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Can someone summarize the economic calculation problem?

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fegeldolfy posted on Wed, Nov 7 2012 8:23 PM

I'm trying to explain it to a fried on facebook, but I don't understand it that well.

 

Thanks.

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FOTH, you are right and I was wrong. Planners could indeed calculate by using units to form tentative prices which they would translate into actual prices via an algorithm. I'm off to join the Zeitgeist movement and become a planner myself. Peace out.

If only Lange and Taylor were geniuses like him.

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If a socialist State were involved in the production of only one type of good (widgets), there would be no calculation problem. If the goal were to produce as many widgets as possible, they could simply choose the method of widget production which yields the most widgets with the given stock of factors. This is a purely technical calculation. The "calculation problem" enters the scene only if the State has to produce multiple goods: e.g. widgets and gadgets. The State knows that more widgets are better than less widgets, and more gadgets are better than less gadgets. But given a certain stock of factors, more widgets means less gadgets, and vice versa. That is, to use factors to produce the one good excludes their use in producing the other good. How does the State determine the optimum widget to gadget ratio in its production plans, without which it cannot know whether to allocate a given factor to widget or gadget production? They need relative values for gadgets and widgets. They need to know the relative costs of producing gadgets and widgets. In the prior instance, when the State was only producing widgets, it didn't have to deal with cost at all. Since nothing but widgets were being produced, there was no cost of producing widgets because the factors, if not used in widget production, would have remained unused. Hence any contribution to widget production totals made by the use of an additional factor is worthwhile, no matter how small, because the alternative is nothing. This changes when two products are being produced. The cost of using a factor to produce widgets is the cost of not using it to produce gadgets, and vice versa. In a market economy, suppose an entrepreneur produces both widgets and gadgets. He owns a factor of production. Should he use it to produce widgets or gadgets? He can calculate the marginal physical product of the factor for each production process, so that he knows exactly the number of additional gadgets or widgets the addition of this factor would yield. This is a technical calculation. Suppose it's 3 gadgets or 4 widgets. He still doesn't know what to do, because he doesn't know whether it is better to produce 3 additional gadgets or 4 additional widgets. Nothing about the physical properties of the products themselves could ever answer this question. It is a question of value. The cost of using a given factor for producing widgets rather than gadgets can only be determined if we know the value of the marginal physical product of that factor when used for widget and gadget production. We need a price of widgets in terms of gadgets or vice versa. Suppose the price is 3 widgets to 5 gadgets, aka one widget is worth 5/3rds of a gadget. Previously, we said the marginal physical product of the factor in gadget production is 3 gadgets and in widget production 4 widgets. We can now calculate the marginal revenue product for the factor, using gadgets as the accounting unit; i.e. the MRP for gadget production is 3 gadgets and the MRP for widget production is 6.66 gadgets (4 * 5/3). Thus, the proper decision is to use the factor in widget production, not gadget production. In the absence of market prices for consumer goods, such calculations are impossible, and the State cannot determine how to use its stock of factors to meet the wants of consumers. If the State doesn't know how many widgets (or gadgets or any other consumer goods) to produce, it doesn't know how many of the factors required to produce widgets should be produced, or how many of the factors required to produce those factors should be produced, all the way back the first stage of production. The State literally has no rational basis for making any production decisions whatsoever. It is, as Mises said, economic chaos.

