Editing Economic calculation problem (section)

== Theory ==

=== Subject ===
The economic calculation problem is primarily applied to centrally planned economies.<ref>{{Cite web |last=Davis |first=Evan |date=2022-10-31 |title=Socialism's Economic Calculation Problem |url=https://econreview.studentorg.berkeley.edu/socialisms-economic-calculation-problem/ |url-status=live |archive-url=https://web.archive.org/web/20240508095519/https://econreview.studentorg.berkeley.edu/socialisms-economic-calculation-problem/ |archive-date=2024-05-08 |access-date=2024-06-21 |language=en-US |quote="It is also worth noting that this problem applies mainly to centrally planned socialist societies. There exist forms of ‘market socialism’, where competitive markets remain, but hierarchical business models are entirely replaced by co-ops. But the majority of Marxian socialists see market competition as an anarchic issue of unplanned chaos to be solved through central planning."}}</ref> 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."<ref name="Mises" />

This, paired with his consistent mention of [[nationalization]] alongside [[Socialization (Marxism)|socialization]], would make the economic calculation problem one solely concerning an [[administrative-command system]].

=== Comparing heterogeneous goods ===
Since capital goods and [[Labour economics|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 (economics)|signalling]] function of [[price]]s as well as the [[rationing]] function which prevents over-use of any resource.<ref>[[Murray Rothbard|Rothbard, Murray]] (1962). ''Man, Economy and the State''. Chapter VIII. Paragraph 6. p. 498.</ref>

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.<ref>Perry, Mark J. (17 September 2013). [http://www.aei.org/publication/thomas-sowell-on-the-minimum-wage/ "Thomas Sowell on the minimum wage"]. American Enterprise Institute. Retrieved 19 February 2019.</ref>

=== 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) to 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 are foundational elements of economic calculation, namely that it 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 [[Supply and demand|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, among buyers, 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 rigors of [[market competition]]. The latter forces producers to produce superior products at appropriate prices to please their consumers. 

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 [[Competition (economics)|market rivalry]].

According to [[Israel Kirzner]] (1973) and [[Don 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. Entrepreneurs would also lack the ability to economize within the production process, causing repercussions for consumers.<ref name=":1" /> 

=== 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 among 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 due to [[local knowledge problem|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.{{Citation needed|date=October 2010}} 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.<ref>{{cite book|last=Hayek|first=Friedrich|author-link=Friedrich Hayek|title=[[The Road to Serfdom]]|publisher=[[University of Chicago Press]]|edition=50th anniversary|year=1994|isbn=0-226-32061-8}}</ref> He contended that the only rational solution is to utilize all the [[dispersed knowledge]] in the market place through the use of [[price signal]]s.<ref>{{cite book|last=Steele|first=David Ramsay|author-link=David Ramsay Steele|title=From Marx to Mises: Post-capitalist Society and the Challenge of Economic Calculation|year=1992|publisher=Open Court|location=La Salle, Illinois|isbn=0-8126-9016-8}}</ref> 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.<ref>{{cite book|last=Nove|first= Alec|title=The economics of feasible socialism|date=1983|publisher=G. Allen & Unwin|isbn=0-04-335048-8|location=London|oclc=8827566}}</ref> It may be impossible to make long-term predictions for a highly complex system such as an economy.<ref>Bergstra, Jan. [http://www.phil.uu.nl/~janb/phloofin/eclog.html "Economic Logic: A Survey and Variations on the Theme"]. {{webarchive|url=https://web.archive.org/web/20070105024440/http://www.phil.uu.nl/~janb/phloofin/eclog.html|date=5 January 2007}} Utrecht University, Department of Philosophy, section Theoretical Philosophy, group of Applied Logic. Retrieved 4 January 2015.</ref>

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.{{citation needed|date=October 2010}} 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|date=April 2008}} 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.<ref>{{cite web|first=Carlo|last=Zappia|title=The economics of information, market socialism and Hayek's legacy|url=http://www.econ-pol.unisi.it/pubdocenti/HEI99.pdf|access-date=3 April 2007|url-status=dead|archive-url=https://web.archive.org/web/20070614110711/http://www.econ-pol.unisi.it/pubdocenti/HEI99.pdf|archive-date=14 June 2007}}</ref>

=== Financial markets ===
The fifth condition for successful economic calculation is the existence of well-functioning [[financial market]]s. 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:
{{Blockquote|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.<ref>Von Mises, Ludwig (1922) [1936]. ''[[Socialism (book)|Socialism]]''. p. 121.</ref>}}

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.