Misean "Calcuation Problem" debunked.

 Note: This article is in reference to the socialist vs capitalist debate, so it doesn't completely apply to TVP vs Capitalist. However, it kind of smashes the economic calculation argument (theory) that we are being told we need to solve and demonstrates how flawed it is.

 Taken from here.
PRELIMINARY CRITICISMS OF THE MISESIAN MODEL

At first blush, the ECA would appear to be highly plausible. However, on closer inspection we can discern hairline fractures in the very foundations of this model which render it highly vulnerable to sustained criticism. Let us consider some of these defects first before turning our attention to the organisation of production and the allocation of production goods in a socialist economy.

A) Subjective valuation and price

According to Mises and the Austrian School of Economics, the value of goods and services is necessarily subjective and does not inhere in the good or service in question; economic costs are essentially subjective, opportunity costs and utility preferences can only be expressed along an ordinal scale – i.e. ranked – as opposed to a cardinal scale which entails precise measurement. How then do we arrive at the necessary data upon which a system of economic calculation is predicated? Salerno puts it thus. The problem with socialism, he claims, is that it lacks “a genuinely competitive and social market process in which each and every kind of scarce resource receives an objective and quantitative price appraisal in terms of a common denominator reflecting its relative importance in serving (anticipated) consumer preferences. This social appraisal process of the market transforms the substantially qualitative knowledge about economic conditions acquired individually and independently by competing entrepreneurs, including their estimates of the incommensurable subjective valuations of individual consumers for the whole array of final goods, into an integrated system of objective exchange ratios for the myriads of original and intermediate factors of production. It is the elements of this coordinated structure of monetary price appraisements for resources in conjunction with appraised future prices of consumer goods which serve as the data in the entrepreneurial profit computations that must underlie a rational allocation of resources.”4

But what is actually happening in this “transformation process” whereby the “incommensurable subjective valuations” of individuals purportedly come to be expressed as objective exchange ratios or prices? Do the latter in fact actually capture the former? There is a kernel of truth in the claim that they do in that obviously if someone is willing to pay a price for a good he or she must ipso facto subjectively value that good. Otherwise the “willingness to pay” for it would not have arisen. But, of course, in a market economy mere “willingness to pay” is not enough; the means of payment – purchasing power- is what is crucially required and it is only willingness to pay that is backed up by purchasing power that actually affects prices. This is what economists call “effective demand” (presumably to be distinguished from “ineffective demand”). The subjective valuation that a pauper places on a square meal may be considerable but in the absence of the wherewithal to pay for such a meal, this counts for nothing. In short, the subjective valuations individuals place on goods cannot reasonably be said to be captured or embodied by the objective prices such goods attract in the market. Indeed, one might add that to suggest that they do, flatly contradicts a key myth of bourgeois economics – namely, that our wants are essentially “infinite” and the resources to meet them, limited.

It may be objected that while it does not aim to “quantify” our wants as such (along a cardinal scale), price does nevertheless reflect our subjective valuations insofar as it sheds light on our preferences (along an ordinal scale). Thus, if we prefer roast beef to a McDonald’s hamburger this will be reflected in the higher price we would be willing to pay for such an item. However, this still does not get round the basic problem: in a market economy you cannot express a preference if you do not have the means to do so: purchasing power. You might prefer roast beef but after consulting your wallet may discover to your consternation that you will just have to resign yourself to the hamburger instead. While, according to conventional economics, effective demand determines price in conjunction with supply of the goods demanded, this effective demand is itself grossly unequally distributed by virtue of the unequal distribution of income. Austrians respond to this by arguing that such differentials reflect the valuations individuals place on different occupations and the different contributions they make to society (which “society” duly “rewards” them for) but there is no way of testing this claim since such valuations are themselves subject to the limitations of “effective demand”. Salerno’s “integrated system of objective exchange ratios” (prices) reflects or is conditioned by, this unequal distribution of effective demand. Thus, frivolous luxury goods can be “valued” more highly – i.e., attract a higher price – than food for the hungry because a rich elite has vastly more purchasing power at its disposal to competitively bid for, and so push up the price of, the former compared to the latter.

