Economic calculation problem
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The problem referred to is that of how to distribute resources rationally in an economy. The free market solution is the price mechanism, wherein people individually have the ability to decide how a good or service should be distributed based on their willingness to give money for it. The price conveys embedded information about the abundance of resources as well as their desirability which in turn allows, on the basis of individual consensual decisions, corrections that prevent shortages and surpluses; Mises and Hayek argued that this is the only possible solution, and without the information provided by market prices socialism lacks a method to rationally allocate resources. Those who agree with this criticism argue it is a refutation of socialism and that it shows that a socialist planned economy could never work. The debate raged in the 1920s and 1930s, and that specific period of the debate has come to be known by economic historians as The Socialist Calculation Debate.
Ludwig von Mises argued in a famous 1920 article "Economic Calculation in the Socialist Commonwealth" that the pricing systems in socialist economies were necessarily deficient because if government owned or controlled the means of production, then no rational prices could be obtained for capital goods as they were merely internal transfers of goods in a socialist system and not "objects of exchange," unlike final goods. Therefore, they were unpriced and hence the system would be necessarily inefficient since the central planners would not know how to allocate the available resources efficiently. This led him to declare "...that rational economic activity is impossible in a socialist commonwealth." Mises developed his critique of socialism more completely in his 1922 book Socialism, an Economic and Sociological Analysis.
Argument in detail
The seeds of the calculation debate had been planted by a host of economists before Ludwig von Mises posed the central question "in such a form as to make it impossible that it should ever again disappear." Mises' article, adapted from a lecture of a year earlier, appeared in the spring of 1920 entitled "Economic Calculation in the Socialist Commonwealth" (pdf). The famous challenge of Mises was uncompromising and to the point: "Where there is no free market, there is no pricing mechanism: without a pricing mechanism, there is no economic calculation." Two years later the argument was enlarged in a wide-ranging critique of socialism, entitled Die Gemeinwirtschaft ("Socialism", html, pdf).
The main effect of Mises' arguments has been best summed up by the renowned socialist economist Oskar Lange: "It was [Mises'] powerful challenge that forced the socialists to recognize the importance of an adequate system of economic accounting in a socialist economy. Even more, it was chiefly due to Professor Mises' challenge that many socialists became aware of the very existence of such a problem." But the real effect, was to force the socialists to retreat from a pure advocacy of Marxian socialism to a compromise watered down with "competitive" infusions - market socialism.
Even if the socialists have been able to create a mighty army of citizens all eager to do the bidding of their masters, what exactly would the socialist planners tell this army to do? How would they know what products to order their eager slaves to produce, at what stage of production, how much of the product at each stage, what techniques or raw materials to use in that production and how much of each, and where specifically to locate all this production? How would they know their costs, or what process of production is or is not efficient?
In any economy more complex than the Crusoe or primitive family level, the socialist planning board would simply not know what to do, or how to answer any of these vital questions. Developing the momentous concept of calculation, Mises pointed out that the planning board could not answer these questions because socialism would lack the indispensable tool that private entrepreneurs use to appraise and calculate: the existence of a market in the means of production, a market that brings about money prices based on genuine profit-seeking exchanges by private owners of these means of production. Since the very essence of socialism is collective ownership of the means of production, the planning board would not be able to plan, or to make any sort of rational economic decisions. Its decisions would necessarily be completely arbitrary and chaotic, and therefore the existence of a socialist planned economy is literally "impossible" (to use a term long ridiculed by Mises's critics).
In the course of intense discussion throughout the 1920s and 1930s, the socialist economists were honest enough to take Mises's criticism seriously, and to throw in the towel on most traditional socialist programs: in particular, the original communist vision that workers, not needing such institutions as bourgeois money fetishism, would simply produce and place their products on some vast socialist heap, with everyone simply taking from that heap "according to his needs."
