Economic calculation problem

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The economic calculation problem is a criticism of socialist economics. It was first proposed by Ludwig von Mises in 1920 and later expounded by Friedrich Hayek.[1][2] According to this criticism, without information provided by market prices it is impossible 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 The Socialist Calculation Debate.[3]

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 the means of production, then no 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.[3] This led him to declare "...that rational economic activity is impossible in a socialist commonwealth."[1]. Mises developed his critique of socialism more completely in his 1922 book Socialism, an Economic and Sociological Analysis.

Contents

[edit] Capitalism

[edit] Relating utility to consumption and capital goods

There are several components to the capitalist solution to the economic calculation problem. First, since capital goods and labor are highly heterogeneous (i.e. they have different characteristics that pertain to physical productivity) economic calculation requires a common basis for comparison for all forms of capital and labor. Second, the common basis for comparison for capital goods must also be connected to consumer welfare. The use of money as a medium of exchange and unit of account is necessary to solve the first two problems of economic calculation. Mises (1912) applied the marginal utility theory developed by Carl Menger to money. Marginal consumer expenditures represent the marginal utility or additional consumer satisfaction expected by consumers as they spend money. This is similar to the equi-marginal principle developed by Alfred Marshall. Consumers equalize the marginal utility of the last dollar spent on each good. So the exchange of consumer goods establishes prices that represent the marginal utility of consumers, and money therefore is representative of consumer satisfaction.

If money is also spent on capital goods and labor, then it is possible to make comparisons between capital goods and consumer goods. The exchange of consumer and capital/labor goods does not imply that capital goods are valued accurately, only that it is possible for the valuations of capital goods to be made. These first elements of the Calculation Critique of Socialism are the most basic element: economic calculation requires the use of money across all goods. This is a necessary but not a sufficient condition for successful economic calculation. The von Mises theory of money and calculation conflicts directly with Marxist labor value theory. Marxist theory allows for the possibility that Labor content can serve as a common means of valuing capital goods, a position now out of favour following the success of the theory of marginal utility.

[edit] Entrepreneurship

The third condition for economic calculation is the existence of genuine entrepreneurship and market rivalry. According to Kirzner (1973) and Lavoie (1985) entrepreneurs reap profits by supplying unfulfilled needs in markets. Entrepreneurship therefore brings prices closer to marginal costs. The adjustment of prices in markets towards ‘equilibrium’ (where supply and demand equal) gives them greater utilitarian significance. The activities of entrepreneurs make prices more accurate in terms of how they represent the marginal utility of consumers. Prices act as guides to the planning of production. Those who plan production use prices to decide which lines of production should be expanded or curtailed.

[edit] Coherent planning

The fourth condition for successful economic calculation is plan coordination among those who plan production. The problem of planning production is the knowledge problem explained by Hayek (1937, 1945) The overall plan for production is composed of individual plans from capitalists in large and small enterprises. Since capitalists purchase labor and capital out of the same common pool of available but scarce labor and capital, it is essential that their plans fit together in at least a semi-coherent fashion. Hayek (1937) defined an efficient planning process as one where all decision makers form plans that contain relevant data from the plans from others. Entrepreneurs acquire data on the plans from others through the price system. The price system is an indispensable communications network for plan coordination among entrepreneurs. Increases and decreases in prices inform entrepreneurs about the general economic situation, to which they must adjust their own plans.

[edit] Financial Markets

The fifth condition for successful economic calculation is the existence of well functioning financial markets. Economic efficiency depends heavily upon avoiding errors in capital investment. The costs of reversing errors in capital investment are potentially large. This is not just a matter of rearranging or converting capital goods that are found to be of little use. The time spent reconfiguring the structure of production is time lost in the production of consumer goods. Those who plan capital investment must anticipate future trends in consumer demand if they are to avoid investing too much in some lines of production and too little in other lines of production. Capitalists plan production for profit. Capitalists use prices to form expectations that determine the composition of capital accumulation, the pattern of investment across industry.