We should bear these points in mind in considering the merits or otherwise of the ECA; it is based on so-called objective data that are fundamentally biased or skewed and cannot be said to correspond truthfully to the subjective valuations of economic actors in the market as claimed. To believe otherwise is to commit what is called the Fallacy of Composition – the illusion that what is true for each part of a whole must be true for the whole It is an error that overlooks the interrelationships between the different parts of the whole.

B) What do we mean by “costs”?

D R Steele contends: “The total cost of producing anything is the total effect in reducing production of other things because of the factors used up. This what we mean by the ‘cost of production’. It is this that we always want to minimise when we produce anything”5. As we saw earlier, this definition of cost equates with opportunity cost. Opportunity costs are often counter-posed to accounting costs . The latter are usually taken to denote the explicit costs represented by the cash outlays that a firm makes in purchasing its inputs, whereas the former are associated with implicit or hidden costs and may be difficult or impossible to quantity, or even be completely unknown. For example, the opportunity cost of spending more money on a new school may be to forego spending this money on improving the local ambulance service which could have meant more lives being saved. But just how do you weigh up the cost of a life?

Going back to our example of consumer good X, we can see that the ECA relies on the notion of accounting cost rather than opportunity cost, despite its copious lip service to the latter. This is because it involves comparing the explicit cash outlays to be made on different combinations of A and B to arrive at a notional “least cost combination”. Certainly there is an opportunity cost in making that decision – this almost goes without saying – but this is not what this example of economic calculation is about. It is not measuring what a factory foregoes in opting to produce 1 unit of Y using method 2. Choosing a least cost combination of factors has essentially to do with accounting costs, not opportunity costs. That being so, one might well ask, how does this help one to calculate the “total effect in reducing production of other things because of the factors used up”? Acknowledging there is, theoretically speaking, a “total effect” is not the same as saying that this is what is being precisely measured – or, indeed, that it can ever be precisely measured. Moreover, who decides which is the “best alternative foregone”? One person’s preference may not be another’s. Such considerations are simply brushed under the carpet by the ECA.

Nevertheless, it is on the point of “precise measurement” that the ECA presses its claim. As Steele points out: “In this case, it so happens that it would be sufficient merely to know which was ‘more’ or ‘less’ but that is just an accident of the way I have set up the example. Generally, we should have to know exactly how much more or less. For instance, if the choice were between a method using 4lbs of rubber and 5 pounds of wood and a method using 5 lbs of rubber and 3 pounds of wood, it would not be enough to know that wood were more costly by weight, then rubber; we should need to know how much more costly”6.

Certainly, accounting costs are amenable to “exact calculation” using monetary prices but the question is what exactly is being accounted for in the process?. “Precise measurements” doesn’t tell us much; a game of monopoly entails precise measurement too but nobody suggests this implies some earth-shattering insight we would be foolish to overlook. What then is the significance of what is being precisely measured using monetary prices?

The ECA asserts that a socialist economy would be unable rationally to chose between different combinations of factors to arrive at a least cost combination. In answer to the obvious retort that a socialist economy would not concern itself with costs in this monetary form, it might be contended that there will still be a need to reckon costs in some other guise and that it is precisely these substantive costs – or if you like, “real world” costs – that the price mechanism is able faithfully to represent via its pattern of objective exchange ratios. But how could this be proven.? To prove this is the case one would have to demonstrate a precise correlation between these “substantive costs” and their monetary representations. One can determine whether such a correlation exists only by measuring one against the other. But that presents a problem for the ECA since, in doing this, one would have inadvertently shown that costs can indeed be independently measured, and rendered calculable, without recourse to market prices.

This places the proponents of the ECA in a invidious position since failure to demonstrate a putative correlation between these substantive costs and their alleged market representations means that all they have to fall back on is a tautology: that only a market economy is able to perform economic calculations couched in market prices. Steele himself has attempted to circumvent this argument with the (specious) claim that it is “parallel to arguments which have frequently been levelled against general theories. Thus every year or so some new genius discovers that Darwin’s theory of natural selection is vacuous, because it says that the fit survive, but there is no way to measure who are fit except by seeing who survive”7. But, of course, the analogy is completely inapt; the relationship between “fitness” and “survival” is a causal one which simply does not apply in this case. What is involved here is nothing quite so grand as a “general theory” but a modest proposition concerning the alleged statistical correlation between two sets of data without causation being invoked in any way.

