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2. Social Cooperation and Resource Allocation
Calculations in Kind in a Primitive Economy
The task of economizing is as applicable to an isolated, self-sufficient person like Robinson Crusoe as it is to someone who lives in a society characterized by extensive division of labor and complex exchange transactions. Robinson Crusoe's task was to employ the means available to him in ways that he hoped would generate the greatest satisfaction. A process of deciding and choosing was essential to his welfare. Similarly, in modern society vast numbers of interacting individuals try to make the best use of all available means for want satisfaction. This economic problem exists whether the choices and decisions are largely left up to a centralized planning board, as envisioned in the theory of socialism, or whether such choices are made more or less freely on the part of individuals acting in a market economy.
Robinson Crusoe could effectively manage only a limited amount of resources and had to make comparatively few plans about directing their use. Because of the relative simplicity of his range of choices, he could make effective decisions without making any quantitative calculations about the possible results of different courses of action. His ability to assess or anticipate results would likely depend on the observation and intuitive grasp of the productive alternatives before him. Calculations in terms of physical output would suffice because his resources would not be highly diversified, and each resource type would lack, for him, a significant degree of versatility.
He would have access to some of the original factors of all production--land, including natural resources, and labor. However, because of his limited ability to produce goods in his isolated situation, these original factors could not be converted into a wide range of intermediate products such as machines and tools. He would be compelled to use the most rudimentary tools since he could neither acquire nor, given his situation, would he need the more intricate and sophisticated machines characteristic of a modern economy. Consequently, his decisions about how he should use the available resources to obtain consumption goods would not be so complicated as to necessitate some sort of objective profit and loss computation, even assuming the availability of something like money that could be used for computational purposes. The uses to which resources could be effectively put would be more or less determinable. The most versatile factor would be his own labor and ingenuity, which he would utilize in combination with natural resources to produce those products that he preferred and whose production was feasible.
His time and energy would be spent making basic tools, hunting for food, building a shelter, and producing clothing as well as resting. Given his particular situation and wants, he would not have to compile and compute data about the past or expected success of these uses of his time and energy and other factors of production. The limited nature of both his time and energy would prevent his exploiting the complete potential of his island's natural resources. His decisions would be based on a subjective calculus of profitability for each considered action; his alternatives would be so limited that he would be able to observe or anticipate the results of his undertakings in real terms in reaching such valuations. And since he would be producing for his own satisfaction, there would be no problem of his being unable to know which good among those producible should be chosen. His own scale of values would be the sole determinant.
A self-sufficient household could also manage its economic resources effectively without involved calculations of any sort, particularly if it had gradually developed a tradition of resource utilization. Whatever calculations of outcomes were necessary in these relatively primitive situations could be captured in terms of the various outputs, sometimes referred to as calculations in kind. Because of the absence of exchange relations there would be no medium of exchange and thus no common denominator for calculation purposes.
Calculations in Kind in an Advanced Economy
Over the centuries an alternative to economic self-sufficiency has evolved to deal with the problem of scarcity. This alternative is social cooperation, the basis of what is called society. Virtually all people have chosen society over self-sufficiency. The enormous increase in productivity resulting from specialization and the division of labor gradually undermined the process of self-sufficient provisioning. Yet despite the comparative abundance of products and services emanating from the process of social cooperation, the economic problem remains: Wants continue to exceed the means or resources for their attainment. The persistence of the problem of scarcity means that even in a modern, highly developed, and productive society decisions have to be made regarding how the various scarce resources should be directed to the satisfaction of the more urgently felt wants of society's members.
These decisions are not as simple to make in an advanced society as they are in a primitive state of economic self-sufficiency. The resources cannot be as easily scrutinized for possible uses. The great enhancement of productivity arising from specialization and the division of labor considerably increases the flexibility of resource utilization. The fruits of social cooperation permit the devotion of a major portion of original resources, land, and labor, to the direct production of what may be called producer's goods, or intermediate products, which ultimately will give rise to consumer's goods when combined with additional increments of land and labor. Herein lies a crucial distinction between economic self-sufficiency and social cooperation: The complexity and intricacy of resource employment in a modern economy require far more complicated decisions than those that Robinson Crusoe had to make.