Prices in futures markets play a special role in economic calculation. Futures markets develop prices for commodities in future time periods. It is in futures markets that entrepreneurs sort out plans for production based on their expectations. Futures markets are a link between entrepreneurial investment decisions and household consumer decisions. Since most goods are not explicitly traded in futures markets, substitute markets are needed. The stock market serves as a ‘continuous futures market’ that evaluates entrepreneurial plans for production (Lachmann 1978). Generally speaking the problem of economic calculation is solved in financial markets. The following quote from Mises explains this last point.

The problem of economic calculation arises in an economy which is perpetually subject to change ... In order to solve such problems it is above all necessary that capital be withdrawn from particular undertakings and applied in other lines of production ... [This] is essentially a matter of the capitalists who buy and sell stocks and shares, who make loans and recover them, who speculate in all kinds of commodities” Mises 1922 [1936] p121

The existence of financial markets is a necessary condition for economic calculation. The existence of financial markets itself does not automatically imply that entrepreneurial speculation will tend towards efficiency. Mises claimed that speculation in financial markets tends towards efficiency because of a “trial and error” process. Entrepreneurs who commit relatively large errors in investment waste their funds over expanding some lines of production at the cost of other more profitable ventures where consumer demand is higher. The entrepreneurs who commit the worst errors by forming the least accurate expectations of future consumer demands incur financial losses. Financial losses remove these inept entrepreneurs from positions of authority in industry.

Entrepreneurs who commit smaller errors by anticipating consumer demand more correctly attain greater financial success. The entrepreneurs who form the most accurate opinions regarding the future state of markets (i.e. new trends in consumer demands) earn the highest profits and gain greater control of industry. Those entrepreneurs who anticipate future market trends therefore waste the least amount of real capital and find the most favorable terms for finance on markets for financial capital. Minimal waste of real capital goods implies the minimization of the opportunity costs of capital- economic calculation. The value of capital goods is brought into line with the value of future consumer goods through competition in financial markets, because competition for profits among capitalists financiers rewards entrepreneurs who value capital more correctly (i.e. anticipating future prices more correctly) and eliminates capitalists who value capital least correctly.

To sum things up, the use of money in trading all goods (capital/labor and consumer) in all markets (spot and financial) combined with profit driven entrepreneurship and Darwinian natural selection in financial markets all combine to make rational economic calculation and allocation the outcome of the capitalist process.

[edit] Socialism

Mises insisted that socialist calculation is impossible because socialism precludes the exchange of capital goods in terms of a generally accepted medium of exchange, or money. Investment in financial markets determines the capital structure of modern industry with some degree of efficiency. The egalitarian nature of socialism prohibits speculation in financial markets. Mises therefore concluded that socialism lacks any clear tendency towards improvement in the capital structure of industry.

More specifically, Mises (1944) and Hayek (1937) insisted that bureaucrats in individual ministries could never coordinate their plans, not without a price system. If decentralized socialism cannot work, central authorities must plan production. But central planners face the knowledge problem in forming a comprehensive plan for production. Mises and Hayek saw centralization as inevitable in socialism.

Hayek (1935, 1937, 1940, 1945) stressed knowledge problem of central planning, partly because decentralized socialism seemed indefensible. Part of the reason that Hayek stressed the knowledge problem was also because he was mainly concerned with debating the proposal for Market Socialism by Oscar Lange (1938) and Hayek's student Abba Lerner (1934, 1937, 1938). Lange and Lerner conceded that prices were necessary in socialism. Lange and Lerner thought that socialist officials could simulate some markets (mainly spot markets) and the simulation of spot markets was enough to make socialism reasonably efficient. Hayek responded by arguing that the simulation of markets in socialism would fail due to a lack of genuine competition and entrepreneurship. Central planners would still have to plan production without the aid of economically meaningful prices. Oddly Lange and Lerner also admitted that socialism would lack any simulation of financial markets, and that this would cause problems in planning capital investment.