Finally, if the ECA is really about narrow accounting costs rather than opportunity costs as such then presumably we have a solid basis for testing the proposition that a system of market prices can faithfully calculate the costs incurred in production decisions. Here we are referring to “costs” in their positive sense, not opportunities foregone. It is evident that in this sense, market-based calculations are far from adequate. There is an enormous literature on the problem of externalities and spill-over effects which illustrates this point very well. Suffice to say that in a competitive market economy there will always be an obvious in-built incentive for competing firms to externalise their costs as far as practically possible or to the extent to which they can get away with doing this. Pollution costs are one example of this and typically necessitate some intervention by the state to impose curbs on the offending firm in question in the interests of other firms who may have to indirectly pick up the tab. “Social costs” are another example. A firm may consider it necessary to lay off part of its workforce to reduce its production costs and remain competitive. However, this reduction of its labour costs has costly repercussions for the workers involved and society in general which tend not to be accounted for on the firm’s own balance sheet.

Attempts to get round the problem of externalities and spill-over effects through the application of concepts such “willingness-to-pay” (WTP) and “willingness-to-accept” (WTA) are problematic and provide little, if any, comfort for proponents of the ECA. WTP has to do with what people would be prepared to pay to mitigate or avert some undesirable effect while WTA refers to the level of financial compensation they would be willing to receive for having to put up with such an effect. Mainstream economists tend to regard the costs involved in both instances as roughly equivalent but there is considerable evidence based on surveys to suggest that this is simply not the case – not according to people’s “subjective evaluations” of environmental losses and gains, at any rate.8 In fact, environmental losses tend to be more highly valued than environmental gains even where similar sums of money are involved. There are a number of other problems associated with these techniques (e.g. the tendency to underestimate the value of future resources; the problem of non-use values and option values which are to do with resources that you do not yourself make use of or might only do so at a later date) all of which highlight the shortcomings of market valuations, shortcomings which the ECA tends to gloss over.

C) The problem of “net income”

According to the ECA not only is there a need to discover the least cost combinations of inputs required to produce a given good; there is also a need to ensure that the revenue obtained from the sale of this good is sufficient to cover the cost of producing it. This can only be done by attaching prices to a firm’s inputs (A and B in our example) as well as its output (good X).

“Net income” is the difference between a firm’s revenue or proceeds and its costs. Positive net income is what is usually referred to as profit; negative net income, as loss. As Mises put it, “Every single step of entrepreneurial activities is subject to scrutiny by monetary calculation. The premeditation of planned action becomes commercial pre-calculation of expected costs and expected proceeds. The retrospective establishment of the outcome of past action becomes accounting profits and losses”9.

This statement is revealing. It inadvertently highlights a serious flaw in the ECA. The ability to compute profit and loss is what in theory is supposed to ensure the efficient – that is “profitable” – allocation of resources. But it turns out that it ensures nothing of the sort. Just because a system of market prices affords one a set of figures with which one can perform precise calculations does not mean that these figures will turn out to be correct – that is to say, will unerringly guide the entrepreneur towards a positive net income.

As Steele puts it: “Since all production decisions are about the future and the future is always uncertain, decision makers have to make guesses, take gambles, play hunches and follow their experienced noses.”10 and “In the market, entrepreneurs anticipate, speculate, agonise, guess and take risks. They also frequently perform elaborate calculations, aware that the results of such calculations are only as good as their assumptions. Always enveloped in a cloud of ignorance, market decision-makers strain to discern the indefinite contours of the changing shapes that loom ambiguously out of the fog.”11

