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[Editor's note: The following is part 1 to this article series.]

For the past 100 years, many authors have criticized socialist systems. These criticism have mostly focused on the moral or historical inspection of socialist regimes and ideas.[1] However valuable these inspections may be, in my view, they pale in comparison to the contributions of Ludwig von Mises and his theoretical analysis of a socialist economy. Socialism , in the 21<sup>st</sup> Century, is still a frequently debated topic, therefore we must familiarize ourselves with its most important yet neglected critic.

The argument between socialists and Austrian economists officially started in 1920 with Mises’ article “Economic Calculation in Socialist Commonwealth” , which reappeared in his book published 2 years later with his complete criticism of the socialist system, entitled “Socialism an economic and sociological analysis”. In the article Mises defended that the central planners in a socialist economy would not be able to allocate resources efficiently because it lacks a vital tool that is, profit and loss calculations. Although economists, with the likes of Yves Guyot[2] and Enrico Barone[3] have touched upon this issue, they have failed to stress its importance.

First, it is important to clarify what exactly Mises is criticizing. By a “socialist economy” we are referring to an economy where the control of the means of production is no longer in the hands of private property owners but the state’s. In a socialist economy, all production is controlled by the state and there is no room for entrepreneurship <span class="underline">Mises’ argument:</span>

We will briefly go over Mises’ primary points so the reader can familiarize themselves with the argument. We will be commenting on it in detail later.

For the sake of the argument Mises assumes away some of the other problems that may prevail in a socialist economy[4]. He assumes that the central planner has all the technological knowledge of his age, a complete inventory of all the material factors of production available and that he and his men have the best intentions possible.

In a socialist economy all the means of production are owned by one institution, the state. Unlike what occurs on the free market every day, the means of production do not exchange hands. There are no buyers and sellers. When there are no buyers and sellers hence, trade, it is impossible for a market of these goods to form. When there is no market for the means of production, there are no prices for them because prices are a phenomenon that is formed thanks to offers and bids, buyers and sellers present each other. When there are no prices for the means of production it is impossible to know if any particular project is profitable or not since there is no common denominator to add up all the different resources that go into production.

In other words, in a capitalist economy entrepreneurs can add up the value of all the heterogeneous means of production by using their money prices to calculate costs. Since there are no money prices for the means of production in a socialist economy, a central planner will not be able to calculate costs.

Mises writes:

The director wants to build a house. Now, there are many methods that can be resorted to. Each of them offers, from the point of view of the director, certain advantages and disadvantages with regard to the utilization of the future building, and results in a different duration of the building's serviceableness; each of them requires other expenditures of building materials and labor and absorbs other periods of production. Which method should the director choose; He cannot reduce to a common denominator items of various materials and various kinds of labor to be expended. Therefore he cannot compare them. He cannot attach either to the waiting time (period of production) or to the duration of serviceableness a definite numerical expression. In short, he cannot, in comparing costs to be expended and gains to be earned, resort to any arithmetical operation. The plans of his architects enumerate a vast multiplicity of various items in kind; they refer to the physical and chemical qualities of various materials and to the physical productivity of various machines, tools, and procedures. But all their statements remain unrelated to each other. There is no means of establishing any connection between them.

Also:

Imagine the plight of the director when faced with a project. What he needs to know is whether or not the execution of the project will increase well-being, that is, add something to the wealth available without impairing the satisfaction of wants which he considers more urgent. But none of the reports he receives give him any clue to the solution of this problem [5].

<span class="underline">The necessary conditions for economic calculation and its function:</span>

Cost accounting has a pivotal role in the market economy, that is to demonstrate to entrepreneurs if the inputs that go into production are more urgently needed in other lines of production.

All the means of production are bid up and down by competing entrepreneurs for the realization of different projects. Let’s take steel as an example. The price/cost of steel is bid up by various entrepreneurs that desire to build bridges, skyscrapers, cars etc. This is because different entrepreneurs believe these projects will provide a return higher than the costs incurred.

Every gram of steel spent in one project could have been spent in the realization of another, how are we to determine how much to spend on each? If the entrepreneur is suffering losses (the costs exceed the return on his investment) it means he is taking away resources from the economy that are bid up and more urgently needed elsewhere, in this case steel.

