L.A. Liberty

The Calculation Problem and Price Theory

Whether it’s the soft central planning of minimum wage laws or absolute unmitigated socialism, the shortcoming is the same: the economic calculation problem.

Rational economic decisions - that is, social exchange of limited resources - requires money and prices. Money is simply an agreed-upon medium of exchange. Prices are merely information. In basic terms, prices relay the demand of the consumer to the producer, and the supply of the producer (along with cost of production) to the consumer. An ounce of gold is worth more than an ounce of sand because sand is more abundant, easier to acquire, and generally less desired.

And price is the result of chasing profit, that which is above the value of the costs and makes the good or service worth trading (subjectively, “an increase in the acting man’s happiness” - what Rothbard called “psychic profit”). As I’ve mentioned before, the promise of profit is what incentivizes people to take risks. Conversely, the potential for loss (or failure) is what incentivizes people to be reasoned, efficient, and prudent in their risk-taking. Profit - either material gain or gains in aforementioned happiness - are what mostly drive human cooperation and innovation.

Therefore, prices - and profit and loss - are crucial for a productive, peaceful society; this information - price - cannot emerge without voluntary exchange. And voluntary, mutually beneficial exchange can only exist when private property rights are acknowledged and secured.

A central planner may know that gold is more valuable than sand, but how much more? Is an ounce of gold worth a pound of sand? A ton of sand? Two tons? 20? 100? Can something as abundant as sand have any value? Why would a planned economy bother producing something with as little value as sand? Or, conversely, why would a planned economy bother with something as difficult to acquire as gold? How would a planned economy know how much resources (including labor) to use in order to efficiently produce sand or gold? How could people in a planned economy ever conserve if they have no prices to signal when resources are being wasted?

Some economists, particularly central planners, point to the Labor Theory of Value as their method of assigning worth to goods and services. This is the theory that labor itself, not productivity or demand or any other subjective measure, imparts value. Essentially, this theory suggests that a person who produces one pair of shoes per hour and someone who produces nine pairs of shoes per hour both impart the same value into their work. Often this also means they are subsequently worth the same wage. A minimum wage fits into this theory in that minimum wage supporters demand that a certain amount of labor, regardless of quality, efficiency, or productivity, deserves a wage high enough to live on (see my post on the minimum wage). While this may seem superficially noble, this is false. If someone whittles away at an unproductive activity and yields nothing of interest to the public, he should not be artificially rewarded by diverting resources from more productive or desired outcomes. After all, true value is subjective to the preferences of individuals. These preferences conserve resources for more desired results. This subjective value also best capitalizes on the comparative advantage of an entity to produce a good or service at a lower opportunity cost than another entity. This leads to specialization, which ultimately leads to greater productivity and more profit, or happiness.

But back to prices.

Play sand in the open market is currently $34 per ton. An ounce of gold is $1360. That means that an ounce of gold is worth 40 tons of sand. Tomorrow, prices may change as supply and demand change. A central planner cannot calculate the value of gold or sand if there is not a free exchange. Value in a planned economy, then, becomes arbitrary. This is a knowledge problem inherent with the system of the central planners.

As Hayek said about the knowledge problem:

Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to co-ordinate the separate actions of different people in the same way as subjective values help the individual to co-ordinate the parts of his plan. …

The most significant fact about this [price] system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned. It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.

As stated above, a free market does not share this knowledge problem because the prices themselves convey everything. If one day gold rains from the sky, the increase in supply will cause the quantity demanded for gold to drop, and the price will follow. You do not need to know about the gold rain (golden shower?), to know that either the supply for gold has increased, the demand for gold has dropped, etc. The price relays information that something has changed. If a new scientific breakthrough requires gold conduits to create new fantastical machines, demand will go up, and the price will follow. You need not know about metallurgy to know that gold is in higher demand. Prices, again, impart the knowledge.

Ludwig von Mises used wine and oil instead of sand and gold, but the issue is the same:

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 orientate 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.

Every interference by government in the marketplace clouds the information derived by the calculation of prices. Tariffs, taxes, subsidies, minimum wages, regulations, licenses, liability caps, etc. all artificially manipulate prices. This bad information causes erroneous economic decision-making, driving resources into less efficient, less viable, or less risk-averse areas.

But even with the relative price equilibrium of a free market, people are not perfect actors. Mistakes and malinvestments will always be made, though non-manipulated markets are more quickly and easily responded to and less disastrous to correct.

Israel Kirzner explained it thusly:

Supply-and-demand theory revolves around the proposition that a free, competitive market does in fact successfully generate a powerful tendency toward the market-clearing price. …

The mainstream textbook approach to this proposition is, in one way or another, explicitly or implicitly, based on the assumption of perfect knowledge. The Austrian approach does not make the perfect-knowledge assumption the foundation for this proposition; quite the contrary, Austrians base the proposition squarely on the insight that its validity proceeds from market processes set in motion by the inevitable imperfections in knowledge, which characterize human interaction in society.

A free market, then, allows for the discovery of prices and the continual mending of information distortions.

The recent housing market boom and subsequent bust/recession is a prime example of government manipulation (including the moral hazard of Fannie Mae, Freddie Mac, and implicit nigh-guaranteed bailouts of the Fed) causing improper investments, and flawed price information skewing market activity away from correction. People who would have otherwise not squandered relatively meager savings into a home were incentivized to do so. Lenders who would have avoided certain borrowers were inoculated from risk. What could have been a minor correction in a free market eventually became a global financial depression (Rothbard would not have called it a recession).

So without free exchange, we cannot have accurate prices. Without accurate prices, we cannot make rational decisions with limited resources and we thus squander said resources. For example, government’s “green” initiatives channel resources into green industries and technologies in a level inconsistent with what a free, open market would bear. Therefore, as a consequence, for every 1.6 to 6.5 green jobs created through government coercion, 10 other jobs are destroyed.

But this isn’t merely the case for relatively new, emerging industries, such as those environmentally inclined. Even an industry as old and fundamental as health care is subject to the same laws of economics.

Imagine a central planning government that is deciding to funnel resources into, say, a cure for cancer. For the sake of simplicity, there are two scientists with different ideas on how to approach the problem. Let’s assume they both have strong, promising theories and they each have the intellectual support of different well-respected peers. But without prices we couldn’t truly compare the viability of the two ideas. For all we know, with the same resources, scientist A can create 1,000 cures for every 1 that scientist B creates. Investing any amount into scientist B’s study, then, will affect the number of cures scientist A can create. Since there are no prices, we couldn’t know this - and the many victims become invisible.

No central planner could ever get it close to right. As I’ve said many times: to paraphrase Hayek, there’s no way to imagine what can be designed by millions of people acting freely; and to paraphrase Mises, it would be impossible to implement any scheme properly or efficiently even if planned by intelligent, well-meaning angels. In other words, non-free market actors have a calculation problem.

Every government interference that stands athwart a free exchange not only curbs liberty, it disrupts rational decision-making and destroys prosperity.

Posted February 15, 2011 at 10:20am in Austrian Economics ∆ minimum wage | comments || home