Open, competitive markets have a resilient capacity to successfully coordinate the actions of billions of people around the world. With an amazing adaptability to changing circumstances, the actions and reactions of suppliers and demanders are brought into balance with each other. Yet, none of this requires government planning or control. But how does this all come about?

The key to this coordinating process is often assigned to the pricing mechanism of the market economy. All the minimal information that anyone needs to bring his own actions as supplier or demander into balance with multitudes of others is provided by the changing pattern of relative prices for finished consumer goods and the four factors of production.

Types and Uses of Knowledge in Society

The medical doctor knows many things that the criminal lawyer does not. Austrian economist Friedrich A. Hayek explained how this came about almost 75 years ago in his famous article, “The Use of Knowledge in Society,” first published in the American Economic Review in September 1945. He emphasized that matching the division of labor is an inescapable division of knowledge. Specialization necessarily means that each of us knows things that others do not.

Each of us possesses different types of knowledge in different complementary combinations. For instance, all of us, to one degree or another, have acquired what Hayek referred to as scientific or “textbook” knowledge. This is the type of knowledge we learned in school, and while we all learned many of the same things in our classroom experiences, we focused on and acquired far more specific knowledge about some certain subject. Individuals select different majors at the same or different institutions of higher learning. The medical doctor knows many things that the criminal lawyer does not, just as the lawyer has a detailed knowledge of his area of the law that the biologist or the architect does not possess based on their classroom and textbook learning.

Localized Knowledge & Inarticulate Knowledge

But Hayek pointed out that there is also another type of knowledge that we each possess in different ways, what he called “the localized knowledge of time and place.” This is a particular knowledge that is only learned, appreciated, and usable based on an individual working and interacting with others in a specific corner of society and the marketplace.

Little of this knowledge could be learned in the classroom. The recently-graduated young employee shows up for his first day of work in the enterprise that has hired him. There is a period of getting oriented: Meeting the other employees and finding out what, exactly, they do; the nature of the way “things are done” within the firm in terms of rules and procedures; learning who are the individuals and groups of buyers and sellers that company sells to or buys from. The production processes or service activities undertaken and performed may be distinctly different from how things are done in competing firms in the same industry or from those in other markets.

Little or none of this knowledge could be learned in the classroom or read about in any readings assigned to pass a course. Yet, such “intimate” knowledge in all these “mundane” matters are crucial for everything in each corner of the market system to run smoothly and effectively.

The entrepreneur, in particular, needs to know all of these and many other details about his specialized area of the market in which he operates if profits are to be earned and losses avoided. In addition, all of these localized circumstances and situations are subject to continual change in a dynamic market setting in which things today may be different from yesterday, just as tomorrow may vary from the situation today.

Think of the auto mechanic who can “just tell” what’s wrong with an engine.

Hayek later highlighted a third type of knowledge, what the chemist Michael Polanyi called “tacit” or “inarticulate” knowledge. This is knowledge that each of us possesses in various forms that concern how to do something but which we often find it difficult or “impossible” to easily put into a word form to convey with others.

Think of the auto mechanic who can “just tell” from listening to and looking at an engine that is not functioning properly what is wrong with it, but he cannot easily put it into words for the car owner. Or the master sculptor who knows just the right amount of hand pressure to place upon the watered piece of clay on the wheel whose speed he is controlling with a foot pedal, but he could never precisely put it down on paper so others could readily copy the technique that he uses to produce a pleasing piece of art.

Using All the Knowledge No Planner Can Master

These diverse types of knowledge, which are possessed in different combinations in the minds of all the interconnected and interdependent individuals in a modern complex market system and social order, can never be known, Hayek argued, by any one mind or group of minds, no matter how wise and determined they may seem or try to be.

