2. KINDS OF KNOWLEDGE AND COMPETITION AND THE ROLE OF SELF-ORGANIZATION

The fundamental epistemic problem of market economies has already been addressed implicitly by the classic invisible hand conjecture. The explicit articulation of the problem by Hayek (Reference Hayek1937) is firmly rooted in the contemporary theoretical debate within economics on the role of prices as a coordination mechanism in free markets. More specifically, can competitive price variation bring about a situation in which all economic agents are able to coordinate their individually optimal plans so that they see them realized? This is the question of whether a general market equilibrium can be reached by a competitive process of simultaneous plan revisions. The question was unresolved at that time (and the notion of general equilibrium not yet interpreted in the strict Arrow–Debreu sense as nowadays). Hayek identifies a precondition that seems necessary, though not sufficient, for attaining an equilibrium. Prices can fulfil the epistemic function of transferring information if, and only if, the agents know all other constraints which become binding for them at the currently quoted prices. Accordingly, if the notion of equilibrium is to have any empirical relevance, then this hinges upon how agents obtain and process the knowledge of what is binding for them in equilibrium.

What looks like a prelude to expanding the theory of the price mechanism by empirical hypotheses on individual learning and knowledge acquisition is, however, not followed by anything like that.Footnote ¹ Instead, Hayek gives his argumentation a turn that is indicative of his politically motivated interest in the epistemic problem (which can indeed be discussed without addressing the empirical conditions of the agents’ knowledge acquisition). He makes the connection to the socialist calculation debate in which he and Mises (Reference Mises1936) were the protagonists of market liberalism (albeit putting forth different arguments, see O'Neill Reference O'Neill2006; see also Boettke Reference Boettke1998). He asks which form of economic organization – decentralized, competitive markets vs. central planning – can be expected to more effectively use and coordinate the dispersed knowledge that exists in the economy. The answer is given in his influential piece in the American Economic Review (Hayek Reference Hayek1945). In the decentralized system of competitive markets, the relevant information is activated and processed, selectively and in parallel, by only those directly involved in the corresponding transactions. In contrast, with its need to centralize information on the one hand and its limited processing capacity on the other, a planning agency is likely to become a bottleneck that prevents an effective and complete use of dispersed knowledge.

In the context of the socialist calculation debate, the epistemic argument serves to demonstrate that central planning cannot be expected to meet the information requirements of a competitive price mechanism. However, besides the functional objections, there are also politically motivated ones. From a liberal point of view, it is even more relevant that centralized and decentralized planning are likely to give different answers to the question of whose ends the information processing serves. Would this be the separate ends of the members of society autonomously deciding on their values and purposes, as in decentralized market transactions? Or would it be the goals of the central planning agency which, in the best case, reflect that agency's views of, and judgements on, individual ends? Needless to say, liberal philosophy would find the latter alternative indefensible.

Hayek's focus in these early reflections is on information contained in, and conveyed through, competitive prices. He deals foremost with the issue of scarce resources and the attainment of comparative advantages by making productive use of them. The dispersed knowledge thus activated and used is the knowledge that already exists in society. But the very process of price and cost competition, forcing the market participants to adjust, also generates new knowledge. This is explained in greater detail in Hayek (Reference Hayek and Hayek1978a). Competition is portrayed there as being tantamount to a discovery procedure. However, the new knowledge Hayek is thinking of as being discovered is of a rather special kind. It is situational knowledge relating to what, in a particular time and place, the markets allow one to do. Hence, what the agents are going to discover is but the insight into which of their plans are feasible and which ones likely to be disappointed, given the prevailing scarcity conditions.

Discovering new knowledge is, of course, not confined to only situational knowledge. Indeed, the very aim of many businesses is to create private knowledge that facilitates a competitive advantage: knowledge about new goods and services, new processes, new resources and/or new commercial practices. The resulting form of competition may be dubbed innovation competition (in contrast to mere price and cost competition). In that case, the notion of competition as a discovery procedure gets a somewhat different meaning. What the agents are going to discover here is hitherto unknown, economically relevant technological knowledge.