This seems unambiguous enough but then, curiously, Steele feels prompted to ask: “Does the fact that production is actually guided by estimates of future prices, and not by reading off ‘current’ (recent) prices, destroy the force of the Mises argument? Apparently not, for two reasons: 1. past prices are a guide which helps people to make more accurate (though still fallible) estimates of future prices; and 2. people’s estimates of future prices are eventually confirmed or refuted. There is an objective test of the accuracy of the estimates: profit and loss.”12

Steele’s first point rather undercuts his previous claim that production cannot actually be guided by current (recent) prices and he does not quite seem able to make up his mind on how relevant the latter are. By his own admission, entrepreneurs can and often do get things spectacularly wrong when relying on current /recent prices – the energy crisis of the 1970s being a case in point. It is also to be noted that these current/recent prices are a record of accounting costs, not opportunity costs, and so do not shed much light on the opportunities foregone in making a production decision since the latter are a “tacit reference to hypothetical future income”13 which can only be guessed at. He admits that entrepreneurs are fallible yet does not seem to see the inconsistency in admitting this and claiming that the price system ensures “exact calculation”.

Steele’s second point – that there is an objective test of the accuracy of entrepreneurial estimates – is presumably the more important one but, even so, holds no water. Remember that what we are looking for is some way of reliably guiding the entrepreneur to make sound production decisions concerning net income in the future – otherwise there would be little point in going on about the need for “exact calculation”. The fact that the market process is retrospectively “self-correcting” in eliminating or bankrupting those firms that err (incur an economic loss) in their future estimates is completely irrelevant. The resource allocations these firms committed themselves to constitute what economists call “sunk costs” and cannot be retrieved once made. Bygones, as the saying goes, are bygones. More importantly, there is no guarantee that those entrepreneurs, having had the good fortune to estimate future prices accurately, will continue to do so. We are emphatically not talking about some selective process at work here which incrementally refines the abilities of entrepreneurs generally to make sound economic judgements which Steele seems to be implying. If this were the case then the history of the market economy would manifest itself as a progressive reduction in uncertainty and risk.

On another matter, when Steele refers to profit and loss as an objective test of the accuracy of estimates of future prices one presumes he is using “profit” here to mean accounting profit or net income. However, this is a little confusing. This is because he also uses the term “profit” in another, more specialised, sense as well. The entrepreneur’s return on her capital, he contends, is called “interest” (or what we would normally called profit) and where this is equal to her accounting profits “there is no profit in the strict economic sense. True profit is a return above interest; loss, a return below interest”14. The irony is that such profit can only arise where the economy departs form the abstract model of perfect competition and optimal resource allocation. As Lachmann observes “profits are earned whenever there are price-cost differences; they are thus a typical disequilibrium phenomenon”15. Thus , according to the free marketeers’ own theory of how the market behaves, the very imperfections which they deplore (such as monopolistic tendencies) “are, in fact, key profit-generating dynamics in the economic system. In other words, market imperfections are the main source of profit in the economy”16. Such profit, as Steele points out, is the result of the entrepreneur outguessing the market and benefiting society in the process. Presumably, such benefits would not be forthcoming in the idealised (and completely unrealistic) competitive model of the free market which free marketeers strive to realise and that what is needed instead is a less competitive model in which price distortions are allowed more free play. But that, of course, undermines an important assumption of the ECA about the need for market forces to be given free rein in order to ensure the “accuracy” of market prices.

According to the ECA, in the absence of market prices that allow entrepreneurs to make profit and loss computations, economic efficiency cannot be assured. This, it is argued, is incompatible with the maintenance of a developed economic infrastructure. However, we have seen just how problematic such profit and loss computations are in the real world despite the evidence of a developed economic infrastructure around us (which the proponents of the ECA themselves delight in pointing out and attributing to the market). This suggests that there must be something seriously awry with the theory itself.

