3. Economic Calculation

The Role of the Price System

It has been shown that the essence of social cooperation is specialization and the division of both labor and knowledge. This fact has two significant implications for the purposes of this study. The first is that social cooperation results in the production of such a wide range of intermediate and final products that calculations in kind will not allocate scarce resources effectively. A common denominator is indispensable. The second is that the concomitance of decentralized decision-making and social cooperation requires a means of coordinating individual plans that are based upon imperfect knowledge and information. These two requirements are fulfilled simultaneously through the price system of the market economy. Detailed treatment of the workings of the price system will be postponed until later. At this point it will be sufficient to discuss the price system in general terms in order to demonstrate its dual function as a means of economic calculation and as a means of coordinative communication. Actually, as will be shown, these two functions are really of a piece; that is, they relate the same problem of resource allocation under an arrangement of social cooperation and a system of market prices.

Economic Calculation vs. Technological Calculation

Economic calculation is not a technological problem. Technology can establish quantitatively the causal relations between a particular set of external things that can be used in various combinations to produce a particular result. The nature of technological calculation is that 6a + 4b + 3c + ...xn will likely create the result 8p. But technology cannot say whether the resulting 8p is the most desirable use of those particular quantities of resources a, b, c, etc., as compared with their possible alternative uses as means to the production of other ends. By the same token, technology is not able to say whether that particular formula for the production of 8p is the preferable one when 8p is also producible by means of other formulae or combinations of different resources. Mises has illustrated the problem as follows:

The art of engineering can establish how a bridge must be built in order to span a river at a given point and to carry definite loads. But it cannot answer the question whether or not the construction of such a bridge would withdraw material factors of production and labor from an employment in which they could satisfy needs more urgently felt. It cannot tell whether or not the bridge should be built at all, where it should be built, what capacity for bearing burdens it should have, and which of the many possibilities for its construction should be chosen.1

Max Weber made the same point in the following statement:

The question of what, in comparative terms, is the cost of the use of the various possible technical means for a single technical end depends in the last analysis on their potential usefulness as a means to other ends.2

Technical calculations can only be calculations in kind. They are not sufficient for human decisions and actions because they are devoid of any preferential quality. The ivory-tower theorist may be right in claiming that an excellent tunnel can be built of platinum. But monetary calculation makes the issue an economic one, and the practical engineer is thereby discouraged from disembarking upon such a scheme as long as platinum has uses deemed more important than the construction of tunnels. Technology is neutral to human valuation; it has nothing to say about the subjective use-value of the various objective uses for resources. As Mises has said, “It ignores the economic problem: to employ the available means in such a way that no want more urgently felt should remain unsatisfied because the means suitable for its attainment were employed--wasted--for the attainment of a want less urgently felt.3

Subjectivity of Value

The task of resource allocation is to satisfy urgently felt human wants, and therefore resources must be devoted to their most important employments. Yet the question must be raised as to how these most important wants or usages are to be determined. It would appear that some means of measuring the value of things is necessary to make these determinations, but this is not the case. There is no such thing as a measuring unit of value, and this fact means that measuring the value of a thing is impossible. Value is a subjective phenomenon that eludes cardinal quantification. A thing’s value is in the mind of the person who is doing the valuing, and this process of evaluating is not a matter of measurement. Because valuation is always a matter of individual preference, ordinal numbers are the only type of numerical treatment that can be accorded the problem of valuation. This is the subjective theory of value which did not enter economic science until Menger, Jevons, and Walras introduced it in their analysis around 1871. Until that time, economists had searched for a source of value for all goods as if value were intrinsic in each good.

The problem of value measurement is indicated by the fact that not only do different people often value the same thing differently, but the same person might value a certain thing differently at different times. And under the operation of the law of diminishing marginal utility, a person will always value each additional unit of a given good less than the prior unit’s value. If value were quantifiable and measurable, there would exist a standard unit of measure that would be unchanging. It is clear that there is no such immutable unit of measure of the value of a good when different people at the same time and the same person at different times often have divergent valuations of the same good.

Valuation necessarily is manifested in the act of choosing or preferring. One is able to say he values A more than either B or C, but he is unable to say quantifiably how much more he prefers A over B or C. He may qualitatively indicate that his preference of A over B is far more intense than his preference of A over C. In that case, he would be ranking his preferences from first to last in the order of A, C, and B. But this ranking is strictly an ordinal, and not a cardinal, use of numbers. The allocation of scarce resources cannot be based upon any alleged method of measuring their values; employment of particular increments of resources can be decided only through ranking one incremental choice over alternative incremental uses of the same or different resources. Resources, since they are means to consumer goods, derive their ranking from the relative importance of their ultimate products. A more detailed look at the subjective theory of value is presented in chapter 3.