Innovation competition is as much of an essential feature of free markets as price and cost competition (Buchanan and Vanberg Reference Buchanan and Vanberg1991). In fact, at the time Hayek published his version of competition as a discovery procedure, innovation competition (or ‘Schumpeterian competition’ as it was then called, see Kamien and Schwartz Reference Kamien and Schwartz1982) had become a hot topic in economic competition theory. Nonetheless, Hayek (Reference Hayek and Hayek1978a) chooses to ignore this essential feature. He explicitly states that he does ‘not consider . . . the undoubted role competition plays in the advance of technological knowledge’ (Reference Hayek and Hayek1978a: 188). Both his inspiration and his message seem to be restricted to a reprise of the socialist calculation debate, offering yet another, original way of reformulating epistemic concerns already issued earlier.

The neglect of innovation competition in this influential paper is remarkable. Prior to the two lectures on which the paper is based, Hayek had read widely on new developments in systems theory, cybernetics, and the biophysics of self-organization and the emergence of order. These readings seem to have led him to the conclusion that the spontaneous order arising from the interactions in free markets is a case of ‘emergence’ in the sense of the theory of self-organizing systems by R. Ashby, H. von Foerster and N. Wiener. Based on this insight, he claimed intellectual precedence for the discovery of the idea of self-organizing systems for Scottish social philosophy: ‘The ‘invisible hand’ that regulated prices to a nicety is clearly this idea. In a free market, says Smith in effect, prices are regulated by negative feedback’ (Hayek Reference Hayek and Hayek1978a: 184). He thus identifies competitive price adjustments with a self-regulating process occurring in the self-organizing system of the free markets.

However, the theory of self-organizing systems distinguishes two types of processes implied by non-linear dynamics (see Jantsch Reference Jantsch1980): self-regulating processes (negative feedback) and temporarily self-amplifying processes (positive feedback). The former stabilizes given states of order. The latter can destabilize an existent state of order beyond a critical threshold and induce a transition to a new state of order. (In the transition between the old and the new state of order, an instability is passed, a phenomenon called phase transition in physics.) Smith's invisible hand metaphor for the working of the price mechanism, i.e. price competition, corresponds to the self-regulation part. Hayek (Reference Hayek and Hayek1978a) also focuses on price competition (which, he explains, feeds on existing knowledge and generates new situational knowledge). The temporarily self-amplifying processes are neglected. Yet, these processes, represented by innovation competition in this context, are no less significant with regards to the extended order of the markets.

In free markets, agents are forced to adjust their economic activities due to price and cost competition. These pressures tend to reduce profit margins and to eliminate existing profit opportunities. However, agents who have been accustomed to earning a certain level of profits are likely to respond by searching for innovations that allow them to stabilize or restore profit opportunities. From the perspective of self-organization theory, this disposition explains why the self-regulating features of the market process may turn into self-amplifying ones. By the agents’ search for innovations, new technological knowledge is introduced to the markets. By way of imitation, its commercially successful elements diffuse throughout the economy. New production technologies and/or goods and services eventually seize the established markets or give rise to entirely new ones. This part of economic self-organization, which is driven by the emergence of new technological knowledge, triggers temporarily de-coordinating effects. By out-competing preceding – and now inferior – products, technologies and resources, innovation competition disrupts the equilibrating tendency of price and cost competition.

In a sense, this is the destructive side of innovation competition, dubbed the ‘perennial gale of creative destruction’ by Schumpeter (Reference Schumpeter1942: ch. 7). It can hit hard the competitors of the innovator(s). This consequence is sometimes characterized by the euphemism of ‘pecuniary externalities’ of innovations. Moreover, by the very fact that innovative products, production processes and resource uses are new, it is not possible to anticipate all their implications and consequences. Therefore, such innovations do not only hold promises. They always also contain an irreducible risk of creating technological externalities in the form of damages to health or the environment. In view of such potentially hazardous effects of innovation competition, the unforeseeable concomitants of market liberalism may not be as unambiguously welcome as the results of mere price and cost competition. The question arises to what extent these features challenge the substance of an epistemic defence of market liberalism.