In any event, the claim that a socialist economy would need to be able to calculate “net income” in some sense does not stand up to close scrutiny. The notion of “net income” in fact derives purely from the functional requirement of capitalism to realise profit through market exchange – that is, it is system-specific. Certainly, this requires inputs and outputs to be reduced to a common denominator – to facilitate comparison and thereby ensure that when one commodity is exchanged for another, they are equivalent to each other. Indeed, market transactions necessitate such equivalence. However, it does not follow that this kind of comparison making use of a common denominator would be required in a socialist economy. In such an economy, “economic exchange” of any sort would no longer apply. It would not be necessary to determine whether “more” or “less” wealth in general was being created than was being used up in the production of that wealth for the very simple reason that the concept of wealth “in general”, a completely abstract and crudely aggregated notion of wealth, is of no practical use in itself and would be utterly meaningless outside the context of commodity exchange. This emphatically does not mean that a socialist economy will have no way of ensuring that resources would be efficiently allocated (which I will consider later); it simply means that such an economy does not need to operationalise this wholly unsatisfactory notion of “net income” in order to achieve this efficient allocation.

D) Estimating the negative effects of misallocation

Mises was clearly adamant that socialism could not be realised because it lacked any method of rational calculation. The implication of such a claim is that the effect of not having such a method would be so devastating as to prevent socialism from ever being realised. However, as Bryan Caplan points out, this flatly contradicts Mises own opinion that “economic theory gives only qualitative, not quantitative laws”17. According to Mises in Human Action (quoted in Caplan), “economics is not, as ignorant positivists repeat again and again, backward because it is not quantitative. It is not quantitative because there are no constants”. But if that is the case, how could you quantity the negative effects of this supposed misallocation in a hypothetical socialist economy and come to the conclusion that they were so severe as to make socialism infeasible?

The Misesian argument would appear to rest on the claim that while there is only a finite number of options concerning the use of inputs that would lead to their efficient allocation, whereas there is an infinity of options that would result in those same inputs being misallocated. The chances are that without the means of making economic calculations, decision-makers in a socialist economy would chose one of the latter options. As Mises put it, economic calculation “provides a guide amid the bewildering throng of economic possibilities. It enables us to extend judgements of value which apply directly only to consumption goods – or at best to production goods of the lowest order – to all goods of higher orders. Without it, all production by lengthy and roundabout processes would be so many steps in the dark … And then we have a socialist community which must cross the whole ocean of possible and imaginable economic permutations without the compass of economic calculation”18.

However, as we shall see later, a socialist economy would be quite capable of avoiding this fate through the institutionalisation of a set of constraints that steer decision makers towards the efficient allocation of resources. In any case, Mises’ claim about the lack of a reliable compass to guide these decision makers might as well be directed at market capitalism. This is what can be inferred from the Theory of The Second Best formulated Richard Lipsey and Kelvin Lancaster in 195619. Looking at the “general equilibrium” model of the economy, they argued that in order for equilibrium (pareto optimal allocation) to obtain a number of equilibrium conditions need to be simultaneously satisfied such as the supply of all goods being exactly equal to the demand for them, the output price of goods being equal to marginal cost of producing them and the long term profit for all firms being equal to zero. Where just one of these optimal conditions is not met then the ‘second best’ position can only be reached by departing from all the other Paretian conditions. To put it in a nutshell, any single price distortion leads to all other prices being distorted because of its ramifying consequences for exchange ratios throughout the economy and since price distortions are inevitably going to arise in the market, capitalist decision makers will likewise have to contend with whole ocean of possible and imaginable economic permutations in which their ability to perform precise calculations using market prices will be to little avail. This is because such prices, being distorted as it were, will almost by definition be unable to provide a reliable guide (in terms of price theory). Of course the notion of a “general equilibrium” is merely an abstraction and has no empirical basis in fact. While Mises acknowledged this he did not seem to perceive the devastating consequences that this had for his own theory of “economic calculation”.