However, what if the State isn't trying to produce for the purpose of satisfying the wants of consumers? That is, what if the State simply declares how many of each type of consumer goods should be produced. Putting asidefor now the question of whether such production goals are good, or on what basis one might even determine whether they're good or not, can it even meet them? Imagine what this would involve. The State has at its disposal a given stock of factors of production: land, labor, and capital. The production possibilities for these factors have to be squared with the production goals. If the production goals are set without reference to the production possibilities, the result will be unpredictable swings between failures to meet overly optimistic goals which exceeded production possibilities (leaving projects unfinished), and underutilization of resources (factors sitting idle) due to overly conservative goals which underestimated production possibilities. Of course, this sounds much like what actually occurred in socialist countries. To avoid this chaos, the State would have to know the production possibilities in full. That is, they would have to perform technical calculations to determine what could be produced for each possible combination of factors. Though possible in principle, I don't know how one would even begin to do this in practice. The possibilities inherent in even a small stock of factors in a simple economy are staggering. How could this be achieved in a modern economy with billions or trillions of factors and consumer goods at multiple stages of production over many decades? Even if possible in practice to amass this vast knowledge, consider how much it would cost to do so; how much labor and other factors would be tied up permanently just trying to figure all this out? Nonetheless, let's grant that the State has acquired all this knowledge. It has its stock of factors, and it knows exactly what could be done with them: i.e. all of the possible combinations of factors and what kinds and quantities of consumer goods these different combinations of factors would yield. Which combination does it choose? Which "basket" of consumer goods does it want to produce? The monumental effort of calculating the production possibilities for their factors would leave the State with a very long list of possible production plans which are all within the production possibilities frontier, and which all involve using all factors. Thus, if they choose their plan from among these, they will experience neither shortages, nor factors sitting idle. But they still have no rational basis for determining which of the baskets of goods should be produced. Ultimately, some official will simply make an arbitrary decision, and that's the end of it.

This is the absolute best case scenario for the socialist State, granting several highly charitable and dubious assumptions about its motives and abilities.

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Anenome: It doesn't actually matter, actually. Because if the producer is incorrect, he will quickly realize this fact or be forced in short order to go out of business. By virtue of losing money he will be unable to bid up the price of that good anymore.

That would true regardless of where his income is coming from. If he is funneling his profits from the sale of good A to start up new production on good B, then a decrease in sales of good A would prevent him from bidding up the price of the factors of good B. But this doesn't mean that good B won't sell at the price he expects it to. Similarly, if no one is currently buying good B, it doesn't mean a priori that no one in the future will buy good B at the expected price. 

Actual consumer demand is tested every day, through actual sales. Businessmen then use that as data today to change strategy for tomorrow and longer-term generally. Thus prices are like an ocean in turmoil, always seeking equilibrium but never finding it, but certainly finding a median value.

So the calculation argument actually rests on empirical reasons? Businessmen study human action in the same way that natural scientists study the weather? 

Absent prices, how would a planner know which of a thousand coal producing pits to buy coal from? He cannot know. Which coal producers are the most efficient? No idea. Which should be rewarded for good management and oversight? Can't tell. Pick one out of a hat.

How does a business determine which employees are most efficient? 

Not solely. Price goes much beyond that. It motivates market activity on both sides. Let's say you sell coal, and the price of coal suddenly begins to increase sharply. You, as a coal producer, can make much more money by increasing production. And if you expect this trend to continue for awhile, that is for prices to stay high, then you might even be willing to take out loans for new equipment to get at certain coal patches that would be otherwise difficult and more expensive to mine. But with coal prices as high as they are now and no end in sight, it will be economical to mine that coal. So you do it, and use price as a signal to increase production.

I meant the prices of both the inputs and the outputs, which gives you the profit.

Not really. His point about an external reference is a reference exteneral to each individual viewer. A price serves that function of external reference. And it arises from realities in other invisible parts of the economy that the individual doesn't need to know about, he only has to see that those events cause an increase or decrease in price to understand what action is in his interest as a result.

Thus, there might be five oil field that dry up. He doesn't need to know this or be told to increase production. He only sees the price of oil rise and realizes it's in his interest to increase production, and thus he will. Absent a price structure, and thus absent that level of fine-grained communication, a planner could not approximate the same result through other communication channels.

I don't think it's that simple. Not only does he need to know that the price has risen (i.e. that people have bought the item at a higher price in the recent past than in the distant past) but also that people will buy the additional goods that he plans to produce. And in order to increase production, resources must be reallocated from another area. What if that area required a lot of oil? Reallocating the resources might then itself reduce the demand for oil. 

 

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filc: Your hope is to find a flaw in a person(s) argumentation as a means to refute Mises and/or praxeology. As opposed to standing up to the theory itself you attack the argumentative abilities of individuals who represent it. 