Economic Calculation Through Money Prices

It is through the pricing process of the market that the relative importance of the various resources and consumer goods is translated into common terms in the form of money prices. Money enables people to make economic calculations because it is the common medium of exchange. All goods and services that are bought and sold on the market are exchanged for sums of money. These money prices are not measurements of value. Money prices are exchange ratios that are expressive of the ranking of the valuations placed upon increments of goods at a given moment by the participants in market exchanges. Money prices are subject to continuous change because of the changeability of people’s subjective valuations and because of changes in the supply of the particular goods and services. The propensity of humans to conceive of changes they deem improvements in their ways of doing things and in the means of attaining satisfaction prevents the emergence of permanently stable prices in the market economy.

Economic or monetary calculation is essentially a matter of providing a comparison between input and output, between sacrifice and result, for past or contemplated lines of resource utilization. It has been shown that calculations in kind, which must necessarily characterize technological computations, will not suffice for the task of economic allocations. Money prices related to particular quantities of goods and services permit the determination of money costs and money revenues, thereby shedding light on the desirability of specific resource employments.

Economic calculation includes both retrospective and prospective monetary calculations. Retrospective calculation is the determination of past monetary profit or loss, i.e., income, resulting from actions already taken and serves two purposes: (1) to the extent that the past is assumed to be indicative of the future, it has instructive value, and (2) the determination of monetary income reveals the extent to which the future capacity to produce can be maintained after current income is withdrawn. The latter function derives from the complementary concepts of capital and income, the ultimate mental tools of economic calculation, which are discussed in the next section. Prospective calculation, which might well be influenced by retrospective calculations of capital and income, is a matter of anticipating the money profit or loss expected to result from specific actions being contemplated. Note that all economic calculation deals with the future. As all action is meant to cause a beneficial change, all action is directed to the future, whether to the next hour, day, year, or longer. Every step along the path of resource utilization has a prospective orientation.

The Concepts of Capital and Income

The essence of modern economic activities is the devotion of resources to the process of production leading to the output of consumer goods and services. The entrepreneur-producer invests funds to acquire productive means by which he hopes to increase his monetary wealth. Through money prices the producer is able to ascertain numerically the economic significance of the factors employed for future production. The determinable amount of money equivalent devoted toward productive activities is called capital, and the aim to keep at least this amount intact is called capital maintenance. Mises defines capital in the following way:

Capital is the sum of the money equivalent of all assets minus the sum of the money equivalent of all liabilities as dedicated at a definite date to the conduct of the operations of a definite business unit. It does not matter in what these assets may consist, whether they are pieces of land, buildings, equipment, tools of any kind and order, claims, receivables, cash or whatever.4

When productive efforts result in net assets whose money equivalent exceeds the capital devoted to such efforts, the business unit is said to have earned an income equal to that excess. The concept of income is the correlative of the concept of capital. Income is the amount that can be consumed without lowering the capital below the sum of the amount dedicated to the business at the start of a given period and any additional investments paid in during that period. If consumption is restricted to the amount of income, capital is maintained. If, on the other hand, consumption exceeds income, capital is not maintained; this difference is referred to as capital consumption. Capital accumulation takes place when consumption is less than the available income, that is, when a portion or all of income is saved. If the business fails to earn income and instead suffers a monetary loss, there is capital consumption, and capital it not maintained unless new funds are invested by the producer. Additional investments, in combination with income and consumption effects, make for either capital maintenance, capital accumulation, or a reduction in capital consumption. As Mises states, “Among the main tasks of economic calculation are those of establishing the magnitudes of income, saving, and capital consumption.”

Although capital may be embodied in produced factors of production (often called capital goods), the idea of capital refers to a concept existing only in the minds of individuals. Man is mentally aware of the monetary significance of the means to which he resorts for productive purposes. This concept is an element in economic calculation and provides a basis for appraising the results of future actions and for ordering subsequent steps of consumption and production through capital maintenance. The concrete capital goods are doomed to eventual dissipation; it is only the value of the capital fund that can be constantly preserved or maintained through a proper arrangement of consumption.5

The establishment of the outcome of past actions involves the calculation of capital both prior to and after the actions. The comparison of these two calculations yields the determination of profit (income) or loss. This retrospective form of economic calculation provides a starting point in the planning of future actions to the extent that the actor deems the past an indicator of future developments. This point illustrates how the knowledge problem previously discussed is partly resolved.

