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. Those who agree with this criticism claim it is a refutation of socialism and that it shows why a socialist command economy could never work.
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Liberal thinkers
Many "Classical Liberal" thinkers, especially those of the Austrian School believed Marxist economics to be impractical because it denied private ownership of productive property. They state that prices represent information about market conditions, and are necessary for economic activity. In this view a socialist economy, therefore, would require a price system in order to operate. The socialist economy is said not to set prices as efficiently as private owners, as private property owners seek the best profits for factors of production they owned, even in constantly changing circumstances. It would be this process that would ensure the best use of resources.
This was first stated by Friedrich von Wieser and a good summation of this case was that of Ludwig von Mises in his article "Economic Calculation in the Socialist Commonwealth".
Friedrich Hayek
Hayek further refined this by pointing out that by the time all the relevant information had been gathered the situation would have changed and so the government would be chasing a moving target. In their view, prices in a free market on the other hand instantly conveyed information on the demand and scarcity of products. In theory, the free market was effectively "self organising" in a way that a centrally planned one could never be. He also felt there were other dangers inherent in a planned economy, illustrated in his "The Road to Serfdom".
Extended explanation of argument
The argument goes roughly as follows:
- The basic economic problem is to produce the "right quantity" of all goods and services, including any capital goods required to produce the finished goods or services. (Assume for this argument that "goods" refers to both goods and services.)
- Since the factors of production are finite, producing more of one good means producing less of some other good. Therefore the basic economic problem can be restated thus: given a fixed quantity of the factors of production, how should they be allocated to produce the "right" set of final goods?
- In a free market, where prices are free to rise and fall without restriction, the price of a good rises when demand increases, and falls when supply increases. If supply is insufficient to meet demand, the price increases, and producers are motivated to make more of that good. If demand is insufficient to purchase the available goods, then prices fall, and less of the good is produced. This is what it means when an economist of the Austrian school says that prices are the mechanism that matches supply with demand.
- Under socialism, prices are not free to rise and fall. Instead, prices are set by central planners. Put differently, because there is no private property in the means of production, individuals have no power to set prices in response to supply and demand.
- Due to these price controls, there is no reliable source of information about demand, and hence no way to decide how much of a good to produce. This is the economic calculation problem.
- Since producing too much of one good implies producing too little of another, the result of the calculation problem is that there will be acute shortages of one good or another. Inherent in the calculation problem is the conclusion that it is impossible to predict which goods will experience shortage, since if that could be predicted, production could be adjusted to eliminate the shortage, and the calculation problem would in fact be solvable. The assertion of Mises is that the calculation problem is inherently unsolvable.
Thus the ostensible result is that socialism produces inefficient distributions of production. Historical examples include the Soviet Union's cyclical shortages of various goods. Efforts to resolve the economic calculation problem was one of the main goals of Chinese economic reform in the 1980s. This argument served as the starting point for F. A. Hayek's work on the use of knowledge in society. He contended that the only rational solution to the economic calculation problem is to utilize all the dispersed knowledge in the market place through the use of price signals.
Simply put, one aspect of the economic calculation problem is that demand cannot be known without prices. Or more precisely, it cannot be known accurately without prices; it would in theory be possible for every citizen to order all of his groceries one year in advance, and to plan a production schedule for the year based on those orders. If one did this, one would know roughly how much of each good was desired, but this information would be inaccurate, if only because some people may become tired of borscht and eat much less of it than they anticipated when they placed their order; others might become ill or disabled and so have no need of the fuel and clothing they ordered at the start of the year, etc. Add to that the possibility of a natural disaster creating a sudden increase in the need for food and clothing across an entire region, and Hayek would say that it becomes clear that even if demand could be measured accurately at a particular point in time, the information would quickly become outdated. Prices, on the other hand, provide a continuous source of feedback as demands change.
Another aspect of the economic calculation problem is that, just as demand can't be known without prices, so costs can't be known without prices. The problem is not one of having a unit of measure, though that is sometimes incorrectly identified as the economic calculation problem. Rather, the problem is that the cost of a good is roughly the demand for the next-most-preferred good. That is to say that if one uses the last of one's flour to bake a cake instead of a loaf of bread, the opportunity cost of the cake is equal to the value one places on the bread one does without. So what is the cost of a space race? To answer the question in a socialist economy requires a knowledge of what people would have done with the time, labor, titanium, land, etc., if it were not instead used to produce a space race, but this is something that fundamentally can't be known. Conversely, in a free market, the fact that someone is willing to pay for a space capsule is regarded as a priori evidence that the opportunity cost of a space capsule is less than the value of the capsule. (See also marginalism).
In a sense the calculation problem is a critique not only of socialist economies, but of any use of price controls. There is a critical difference, however, in that socialist economies implement price controls across the entire spectrum of goods. In a nominally free market, price controls are applied to only a small number of goods, and it is usually clear from circumstances whether the price is being held too high or too low--for example, one speaks of a price floor (minimum) or ceiling (maximum), depending whether the price is being held above or below the market price, respectively. In the case of a price floor it can be predicted that supply will exceed demand, creating a surplus, and in the case of a price ceiling it can be predicted that demand will exceed supply, creating a shortage. The economic calculation problem differs in that, lacking any knowledge of the market price of goods, one cannot say which goods will be in surplus and which will suffer shortage.
Example
A road needs to be built from Place A to Place B. In between, there is a mountain.
Several methods could be used:
- The road could go around the mountain.
- The road could tunnel through the mountain.
- The road could go over the mountain.
Each method has costs and benefits.
