It's Knowledge, Stupid

The (sometimes) elusive role of knowledge in most economic models

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Economics is about choice. On the first day of the semester, I tell my students (stealing from Anthony Carilli) that to choose is “to apply means to ends, according to ideas.” This seems more or less standard economics. In consumer theory, ends are preferences. The means determine which ends are mutually compatible. For example, my budget of $50 at the grocery store limits the ends I can achieve. I can’t get the $30 bottle of wine and the $30 steak.

But ideas??? Where do ideas fit in?

We (economists) know how important ideas and information are. It’s all in Hayek! Hayek taught us that the data, the facts, the ideas, and the knowledge in an economy don’t just exist out there in the ether. Data, facts, ideas, and knowledge are possessed by people. As with much of Hayek, this seems obviously true. (I may have no idea what it means, but it seems obviously true.)

Yet the basic consumer/producer theory in economics, the stuff the textbook says I should teach, basically ignores the role of ideas and knowledge. Back to me as the consumer at the grocery store, just buying food turns it into utils.

I hate to break it to economists…. But that’s not how it works. Food doesn’t just turn into utils. If you buy raw ingredients, the utility will not only depend on how much income you have but also your knowledge of how to prepare meals. There is a production process that differs depending on the knowledge of the consumer. A set of ingredients in my shopping cart will lead to a different outcome for someone who actually knows how to cook.

For the price theory nerds, this should remind you of Gary Becker’s work on the allocation of time, goods don’t just miraculously turn into utils. Instead, Becker emphasizes the need to allocate time to make that happen. He was digging into the details of how households operate by reimagining them as producers who combine time and market goods through "production functions” to produce what ultimately matters.

Further down the price theory nerd rabbit hole, Philip Wicksteed (who first disputed the idea of supply curves) called the details of how to turn the raw ingredients into what people actually want “household administration.” That’s a good term. Once you take a household administration lens and frame the problem facing households that way, the role of knowledge can take center stage. Louis Makowski and Joseph Ostroy call this “know-how.” I steal much of this newsletter’s idea from their unfinished paper.

There Is No Such Thing As Supply

Good economic theory allows us to find similarities that we would never have thought of without the theory. Becker’s work shows how we can gain from thinking of households like firms.

I want to argue we can gain by thinking about firms like household administrators. Just like the consumer turns food into utils, in the standard model, the producer turns inputs into outputs by the magic of the production function. There is a form of knowledge embedded in the production function.

But as Hayek forced us to ask, who has that knowledge? In the standard formulation, there are owners of the firm. Those owners maybe share profits. But if one of those owners dies, nothing changes. When Elon Musk buys Twitter, nothing changes. The firm doesn’t change. The knowledge isn’t lost. Since the production function fell from the sky and no one owns the knowledge of the production function, we keep trudging along.

The knowledge aspect of production is fundamentally different from the other inputs. This isn’t a new idea. The Marshall-Arrow-Romer model of endogenous growth stresses that knowledge is non-rivalrous and that there are spillovers between firms. Because of these features, ideas aren’t subject to the same diminishing returns, and you can even have increasing returns.

When Supply Curves Slope Down

Imagine one person does possess the ideas or knowledge about how to turn inputs into outputs. Paul Romer sometimes uses the word “blueprints”. That’s a great word because it highlights that it doesn’t fall from the sky (like a production function), but someone initially comes up with a blueprint.

I want to stress a different aspect than Romer. Instead of simply being a public good that anyone can pick up, knowledge is actually hard to transfer.

The problem is that I can’t easily buy and sell knowledge. Sometimes you can sell knowledge: people sell patents, people sell software, people sell books. However, a lot of knowledge can’t be sold. The term “blueprint” misses that. There’s an indivisibility, a lumpiness, to knowledge that makes it different from other assets that I could bring to a production process. I can’t sell a small chunk of it and receive its marginal product. When ideas are challenging to sell, the structure of production changes.

Let’s consider Smith’s pin factory. There are many steps along the way, from the inputs to the final output of a pin. However, it need not occur in a factory. Historically, workers carried out some of the steps in their homes. We could imagine that the person who washes and wraps the wire could sell that to the person who pulls the wire. That person could sell it to the next. The firm isn't necessary if you can break down production into neat steps. As Coase pointed out, production could happen, step by step, through markets without transaction costs. The firm contributes nothing when trading is possible.

It is common to imagine a firm as a bunch of capital. If the owners could sell that, then the opportunity cost of running the firm is the value of selling the capital. In the extreme, if the owners of a firm could sell every single asset they own, including the entrepreneurial ideas, they may still run the firm. Still, they make no profit relative to simply being an intermediary. If knowledge is the same as other assets and other firms don’t have your knowledge, you could sell it to them.

Let’s return to Smith’s pin factory. Someone needs to know the process, not just each step. Moreover, the production is lumpy in that a half-finished pin is not valuable. Only the whole production process generates something valuable. And given that it takes knowledge to complete the process, someone needs the overall blueprint.

If production needs to be thought of as one whole process, compared to a bunch of unique steps, I’d expect the process to be organized under one roof. Let’s call that a firm. In Alchian and Demsetz’s original theory of the firm, written 50 years ago this year, they stress the role of the firm as a monitor of workers. But “monitor” is very broad

It connotes measuring output performance, apportioning rewards, observing the behavior of inputs as means of detecting or estimating their marginal productivity and giving assignments or instructions in what to do and how to do it. (emphasis added)

Most economists stress the first part of that quotation, but the italicized part matters too. A central role of the firm is to give out instructions on what to do and how to do it. If the firm is successful, it earns profits. Nicolai Foss and Peter Klein stress a similar knowledge-based explanation of firms and profits under what they call “judgment,” which stresses it’s not as predictable as the story above supposes.

Let’s close out by returning to Hayek and the role of prices with knowledge. People will often talk about how prices are great because they convey information about market conditions. When there is a drop in tin production, consumers gain knowledge of this through prices.

I understand why the connection between prices and knowledge is framed this way, but that’s exactly backward. Prices are informationally efficient because they don’t convey knowledge. Instead, prices let everyone else make decisions based on their private knowledge, without needing to know what anyone else knows. Prices work, despite the fact that they do not convey knowledge. Given entrepreneurs can’t rely on prices to convey knowledge, they won’t be rewarded by the market for their knowledge. It’s only once the process no longer requires much knowledge that it becomes a finished product that is sold on the market.