The socialist economists also abandoned the Marxian variant that everyone should be paid according to the labor time embodied into his product. In contrast, what came to be known as the Lange-Lerner solution, acclaimed by virtually all economists, asserted that the socialist planning board could easily resolve the calculation problem by ordering its various managers to fix accounting prices. Then, according to the contribution of Professor Fred M. Taylor, the central planning board could find the proper prices in much the same way as the capitalist market: trial and error. Thus, given a stock of consumer goods, if the accounting prices are set too low, there will be a shortage, and the planners will raise prices until the shortage disappears and the market is cleared. If, on the other hand, prices are set too high, there will be a surplus on the shelves, and the planners will lower the price, until the markets are cleared. The solution is simplicity itself!
Set aside the obvious absurdity of trusting a coercive governmental monopoly to act somehow as if it were in "perfect competition" with parts of itself. Another grievous flaw in the Lange model is thinking that general equilibrium, a world of certainty where there is no room for the driving force of entrepreneurship, can somehow be used to depict the real world. The actual world is one not of changeless "givens" but of incessant change and systemic uncertainty. Because of this uncertainty, the capitalist entrepreneur, who stakes assets and resources in attempting to achieve profits and avoid losses, becomes the crucial actor in the economic system, an actor who can in no way be portrayed by a world of general equilibrium. Furthermore, it is ludicrous, as Hayek pointed out, to think of general equilibrium as the only legitimate "theory," with all other areas or problems dismissed as mere matters of practicality and degree. No economic theory worth its salt can be worthwhile if it omits the role of the entrepreneur in an uncertain world. The "equations" are not simply excellent theory that faces problems in practice; for in order to be "good," a theory must be useful in explaining real life.
Moreover, in his later rebuttal to the champions of the Pareto-Barone equations, Mises points out that the crucial problem is not simply that the economy is not and can never be in the general equilibrium state described by these differential equations. In addition to other grave problems with the equilibrium model (e.g.: that the socialist planners do not now know their value scales in future equilibrium; that money and monetary exchange cannot fit into the model; that units of productive factors are neither perfectly divisible nor infinitesimal-and that marginal utilities, of different people cannot be equated-on the market or anywhere else), the equations "do not provide any information about the human actions by means of which the hypothetical state of equilibrium" has been or can be reached. In short, the equations offer no information whatever on how to get from the existing disequilibrium state to the general equilibrium goal.
Another grave flaw in the Lange-Taylor trial-and-error approach is that it concentrates on consumer goods pricing. It is true that retailers, given the stock of a certain type of good, can clear the market by adjusting the prices of that good upward or downward. But, as Mises pointed out in his original 1920 article, consumers goods are not the real problem. Consumers, these "market socialists" are postulating, are free to express their values by using money they had earned on a range of consumers' goods. Even the labor market — at least in principle — can be treated as a market with self-owning suppliers who are free to accept or reject bids for their labor and to move to different occupations. The real problem, as Mises has insisted from the beginning, is in all the intermediate markets for land and capital goods. Producers have to use land and capital resources to decide what the stocks of the various consumer goods should be. Here there are a huge number of markets where the State monopoly can only be both buyer and seller for each transaction, and these intra-monopoly, intra-state transactions permeate the most vital markets of an advanced economy — the complex lattice-work of the capital markets. And here is precisely where calculational chaos necessarily reigns, and there is no way for rationality to intrude on the immense number of decisions on the allocation of prices and factors of production in the structure of capital goods.
Mises discussed in Human Action the "trial-and-error" method, and pointed out that this process only works in the capitalist market. There the entrepreneurs are strongly motivated to make greater profits and to avoid losses, and further, such a criterion does not apply to the capital goods or land market under socialism where all resources are controlled by one entity, the government.
This was a critique, not only of socialism, but of the entire Walrasian general equilibrium model. The major fallacy of the "market socialists," Mises pointed out, is that they look at the economic problem from the point of view of the manager of the individual firm, who seeks to make profits or avoid losses within a rigid framework of a given, external allocation of capital to each of the various branches of industry and indeed to the firm itself. In other words, the "market socialist" manager is akin not to the real driving force of the capitalist market, the capitalist entrepreneur, but rather to the relatively economically insignificant manager of the corporate firm under capitalism.