The increased complexity of economic decisions is partly attributable to the immense variety of consumer's goods and services that a high-level economy is capable of generating. Choices have to be made as to which ones should be produced and in what quantity; the larger the number of alternatives, the more difficult these decisions. However, decisions concerning ends are not the only vital decisions that must be made. As did Robinson Crusoe, people in society must make choices that relate resources to ends. How are the resources to be used? What makes this question hard to answer is that the economic resources in an advanced economy are extremely versatile and diversified. Their versatility can be traced to the wide range of uses to which they can be adapted as a result of advances in technology and productive skills, results that include the beneficial effects of the division of labor and specialization. And these numerous adaptations entail the conversion of original factors of production into a diversity of produced resources, thereby creating countless types of particular resources.
It is clear that with such an infinite array of steps that can be taken toward the production of finished products and services, the most economical or fruitful choices cannot be made simply by reviewing calculations in kind. The very abundance of resources makes it impossible rationally to assign and direct original factors of production to yield more refined means of production without some basis for comparison of the results. For example, iron can be used in the manufacture of locomotives, farm tractor equipment, textile spinning and weaving machinery, building frames, oil drilling equipment, and thousands of other items. And the problem is compounded when one remembers that for many uses other resources offer effective substitutes. Thus copper, tin, and aluminum can be used in place of iron or steel for certain items. The problem widens as the full range of alternatives is considered. Decisions concerning resource utilization would be a matter of immense confusion if calculations in kind were the only calculations. The allocation of scarce resources would be chaotic and seriously imprecise.
Once the shackles of self-sufficiency are removed and production for exchange is assumed, the epitome of which is a full-fledged market society, the need emerges for more precise calculations regarding the past and is met by the very factor that permits widespread exchanges to occur: money, the economy's medium of exchange. Monetary calculation provides an indispensable means by which a modern economy can translate the myriad of physically different resources and output into a common denominator. It is this monetary common denominator that provides the basis for an input-output calculus, a capital-income calculus that is crucial to the allocation of scarce resources. This calculus is necessary because the scarcity of means requires the careful comparison of costs and benefits, of inflows and outflows in the production process.
It is generally agreed that in a modern economy calculations in kind are not the proper basis for resource allocation. A brief look at how certain leading advocates of socialism came to recognize the inadequacy of calculations in kind reveals that even the most enthusiastic opponents of the market economy now recognize the need for a common denominator for the purpose of rational resource allocation.
In 1920 Ludwig von Mises challenged the theory of socialism when he contended that socialism is unworkable in an advanced economy because of the inadequacies of calculations in kind.1 He accused the socialist theorists of having ignored the critical task of resource allocation in a modern economy. They had assumed away this problem in their ecstatic belief that socialism is inevitable and thus naturally feasible. Not one eminent spokesman for the cause of socialism had bothered to explain just how rational decisions would be reached concerning the employment of scarce resources. Now they were forced to face the issue; faith in inexorable laws of history has no place in the realm of scientific discussion and inquiry. The socialist thinkers were challenged to resolve theoretically the problem of calculation.