The implication of Mises’ argument is that the more scope one allows for the free interplay of market forces the more efficient and reliable the allocation process. Can this claim be empirically tested? It is often argued for example that so-called free market economies perform better than their more interventionist, state capitalist, competitors. But this can be for any number of reasons other than “economic calculation”: differences in natural and labour resource endowments, the prevalence of natural disasters, historical circumstances (e.g. civil conflict), the incentive problem in oppressive regimes (a point that Caplan makes) and economic dependence (a reference to “dependency theory” and the argument that the already developed First World systematically “under-develops” the Third World). There is a further problem of disentangling cause and effect. For example, is it the case that relatively successful economies are successful as a result of implementing free market policies or are those policies themselves the result of economic success? Those economies that are more competitive are likely to be more favourably disposed towards free trade for the obvious reason that they have little to fear from competition, whereas, conversely, less competitive or economically successful economies will tend to want to adopt a more protective and interventionist approach to protect their own interests. Indeed this is what enabled Germany, at the end of the 19th century to overtake Britain in terms of industrial production: Whereas the latter was still relatively laissez-faire in its outlook, Germany and other continental economies at the time relied heavily on tariffs and other interventionist measures to build up their industries.

Empirical support for the economic calculation thesis is thus remarkably weak. In any case, there is not, never has been and never will be such a thing as a strictly “free market” economy in the real world. In the real world, the market necessarily operates closely in tandem with the capitalist state, varying only in the degree to which this happens. As Karl Polanyi has noted: “The road to the free market was opened up and kept open by an enormous increase in continuous, centrally organised and controlled intervention”20.

E) The costs of economic calculation

What is often overlooked is that accounting, while it might concern itself with cutting costs, is itself a significant cost. This has important implications for the ECA. Parallel to a system of physical accounting (see section 5) what we have today as well is a system of monetary accounting. Monetary accounting is a highly complex process in which all enterprises in a capitalist economy must of necessity engage, even though it plays a supernumerary role as far as the physical process of organising production is concerned. In earlier class-based social formations money played a secondary role in the economic life of society; in modern capitalism, however, its influence is all-pervasive. Its purpose is not to ensure the efficient allocation of resources as such but to expedite market exchanges by providing a universal equivalent against which all other commodities exchange, so enabling the computation of profits and losses by competing actors engaged in these market exchanges. That is why it eventually supplanted the traditional system of barter – because of the obvious structural shortcomings of the latter which impeded market exchanges. For example, you cannot swap your pig for two chickens from your neighbour if he or she already has an ample supply of pigs; paying your neighbour in cash overcomes this problem.

As well as enjoining economic actors to engage in monetary accounting, the development of capitalism gave rise to a whole plethora of institutions and economic activities directly or indirectly concerned with the handling and circulation of money rather than the production of use values as such – for example, banks, insurance companies, pay departments, building societies and so on. Indeed, this already vast and steadily proliferating sector of the economy is a natural outgrowth of the systemic needs of an economic system centred on the competitive accumulation of capital; such institutions and activities arose precisely to service those needs. One might want to argue that a bank, for example, performs a useful role in that it lends money to a factory and thus enables the latter to manufacture useful things that consumers in a market economy may value. Therefore, banks perform no less a useful role than factories in the production of these useful things. But this is to engage in a sleight of hand; it is to overlook the distinction that needs to be made between the specific conditions under which a factory has perforce to operate within a given socio-economic system and the physical process of production itself. It is the former that is precisely being questioned which proponents of the ECA, on the other hand, take wholly for granted and assume is seamlessly linked to the latter. That is to say, they assume what they need to prove: that you cannot operate a modern system of production without market prices (and hence those kind of institutions – like banks – linked with market exchanges in capitalism).

It is the elimination of such activities and institutions , essential though they may be to a functioning market economy but unproductive in themselves from the standpoint of producing use values or meeting human needs, that constitutes perhaps the most important (but by no means only), productive advantage that a socialist economy would have over a capitalist economy. The elimination of this structural waste intrinsic to capitalism will free up a vast amount of labour and materials for socially useful production in socialism. Just how much resources will be made available for socially useful production in this way is a moot point. Most estimates suggest at least a doubling of available resources by comparison with the present.21 Yet the proponents of the ECA, while claiming that socialism would sink into the slough of inefficiency and falling output without the guidance of market prices, seem wilfully determined to deny socialism this particular productive advantage that it has over capitalism by positing the necessity for institutions such as banks – or some analogue of banking – in a socialist economy. This is a specious claim; it is unwittingly reading into socialism the functional requirements of capitalism.