This is also where the term “opportunity cost” originates from, the valuation of opportunities lost when choosing a certain course of action over potential plans and projects. It is important to emphasize that costs are not an objective phenomenon. The opportunity cost of any action is dependant on the preference scale of the actor, his next highest valued achievable end. If a farmer decides to plant corn, the opportunity cost would be his next highest valued alternative, for example wheat. This is because on the farmers scale of preference wheat comes after corn.

On the other hand there is the objective monetary cost, the market price of a good. It must not be confused that because prices are objective, costs are objective. Objective prices only manifest themselves because of subjective evaluations through markets.

When we use a thermometer to measure the temperature inside an oven, the thermometer transmits objective physical information to us; however, when we ask what is the cost of the oven, there is no device that can measure this. There is no objective cost ingrained in the oven but only subjective preferences. The only way to put a numerical value to the alternative uses of the resources that go into producing an oven is through market processes.[6]

However, economic calculation is only performable under certain conditions. As you may have guessed, in a moneyless pure barter economy economic calculation cannot be performed. There has to be a commonly used medium of exchange that can be used as a common denominator.

Economic calculation is also not necessary under stationary conditions. Profits and losses only emerge under dynamic market conditions. In a society where there is no change in market data, there is no need for economic calculation. As Mises points out:

The static state can dispense with economic calculation. For here the same events in economic life are ever recurring; and if we assume that the first disposition of the static socialist economy follows on the basis of the final state of the competitive economy, we might at all events conceive of a socialist production system which is rationally controlled from an economic point of view. But this is only conceptually possible. For the moment, we leave aside the fact that a static state is impossible in real life, as our economic data are forever changing, so that the static nature of economic activity is only a theoretical assumption corresponding to no real state of affairs, however necessary it may be for our thinking and for the perfection of our knowledge of economics.[7]

The static state also referred to as “general equilibrium” describes a state in which there is no change in the economy. In this state, the prices of consumption goods is equal to the costs of producing them and there is no room for arbitrage gains. “Each economic means of satisfaction is to be disposed of in such a manner as will add the greatest utility to the otherwise assured total”[8]

This is not meant to be a description of the real economy but a mental construct to better understand certain economic concepts.

Profits emerge when there is a discrepancy between the prices of means of production and consumer goods produced. Hence, in disequilibrium. This is part of a greater point that money itself only exists under dynamic conditions[9]

In reality the world is forever changing. Mises lays out 6 great classes of change in an economy[10]:

1. Changes in external Nature. Changes in natural conditions independent of human action like the climate but also changes arising from operations carried out within these conditions like exhaustion of soil, consumption of timber or mineral deposits.

2. Changes in the quality and quantity of the population.

3. Changes in the quality and quantity of capital goods

4. Changes in the technique of production

5. Changes in the organization of labor

6. Changes in demand, that is changes in the quality and quantity of products consumers desire.

Even disregarding these changes, the transition to a socialist economy itself would cause changes in market data by readjusting the wealth distribution in society.

It is important to stress this point that will be brought up many times in our examination of the responses to Mises’ challenge which was misunderstood by socialist thinkers. In a static economy where there is no change in market data, there is no problem of economic calculation The market reaches equilibrium and every day is exactly the same as the day before. Profits cannot exist in such a state because all the profit opportunities would have been exhausted during the establishment of equilibrium. The cost of all the factors of production would be bid up to equal the price of goods produced. The problem only arises in a world of uncertainty and change, when prices of goods produced can be higher than the cost of producing them thanks to entrepreneurs finding new lines of production not yet fully discovered.

<span class="underline">Attempts to solve the problem:</span>

There have been many attempts by socialist thinkers to implement some sort of calculation method, a way to bring order to the economic chaos that would ensue under central planning. We will be going over the main alternatives which “market socialists” have tried to find to rationally allocate resources. One thing they all have in common is the admission of a need for markets in consumer goods while maintaining state ownership of factors of production.

<span class="underline">Calculation in terms of Labor Hours:</span>

We don’t have to go over the entire “Labor theory of value” debate here which the Austrian economist Eugen von Böhm-Bawerk has done extensively[11]. Nevertheless this is one of the ways to reduce commodities into a common denominator to determine exchange ratios in the market.