But if I ignored my opponents actual arguments then I'd be accused of strawmanning them. 

What could I do that would be acceptable to you?

(And I don't see myself as refuting praxeology, just Mises's application of it.)

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Jon: The point of economies is to fulfill the wants of their participants. This provides a ready "yardstick" by which to compare them, i.e. economic efficiency. But I do not object to the usage of the speak of systems for that reason, but rather because you are in so doing conflating the market with a single owner of capital goods, on par with the socialist world state, and then asking what is the external point of reference for this arbitrary construct, which you would have to argue in terms of for the analogy to actually work.

What do you mean by a "single owner"? Who is the single owner in a "socialist state"?

A survey is just a wishlist. One can wish for anything.

Only if the survey allows you to wish for anything. The business I work for uses customer surveys to plan production. 

Then I am sure you can step in for them, since they are all wrong, and provide an explanation that occured to neither Lange nor Taylor nor Mises, as to how consumer goods will be allocated in an economically efficient manner absent market pricing. Lange and Taylor only got as far as they did because they bypassed the problem consumer goods posed. Additionally, what do you propose as the unit of account?

Unit of account for what? If labor is heterogeneous, as Mises's claims, then a single unit of account might not be appropriate. (I should probably actually read Lange and Taylor's own words before dismissing them as I did.)

Criteria for what? Determining whether the good was worth producing? That isn't the criterion. The criterion, on the consumer's end, was fulfilling the consumer's want, which they valued more highly than the resource already in their possession.

You said: "What determines whether the good was "worth" producing was whether it went to satisfying some want, which the consumer is willing to sacrifice resources for in exchange." My question is: What determines whether the resource the consumer sacrifices was worth producing? Your answer seems to be the fact that the other producer was willing to sacrifice his resource for it. What I think this really indicates is that the resources were worth exchanging, not producing. It makes perfect sense to say that the labor required in producing the sacrificed good was not worth the exchanged for good regardless of the fact that it was exchanged. 

Say was dealing with a specific argument regarding shortages/surpluses on a market. He was not arguing that supplying a good means it will be demanded because it is being supplied. That would be to reject the subjective theory of value. Providing a supply of goods in turn furnishes the supplier with the means to demand other goods and procure them. That is all the argument states.

But my point is that there could be a situation where all goods produced could have very little value and yet they can be exchanged because the relative values of the goods are different. I could spend hours digging holes and you could spend hours making mud pies. The fact that I can make a "profit" off of selling my holes for your mud pies merely indicates that I prefer your mud pies to my holes and you prefer my holes to your mud pies. It doesn't tell us that making houses and bread would be more worthwhile. 

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They don't have to be constant, they just have to change slowly enough to make statements with reasonable surety. For instance, the best indicator, believe it or not, of how busy a restaurant is going to be tomorrow is how busy it was on that exact same day last year.

Hmm, you might have a point. I'll have to think that over. One of the things I was concerned with though was Mises's claim that economics was a priori and not empirical. I hear the Ludwig Lachmann has a concept about "radical uncertainty." I wonder what that's about. 

Similarly, people need to stay alive, need to be clothed, entertained, need transportation, and consume a million other things.

But I think Clayton raised a good point earlier about it not being simply about "clothes" but about what type of clothes. Given that people prefer different types of clothes, then a shift in the distribution of wealth would seem to shift the demand for types of clothes--unless the size of the economy would average things out. 

But then if things don't really change that much and people are largely the same, then wouldn't that make calculation under socialism much easier as well?

To return to the topic: Many leading socialists back in the 50's conceded Mises's point on the economic calculation problem.

Which ones exactly (I honestly don't know)?

Every attempt to communize completely, ie: farming, has led to mass starvation in the countries that tried it--China's great leap forward, 20+ million people died.