[edit] Example

Von Mises gave the example of choosing between producing wine or oil:

“

It will be evident, even in the socialist society, that 1,000 hectolitres of wine are better than 800, and it is not difficult to decide whether it desires 1,000 hectolitres of wine rather than 500 of oil. There is no need for any system of calculation to establish this fact: the deciding element is the will of the economic subjects involved. But once this decision has been taken, the real task of rational economic direction only commences, i.e. economically, to place the means at the service of the end. That can only be done with some kind of economic calculation. The human mind cannot orientate itself properly among the bewildering mass of intermediate products and potentialities of production without such aid. It would simply stand perplexed before the problems of management and location.[1]

 ”

Such intermediate products would include land, warehouse storage, bottles, barrels, oil, transport, etc. Not only would these things have to be assembled, but they would have to compete with the attainment of other economic goals. Without pricing for capital goods, essentially, Mises is arguing, it is impossible to know what their rational/most efficient use is. Investment is particularly impossible, as the potential future outputs, which cannot be measured by any current standard, let alone a monetary one required for economic calculation. The value consumers have for current consumption over future consumption cannot be expressed, quantified or implemented, as investment is independent from savings.

[edit] Computational complexity

Opponents argued that in principle an economy can be seen as a set of equations. Thus, there should be no need for prices. Using information about available resources and the preferences of people, it should be possible to calculate an optimal solution for resource allocation. Friedrich von Hayek responded that the system of equations required too much information that would not be easily available and the ensuing calculations would be too difficult.[3] This is partly due to the fact that individuals possess useful knowledge but do not realise its importance, or may have no incentive to transmit the information.[4] He contended that the only rational solution is to utilize all the dispersed knowledge in the market place through the use of price signals.[5] The early debates were made before the much greater calculating powers of modern computers became available but also before research on chaos theory. It may be impossible to make long-term predictions for a highly complex system such as an economy.[6]

One criticism, though, has been that proponents of the problem overstate the strength of their case, in describing socialism as impossible, rather than inefficient.[7] It has also been claimed that the contention that finding a true economic equilibrium is not just hard but impossible for a central planner applies equally well to a market system; As any Universal Turing Machine can do what any other Turing machine can, a system of dispersed calculators (i.e. a market) has no in principle advantage over one central calculator.[8] Some writers have gone on to suggest that with detailed use of real unit accounting and demand surveys a planned economy could operate without a capital market, in a situation of abundance,[9][10] The purpose of the price mechanism is to allow individuals to recognise the opportunity cost of decisions: in a state of abundance, there is no such cost.

Market socialism was developed in response to the calculation argument. Oskar Lange created the Lange Model and argued that prices can be seen merely as an accounting practice. In principle, claim market socialists, socialist managers of state enterprises could use a price system, as an accounting system, in order to minimize costs and convey information to other managers.[3] However, while this can deal with existing stocks of goods, providing a basis for values can be ascertained, it does not deal with the investment in new capital stocks.[citation needed]

[edit] Dispersed knowledge

Hayek's argumentation is not only regarding computational complexity for the central planners, however. He further argues that much of the information individuals have cannot be collected or used by others. First, individuals may have no or little incentive to share their information with central or even local planners. Second, the individual may not be aware that he has valuable information, and when he becomes aware, it is only useful for a limited time, too short for it to be communicated to the central or local planners. Third, the information is useless to other individuals if it is not in a form that allows for meaningful comparisons of value (i.e. money prices as a common basis for comparison). Therefore, Hayek argues, individuals must acquire data through prices in real markets.[11]

[edit] Implementation of central planning decisions

Hayek (1944) also argues that the central administrative resource allocation, which often must take away resources and power from subordinate leader and groups, necessarily requires and therefore selects ruthless leaders and the continued strong threat of coercion and punishment in order for the plans to be somewhat effectively implemented. This, in combination of the failures of the central planning, slowly leads socialism down the road to an oppressive dictatorship.[12]

[edit] Markets not efficient

Another counter-argument is to dispute the claim that a free market is efficient at resource allocation. Alec Nove argues that in "Economic Calculation in the Socialist Commonwealth" von Mises "tends to spoil his case by the implicit assumption that capitalism and optimum resource allocation go together",[13] and Joan Robinson further avers that "private property in the means of production, combined with rights of inheritance produces a totally irrational distribution of purchasing power within society which completely undermines the whole conception" that markets rationally allocate resources. She further claims many prices in modern capitalism are effectively "administered prices" created by "quasi monopolies", thus challenging the connection between capital markets and rational resource allocation.[14]