Hayek’s point was that if we are all to benefit from what others know that we do not, but which, when brought to bear, can improve our circumstances in ways we cannot fully imagine ahead of time, then the individuals possessing all this diffused knowledge must have the liberty and market-based latitude to utilize it in ways that they understand best. Otherwise, much that is known and potentially used by many others that could improve our own circumstances will not be taken advantage of or even discovered.

But if not under the commanding instructions of a central planner or government regulator, how will people know how, when, and for what to apply their unique bits of knowledge, which cumulatively add up to all “the knowledge in the world,” but resides in no one mind or group of minds?

Worldwide Knowledge and the Price System

Hayek’s answer was the competitive pricing system of a free market. It is not necessary for everyone to know what all the others in society possess as their unique knowledge. It is sufficient if there is an institutional mechanism through which people can convey a minimum required amount of information to others, so producers and suppliers may know what products consumers want and how intensely they desire them.

Consumers and producers “speak” to each other through prices. Likewise, it is not necessary for every private enterpriser to know all the other businessmen who have a competing use for all the different types of means of production to make up their minds about how best to manufacture a product that minimizes the cost outlays to maximize the profits that might be earnable.

Consumers and producers “speak” to each other through the prices that are offered on the market. This tells multitudes of suppliers what products are wanted by consumers and what price might be paid for them. The prices offered by rival enterprisers and accepted by labor and resource owners looking for employment tell each businessman the relative costs to be paid to hire or purchase various combinations of inputs relative to the anticipated selling price.

Thus, businessmen and workers and resource owners thousands of miles away from each other on other sides of the world can make reasonable and informed decisions about how to apply their own specialized forms of knowledge in ways that they hope profitably improves their own circumstances by satisfying the wants and desires of many others; others who they will never meet or personally know and who may live far away or around the corner, nor do they need to.

Knowledge Needed for Forming Expectations

Prices need to be interpreted to successfully form expectations about the actions and reactions of others. But there is a fourth type of knowledge that is equally essential for social and market participants to successfully coordinate all they do that is interdependent with the actions of others. Hayek insightfully explained the central role of market-based prices for bringing together the dispersed knowledge of the world to help bring into balance all that is done by those buying and selling in the social system of division of labor.

But when prices change, or even stay the same, what are they telling the relevant market participants about what it suggests will be the situation tomorrow?

Prices need to be interpreted to successfully form expectations about the actions and reactions of others in the marketplace in deciding how best to use one’s own specialized knowledge in effective ways for the achievement of one’s own ends.

An understanding of how people actually form many of the expectations that guide and direct their interactions with others was developed in the writings of the famous German sociologist Max Weber (1864-1920) in his monumental work, Economy and Society (1921), in the works of the Austrian sociologist Alfred Schutz (1899-1959) especially in The Phenomenology of the Social World (1932) and in a variety of his essays written in the 1950s, and in the works of Ludwig von Mises, most particularly in Human Action: A Treatise on Economics (1949, 3rd revised ed., 1966) and Theory and History (1957).

Max Weber on Meaningful Action and Ideal Types

Weber argued that what makes “human action” distinct is that it is conscious conduct to which an individual assigns a “subjective” (a personal) meaning, and that the meaning defines what kind of action the individual is undertaking and with what end in mind. But no man is an island; he interacts and associates with others. As a result, Weber said, “social action” is conscious human conduct in which individuals “orient” their actions intentionally toward one another.

What makes the transfer of objects between individuals an act of “free exchange” is how the transactors view their own intentions.

For instance, Weber argued that what makes the physical transfer of two objects between two individuals an act of “free exchange,” as opposed to being some compulsory transfer, is how the transactors view their own intentions and that of the other with whom they are interacting. Weber’s primary focus was developing various interpretive tools of analysis for the study of history.

Thus, he argued that a central tool of history and sociology is the “ideal type.” This was meant to be a composite image of a “type” of an historical person or activity. Thus, one might construct an image, or “mental picture,” of the “typical” characteristics of a Latin American military dictator, or the qualities and characteristics of the “typical” Medieval “lord of the manor.” Or it might reflect the “typical” aspects and forms of development of the “typical” Western European city in the modern era.

