense of constituting a personal incentive to the decision maker.”

Sowell is skeptical though:

“The competition among political groups does not therefore bring to bear more accurate knowledge, as in economic competition, but promotes exaggerated hopes and fears-and sometimes deeds.”

On formal versus informal processes

Society is built on increasing returns to scale, which has an all too familiar impact on economic activity: goods and services become homogeneous. We all use similar types of toothpaste, have the same working environment, and operate using similar email protocols. Only then top executives can rely on statistics and formal chains of command to make competitive decisions. And this has consequences for our behavior:

“almost by definition, key indicators can never tell the whole story. This affects not merely the justice or injustice of the reward, but also the very nature of the behavior that occurs within the given structure of incentives.”

“Informal relationships are not only able to acquire much knowledge at lower cost than formal organizations in some cases, but are generally able to apply it in a more specific or “fine tuned” fashion in making decisions. Among the reasons are that informal decision making is more likely than formal procedures to be incremental rather than categorical, individualized rather than “package deals,” and episodic rather than precedential.”

“The apportionment of decision making as between informal and formal processes involves a trade-off of flexibility for security. A’s flexibility is B’s uncertainty as to what A will do.”

On non-monetary trade-offs

There are several other non-monetary social and political values which Sowell examines (it is unclear if he thinks these are the most important, I think it is mostly to make a point about how life is always about trade-offs):

the sorting and labeling of people, activities, and things
time
safety
freedom
rights

The main argument goes as follows: significant parts of society are structured to balance these values to a certain degree. We sort- and label things to assess them quicker, but thereby always lose some information. We apportion a certain amount of freedom, but thereby also risk making society less fair. The organizations and processes we build never satisfy everyone’s desires or all of the values. This makes it important to care about general characteristics like good feedback mechanisms and incremental improvements.

Democracy does not equal freedom:

“Indeed, democracy itself is a consideration that is traded against freedom, and at one time this trade-off was both recognized and feared.”

Nor do rights equal justice:

“Rights in this sense are simply factual statements about the availability of state power to back up individual claims. They are simply options to use governmental force at less than its cost of production-ideally at zero cost.”

Conclusion

I can’t shake the feeling that throughout the book Sowell tries to make a case for a more right-wing/free-market point of view without admitting it, albeit in the most eloquent manner. But there are some one-liners to keep thinking about for a long time:

“The desire for freedom and for its opposite, power, are as universal as any human attributes.”