The economic calculation problem is a criticism of using economic planning as a substitute for market-based allocation of the factors of production. It was first proposed by Ludwig von Mises in his 1920 article "Economic Calculation in the Socialist Commonwealth" and later expanded upon by Friedrich Hayek.
In his first article, Mises describes the nature of the price system under capitalism and describes how individual subjective values are translated into the objective information necessary for rational allocation of resources in society. He argues that economy planning necessarily leads to an irrational and inefficient allocation of resources. In market exchanges, prices reflect the supply and demand of resources, labor and products. In the article, Mises focused his criticism on the inevitable deficiencies of the socialisation of capital goods, but he later went on to elaborate on various different forms of socialism in his book Socialism.
Mises and Hayek argued that economic calculation is only possible by information provided through market prices and that bureaucratic or technocratic methods of allocation lack methods to rationally allocate resources. Mises's analysis centered on price theory while Hayek went with a more feathered analysis of information and entrepreneurship. 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. Mises's initial criticism received multiple reactions and led to the conception of trial-and-error market socialism, most notably the Lange–Lerner theorem.
In the 1920 paper, Mises argued that the pricing systems in socialist economies were necessarily deficient because if a public entity owned all the means of production, no rational prices could be obtained for capital goods as they were merely internal transfers of goods and not "objects of exchange", unlike final goods. Therefore, they were unpriced and hence the system would be necessarily irrational as the central planners would not know how to allocate the available resources efficiently. He wrote that "rational economic activity is impossible in a socialist commonwealth". Mises developed his critique of socialism more completely in his 1922 book Socialism, arguing that the market price system is an expression of praxeology and can not be replicated by any form of bureaucracy.
In his first article, Mises describes the nature of the price system under capitalism and describes how individual subjective values are translated into the objective information necessary for rational allocation of resources in society. He argues that economy planning necessarily leads to an irrational and inefficient allocation of resources. In market exchanges, prices reflect the supply and demand of resources, labor and products. In the article, Mises focused his criticism on the inevitable deficiencies of the socialisation of capital goods, but he later went on to elaborate on various different forms of socialism in his book Socialism.
Mises and Hayek argued that economic calculation is only possible by information provided through market prices and that bureaucratic or technocratic methods of allocation lack methods to rationally allocate resources. Mises's analysis centered on price theory while Hayek went with a more feathered analysis of information and entrepreneurship. 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. Mises's initial criticism received multiple reactions and led to the conception of trial-and-error market socialism, most notably the Lange–Lerner theorem.
In the 1920 paper, Mises argued that the pricing systems in socialist economies were necessarily deficient because if a public entity owned all the means of production, no rational prices could be obtained for capital goods as they were merely internal transfers of goods and not "objects of exchange", unlike final goods. Therefore, they were unpriced and hence the system would be necessarily irrational as the central planners would not know how to allocate the available resources efficiently. He wrote that "rational economic activity is impossible in a socialist commonwealth". Mises developed his critique of socialism more completely in his 1922 book Socialism, arguing that the market price system is an expression of praxeology and can not be replicated by any form of bureaucracy.
Theory
Comparing heterogeneous goods
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 labour.
As a means of exchange, money
enables buyers to compare the costs of goods without having knowledge
of their underlying factors; the consumer can simply focus on his
personal cost-benefit decision. Therefore, the price system is said to
promote economically efficient use of resources by agents who may not
have explicit knowledge of all of the conditions of production or
supply. This is called the signalling function of prices as well as the rationing function which prevents over-use of any resource.
Without the market process to fulfill such comparisons, critics
of non-market socialism say that it lacks any way to compare different
goods and services and would have to rely on calculation in kind. The resulting decisions, it is claimed, would therefore be made without sufficient knowledge to be considered rational.
Relating utility to capital and consumption goods
The common basis for comparison of capital goods must also be connected to consumer welfare.
