The economic calculation problem (ECP) is a criticism of using central economic planning (rather than market-based mechanisms) for the 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, who reframed the issue as a knowledge problem: the relevant information is dispersed, tacit, constantly changing, and thus cannot be centralized.Hayek, Friedrich (1935). "The Nature and History of the Problem"; "The Present State of the Debate". Collectivist Economic Planning. pp. 1–40, 201–243.
In his first article, Mises described the nature of the price system under capitalism and described how individual subjective values (while criticizing other theories of value) are translated into the objective information necessary for rational allocation of resources in society. He argued that central 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 deficiencies of the socialisation of capital goods, but he later went on to elaborate on various different forms of socialism in his book Socialism. He briefly mentioned the problem in the 3rd book of Human Action: a Treatise on Economics, where he also elaborated on the different types of socialism, namely the "Hindenburg" and "Lenin" models, which he viewed as fundamentally flawed despite their ideological differences.
Mises and Hayek argued that economic calculation is only possible by information provided through market prices and that centralist 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' 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 state 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 cannot be replicated by any form of bureaucracy.
Notable critics of both Mises's original argument and Hayek's newer proposition include anarcho-capitalist economist Bryan Caplan and Marxist computer scientist Paul Cockshott, as well as other communists.
Theory
Subject The economic calculation problem is primarily applied to centrally planned economies. Mises had utilized Economic Calculation in the Socialist Commonwealth to counterargue Otto Neurath's statements concerning central planning's feasibility, invoking "the supreme economic council" and equating socialism to "a society where the means of production are State controlled."
Comparing heterogeneous goods Hayek argues that money, as a medium of exchange, 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. He asserts that the price system promotes an efficient allocation 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.Rothbard, Murray (1962). Man, Economy and the State. Chapter VIII. Paragraph 6. p. 498.
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.Perry, Mark J. (17 September 2013). "Thomas Sowell on the minimum wage". American Enterprise Institute. Retrieved 19 February 2019.
Entrepreneurship According to Mises, entrepreneurs lack the profit motive to take risks under socialism and so are far less likely to attempt to supply consumer demands. He states that 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. He also concluded that entrepreneurs would also lack the ability to economize within the production process, causing repercussions for consumers.
Coherent planning As for socialism, Mises (1944) and Hayek (1937) insisted that bureaucrats in individual ministries could not coordinate their plans without a price system due to the local knowledge problem. Opponents argued that in principle an economy can be seen as a set of equations. Thus, 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 realize 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, Alexander Nove argued that the calculations would take millions of years even with the best computers. It may be impossible to make long-term predictions for a highly complex system such as an economy.Bergstra, Jan. "Economic Logic: A Survey and Variations on the Theme". Utrecht University, Department of Philosophy, section Theoretical Philosophy, group of Applied Logic. Retrieved 4 January 2015.
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
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:
Example Mises gave the example of choosing between producing wine or oil within a centrally planned economy, making the following point:
Implementation of central planning decisions In The Road to Serfdom, Hayek also argues that the central administrative resource allocation, which he says often must take away resources and power from subordinate leaders 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, he concludes, in combination with what he sees as failures of the central planning, slowly leads socialism down the road to an oppressive dictatorship.
Central planning was also criticized by socialist economists such as Janos Kornai and Alexander Nove. Robin Cox has argued that the economic calculation argument can only be successfully rebutted on the assumption that a moneyless socialist economy would be to a large extent spontaneously ordered via a self-regulating system of stock control which would enable decision-makers to allocate production goods on the basis of their relative scarcity using calculation in kind. This was only feasible in an economy where most decisions were decentralised.
Limitations and criticism Efficiency of markets Some academics and economists argue that the claim a free market is an efficient, or even the most efficient, method of resource allocation is incorrect. Alexander Nove argued that Mises "tends to spoil his case by the implicit assumption that capitalism and optimum resource allocation go together" in Mises' "Economic Calculation in the Socialist Commonwealth". Joan Robinson 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.
Socialist market abolitionists argue that whilst advocates of capitalism and the Austrian School in particular recognize equilibrium prices do not exist in real life, they nonetheless claim that these prices can be used as a rational basis when this is not the case, hence markets are not efficient. Robin Hahnel further argued that market inefficiencies, such as externalities and excess supply and demand, arise from buyers and sellers thoughtlessly maximizing their rational interests, which free markets inherently do not deter. Nonetheless, Hahnel commended current policies pursued by free market capitalist societies against these inefficiencies (e.g. Pigouvian taxes, antitrust laws etc.), as long as they are properly calculated and consistently enforced.Hahnel, Robin (2007). "The Case Against Markets". Journal of Economic Issues. 41 (4): 1139–1159.