In addition to serving instructive aims, the determination of profit or loss resulting from past actions provides the only means by which the actor or actors can ascertain whether or not the capacity of the business unit to produce in the future has been impaired. Like anyone else, producers are interested in attaining the satisfaction of their personal wants, and the calculation of profit or loss reveals the extent to which they can enjoy consumption expenditures without encroaching on the capital base necessary to continue productive operations at a level comparable to that of the past. This calculation may show that additional investment is required in order to offset the dissipation of capital as a result of unprofitable operations or to achieve desired capital accumulation. And the most recent determination of capital affords a point of comparison for the calculation of profit or loss resulting from actions taken in the succeeding period. Thus retrospective economic calculation is significant only because it facilitates the planning of future actions; without this use it would be merely dead history.

Every productive undertaking is guided by the calculation of anticipated future costs and proceeds expected to result from the project or activity. The determination of past revenues and costs may be of substantial assistance in the projection of these results. For most entrepreneur-producers, only those actions will be pursued that promise a monetary output that sufficiently exceeds the expected monetary input, including capital dissipation, necessary to carry them out.6 Resources then are directed into their most profitable uses by means of anticipatory calculations built on expected prices for various goods and services. Mises has made clear the overriding significance of monetary calculation:

Monetary calculation is the guiding star of action under the social system of division of labor. It is the compass of the man embarking upon production, He calculates in order to distinguish to remunerative lines of production from the unprofitable ones, those of which the sovereign consumers are likely to approve from those of which they are likely to disapprove. Every single step of entrepreneurial activities is subject to scrutiny by monetary calculation. The premeditation of planned action becomes commercial precalculation of expected costs and expected proceeds. The retrospective establishment of the outcome of past action becomes accounting of profit and loss.7

It warrants reiteration at this point that economic or monetary calculation is not a process of measurement. Monetary numbers provide no standard unit of value. The infinite possible uses of productive resources dictate that choices or preferences, not value measurement, characterize the nature of the economic problem. Monetary calculations, through past and anticipated market prices, indicate preferences or the relative importance of alternative undertakings.

Risk and Uncertainty

There is no precision in economic calculation because of the uncertain future that pervades all activities in the market economy. Predicted future costs and revenues are anticipations on the part of the entrepreneur-producer, who possesses no superhuman ability to know the future. This uncertainty no less affects the retrospective calculation of profit and loss because the most recent calculation of capital is tenuously based on a money equivalence that the future may not uphold. An individual decision maker is unable to know precisely the future preferences of consumers, the future changes in technology, the future plans and actions of other producers, and the infinite number of other external events that will occur in the future. The gathering of empirical data as is done in establishing actuarial tables is not sufficient for the purposes of entrepreneurial activities in the market economy. Actuarial science is predicated on determining classes of homogeneous events. Each class is made up of a large number of past similar events that are subject to a statistical analysis that reveals the percentage of instances in which a given event has transpired. But the preponderance of the entrepreneur’s dealings is not with matters of a homogeneous nature. To the extent that he does concern himself with actuarially describable events, he resorts to insurance in order to recognize the probable cost of detrimental happenings. But most of his concerns are of such a comparatively rare nature that the grouping or categorizing of them into classes for the purposes of computing class probabilities is impossible.

Frank Knight developed this idea in distinguishing between risk and uncertainty.8 Risk is subject to numerical computation based on statistical data pertaining to a large number of similar events that are expected to recur. This is the nature of actuarial probabilities. Uncertainty relates to situations that are unique; each situation is a case in itself as opposed to being a member of a class or large number of homogeneous events or circumstances. Uncertainty is not numerically calculable because of the lack of sufficient past experiences relating to the particular set of circumstances being considered.9 Comprehensive empirical data are not available in the varied classifications necessary to permit calculating the probability of success for each of the innumerable ventures that are underway. Knight explains the problem this way:

The liability of opinion or estimate to error must be radically distinguished from the probability or chance of either type (a priori and statistical), for there is no possibility of forming in any way groups of instances of sufficient homogeneity to make possible a quantitative determination of true probability. Business decisions, for example, deal with situations which are far too unique, generally speaking, for any sort of statistical tabulation to have any value for guidance. The conception of an objectively measurable probability or chance is simply inapplicable....10