Alfred Schutz and the World of Intersubjective Meanings

But it was the Austrian sociologist Alfred Schutz, who had studied at the University of Vienna and who was part of Ludwig von Mises’s circle of scholars in Vienna of the 1920s and early 1930s, who took Weber’s ideas and combined them with aspects of Austrian Economics to develop a theory of how expectations are formed and used by human actors in society.

While we may reasonably speak about the general qualities discoverable in all human conduct – what Mises named “praxeology,” the logic of human action – Schutz emphasized that filling in the actual “content” of that general logic of action comes from the social setting into which people are born and within which they interact with others.

Regardless of which individual is playing this role in society, we anticipate each will act toward others in a generally prescribed way. We are born into an existing social world, and we learn a language, customs, traditions, rules of conduct, etc., by growing up in a family, around friends, within a society of other human actors from whom we absorb the interpersonal structures of meaning that define and “objectify” the meaning of actions and objects.

For instance, this object is a “book” and this other object is a “Halloween mask.” This object is a “knife” for carving meat, while another sharp object is a “surgeon’s scalpel” for performing a “medical operation.” This person’s “kneeling” before a woman is a “proposal of marriage,” while this other person’s “kneeling” before a “royal queen” is being “knighted” for acts of “valor” or “heroism.”

The division of labor brings about not only a specialization of tasks but particular forms of standardized conduct in performing them in various social and market settings, Schutz explained. Thus, we come to expect that anyone understood as performing a certain task in a certain way, and, perhaps, dressed in a specific manner is a “policeman,” or “fireman,” or airplane “steward,” or “bank manager,” or “server” at a restaurant, or “mailman” on their delivery rounds, or . . .

Regardless of which individual is “playing this role” in society, we anticipate each will act toward any others with whom they interact in a generally prescribed way. Likewise, that person expects anyone interacting with them to act and interact in expected ways.

The mailman does not expect any of us to ask him what may be the cause of a heart palpitation. Nor will the fireman expect that a person whose house is on fire is going to ask him what is on the menu for lunch in business class on a flight they are scheduled to be on later in the week. These “ideal typifications” of tasks and routinized conduct in various specialized roles in the division of labor provide essential everyday points of interpersonal orientation and expectations for planning one’s own actions.

Thus, if I go into a bank I know that if I sit down with a bank manager he will be able (and is expecting to) to offer information to me for applying for a home or car loan or opening a new account. If I make an appointment with a dermatologist, I know he will be able (and he expects) to do an examination and offer a diagnosis of a skin problem I may have.

Our Personal “Ideal Types” of Each Other

Alfred Schutz also highlighted that such “ideal types” of people are along a spectrum. At one extreme are those most general characteristics of all human action, which is the basis for Ludwig von Mises’s formulation of a general logic of choice and action, “praxeology.” In the middle of this spectrum of ideal types are those just explained of “typical” roles and specialized activities often routinized in the division of labor.

As they sit in the class and interact with me they come to formulate an image, an “ideal type,” not of all men, but of me. And at the other end of this spectrum is what Schutz called the “personal ideal type.” This is not the general characteristics discoverable in any human action or the specialized “types” of actions expected from any individual performing a particular role. Instead, these are the qualities or characteristics “typifying” a particular, distinct individual. This is our “mental image” not of all men, or some men performing specialized tasks, but of this specific human being.

I explain to my students that when they entered one of my classrooms for the first time, what could they anticipate about me? Certainly, that I am a human being and they could expect that I would demonstrate those qualities known to be true about any other person. But they also had an image in their mind, an “ideal type,” of a “college professor,” and a college professor who (hopefully!) knows what he is talking about in an introductory economics class.

But as they sit in the class and interact with me they come to formulate in their minds an image, an “ideal type,” not of all men, or some men in the division of labor, but of me.

