An Introduction to the "Economic Calculation Problem" of Socialism

Socialism is no stranger to controversy and debate. Both in theory and in practice, it continues to be a source of disagreement and discussion to this day and will continue to be in the future. Ludwig von Mises is an Austrian Economist, famous for his contributions to economic thought and seminal works like “Human Action”. His most famous contribution, however, is an argument against socialism called the “Economic Calculation Problem”. Under Socialism, the government controls the means of production, meaning that there are no private businessman, markets, or prices for any goods. Mises argues that in this scenario, the government has no method or mechanism by which they can make decisions about production.

However, before we can examine how the economy goes wrong under socialism, we have to see how the economy can go correctly under laissez-faire. To Mises, economic calculation is the key to a market economy. Economic calculation is simply the process of measuring revenue against costs to determine profit or loss. To the businessman, this idea is straightforward. An entrepreneur will seek to avoid any lines of production that result in loss and pursue those that grant the highest amount of profit possible.

However, Mises sees this process of profit-chasing as serving another purpose as well. Economic calculation is how economies make the best use of the resources they have and in the process make society much wealthier. Mises sees profit and loss as signals. Specifically, they are signalling if the entrepreneur is using his resources, which are his costs, in a way valued by consumers, which is his revenue.

There are two different aspects of profit/loss that we need to examine to receive the full picture of these signals. The first aspect is the business man’s revenue, which he receives from his customers. The second are his costs, which is what he pays to have the resources to make the products or services that he sells. 

The revenue his receives will depend on how high consumers value the product or service that he sells. If he receives very high revenue, than consumers obviously value his product or service very highly. Likewise, if his revenue is low, this means that consumers do not value his product or services very highly.

How high an entrepreneur's costs are is determined by the supply of the goods he is buying and the demand for these goods by other businessman. Just like any other market, supply and demand result in a price. Just like any other market, if the supply goes down, demand goes up, this will result in a higher price. Supply going up or demand going down results in lower prices.

Profit and loss act as signals exactly by using these two aspects of business. If a businessman Smith finds that his business is losing money because his costs have risen, what does that mean? This means that either the supply of the goods he uses has fallen, or the demand has risen. For the sake of our example, let's say that other businessman have entered the market that Smith is in, and because of this, the price of resources Smith uses to produce his goods is rising. If this situation persists, Smith may decide to shut down and open up a new store, in a more profitable industry, or just go out of business altogether. This raises a question: where did the other businesses get the money to be able to pay the higher price for these resources. If Smith could not afford the higher price, how can they afford it? They were able to afford these higher prices because they had higher revenue. Because they had higher revenue, this means that consumers were valuing their products more highly than the products of Smith.

To be clear, it was not the case that the businessman who was priced out did not provide products of value. He did, but the question of economic calculation is not how highly your products are valued, but how much value at how high a cost. Consumers, through their buying and spending, signalled to all the businessman involved that they cared for other goods more than they cared for Smith’s goods. Because the resources needed to make these goods are limited, and because consumers did not show preference to Smith, his revenue fell below the cost and either has to make a change in the way he does business, or go out of business.

The above scenario shows a situation where a business was taking losses and was eventually priced out altogether. The situation for the profit-making business is the opposite. For instance, let's take another businessman who suddenly finds his revenues to be increasing. To help clarify the point, let's say that before this occurrence, his business had made no profit, and suffered no loss. This businessman now finds that his revenues are exceeded his costs, and that he has extra funds to allocate. This increase in revenue must be a result of consumers valuing this businessman’s products more highly. If this profit-making continues, then what would we expect to happen in the market that Jones is operating in? Knowing that all businesses chase profit and avoid loss, we would expect other businesses to come into the same market as Jones and try to replicate his success and turn a profit, as Jones is doing. 

It must be emphasized however, that profit is not permanent. Whenever other businessmen start moving into the industry that Jones is operating in, two different phenomena will occur. The price of Jones’ goods and services will have to go down to stay competitive, and the costs of his resources that he uses to provide his goods and services will go up. These are just a necessary result of other businesses coming into his field. Other businesses will be producing goods and services, and because there are now more goods and services in the market than there were before, the price of these goods and services will necessarily go down. Likewise, because more businesses are buying the resources needed to provide the goods and services, the price of these resources will go up.

The result of this is that there is a tendency that Jones’ profit will be shrunk and then eliminated as more businesses come into his industry. Profit, therefore, must always be chased by entrepreneurs. If they stagnate, then they will lose their profits, and possibly start taking loses. This search for profit leads businessman to go into new industries and innovate to try and stay ahead.

The signals of profit and loss are critical in allocating resources and economizing means to produce the highest valued goods in markets. However, for profit and loss signals to function, there must be free markets and private ownership of the means of production. If there is interference in prices, than the signals given will not be accurate to the actual valuation of resources by businessman and goods by consumers. 

Mises posits that it is when the government controls the means of production, i.e. there are no free markets, that things go wrong. Without any prices, because there are no markets, there is obviously no profit or loss either. The government has to answer the question of what to produce. However, they have no way of doing so without any signals from consumers. Because there are no prices for the resources used in producing goods, there is no way for the government to know what lines of production should be cut in favor of other lines. Markets solve these problems without automatically without any direction to do so. Businessman will automatically seek profit and avoid loss. The government does not have this luxury.

For any further reading the “Economic Calculation Problem”, Mises gives his argument in a clear and fairly concise manner in his essay titled, “Economic Calculation in the Socialist Commonwealth.” Murray Rothbard has written an paper titled, “The End of Socialism and the Calculation Debate Revisited”. Rothbard gives a retrospective history of the debate around Mises’ calculation argument and the various responses to it.

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