The proponents of this theory believe the value of a good is determined by the labour time socially necessary that is required to produce an article under the normal conditions of production, and with the average degree of skill and intensity prevalent at the time. Under such a system workers would be given labor vouchers according to the amount of labor hours they have worked and these vouchers could be exchanged for consumption goods. These are not money prices since their exchange ratios are determined beforehand by their labor content

Marx writes:

He receives a certificate from society that he has furnished such-and-such an amount of labor (after deducting his labor for the common funds); and with this certificate, he draws from the social stock of means of consumption as much as the same amount of labor cost. The same amount of labor which he has given to society in one form, he receives back in another [12].

According to Marx, natural resources or non reproducible goods such as virgin land or wood growing in the wild are not commodities since they embody no human labor [13], this poses a great problem. Central planners have to use these non reproducible goods in production and know their most urgent use. Even if we were to say that the labor time necessary to extract these resources determine their value, it is certainly possible that natural resources are being exhausted while labor costs of extracting are diminishing. In such a case scarce resources would be undervalued and overused [14].

Second problem is that labor is not homogenous and comes in different forms. Every hour of labor is not valued the same, this is especially evident in the market in terms of wage rates. It is impossible to perform arithmetic operations when there is no common unit to do addition and subtraction to calculate the cost of various types of labor used.

One might try to get around the issue by saying “skilled labor counts only as simple labour intensified, or rather, as multiplied simple labor, a given quantity of skilled being considered equal to a greater quantity of simple labor.” [15] This however, doesn’t explain how a reduction of skilled labor into simple labor is to be performed and in which ratios. It is not possible to determine how valuable an hour of labor of a worker is relative to another while abstracting from wage rates in terms of actual money prices determined within the market system. Without money prices, there is no common denominator to compare different types of labor.

The question of whether electrical engineer­ing labor hours are more valuable than janitorial ones, and. if so, how much more valuable they are, can be answered only by imput­ing consumer evaluations through many stages of the structure of production in order to attribute to each factor its part in producing the final product [16].

If the Labor theory of value is meant to explain every day prices in the market then it is useless since by definition inputs of labor hours and outputs are the same, there can be no comparison of value of the means of production and the goods produced. If it is meant to explain equilibrium prices like most Marxists seem to claim, then it is superfluous since the problem of economic calculation specifically is in regards to price deviations from equilibrium (when marginal costs are not equal to marginal revenue) and the entrepreneurs function in fixing the everyday discoordinations that are only visible when money prices are allowed to form for the means of production and consumption goods.

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<span class="underline">The mathematical solution:</span>

It was argued by various economists like Friedrich von Wieser[17] that even in a communist society the concepts of value and interest would have to be maintained. There was a “formal similarity” between the capitalist and the socialist economy. This was one of the reasons for the shift in the debate to general equilibrium models represented by mathematical equations. It became common think that even though the problem of economic calculation was solvable, there was a technical difficulty in solving the vast numbers of algebraic systems of equations which we can refer as the “computational problem”.

We may attribute this confusion to 2 particular quotes. Hayek writes:

Now the magnitude of this essential mathematical operation will depend on the number of unknowns to be determined. The number of these unknowns will be equal to the number of commodities which are to be produced ... At present we can hardly say what their number is, but it is hardly an exaggeration to assume that in a fairly advanced society, the order of magnitude would be at least in the hundreds of thousands. This means that, at each successive moment, every one of the decisions would have to be based on the solution of an equal number of simultaneous differential equations, a task which, with any of the means known at present, could not be carried out in a lifetime.[18]

Enrico Barone writes:

It is not impossible to solve on paper the equations of the equilibrium. It will be a tremendous – a gigantic – work: but it is not an impossibility[19]

Barone only near the end of his article vaguely indicates that the necessary information for the formation of these equations could not be known. The problem is however not solving these equations, which is why socialists claim the existence of super-computers facilitates central planning, but forming said equations while abstracting away from market operations. We will be examining various writers and their responses to the challenge posed by Mises. Mostly notably, Oskar Lange.

<span class="underline">Fred M. Taylor and H. D. Dickinson – the trial and error method:</span>

Taylor was the first to propose a mathematical solution. In his brief paper[20], Taylor proposes the utilization of “factor-valuation tables” that will represent the effective importance of “primary factors” in terms of money prices. In other words, instead of letting prices form naturally in the market to determine costs and the alternative uses of the factors of production, central planners would impute their values through trial and error. What this process of trial and error entails was quite ambiguous in Taylor’s article, however he lays out 5 distinct steps which can be summarized as:

  1. Central planners would construct factor-valuation tables and approximate the value of the means of production on the basis of careful study of the relevant facts.