It must also be able to compare the desired trade-off between present
consumption and delayed consumption (for greater returns later on) via
investment in capital goods. 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 (amount of satisfaction) of the
last dollar spent on each good. Thus, the exchange of consumer goods
establishes prices that represent the marginal utility of consumers and
money 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, namely
economic calculation requires the use of money across all goods. This is
a necessary, but not a sufficient condition for successful economic
calculation. Without a price mechanism, Mises argues, socialism lacks
the means to relate consumer satisfaction to economic activity. The
incentive function of prices allows diffuse interests, like the
interests of every household in cheap, high quality shoes to compete
with the concentrated interests of the cobblers in expensive, poor
quality shoes. Without it, a panel of experts set up to "rationalise
production", likely closely linked to the cobblers for expertise, would
tend to support the cobblers interests in a "conspiracy against the
public". However, if this happens to all industries, everyone would be
worse off than if they had been subject to the rigours of market competition.
The Mises theory of money and calculation conflicts directly with Marxist labour theory of value.
Marxist theory allows for the possibility that labour content can serve
as a common means of valuing capital goods, a position now out of
favour with economists following the success of the theory of marginal utility.
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
all markets. Thus, entrepreneurship 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.
Entrepreneurs lack the profit motive
to take risks under socialism and so are far less likely to attempt to
supply consumer demands. Without the price system to match consumer
utility to incentives for production, or even indicate those utilities
"without providing incentives", state planners are much less likely to
invest in new ideas to satisfy consumers' desires.
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), but
first mentioned and illustrated by his mentor Mises in Socialism (1922), not to be mistaken with Socialism: An Economic and Sociological Analysis
(1951). The planning could either be done in a decentralised fashion,
requiring some mechanism to make the individual plans coherent, or
centrally, requiring a lot of information.
Within capitalism, the overall plan for production is composed of
individual plans from capitalists in large and small enterprises. Since
capitalists purchase labour and capital out of the same common pool of
available yet 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.
As for socialism, Mises (1944) and Hayek (1937) insisted that
bureaucrats in individual ministries could not coordinate their plans
without a price system. If decentralized socialism cannot work, central
authorities must plan production. However, central planners face the local knowledge problem
in forming a comprehensive plan for production. Mises and Hayek saw
centralization as inevitable in socialism. 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.
This is partly because individuals possess useful knowledge but do not
realise its importance, may have no incentive to transmit the
information, or may have incentive to transmit false information about
their preferences. He contended that the only rational solution is to utilize all the dispersed knowledge in the market place through the use of price signals. The early debates were made before the much greater calculating powers of modern computers became available but also before research on chaos theory. In the 1980s, Alec Nove argued that even with the best computers, the calculations would take millions of years. It may be impossible to make long-term predictions for a highly complex system such as an economy.
Hayek (1935, 1937, 1940, 1945) stressed the 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 and the Lange model by Oskar R. Lange (1938) and Hayek's student Abba Lerner
(1934, 1937, 1938) which was developed in response to the calculation
argument. 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. Lange 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.
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.
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. Lange and Lerner also admitted that
socialism would lack any simulation of financial markets, and that this
would cause problems in planning capital investment.
However, Hayek's argumentation is not only regarding
computational complexity for the central planners. 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.
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. Those who
invest in accordance with consumers' desires are rewarded with profits,
those who do not are forced to become more efficient or go out of
business.
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 as Mises argued:
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.
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 argued 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's 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 capitalist 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.
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. Therefore, Mises concluded that
socialism lacks any clear tendency towards improvement in the capital
structure of industry.
Example
Mises gave the example of choosing between producing wine or oil, making the following point:
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 orient 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.
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 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.
Criticism
Efficiency of markets
One
criticism is that the claim that a free market is efficient at resource
allocation is incorrect. Alec Nove argues that in his "Economic
Calculation in the Socialist Commonwealth", Mises "tends to spoil his
case by the implicit assumption that capitalism and optimum resource
allocation go together". Economist Joan Robinson
also argued that many prices in modern capitalism are effectively
"administered prices" created by "quasi monopolies", thus challenging
the connection between capital markets and rational resource allocation. The economist Robin Hahnel
has argued that free markets are in fact systematically inefficient
because externalities are pervasive and because real-world markets are
rarely truly competitive or in equilibrium.
Milton Friedman agreed that markets with monopolistic competition are not efficient, but he argued that in countries with free trade the pressure from foreign competition would make monopolies behave in a competitive manner.