They consider the structure of industrial production and the allocation of capital to the various branches and production aggregates as rigid, and do not take into account the necessity of altering this structure in order to adjust it to changes in conditions. They fail to realize that the operations of the corporate officers consist merely in the loyal execution of the tasks entrusted to them by their bosses, the shareholders. The operations of the managers, their buying and selling, are only a small segment of the totality of market operations. The market of the capitalist society also performs those operations which allocate the capital goods to the various branches of industry. The entrepreneurs and capitalists establish corporations and other firms, enlarge or reduce their size, dissolve them or merge them with other enterprises; they buy and sell the shares and bonds of already existing and of new corporations; they grant, withdraw, and recover credits; in short they perform all those acts the totality of which is called the capital and money market. It is these financial transactions of promoters and speculators that direct production into those channels in which it satisfies the most urgent wants of the consumers in the best possible way.
But no "market socialist" has ever suggested preserving or carrying over, much less understood the importance of, the specifically entrepreneurial functions of capitalism:
Nobody has ever suggested that the socialist commonwealth could invite the promoters and speculators to continue their speculations and then deliver their profits to the common chest. Those suggesting a quasi-market for the socialist system have never wanted to preserve the stock and commodity exchanges, the trading in futures, and the bankers and money-lenders as quasi-institutions. One cannot play speculation and investment. The speculators and investors expose their own wealth, their own destiny. This fact makes them responsible to the consumers, the ultimate bosses of the capitalist economy. If one relieves them of this responsibility, one deprives them of their very character. They are no longer businessmen, but just a group of men to whom the director has handed over his main task, the supreme direction of the conduct of affairs. Then they--and not the nominal director--become the true directors and have to face the same problem the nominal director could not solve: the problem of calculation.
For Mises, in short, the key to the capitalist market economy and its successful functioning is the entrepreneurial forecasting and decision-making of private owners and investors. The key is emphatically not the more minor decisions made by corporate managers within a framework already set by entrepreneurs and the capital markets.
For Hayek, the major problem for the socialist planning board is its lack of knowledge. Without a market, the socialist planning board has no means of knowing the value-scales of the consumers, or the supply of resources or available technologies. The capitalist economy is, for Hayek, a valuable means of disseminating knowledge from one individual to another through the pricing "signals" of the free market. A static, general equilibrium economy would be able to overcome the Hayekian problem of dispersed knowledge, since eventually all data would come to be known by all, but the ever-changing, uncertain data of the real world prevents the socialist planning board from acquiring such knowledge. The knowledge which is yielded by market-pricing cannot be collected by a central authority or programmed into a mechanical device, not just because it is too complex, but rather because it is knowledge given only in use. Unhampered markets transmit this knowledge, which is otherwise irretrievable, dispersed in millions of people.
Hence, as is usual for Hayek, the argument for the free economy and against statism rests on an argument from ignorance. But to Mises the central problem is not "knowledge." He explicitly points out that even if the socialist planners knew perfectly, and eagerly wished to satisfy, the value priorities of the consumers, and even if they enjoyed a perfect knowledge of all resources and all technologies, they still would not be able to calculate, for lack of a price system of the means of production.
In a critique of socialism by Professor Georg Halm:
Because capital is no longer owned by many private persons, but by the community, which itself disposes of it directly, a rate of interest can no longer be determined. A pricing process is always possible only when demand and supply meet in a market…. In the socialist economy … there can be no demand and no supply when the capital from the outset is in the possession of its intending user, in this case the socialistic central authority. Now it might perhaps be suggested that, since the rate of interest cannot be determined automatically, it should be fixed by the central authority. But this likewise would be quite impossible. It is true that the central authority would know quite well how many capital goods of a given kind it possessed or could procure…; it would know the capacity of the existing plant in the various branches of production; but it would not know how scarce capital was. For the scarcity of means of production must always be related to the demand for them, whose fluctuations give rise to variations in the value of the good in question… If it should be objected that a price for consumption-goods would be established, and that in consequence the intensity of the demand and so the value of the means of production would be determinate, this would be a further serious mistake…. The demand for means of production, labor and capital goods, is only indirect.