How does one calculate the comparative costs of different options, without prices? Vital information about the relative cost of labor, materials, delays, impact on travel time, etc. is automatically aggregated from thousands of factors into prices, in a market economy. It would be impractical for a central planning authority to gather and compare all this information, changing it in real time.
Debate
This conclusion was attacked directly on two fronts. Firstly, by believers in the general equilibrium theory who maintained that all that matters is the knowledge of the most effective use of materials as long as the price system was in use; effective use of materials could then be calculated by any method, and in essence, other signals would take place of price for intermediate goods. Secondly, by Marxists, who see prices, e.g. the ratio in which commodities (including money) are exchanged with one another, as just one small part of a process of production which has the primary purpose of profit according to the Labor theory of value; according to that theory, prices in capitalism do not in fact serve as demand signals. If either of those alternative theories of price is accepted, in place of the marginalist theory presently most popular among economists, the calculation problem becomes harder to formulate.
A related point sometimes made by socialists (or, for a different purpose, Rothbard-inspired anarcho-capitalists) is that in actually existing capitalism, prices are often set by central planners. Large corporations set retail prices by central policies, which must in turn be determined by calculations of the sort that, arguably, ought to be impossible according to proponents of the calculation argument. For example, in response to the road-construction example above, it might be claimed that the costs and benefits of the impact on travel time couldn't be determined ahead of time by judgement-free summing of prices alone in even the most free-market economy.
It could also be argued that the philosophical basis of the calculation problem has a fatal flaw. Proponents argue that optimum economic settings are unknowable but also purport to know that the market can provide them.
Decentralized Socialism
Some socialists respond less directly, that this argument rests on the assumption that socialism would be a completely centralised economy based on society wide planning, but that in fact it need not necessarily be so. This counter-argument suggests a decentralized form of socialism with different levels of planning -- local, regional and global. This, they claim, would allow for a self-regulating mechanism of stock control to come into play (which cannot happen in the case of society-wide or central planning).
In this model, distribution points replenish stock as it is removed from the shelves by signaling to producers’ orders for new stock. Producers in turn contact their own suppliers of inputs as and when it is required and so on down the production.
According to the law of the minimum (after Justus von Liebig) those factors that are most scarce in relation to demand, that constitute the "limiting factor" which proximately limits the production of any good, are precisely those that need most to be economised. The shortage of such factors as revealed via the self-regulating system of stock control will trigger the search for more abundant substitutes. This, some socialists claim, would overcome the economic calculation problem. An elaborated model of the socialist economisation process as well as a detailed critique of the Economic Calculation Argument appears in issue no.3 of Common Voice http://www.cvoice.org/current.htm
Rebuttal
One response to this criticism is that fundamentally the calculation problem does not in fact rest on an assumption of centralization of decision making. Indeed, problems very similar can occur in decentralized systems, wherever the persons making choices are insulated from the inefficiencies of those choices.
Another response is to point out that the "stock control plus law of the minimum" proposal ignores the key difficulty identified by the economic calculation problem: the measurement of costs of production according to a common unit. For efficient allocation, it's necessary to have a common unit of cost for all the many thousands of productive inputs. Such a unit is given by market prices, but is not given by stock control or by the law of the minimum.
The classical economic critique of this theory is to point out that all real-world instances of socialism have involved central planning to a greater or lesser degree, and absent any example of actually functioning "Decentralized Socialism" it should be assumed to suffer from the economic calculation problem the way all other socialist economies have.
Reply
Decentralist socialists argue that while the calculation problem may not in itself rest on the assumption of society-wide or central planning, the attempted resolution of that "problem" in a non-market society will remain obfuscated or hidden from view if one assumes such a society to be a central planned one in this sense, as do most proponents of the calculation argument against socialism. This is because the notion of central planning necessarily precludes the operation of a self regulating system of stock control which is a key component of an effective counter-argument to the economic calculation argument along with calculation in kind (Otto Neurath) and the law of the minimum.
Chinese socialism
The method used by China to resolve the economic calculation problem is that of a socialist market economy, in which the goals and the ownership are largely public, but this exists within a market pricing system. Of course, one might question whether China is still a socialist economy as it claims, when the means of production are increasingly privately owned and the Gini coefficient is higher than many capitalist countries.
Trotsky
One of the more surprising entries in the debate was this from Trotsky:
If there existed the universal mind, that projected itself into the scientific fancy of Laplace; a mind that would register simultaneously all the processes of nature and of society, that could measure the dynamics of their motion, that could forecast the results of their inter-reactions, such a mind, of course, could a priori draw up a faultless and an exhaustive economic plan, beginning with a number of hectares of wheat and down to the last button for a vest. In truth, the bureaucracy often conceives that just such a mind is at its disposal; that is why it so easily frees itself from the control of the market and of Soviet democracy.
The innumerable living participants of economy, State as well as private, collective as well as individual, must give notice of their needs and of their relative strength not only through the statistical determinations of plan commissions but by the direct pressure of supply and demand. The plan is checked and to a considerable measure, realized through the market. The regulation of the market itself must depend upon the tendencies that are brought out through its medium. The blueprints produced by the offices must demonstrate their economic expediency through commercial calculation.
...
Economic accounting is unthinkable without market relations.
Leon Trotsky, "Soviet Economy in Danger", New York, 1933. Quoted in "Real Socialism Wouldn't Work Either".
(It should be noted, however, that this quotation refers to the transition period between the New Economic Program, better known as the NEP, and the planned economy in the USSR.)
See also
For elucidation of the economic calculation problem, see:
References
D.R. Steele, From Marx to Mises (Chicago: Open Court, 1992) ISBN 0812690168