Leading socialist theorists subsequently agreed that their theory was in need of elaboration on this point. They then began to explain how they believed that the process of allocation could be directed by central planners in the absence of competitively established market prices. What this explanation amounted to was the recognition that the planning authorities would require some method of calculating in common terms the effects of alternative economic actions.2 They agreed that Mises was right in pointing out that they had failed to confront this matter in all of their previous works. They had been convinced that calculations in kind are insufficient in the management of a modern economy. Their replies largely culminated in the contention that the central planning authorities could establish prices through trial and error, guided by the existence of surpluses and shortages for each particular good. And these prices, stated in terms of the economy's medium of exchange, would serve as beacons in the task of resource allocation. Shortages called for upward adjustments in the prices of those items; surpluses signaled for price reductions. These price adjustments would lead to proper production adjustments--price increases would induce supply increases while price decreases would effect supply decreases--so that eventually equilibrating prices would be set, thereby removing various shortages and surpluses in both intermediate and finished goods. Resources would be employed rationally through the monetary guides issued by the central pricing and planning authorities. The socialist position now is that a socialist economy is not doomed to calculations in kind, and that, thanks to Mises, they had been spurred to demonstrate this point.3
The Problem of Coordination and Knowledge
The overriding difference between self-sufficient production and production on the basis of social cooperation is that only under the latter arrangement are people able to realize the overwhelming benefits of specialization and the division of labor. In addition, while a self-sufficient producer generates goods solely for his own satisfaction, an arrangement of social cooperation necessarily means that producers create products to satisfy other people. Virtually every person in a modern economy devotes his skills and energies to a highly specialized activity that provides a product or service to be used by someone else. We would all be in a sad state if each of us were suddenly compelled to produce only for himself.
The reliance on the elements of specialization and division of labor complicates the problem of efficient resource allocation because it makes necessary some means of unifying or coordinating the separate plans and efforts of many actors. Underlying the problem of the division of labor, then, is the problem of what Hayek calls the "division of knowledge," which is "the really central problem of economics as a social science." Hayek has stated the central question as follows:
How can the combination of fragments of knowledge existing in different minds bring about results which, if they were to be brought about deliberately, would require a knowledge on the part of the directing mind which no single person can possess? To show that in this sense the spontaneous actions of individuals will, under conditions which we can define, bring about a distribution of resources which can be understood as if it were made according to a single plan, although nobody has planned it, seems to me indeed an answer to the problem which has sometimes been metaphorically described as that of the "social mind."4
The seriousness of this problem of knowledge must not be underrated. Clearly a system of division of labor harbors the potential for chaos and confusion. If it is to work, there must be some means of synchronizing individual decisions and actions throughout the economy. For example, if the majority wants more timber to be used for the production of houses than for the production of paper products, then signals must be effectively communicated to induce this shift in resource usage. Otherwise a scarce resource will not be employed in the most desirable way; it will be employed for the satisfaction of less urgently felt human wants.
Yet the conventional model of so-called perfect competition, with its assumption of perfect knowledge, completely avoids treatment of the task of synchronizing decisions. The model assumes that knowledge concerning technology, tastes, etc., is given, and all individual plans are imagined as meshing consistently with one another. Knowledge is depicted as data similar to the facts used in the physical sciences. But this view of knowledge misconstrues the nature of knowledge in the social sciences. The knowledge that underlies human decisions and actions is grossly imperfect simply because a significant part of the "knowledge" in the mind of each individual consists of suppositions about the future decisions and actions of other individuals. These suppositions are subjective perceptions that are devoid of the certainty possessed by the facts used in the physical sciences.
And since a person's decisions and actions are likely to be modified as he gains additional experience of both external objective facts and other persons' decisions and actions, the notion that all separate plans and actions will eventually interlock and that the result will be a static, long-run equilibrium is totally unrealistic. By assuming perfect knowledge, the model fails to focus on the problem of the "division of knowledge." The model is a useful analytical construct in assisting the theorist's understanding of the logical result of an atomistic economic process in which unforeseeable changes were to disappear. But it is a construct that must be used carefully if the element of uncertainty is not to be erroneously omitted from the study of the real world.