3. SOCIAL JUSTICE AND THE ‘LIBERTARIAN PUZZLE’

There is ample evidence for a causal relationship between innovation competition characteristic of liberal market regimes and the growth performance and the wealth of economies with such regimes (Rosenberg and Birdzell Reference Rosenberg and Birdzell1986, Mokyr Reference Mokyr1990). This evidence notwithstanding, the outcome of innovation competition does not receive the unconditional approval of public opinion. Rather, liberal market regimes are often criticized for the resultant unequal distribution of income and living conditions. Calls for social justice create pressure for correcting the market results through government interventions. The notion of ‘social justice’ can, of course, have different connotations. It is often conceived as a quest to improve the lot of the less fortunate. Not so by Hayek. Although he does not discuss the disruptive forces of innovation competition, he notices the emerging quest for social justice and associates it with a specific kind of rent seeking: ‘the protection of certain groups against the necessity to descend from the absolute or relative material position which they have for some time enjoyed’ (Hayek Reference Hayek and Hayek1978a: 186; see also Hayek Reference Hayek1976: 139–142).

In such an interpretation, social justice becomes a cipher for mere income redistribution. Attacked by many market liberals, and certainly by Hayek, it is conceived as an outgrowth of the welfare state. Its proponents try to exploit what in Hayek's (Reference Hayek1976: ch. 9; Reference Hayek and Hayek1978b) view is a misconceived notion of justice. The misconception invites excessive government intervention and ultimately threatens individual liberties. Moreover, it destroys the incentives to adopt the best of the newly available commercial methods, discourages investment, and undermines allocative efficiency. Ultimately, redistribution in the name of ‘social justice’ is thus argued to infringe on the welfare of all members of society.Footnote ²

By the rules of liberal market regimes it is indeed not unusual that economic agents have ‘to descend from the absolute or relative material position which they have for some time enjoyed’. More specifically, such ‘descent’, i.e. loss of income and/or status for a segment of the population (at least temporary) is an inevitable effect of unconstrained and uncompensated innovation competition.Footnote ³ For that reason, the popularity which the quest for social justice often enjoys may well be a reaction to the threats that such disastrous consequences imply for some members of society. To be sure, ‘social justice’ is also often claimed by interest groups in an attempt to camouflage rent-seeking activities – many of them justly nourishing libertarian resentments against ‘the welfare state’ (Hayek Reference Hayek1960: ch. 17). However, in many democracies, there is a broad consensus endorsing transfer payments. In the name of social justice they are meant to protect against, or compensate for, poverty, unemployment, devaluation of job qualifications, etc. (see Boeri et al. Reference Boeri, Börsch-Supan and Tabellini2001). Such unfortunate occurrences often result in a ‘necessity to descend’. If the transfers were merely the result of the successful rent-seeking activities of comparatively small groups with little voting power, then how can it be explained that, in many countries, a majority of voters reveal a political preference for them?Footnote ⁴

A political preference that corrects, as it were, for the outcomes of competition in free markets may indeed pose a puzzle for libertarians (see Wegner Reference Wegner2008: ch. 1; Reference Wegner2009). The unbounded exercise of political liberty results in a majority of citizens casting their votes in support of a legislation that restricts economic liberties and/or corrects, by coercive means, the results of a liberal market regime. In light of such voter preferences, political liberty and the free play of the markets (effecting in the view of market liberals a maximum of welfare) seem to be incompatible. Wegner explains the apparent inconsistency as a failure on the part of the voters to foresee the consequences of their own political choices. In a world of complex political contingencies, imperfect foresight, and low incentives for monitoring the machinations of the political process, such an explanation cannot be rejected on a priori grounds. However, when all of the consequences of innovation competition are considered, quite a different conclusion can be drawn from the observed voting behaviour. In fact, voters may have a specific reason to support such transfer payments, and this reason relates to the epistemic argument: They are likely to recognize that, in an innovative economy, they cannot foresee whether they themselves will be the ones who will have to ‘descend’ as a result of someone else's future innovation.