Uncertainty is the overwhelming obstacle that each entrepreneur-producer faces in the market economy, and his attempt to foresee the future is a subjective matter that escapes mathematical equations and formulae. The businessman is not dealing with objects whose behavior is predictable as is a physicist or engineer. The object of the producer’s attention are the wants of other people and the plans of other producers; it is not possible to know what changes they will undergo. The unexpected innovations and applied inventions on the part of competing producers have often spelled the downfall of less enterprising businesses. The changeability of customers’ preferences and of resource availabilities are persistent problems confronting the producer. The uncertainty is primarily due to the unpredictability of the actions of other people. This is the central theme of the following remarks by Mises:

In the real world acting man is faced with the fact that there are fellow men acting on their own behalf as he himself acts. The necessity to adjust his actions to other people’s actions makes him a speculator for whom success and failure depend on his greater or lesser ability to understand the future. Every action is speculation. There is in the course of human events no stability and consequently no safety.11

This does not mean that the future is so uncertain that every business action is a gamble or that each situation is so unusual that there exists no basis for planned action. Experience provides an invaluable guide to action. Past prices are the starting point for predicting future prices. However, for the problems of the entrepreneur-producer, experience is too diverse and complex to enable him to quantify the probability of the success of alternative actions. In the market economy there are no fixed relations. The producer’s reliance on past experience is necessarily judgmental and qualitative.

The Tenuousness of Economic Calculation

Since all anticipatory economic calculation deals with an uncertain future, all such calculations are tenuous and indefinite. Because no entrepreneur can know the future, errors in anticipations are inevitable, and success or profit comes to those whose foresight is the least erroneous or most nearly correct. Even the capital arising from the results of past events and transactions and used in determining past profits is but an interim level of wealth since its permanence is not assured in an uncertain future. Mises describes the tenuousness of the figures reported in business financial statements:

The main thing in balance sheets and in profit-and-loss statements is the evaluation of assets and liabilities not embodied in cash. All such balances and statements are virtually interim balances and interim statements. They describe as well as possible the state of affairs at an arbitrarily chosen instant while life and action go on and do not stop....12

Monetary calculation may lack preciseness and certainty, but that does not mean it does not fulfill its task of guiding future actions according to a producer’s view of what the future want-satisfactions of other people will be. It is not the fault of the system of economic calculation that uncertain calculations exist. They arise necessarily because human action always occurs in the face of an uncertain future. Under a social organization with an extensive division of labor, producers require a means of calculation on the basis of a common denominator. Monetary calculation affords this means, although it is not definite or certain. Resources are directed to those used that the owner deems the most promising and remunerative as indicated by his money calculations. Monetary calculation is possible only in a market economy in which the factors of production can be related to money prices. There can be no monetary calculation in a barter economy or on Robinson Crusoe’s island. Even socialist theorists have admitted that the allocation of productive resources in a socialized economy would require the establishment of money prices by the central authorities in order to correct discrepancies between supply and demand.

The Rationalizing Effect of Monetary Calculation

The recognition of the significance of economic calculation has not been restricted to Austrian economists. Max Weber attributed to the tool of monetary calculation or capital accounting the dominant rationalizing influence in the technological development of western capitalism:

...it is one of the fundamental characteristics of an individualistic capitalistic economy that it is rationalized on the basis of rigorous calculation, directed with foresight and caution toward the economic success which is sought in sharp contrast to the hand-to-mouth existence of the peasant, and to the privileged traditionalism of the guild craftsman and of the adventurers’ capitalism, oriented to the exploitation of political opportunities and irrational speculation.13

The instruments of money and monetary calculation are the means by which versatile and diversified resources can be rationally allocated to the satisfaction of urgent wants. The advances of technology are dependent on the guidance offered by such means. The great advantages of the division of labor could not have been realized without the calculations made possible in common terms by a common medium of exchange and its correlative, money prices. As Mises states: “Economic calculation is the fundamental issue in the comprehension of all problems called economic.”14

And yet economic calculation is not without its limitations. Those things that cannot be bought and sold are outside the realm of monetary calculation. A man’s devotion to good character or to another person may not be subject to compromise at any price. In a society that forbids slavery, human life has no money price. A person may own something that he so cherishes for its beauty or for sentimental reasons that he would not exchange it for any amount of money. Such matters cannot be related to money prices. But the existence of these exceptions does not hinder the effectiveness of money prices in guiding the utilization of the vast amount of goods and services that do not fall outside the pale of market activities.