Mainstream economists, such as Paul Samuelson have argued however that markets are, on the whole, allocatively efficient[citation needed] and Milton Friedman has argued that, due to the pressure from free trade of potential competition, monopolies still have to behave in a competitive manner.[15]

[edit] Steady state

Robinson also noted that in a non-growth economy (what Marxists would call a situation of simple reproduction) there would be an effective abundance of means of production, and so markets would not be needed.[16] Von Mises acknowledged such a theoretical possibility in his original tract:

“ The static state can dispense with economic calculation. For here the same events in economic life are ever recurring; and if we assume that the first disposition of the static socialist economy follows on the basis of the final state of the competitive economy, we might at all events conceive of a socialist production system which is rationally controlled from an economic point of view.[1] ”

He contended, however, that stationary conditions never prevail in the real world. Changes in economic conditions are inevitable.

[edit] Real World Examples

Project Cybersyn is an example of attempting to plan the Chilean Economy through computer-aided calculation. It consisted of Telex machines located in workplaces communicating information in real time to a central control system. Its overall impact is difficult to assess, as it was destroyed after the military coup on September 11, 1973 before the system was fully completed.

[edit] Bibliography

  • Boettke, Peter 1990 The Political Economy of Soviet Socialism
  • Caldwell, B: 1997. Hayek and Socialism The Journal of Economic Literature V35 1856-1890
  • Cottrell, Allin and Cockshott WP "Calculation, Complexity and Planning: The socialist calculation debate once again" Review of Political Economy
  • Dickinson HD 1933 Price Formation in a Socialist Community in The Economic Journal
  • Dickinson, HD 1939 The Economics of Socialism
  • Hayek, FA 1935 Collectvist Economic Planning
  • Hayek FA 1937 Economics and Knowledge Economica V4 N13 33-54.
  • Hayek FA 1940 The Competitive "Solution" Economica V7 N26 pp 125-149
  • Hayek, FA The Road to Serfdom
  • Hayek, FA 1945 The Use of Knowledge in Society The American Economic Review
  • Hayek, FA 1952 The Counter Revolution of Science
  • Hayek, FA 1967 The New Confusion about Planning
  • Kirzner, Israel 1973 Competition and Entrepreneurship
  • Lavoie, Don 1985 Rivalry and Central Planning
  • Oscar Lange On the Economic Theory of Socialism I, 1936, Review of Economic Studies. V4 N1 53-71
  • Oscar Lange 1937 "On the Economic Theory of Socialism II, . Review of Economic Studies. V4 N 123-142
  • Oscar Lange On the Economic Theory of Socialism, 1938.
  • Oscar Lange 1942 The Economic Operation of a Socialist Society I+II Contributions to Political Economy V6 p3-12, 13-24
  • Oscar Lange 1957a Political Economy of Socialism
  • Oscar Lange 1957b. Role of Planning in a socialist economy
  • Oscar Lange 1967 The Computer and the Market in Socialism, Capitalism, and Economic Growth Feinstein Ed.
  • Lachmann, L: 1978 Capital and Its Structure. Sheed, Andrews, and McMeel, Kansas City
  • Lavoie, D: 1981. A Critique of the Standard Account of the Socialist Calculation Debate Journal ofLibertarian Studies N5 V1 41-87
  • Lavoie, Don 1985 Rivalry and Central Planning
  • Lerner, AP 1934 Economic Theory and Socialist Economy The Review of Economic Studies V2 N1 51-61
  • Lerner, AP 1936 A note on Socialist Economics The Review of Economic Studies V4 N1 72-76
  • Lerner, AP 1937 Statics and Dynamics in Socialist Economics The Economic Journal V47 N186 253-270
  • Lerner, AP 1938 Theory and Practice in Socialist Economics The Review of Economic Studies V6 N1 71-5
  • Lerner, AP 1944 The Economics of Control
  • MacKenzie, DW 2008 "Social Dividends, Bureacratic Rules, and Entrepreneurial Discretion" Eastern Economic Journal
  • MacKenzie, DW 2006 "Oscar Lange and the Impossibility of Economic Calculation", Studia Economicze
  • Mises LE 1912 The Theory of Money and Credit
  • Mises LE 1920 Economic Calculation in the Socialist Commonwealth, reprinted in Hayek (1935)
  • Mises LE 1922[1936] Socialism, and Ecomomic and Sociological Analysis
  • Mises 1933 Planned Economy and Socialism; reprinted in Selected Writings of Ludwig von Mises, The Liberty Fund (2002) Richard M Ebeling ed.
  • Mises LE 1944 Bureacracy
  • Mises LE 1944 Omnipotent Government
  • Mises LE 1949 Human Action
  • Mises LE 1957 Theory and History
  • Roemer, John (1994). A Future for Socialism, Verso Press.
  • Stiglitz, J: 1994. Whither Socialism? MIT Press
  • Vaughn, Karen. 1980. Economic Calculation under Socialism: The Austrian Contribution. Economic Inquiry 18:535–54
  • Yunker, James A. Post-Lange Market Socialism" 1995, Journal of Economic Issues