The evidence showing that innovation competition greatly fosters economic growth is paired with an equal evidence for the fact that innovation competition regularly also produces losers. Specific investments made by one party before a certain innovation was introduced to the market by another party may be devalued or even lost as a result of the innovation. Capital owners may face losses on their expected returns. Labour may face losses on the expected income from human capital investments. The burden of such negative ‘pecuniary’ externalities of innovation is distributed very unevenly across the members of society. For the economy as a whole, the gains from innovation competition usually exceed what is lost from pecuniary externalities. Nonetheless, this outcome is not unambiguous. The resulting growth of average per capita income and a growing income for all members of society are two different pairs of shoes.

A growing income for all is likely to occur (if at all) only in the longer run – which for some agents may be too late to compensate them for losses they suffer in the meantime. Innovation competition, accompanied by pecuniary externalities, is therefore not necessarily desirable for everyone. From the point of view of the individual member of society, the possible long-term benefits have to be assessed against the uncertain medium-term prospects of being either on the winning side or the losing side. The respective, subjective conclusions drawn can be expected to differ greatly, depending on the individual risk preferences. For risk-averse members of society, the pecuniary externalities of unbounded innovation competition may well appear unacceptable.

In a market economy, risk aversion is usually alleviated by the institution of insurances offering protection against insured risks at a premium. However, insurance against the risk of suffering losses from someone else's not-yet-known innovation is not available, simply because there is no basis upon which risk can be calculated. Since free markets have no other institutional solution to address widespread risk aversion in this context, the unsatisfied preferences are likely to be voiced in the political arena. The political process is then expected to generate alternative proposals which do, or do not, mandate restrictions on innovation competition or provide compensation for suffering pecuniary externalities. In this vein, the actual distribution of the risk preferences of the members of society can be inferred from the ballots going to the rivalling proposals (Witt and Schubert Reference Witt and Schubert2008). The democratic process thus accounts for the actual risk preferences of a majority of voters.

A complete ban on innovation competition has high costs in terms of foregone future growth. It can be conjectured that it is, therefore, unlikely to find majority consent. On the other hand, it is also difficult to imagine that a completely libertarian regime (without any compensatory measures) would find majority support in a society, unless the society is highly risk-friendly.Footnote ⁵ Indeed, in many democracies, the majority of voters occupy a middle position. They endorse innovation competition while at the same time showing a rather consistent tendency to support transfer payments and subsidies in the case of poverty, loss of employment, devaluation of job qualifications, etc. (though much less so in relation to capital losses). The occurrence of such misfortune is highly correlated with the pecuniary externalities of large-scale innovativeness in an economy.

Transfer payments of this kind are financed by taxes and/or paid out of a compulsory (and usually government-run) insurance. These compulsory and publicly organized mechanisms would not be necessary, if there were a private insurance market that covered the personal risks arising from yet unknown pecuniary externalities of future innovations. Hayek's disinterest in innovation competition may explain why he ignores this fact. Following a claim already made by some classical liberals, he does endorse a public assurance of a mere subsistence level. He explicitly mentions ‘those who for various reasons cannot make their living in the market, such as the sick, the old, the physically or mentally defective, the widows and orphans’ (Hayek Reference Hayek1979: 54–56). Building support for this idea, he refers to the broad public approval in modern democracies for income transfers covering these – not economically caused – risks. As it seems, in these cases he considers the majority support a sufficient legitimation.

However, most voters are also owners of factors of production. In that role they may also feel unduly exposed to the unknown risk of belonging to those who have to bear the pecuniary externalities of future innovations in the form of poverty, unemployment or devaluation of jobs qualifications. A sound account of market liberalism cannot disregard the failure of free markets to address their risk-averse preferences. Nor can it dismiss the political consequence – the quest for social justice done within limited bounds to the losers of innovation competition – as an error or even as mere rent seeking. By endorsing transfer payments, their voting power enables a majority of risk-averse voters to bring the results of free market competition closer in accordance with their risk preferences. Such an institutional development may well be considered part of a more encompassing self-organization process.