We all develop and use these “personal ideal types” of others, and on the basis of which we form expectations when we interact with these specific individuals. If you laugh at Joe’s jokes, he is likely to buy you a round of drinks. If you mention sex to Bob, he usually acts embarrassed and becomes quiet. If you mention to Sally that “a woman’s place is in the kitchen,” you’re going to get a “lecture” on the place of women in modern society. If you criticize socialized medicine in Europe, George is likely to go into a rant on the “evils” of the profit motive.

It should be evident that many, if not most, of the ideal types discussed by Alfred Schutz overlap with that category of tacit or inarticulate knowledge. In our interactions with others, we all form these types of mental images of those with whom we associate in various settings. But it is something we do “tacitly,” that is, without consciously thinking about it very much, if at all.

And while we often know “how to interact” with someone based on our “ideal type” of them in our mind, it is not always easy to express in words to someone else how and why we see these characteristics in that other person, or how and why we “just know” most of the time that if we do or say “X” around that person we are fairly confident that it will bring about response “Y.”

Ludwig von Mises and the “Thymology” of Market Expectations

Ludwig von Mises came to call this method of understanding and interpreting others through ideal types as the subject matter of “thymology,” the study of how individuals form images of others in their minds to generate expectations for purposes of interpersonal understanding, planning, and coordinating one’s own actions with those of others.

In Mises’s theory of the market process, a central actor is an entrepreneur. The entrepreneur must make informed judgments, and in doing so, Mises said, he must form expectations of individuals and groups on both the demand- and supply-sides of the market. The knowledge on the basis of which he does so is built up from the experiences he has personally had, or heard about, or learned from others in some manner concerning the likely actions and reactions of those with whom he interacts in the marketplace, and whose future actions he must anticipate the best he can.

Mises pointed out that many might consider this a rather unsatisfactory method of anticipating possible social actions. Ideal types, Mises argued, enable the acting man to be what he called “the historian of the future.” Forming composite pictures of individuals from their past actions in terms of characteristics, qualities, motives, and meanings, “ideal types” enable an individual decision-maker to project himself into the future, imagine that another individual or group are confronted with a particular event or change in their circumstance, and then ask the question, “What responses would these individuals manifest in this situation?” It enables the formation of expectations concerning patterns or “types” of response for prediction of a wide variety of circumstances. No matter how imperfect, it introduces an additional source of knowledge for coordination of plans in the complex social setting of the market.

Indeed, it is the “ideal types” of these various forms within the wider social structure of intersubjective meanings, that allows entrepreneurs and other market participants to evaluate the meaning behind competitive prices and changes in them so as to form expectations of what those prices are “saying.”

Mises pointed out that many might consider this a rather unsatisfactory method of anticipating possible social actions in comparison to the claims of more detailed and determinate predictive power in the natural sciences. But he argued that given the unique qualities of human action in the social world, this, in fact, might be the best that can be hoped for, given the intentional and choice-based reality of human conduct.

Ideal Types, Expectations, and the Free Society

One other aspect of this social institution of “ideal types” for interpersonal plan coordination is that it is part of the wider “spontaneous order” of the social system. That is, the social structures of intersubjective meaning, the “ideal types” of actors and actions in various face-to-face and “role-playing” tasks in the division of labor, and the formation of expectations by people in their respective locations within the market order emerge out of the actions and interactions of multitudes of people in various societal settings at a moment and over time.

They are part of the societal “glue” for coherence, cooperation, and coordination, with degrees of complexity and adaptability that defies the very notion of intentional planning by political actors asserting the need for and their ability to impose “order” on communities of human beings.

Appreciation for the nature, workings, and importance of expectations formation in the marketplace of the free society demonstrates once more the superiority of the classical liberal system of individual liberty, free markets, and limited government, and the absurdity of the pretense of knowledge claimed by political paternalists and social engineers.

This article was originally published on FEE.org. Read the original article.