[edit] References

  1. ^ a b c d Von Mises, Ludwig (1990). Economic calculation in the Socialist Commonwealth (pdf) (in English), Ludwig von Mises Institute. Retrieved on 2007-04-03. 
  2. ^ 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.
  3. ^ a b c d Fonseca, Gonçalo L. (200?). The socialist calculation debate (HTML) (English). HET. Retrieved on 2007-04-03. “The information here has not been reviewed independently for accuracy, relevance and/or balance and thus deserves a considerable amount of caution. As a result, I would prefer not to be cited as reliable authorities on anything. However, I do not mind being listed as a general internet resource. ([1])”
  4. ^ Hayek, Friedrich (1994). The Road to Serfdom, 50th anniversary ed., University of Chicago Press. ISBN 0-226-32061-8. 
  5. ^ Steele, David Ramsay (1992). From Marx to Mises: post-capitalist society and the challenge of economic calculation. La Salle, Ill.: Open Court. ISBN 0-8126-9016-8. 
  6. ^ Economic Logic: a survey and variations on the theme (HTML) (English). Retrieved on 2007-04-03.
  7. ^ Boettke, Peter J.; Peter T. Leeson (2004). Socialism: still impossible after all these years (PDF) (in English), Ludwig von Mises Institute. Retrieved on 2007-04-03. 
  8. ^ >Cottrell, Allin; Paul Cockshott, Greg Michaelson (2007). Is Economic Planning Hypercomputational? The Argument from Cantor Diagonalisation (PDF) (in English), International Journal of Unconventional Computing. Retrieved on 2008-03-13. 
  9. ^ Ticktin, Hillel (1997). in Bertell Ollman: Market Socialism: The Debate Among Socialists. New York; London: Routledge. ISBN 0-415-91967-3. 
  10. ^ Neurath, Otto (2004). Economic writings: selections 1904-1945. Dordrecht; London: Kluwer Academic. ISBN 1402022735. 
  11. ^ Zappia, Carlo. The economics of information, market socialism and Hayek's legacy (PDF) (English). Retrieved on 2007-04-03.
  12. ^ Hayek, Friedrich (1994). The Road to Serfdom, 50th anniversary ed., University of Chicago Press. ISBN 0-226-32061-8. 
  13. ^ Nove, Alec (1972). in Alec Nove & D. M. Nuti: Socialist economics: selected readings. Harmondsworth, Middlesex: Penguin books. 
  14. ^ Robinson, Joan (1972). in Alec Nove & D. M. Nuti: Socialist economics: selected readings. Harmondsworth, Middlesex: Penguin books. 
  15. ^ Free to Choose, Milton Friedman, 1979, Secker and Warburg
  16. ^ Robinson, Joan (1966). An essay on Marxism. London: Macmillan. ISBN 0333020812. 

[edit] See also

[edit] External links