​I don't support a China-style economy. I'm not very familiar with the famine, but it certainly seems that government policy was largely at fault. However, I'm not sure the calculation argument is the best means for explaining the disaster. The government pretty much forced "collectivization" on the people, didn't base their plans on their input, and instead changed their farming methods based on the ideas of some crackpot. There also seemed to be an incentive to overreport farm production among local bureaucrats. And if it was because of the calculation problem, what does that mean? The demand for food changed? It didn't change but the government stupidly thought that it decreased?

As for the famines in the Soviet Union under Stalin, it's my understanding that those were intentional and not the result of a miscalculation. 

I don't believe that the collective farming in revolutionary Spain led to mass starvation. Actually, I've heard that it led to increased productivity. I suppose that is too short of a time to say much about though. 

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Fool on the Hill:
One of the things I was concerned with though was Mises's claim that economics was a priori and not empirical.

You can't perform math on ordinal preferences, and empirics suffers from the correlation-causation problem. That's why you need theory. It would be like saying you have serious concerns about philosophy not being empirical. Philosophy could not be empirical, and trying to do so would likely be laughed at.

Fool on the Hill:

Similarly, people need to stay alive, need to be clothed, entertained, need transportation, and consume a million other things.

...But then if things don't really change that much and people are largely the same, then wouldn't that make calculation under socialism much easier as well?

Easier, but still not as efficient. And the larger that economy scales the less efficient as the consequences of misallocation become bigger.

Fool on the Hill:

To return to the topic: Many leading socialists back in the 50's conceded Mises's point on the economic calculation problem.

Which ones exactly (I honestly don't know)?

I don't know for sure either. The source I'd read that from (iirc: Rothbard) mentioned them as all the economists of the former soviet eastern block whom, while still calling themselves socialists, led the way back to market-based economies and reforms and away from command economies. I don't know if the writer meant this as a concession by action rather than verbally or not.

Rothbard wrote an economic history, here's a brief preview from that which is fairly relevant to this discussion.

Fool on the Hill:

Every attempt to communize completely, ie: farming, has led to mass starvation in the countries that tried it--China's great leap forward, 20+ million people died.

​I don't support a China-style economy. I'm not very familiar with the famine, but it certainly seems that government policy was largely at fault. However, I'm not sure the calculation argument is the best means for explaining the disaster. The government pretty much forced "collectivization" on the people, didn't base their plans on their input, and instead changed their farming methods based on the ideas of some crackpot. There also seemed to be an incentive to overreport farm production among local bureaucrats. And if it was because of the calculation problem, what does that mean? The demand for food changed? It didn't change but the government stupidly thought that it decreased?

When collectivization is a market replacement. The two generally don't co-exist. Markets presume individual ownership. Without that you can't have trade and thus no market and certainly no prices. No, to each according to need was to replace prices. Thus, command economies and replacement of markets.

Any time you try to reproduce the action of a market with a command economy you hit headlong into the economic calculation problem.

Sowell deals with this well in Knowledge and Decisions, which I found to be a stunning refutation of socialism on a very granular level, taking reasoning back to the level of the farmer and the incentives he faces under either system, and showing exactly why farm collectivization failed and why this is an intractable problem in all command economies.

Fool on the Hill:

As for the famines in the Soviet Union under Stalin, it's my understanding that those were intentional and not the result of a miscalculation.

Well yeah, I was subtly suggesting that command economies create opportunities for politicization of distribution--that's actually the purpose of the command economy, but unfortunately it allows for things like that in the Ukraine to happen, and there's no analogous market risk. That absent a market deciding what gets destributed where, that decision can or will be made politically, at the whim of the politically powerful. Thus a mass-starvation results. In fact, around the world, the major starvations of the world are all generally politically caused now. even the recent African ones, where starvation was used as a political tool against enemies, just as in the Ukraine.

Fool on the Hill:
I don't believe that the collective farming in revolutionary Spain led to mass starvation. Actually, I've heard that it led to increased productivity. I suppose that is too short of a time to say much about though.

Yeah I haven't much looked into the Spain incident. Any number of reasons why that could result tho. We know that generally that won't be the case in the long-run. The Chinese have made their factories competitive, but it may be by subsidizing them, which may benefit us more than them in the long run.