  2. The planners would continue their manager roles as if the valuation were correct.

  3. As the economy functions, the planners would try to detect any mistakes that might have occurred during the evaluation.

  4. If any mistakes are visible, the planners would either lower or increase the valuation.

  5. This procedure would be repeated until no errors were present.

Taylor summarizes:

In other words, a too-high valuation of any factor would cause the stock of that factor to show a surplus at the end of the productive period.

And lastly; “… if the economic authorities of a socialist state would recognize equality between cost of production on the one hand and the demand price of the buyer on the other as being the adequate and only adequate proof that the commodity in question ought to be produced, they could, under all ordinary conditions, perform their duties…”

A similar explanation of this method can be found in Dickinson’s works[21] which drew much more attention. Dickinson argues, although it would be very difficult to formulate a Walrasian system of simultaneous equations, this can be simplified by grouping together closely related goods. In this economy, all the information regarding sales, costs, stocks etc. will be publicly available, “all enterprises work as it were within glass walls.” According to Dickinson this will make it easier to draw up demand curves for consumption goods. All the criticism presented here will still be relevant for our examination of Oskar Lange’s contributions

Both of these “solutions” involve grave errors on the part of the theorists. Taylor’s conception of the entrepreneur is similar to that of a company manager whose goal is to “clear the market” for the consumption goods at his disposal. This way, the central planner will continue to try to equalize the arbitrary prices, set by himself, of the factors of production with the consumption goods. Not only is this state of equalization impossible but all the numerical values given by the planners are useless. The problem is not the existence of the numerical values per se but the meaningfulness of the data themselves. Appraisement of the factors of production constitutes the essence of the calculation problem. What is meant by appraisement is the process in which entrepreneurs forecast future returns on investment and bid for the factors of production accordingly. The expectations of entrepreneurs is not something that can be communicated with ordinary language, this knowledge can only be transmitted through the complex market system in terms of prices they are willing to pay.

This can only be realized under an economic system that allows individuals to reflect their evaluations of the future return of the factors of production in terms of real market prices[22].

The numbers that the central planner assigns would reflect his own thoughts and beliefs, not the valuation of the alternative uses of the resource. An intellectual division of labor is needed, this requires the existence of multiple intellects or wills acting on the market instead of a socialist planner that operates as one will alone.

Mises explains why the trial and error method is futile when it comes to discovering truths previously unknown:

The method of trial and error is applicable in all cases in which the correct solution is recognizable as such by unmistakable marks not dependent on the method of trial and error itself ... Things are quite different if the only mark of the correct solution is that it has been reached by the application of a method considered appropriate for the solution of the problem. The correct result of a multiplication of two factors is recognizable only as the result of a correct application of the process indicated by arithmetic. One may try to guess the correct result by trial and error. But here the method of trial and error is no substitute for the arithmetical process. It would be quite futile if the arithmetical process did not provide a yardstick for discriminating what is incorrect from what is correct ... If one wants to call entrepreneurial action an application of the method of trial and error, one must not forget that the correct solution is easily recognizable as such; it is the emergence of a surplus of proceeds over costs. Profit tells the entrepreneur that the consumers approve of his ventures; loss, that they disapprove. The problem of socialist economic calculation is precisely this: that in the absence of market prices for the factors of production, a computation of profit or loss is not feasible [23].

Dickinson on the other hand suffers from a similar misunderstanding of the market process and the economic literature up to his time. The general equilibrium models were proposed by Walras and Pareto only to demonstrate a formal similarity between a socialist and a market economy, they did not believe that the information necessary to form these equations would ever be available other than through the market process.

In order to form these equations one of the necessary types of information is the scale of preference of the consumers in the future. This is impossible, even today’s preferences are only known to us through the price system. We do not know what the demand for any particular commodity would be at some other prevailing price. We do not know the shape of the supply and demand curves, these are merely graphic illustrations used as pedagogic devices to teach market phenomenon. They have no counterpart in reality [24].