Coordinative Communication Through Market Prices

In addition to the need for a common denominator for calculation purposes, we have seen that another requirement of social cooperation based on specialization and division of labor and knowledge is for a means by which the multitude of individual plans and actions can be coordinated into a consistent pattern. The interrelationship of specialized activities demands a system of apprising decision makers of changes relevant to their activities. Each decentralized planner cannot make decisions strictly on the basis of his awareness of his immediate surroundings. His decisions need to be harmonized with those of other planners so that the larger economic system operates as smoothly and effectively as possible.

Money prices are the medium through which the communication of necessary information is made to coordinate effectively the actions of individual planners. As Hayek has pointed out, each particular decision maker does not need to know all the facts pertaining to the changes in resource usage. What is relevant to each is “how much more or less urgently wanted are the alternative things he produces or uses.”15 The economic question is always a question of the relative importance of specific things available for the satisfaction of human wants. Each planner does not usually need to know why the relative importance of the things that he uses or produces has changed. What he does need is some indication of the extent to which its relative importance has been altered. The crucial objective of such information is to see that each individual planner acts in the light of changes in the relative importance of the things with which he is concerned. Market prices at any moment reflect the relative importance most recently ascribed at the margin to goods and services exchanged on the market. Thus changes in the relative importance of goods and services are reflected in changes in their money prices.

The coordinating function performed by the price system can be illustrated by assuming a sudden shortage of some resource. Those people who will eventually solve the problem of the shortage do not need to understand its cause. The price of a unit of the resource will be driven upward as those who employ it in the most important usages, i.e., use it for the generation of products promising the highest return, outbid those producers who plan to use it in less remunerative products. The shortage has meant that the marginal uses of the resources that could be supplied before the advent of the shortage cannot be provided for as long as the shortage persists. The higher price successfully causes the curtailment of the employment of the resource in its marginal uses. Hayek has poignantly articulated the role of the price system:

...the marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; that is, they move in the right direction....I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind. Its misfortune is the double one that it is not the product of human design and that the people guided by it usually do not know why they are made to do what they do.16

People far removed from the origin of the shortage are thereby led to plan and act in accordance with the fact that the supply of a particular factor of production has diminished. The higher price not only signals for adjustments in the quantities demanded; it also induces a search on the part of suppliers to increase the available supply of the resource. And to the extent this search is successful, the price of the good will fall accordingly, thereby indicating that the good is now available for employment in less remunerative lines. The price system operates in the same way to guide the actions of consumers in their acquisition of consumer goods and services. Hayek’s further description of the effectiveness of the price system as a means of communicating information to dispersed decision makers is useful:

...The most significant fact about this 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...a system of telecommunications which enables individual producers to watch merely the movement of a few pointers...in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.17

Let us not fail to recognize that the effective operation of the price system can be thwarted by political interferences. Thus, past problems in oil and gasoline stemmed from the refusal on the part of those in power to allow the market system to function openly. The prices set by OPEC and by the Department of Energy were not prices freely set in the open market, and the distortions in supply and the gasoline lines were not the outcome of open-market decisions. Price controls hold prices down at points that cause frustration on the part of buyers, who are misled into thinking their demands at those prices can be met. These same price controls preclude the adequate search by oil producers to discover and market additional supplies of petroleum. Interferences with the price system perpetuate the problem of a “shortage” of fuel.

Money prices simultaneously fulfill the needs for a common denominator for calculation purposes and a process by which the individual decisions of dispersed people can be coordinated. Prices established on the market are coordinative precisely because they are a major factor taken into consideration in the economic calculations underlying the actions taken by various decision makers. Past prices are useful guides to the anticipation of prices expected to exist in the immediate future. Perceptions of opportunities for profitable alterations in economic activities engender actions that influence the eventual configuration of future prices. Through such changes in prices additional information is communicated to other market participants. The knowledge problem is further alleviated as such price signals now reflect the new decisions and induce others to plan their affairs in ways consistent with the new market data. The tendency for separate decisions to be consistent with one another was the natural outcome of establishing a medium of exchange that furnished to everyone a common denominator to be used for their economic calculations. Without a common denominator the need for coordinating the plans of various people would not be so great. The reliance on calculations in kind would significantly restrict the development of specialization and division of labor. Exchanges would be limited to pure barter relations. The rational allocation of scarce resources in a system of fruitful and extensive social cooperation is the great advantage emanating from a market economy and its counterpart, monetary calculation.

An Introduction to Austrian Economics