If production did go up after the communist takeover, it's probably due to how miserable the conditions had degraded to under that turmoil, for whatever reason, prior to the communist takeover.

 
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Economic Calculation In The Socialist Commonwealth

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Briefly, Mises used an ideal socialist state with a central planning committee as the decision making body for production, provision and distribution. How did the Sovietunion and its clones do that in reality?

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What do you mean by a "single owner"? Who is the single owner in a "socialist state"?

No one but the state. No need for quotation marks, the terms are accurate. Mises is dealing with the position where private ownership and therefore exchange of capital goods is prohibited.

Only if the survey allows you to wish for anything. The business I work for uses customer surveys to plan production. 

Yeah, with the backdrop of prices to assist them. They may use surveys to fine-tune or forecast possible future demand. Surveys tell producers nothing about relative scarcity and actual consumer willingness to depart with scarce goods in exchange for other scarce goods. Socialist managers can try guess what consumers want but what actually signals to them that they have succeeded in allocating scarce resources to satisfy these wants? What incentivises them to do so?

Unit of account for what? If labor is heterogeneous, as Mises's claims, then a single unit of account might not be appropriate. (I should probably actually read Lange and Taylor's own words before dismissing them as I did.)

Transactions. Money eliminates this problem by providing a single unit of account as it is the most widely demanded and accepted good. I don't see how it follows from the fact that goods are heterogeneous that therefore money too must be. Why? As for labour, why is it even uniquely relevant? It's a factor of production amongst others. Under barter and absent money there are multiple units of account and the strong possibility of a lack of a double coincidence of wants. What makes money valued is the fact that it will predictably be accepted in any transaction for the fact that someone down the line will also accept it as such. I cannot see why some socialists hold so much hostility towards it.

My question is: What determines whether the resource the consumer sacrifices was worth producing? Your answer seems to be the fact that the other producer was willing to sacrifice his resource for it. What I think this really indicates is that the resources were worth exchanging, not producing. It makes perfect sense to say that the labor required in producing the sacrificed good was not worth the exchanged for good regardless of the fact that it was exchanged.

No, what I am saying is that the producer is willing to sacrifice the resource in order to obtain another resource that is more useful to them. In turn, then consumer is sacrificing their own resource for what they deem more valuable in their hands.

But my point is that there could be a situation where all goods produced could have very little value and yet they can be exchanged because the relative values of the goods are different. I could spend hours digging holes and you could spend hours making mud pies. The fact that I can make a "profit" off of selling my holes for your mud pies merely indicates that I prefer your mud pies to my holes and you prefer my holes to your mud pies. It doesn't tell us that making houses and bread would be more worthwhile.

The virtue of private ownership of capital goods is that if an entrepreneur speculates wrongly as to what goods consumers will consider valuable, which combinations of capital goods and other factors will provide the most cost-efficient means of producing the goods etc. is that they will suffer losses and thereby be signalled that consumers are not sufficiently willing to part with resources for the good.

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filc replied on Tue, Apr 30 2013 4:22 PM

Fool on the Hill:

filc: Your hope is to find a flaw in a person(s) argumentation as a means to refute Mises and/or praxeology. As opposed to standing up to the theory itself you attack the argumentative abilities of individuals who represent it. 

But if I ignored my opponents actual arguments then I'd be accused of strawmanning them. 

What could I do that would be acceptable to you?

(And I don't see myself as refuting praxeology, just Mises's application of it.)

Not wanting to read the whole thread I believe things have become unecessarily complicated. Economic calculation, in crude laymens terms, is boiled down to man's current  inability to appraise fleeting individual preference on a second by second bases for every man women and child of every moment on earth. IE we need omniscience and omnipotence to solve the equation. Mises calls this out and explains how the price mechanism offers a solution.

Once this problem is solved we can move forward with our star-trekian superabundant utopia. Untill then I don't even know why people are arguing the point. Unless you have the solution for omniscience and omnipotence there is no need to further discuss the issue.

With respect.

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