4. TECHNOLOGICAL EXTERNALITIES, INDIVIDUAL AUTONOMY AND THE INNOVATION DILEMMA

Pecuniary externalities of innovations are not the only unforeseeable effect of innovation competition. Innovations can also cause technological externalities. The positive ones, contributing to the growth-enhancing effect of innovations, are welcome. Problems arise from the negative technological externalities. In Hayek's epistemic rectification of market liberalism this problem is ignored – not only in Hayek's (Reference Hayek and Hayek1978a) interpretation of competition as a discovery procedure, but also more generally (see e.g. Hayek Reference Hayek1960: ch. 17). Yet, in assessing the consequences of market liberalism from a utilitarian point of view, negative technological externalities seem of even greater significance than their pecuniary counterparts.

In the case of negative pecuniary externalities and under freedom of contract, the sum of private gains from an innovation commonly exceeds the sum of private losses. (In principle, the losers could therefore be compensated out of society's innovation gains, if transaction costs associated with a compensation scheme would not be prohibitive.) In the case of the negative technological externalities of an innovation, however, the consequences can be dramatically different. The social costs can by far exceed the sum of the private gains of the agents who profit from an innovation.Footnote ⁶ Therefore, a compensation of those who bear the social costs would not even be possible in principle. Society suffers a net loss. Moreover, where innovations turn out to cause excessive social costs, this usually only becomes apparent after considerable delay. Examples are abundant (see Tenner Reference Tenner1996).

A paradigmatic case is chlorofluorocarbon gas, a major chemical innovation. It was introduced as a means to produce, among others, multi-purpose lubricants, refrigerants, fire-extinguishing agents, insulators and aerosol propellants (such as hair spray) in a cheap and easy way. Only years after its large-scale market penetration was it discovered to play a crucial role in the depletion of the Earth's stratospheric ozone layer. The industrial use of chlorofluorocarbon gas has now been banned, but it will take years, if not decades, before the ozone layer recovers. By now it has also become apparent that the gas contributes significantly to the greenhouse effect.

With respect to negative technological externalities more generally, market liberalism favours a solution as outlined by Coase's (Reference Coase1960) classical formulation of the problem of social costs. The solution is to simply leave the way in which the social costs are internalized to private negotiations between the agent(s) causing an external effect and the agent(s) suffering from it. Again alluding to the epistemic argument in favour of decentralization, these parties are expected to find the most efficient way of dealing with the externality.Footnote ⁷ Only where such negotiations are not feasible, e.g. because of prohibitive transaction costs, should government intervene and try to enforce an internalization of the social costs. By such measures as levying taxes and/or creating quasi-property rights (e.g. by emission vouchers), a solution should be sought that approximates as closely as possible what the parties would have negotiated.

However, for negative technological externalities that may result in the future from innovations (to be) undertaken, a Coasian approach encounters difficulties. Regarding the expected externalities, theoretical knowledge and past experience may provide a sufficient foundation for predicting, and even quantifying, the likely effects. The problem is the still unknown harmful effects. They cannot be made the object of private negotiations. Even if transaction costs were zero, who would reasonably want to negotiate about the unknown? The powerful epistemic function of free market finds its limitations here. Moreover, there is also no basis for specific governmental regulations. Only when the harmful effects of an innovation are revealed, do taxing, trading or negotiating become feasible, although it may then be too late to avoid irreversible damages and net social losses.

Market liberalism faces a dilemma at this point. It arises from the two basic normative postulates of liberal philosophy formulated already by Mill (Reference Mill1993). The first postulate acknowledges the autonomy of individual preferences and/or decisions as the constitutive norm of freedom. The second postulate recognizes the need to protect the freedom of others, defined in terms of negative rights that set limits to individual autonomy. Both postulates together determine, and set limits to, the freedom that the members of society can exercise in the face of potential conflicts of interest (see Berlin Reference Berlin1969, MacCallum Reference MacCallum, Runciman and Skinner1972, Buchanan Reference Buchanan and Buchanan1991). Obviously, neither of the two extreme cases, in which either the one or the other liberal postulate is discarded, seem desirable from a liberal perspective. The liberal's problem is to determine an appropriate balance. This is no different in the case of conflicts of interest arising from the fact that innovations can have negative technological externalities. What complicates things is that such conflicts are to a large extent unpredictable.