In countries with protectionist policies, foreign competition cannot
fulfill this role, but the threat of potential competition, namely that
as companies abuse their position new rivals could emerge and gain
customers dissatisfied with the old companies, can still reduce the
inefficiencies.
Other libertarian capitalist analysts believe that monopolies and
big business are not generally the result of a free market. Rather,
they say that such concentration is enabled by governmental grants of
franchises or privileges.
They adamantly oppose any distortion of market structure by the
introduction of government influence, asserting that such interference
would be a form of central planning or state capitalism, insofar as it would redirect decision making from the private to the public sector.
Joseph Schumpeter
argued that large firms generally drive economic advancement through
innovation and investment and so their proliferation is not necessarily
bad.
Equilibrium
It
has also been argued 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 central calculator in
principle has no advantage over a system of dispersed calculators (i.e.,
a market), or vice versa.
In some economic models, finding an equilibrium is hard. For instance, finding an Arrow–Debreu equilibrium is PPAD-complete. If the market can find an equilibrium in polynomial time, then the equivalence above can be used to prove that P=PPAD. Don Lavoie makes the same point in reverse. The market socialists pointed out the formal similarity between the neoclassical model of Walrasian general equilibrium
and that of market socialism. Simply replace the Walrasian auctioneer
with a planning board. However, this emphasizes the shortcomings of the
model. According to Lavoie, by relying on this formal similarity the
market socialists must adopt the simplifying assumptions of the model.
The model assumes that various sorts of information are "given" to the
auctioneer or planning board. However, without a capital market, this
information does not exist; and if it does exist, it exists in a
fundamentally distributed form, unavailable to the planners. If the
planners somehow captured this information, it would immediately become
stale and relatively useless unless reality somehow imitated the
changeless monotony of the equilibrium model. The existence and
usability of this information depends on its creation and situation
within a distributed discovery procedure.
Scale of problem
One
criticism is that proponents of the theory overstate the strength of
their case by describing socialism as impossible rather than
inefficient.
Steady-state economy
Joan Robinson argued that in a steady-state economy there would be an effective abundance of means of production and so markets would not be needed. Mises acknowledged such a theoretical possibility in his original tract when he said the following:
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.
However,
he contended that stationary conditions never prevail in the real
world. Changes in economic conditions are inevitable; and even if they
were not, the transition to socialism would be so chaotic as to preclude
the existence of such a steady-state from the start.
Some writers have argued 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. 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; which is
to say that in situations where one need not economize, economics does
not apply, e.g. areas with abundant fresh air and water.
Use of technology
In Towards a New Socialism's "Information and Economics: A Critique of Hayek" and "Against Mises", Paul Cockshott
and Allin Cottrell argued that the use of computational technology now
simplifies economic calculation and allows central planning to be
implemented and sustained. Len Brewster replied to this by arguing that Towards a New Socialism establishes what is essentially another form of a market economy, making the following point:
[A]n examination of C&C's New Socialism confirms Mises's conclusion that rational socialist planning is impossible. It appears that in order for economic planners to have any useful data by which they might be guided, a market must be hauled in, and with it analogues of private property, inequality and exploitation.
In response, Cockshott argued that the economic system is
sufficiently far removed from a capitalist free-market economy to not
count as one, saying:
Those that Hayek was arguing against like Lange and Dickinson allowed for markets in consumer goods, this did not lead Hayek to say : Oh you are not really arguing for socialism since you have conceded a market in consumer goods, he did not, because there remained huge policy differences between him and Lange even if Lange accepted consumer goods markets. It is thus a very weak argument by Brewster to say that what we advocate is not really socialist calculation because it is contaminated in some way by market influences.
Cosma Shalizi articulated the problems that come with central
planning using supercomputers in a 2012 essay. He cited the sheer
complexity of the problem as well as the difficulty of negotiating
between preferences as being the central problems with such a system.
Leigh Phillips and Michal Rozworski released a book in 2019 that
argues that multinational corporations like Walmart and Amazon already
operate centrally planned economies larger than the Soviet Union,
proving that the economic calculation problem is surmountable.