Halm then adds that the central authority, contrary to his above concession, would not even be able to find out how much capital it is employing, since capital goods are heterogeneous, and therefore how "can the total plant of one factory be compared with that of another? How can a comparison be made between the values of even only two capital-goods?" In short, while under capitalism such comparisons can be made by means of money prices set on the market for every good, in the socialist economy the absence of genuine money prices arising out of a market precludes any such value comparisons. Hence, there is also no way for a socialist system to rationally estimate the costs (which are dependent on prices in factor markets) of any process of production.
But the decisive rebuttal has been leveled by Mises in Human Action: the Soviet Union and Eastern European economies were not fully socialist because they were, after all, islands in a world capitalist market. The communist planners were therefore able, albeit clumsily and imperfectly, to use prices set by world markets as indispensable guidelines for the pricing and allocation of capital resources.
Mises's insight was confirmed as early as the mid-1950s, when the British economist Peter Wiles visited Poland, where Oskar Lange was helping to plan Polish socialism. Wiles asked the Polish economists how they planned the economic system. As reported, "What actually happens is that "world prices", i.e. capitalist world prices, are used in all intra-[Soviet] bloc trade. They are translated into rubles ... entered into bilateral clearing accounts."
- Von Mises, Ludwig (1990) (pdf). Economic calculation in the Socialist Commonwealth. Ludwig von Mises Institute. http://mises.org/pdf/econcalc.pdf. Retrieved 2008-09-08.
- F. A. Hayek, (1935), "The Nature and History of the Problem" and "The Present State of the Debate," om in F. A. Hayek, ed. Collectivist Economic Planning, pp. 1-40, 201-43.
- David Gordon. "Gray's Anatomy: Selected Writings", Mises Daily, September 10, 2009. Referenced 2011-03-06.
- Murray N. Rothbard. "The End of Socialism and the Calculation Debate Revisited", Mises Daily, reposted from The Review of Austrian Economics in 1991. Referenced 2010-07-07.
- Hayek, F. A. (1945). "The Use of Knowledge in Society". The American Economic Review 35 (4): 519-530. http://www.jstor.org/stable/1809376.
- Hoppe, Hans-Hermann (1996). "Socialism: A Property or Knowledge Problem?". The Review of Austrian Economics 9 (1): 143-149. doi:10.1007/BF01101888. http://mises.org/journals/rae/pdf/rae9_1_13.pdf.
- Mises, Ludwig von (2012). Economic Calculation in the Socialist Commonwealth. Auburn, Alabama: Ludwig von Mises Institute. ISBN 978-1-61016-550-1. http://mises.org/document/448/Economic-Calculation-in-the-Socialist-Commonwealth.
- Rothbard, Murray N. (1991). "The End of Socialism and the Calculation Debate Revisited". The Review of Austrian Economics 5 (2): 51-76. doi:10.1007/BF02426928. https://mises.org/journals/rae/pdf/rae5_2_3.pdf.
- The Impossibility of Economic Calculation Under Socialism by Ludwig von Mises
- The End of Socialism and the Calculation Debate Revisited by Murray N. Rothbard
- Oskar Lange and the Impossibility of Economic Calculation by D.W. MacKenzie
- Socialism: Still Impossible After All These Years by Peter J. Boettke and Peter T. Leeson
- Must Economies Be Rational? by David Gordon
- Calculation and Socialism by Joseph T. Salerno, Recorded July 27, 2010 in Auburn, Alabama. Includes an introduction by Mark Thornton (1:00:38).