Consider a producer who discovers a new material, say, or a new manufacturing process. Assume that it is regarded as a profitable innovation. If innovators enjoy an unconstrained autonomy in their decision making, the producer is likely to introduce the innovation. At that point in time it cannot reliably be predicted, however, whether, and if so to what extent, the innovation will cause yet unknown damages in the future. Since, by definition, negative technological externalities, if they occur, would not be fully internalized by the innovator, the social costs would exceed the private costs. All agents affected by the damages would have to bear a share in the social costs – whether or not they have implicitly endorsed the innovation through contract with the innovator or other means. To each who suffers from the consequences of an innovation not endorsed, the innovation results in an infringement of her or his negative rights.

On the one hand, there is thus the liberal value of individual autonomy to undertake an innovation. On the other hand, there is the claim of others to protect their future autonomy from being curtailed by the still unknown, potentially negative technological externalities of someone else's decision to innovate today. Where should the limits of the innovator's autonomy be drawn? How much protection from unknown harm do the abstract negative rights to future autonomy deserve? If market liberalism is meant to imply that the individual freedom to innovate should be favoured, this may infringe to unknown extent upon the freedom of others from being affected by unforeseen damages. If, however, market liberalism is meant to guarantee the individual's negative rights, innovations (of the kind considered here) would have to be prohibited.Footnote ⁸ Potential innovators will then be deprived of their autonomy to decide. It is precisely on epistemic grounds that, based on a utilitarian assessment, a market liberal position cannot decide ex ante how to weigh these conflicting claims.

The dilemma has particular significance at a time when large-scale environmental stress and degradation, waste and exhaustion of common resources are increasingly identified as the massive technological externalities of earlier innovations. In a sense, this is the ominous side of that large-scale innovation competition which, in the past, has led to technological progress, economic growth and an unprecedented standard of living for a large fraction of the world's population. A market liberalism that has given priority to the autonomy of innovators can claim credit for these accomplishments, as there have only been weak constraints, if any, on innovations in the past and little, if any, liability for damages later discovered. Yet, the ‘greening’ of politics in many developed countries in recent decades may point to a political preference revelation process analogous to that in the context of pecuniary externalities discussed in the previous section.

In practice, the ex ante decision on the innovation dilemma is made at the political level. In liberal democracies, competing proposals attempt to account for different perceptions and risk preferences which the voters may have regarding the possible, non-quantifiable, future threats implied by innovation competition. In this way, political competition tends to reveal the preferences that a majority of voters has with respect to the innovation dilemma. The revealed preferences seem to differ considerably across different societies. In some of the most developed countries and in most of the newly industrializing ones, priority continues to be given to the decision autonomy of the innovator – at the expense of attenuated negative rights protecting other members of society.

Several liberal democracies have, however, seen a rise of a ‘green’ political movement in recent times. This seems to reveal a shifting perception of the balance of rights, indicating a changing risk perception and/or preference on the part of voters. There seems to be a growing recognition of, and aversion to, the potential threats of technological externalities. This has led, in particular, to an increasing regulation of, or even a ban on, some systemic innovations such as nuclear power, genetic engineering, deep-sea oil drilling and so on. These developments can be interpreted as a strengthening of the negative rights of those not endorsing innovations like these – at the expense of the decision autonomy of innovators.Footnote ⁹ Because of the innovation dilemma, these political changes cannot per se be dismissed as incompatible with liberal values. Some market liberals, in concordance with Hayek, may favour a different balance between the liberties exercised by innovators and the negative rights of others protecting them against potential damages. This is a question of their own risk perceptions and preferences. However, they cannot contend that liberal values lend exclusive normative support to the personal attitude they, or anyone else, take in that respect.