There is however, another layer to Mises’ argument which was not present in his original article but was developed in 1949. This point ,which also has not been refuted, has not received the attention it rightfully deserves from either side of the debate [25].

For the sake of the argument Mises concedes that the central planner has miraculously solved the impossible problem of forming the equations necessary for the state of equilibrium. When we are referring to absence of change during the formation of the state of equilibrium, we are referring to the absence of changes in market data that derange the adjustments toward equilibrium, not the tendency toward the establishment of the equilibrium itself.

Let us call the current day D<sub>1</sub> and the day of equilibrium D<sub>N</sub>. The total supply of produced factors of production on D<sub>1</sub> shall be called P<sub>1</sub> and on D<sub>N</sub> it shall be called P<sub>N.</sub> The magnitude of P<sub>1</sub> is necessarily different than that of P<sub>N</sub> since we are not in equilibrium today. P<sub>1</sub> is the outcome of past valuations and information which was different than the present state. There exists plants, tools and supplies of other factors of production that would disappear under equilibrium, and other plants, tools, supplies that must be produced for the establishment of equilibrium. Equilibrium will only emerge when the disturbing parts of P<sub>1</sub>, as far as they are still utilizable, will be worn out and replaced by items which correspond to the state of synchronous data. Information regarding the static economy is useless for the acting man, he is not interested in the state of equilibrium distant in the future, he must act now. What he needs is the information about the most appropriate method for the transforming, by successive steps, P<sub>1</sub> into P<sub>N.</sub> What the available equation tells us is simply that under static conditions, m units of a are employed for the production of x, z units of b are employed for the production of y…

It does not tell us anything about the procedures that are necessary for the establishment of equilibrium. Today we are confronted with the supply of P<sub>1</sub> which differs from P<sub>N</sub>, when acting we must take into account the real conditions available to us and know its most appropriate usage not the hypothetical conditions of P<sub>N</sub>. The central planners task is not to start from the very bottom of civilization with untouched natural resources, but to operate within the framework of already produced factors of production available to him.

Later, Dickinson in 1939 concedes that the method of determining prices based on thousands of simultaneous equations will not work in an economy where the market data is continuously changing.[26] This has been precisely the argument Austrians have offered against any sort of mathematical solution.

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[1] Hans Hermann Hoppe, “A Theory of Socialism and Capitalism”

[2] <span class="underline">Yves</span> Guyot, “Socialistic Fallacies”

[3] E. Barone, “The Ministry of Production In The Collectivist State” in Collectivist Economic Planning

[4] Ludwig von Mises “Human Action” p. 692

[5] Ludwig von Mises , “Human Action” p.694

[6] Robert Murphy, “Socialism: The Calculation Problem Is Not the Knowledge Problem”

[7] Ludwig von Mises, “ Economic Calculation in Socialist Commonwealth” p. 22-23

[8] Friedrich von Weiser, “Social Economics” p.53

[9] Ludwig von Mises, “Human Action” p. 250

[10] Ludwig von Mises , “Socialism: An Economic and Sociological Analysis” p. 196-202

[11] Eugen von Böhm Bawerk, “Karl Marx and the Close of his System”

[12] Karl Marx, “Critique of the Gotha programme” Part 1

[13] Karl Marx, “Capital Volume 1” p. 30

[14] Don Lavoie , “Rivalry and central planning” p. 70

[15] Karl Marx, “Capital Volume 1” p. 32

[16] Don Lavoie , “Rivalry and central planning” p. 72

[17] Friedrich von Wieser , “Natural Value”

[18] F.A Hayek, “The present state of the debate” in Collectivist Economic Planning p.212

[19] E. Barone, “The Ministry of Production In The Collectivist State” in Collectivist Economic Planning p. 287

[20] Fred M. Taylor, “The Guidance of Production in a Socialist State”

[21] H. D. Dickinson, “Price Formation in a Socialist Community”

[22] J. Salerno, “Reply to Leland B. Yeager on ‘Mises and Hayek on Calculation and Knowledge’”

[23] Ludwig von Mises , “Human Action” p.700

[24] Ludwig von Mises, “The equations of mathematical economics and the problem of economic calculation in a socialist state”

[25] Ludwig von Mises , “Human Action” p.706-711

[26] H. D. Dickinson, “Economics of Socialism” p. 104