Thus the task of rational allocation is not a simple matter of utilizing "given perfect knowledge" in the process of making economic decisions and actions. The knowledge that exists is "given" only in innumerable, scattered pieces and not in one single mind. Each individual has unique information regarding his particular circumstances of time and place, and others benefit from the actions taken by each individual because of his being particularly informed about his limited situation. However, because his particular information relates only to his limited situation, he may use his knowledge in a manner that is inconsistent with the plans of others. Social cooperation requires some method that will enable that part of each person's particular knowledge that is relevant to the plans of others to be disseminated as widely as possible. And this method must provide for the continuous dissemination of knowledge in the midst of relentless change. For as Hayek states,"...economic problems arise always and only in consequence of change. As long as things continue as before, or at least as they were expected to, there arise no new problems requiring a decision, no need to form a new plan."5
The coordination problem is inextricably connected to the fact that all data relevant to economic action are never simply given, as conventional price theory, dwelling upon the conditions of equilibrium, would have you believe. Market forces, the culmination of decisions by market participants--the consumers, entrepreneur-producers, and resource owners--are continuously effecting change in the market. What should be examined is not a static condition of equilibrium but the dynamic nature of the market process, striving unceasingly toward equilibrium.Decisions are made without perfect knowledge, which means the underlying data, far from being a given for all to use, are elusive and tenuous and available only by discovery and perception. Thus the market process is in essence a continuum of trial and error as new perceptions on the part of participants result in changes in plans and actions.
The driving forces in the market process are the producer-entrepreneurs who see profit opportunities arising from potential improvements in market activities. The process of the market is ongoing because of the relentless search for profit and the resultant alterations in the market effected by competitive producer-entrepreneurs. While other market participants are more or less passive, unaware of or perhaps uninterested in profit-related opportunities, entrepreneur-producers search out and exploit profit potentials. The data they detect and act upon may be erroneous, and the subsequent realization of errors, manifested in monetary losses, provokes further alterations in the market. Once the condition of imperfect knowledge is introduced, price theory and the picture drawn of the market are vastly changed from that of orthodox discussion. The role of entrepreneurial profits and losses will be explored in greater depth in a later section.6
Hayek, Friedrich A., ed. Collectivist Economic Planning. Clifton: N.J.: Kelley, 1975.
———. The Counter-Revolution of Science: Studies on the Abuse of Reason. New York: Free Press, 1952.
———. Individualism and Economic Order. Chicago: The University of Chicago Press, 1948. Particularly the essays "Economics and Knowledge," "The Facts of the Social Sciences," and "The Use of Knowledge in Society."
Kirzner, Israel M. Market Theory and the Price System. New York: Van Nostrand, 1963, pp. 33-44.
Mises, Ludwig von. Human Action: A Treatise on Economics. 3rd rev. ed. Chicago: Henry Regnery Company, 1966, pp. 143-76 and 698-710.
- 1. Ludwig von Mises, "Economic Calculation in the Socialist Commonwealth," paper republished in English in Collectivist Economic Planning, ed. F. A. Hayek (London: G. Routledge & Sons, Ltd., 1935), pp. 87-130.
- 2. Fred M. Taylor, "The Guidance of Production in a Socialist State," American Economic Review, no. 1 (March 1929): 1-8; also Oskar Lange, "On the Economic Theory of Socialism," Review of Economic Studies, IV, nos. 1 and 2 (October 1936): 53-71 and (February 1937): 123-42.
- 3. Austrian theory nonetheless remains steadfast in its contention that economic calculation is impossible in a purely socialist society. Without actual market prices, edicts by central authorities become abysmally inept attempts to simulate market forces and are to no avail. See Ludwig von Mises, Human Action: A Treatise on Economics (Chicago: Henry Regnery Company, 1966), pp. 698-715. The fact that socialist societies today are able to utilize price information emanating from market societies must not be overlooked. Socialist decisions concerning resource allocations do not arise from within a purely and isolated socialist environment.
- 4. F. A. Hayek, "Economics and Knowledge," Individualism and Economic Order (Chicago: University of Chicago Press, 1948), p. 54.
- 5. Hayek, "The Use of Knowledge in Society," p. 82.
- 6. 6. For a penetrating analysis of the market process and its corollary, competitive entrepreneurial activity, see Israel M. Kirzner, Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973).