Mises Wire

Economic Calculation Is Nonbinary

One of Ludwig von Mises’s important contributions to economics was demonstrating the impossibility of economic calculation under socialism. He did it by showing three necessary preconditions for the generation of meaningful market prices in the factors of production—private property, freedom of exchange, and sound money. Since socialism would, by definition, socialize the factors of production, there would be no nonarbitrary and meaningful way to calculate the prices of various factors of production, the costs of alternative plans in money prices, and expected future profits of a given plan minus the costs.

In short, when factors of production—producer goods (tools, machines, etc.)—are privately owned, there is freedom to trade property. When the economy has advanced to using money, which allows for calculating everything in market prices, entrepreneurs can compare costs of plans. For example, imagine two alternative plans to achieve the same end (e.g., building a railroad track around a mountain):

Plan A: one stock of input costs in market prices subtracted from expected future profit

Plan B: a second stock of input costs in market prices subtracted from expected future profit

Economic calculation enables entrepreneurs to choose between alternative plans because they can evaluate these plans in money prices. Entrepreneurs can evaluate the costs based on the prices of what goes into producing a consumer good or service. The entrepreneurs hope to sell the final product or service to the consumer at a price greater than the combined prices of all the input costs to make the product.

Ultimately, the consumer decides to accept or reject the goods or service at a given price (so the costs do not determine the prices). Based on the decisions of the consumers, the entrepreneurs either realize a profit or a loss.

As a simple example, imagine no one had ever invented cake before. An entrepreneur first imagines a new consumer good to produce—chocolate cake. This is a new recipe. In fact, the term “recipe” is completely appropriate because Murray Rothbard employed it in Man, Economy, and State to discuss the technological idea or plan to arrange resources into something new:

Without such plans or ideas, there would be no action. These plans may be called recipes; they are ideas of recipes that the actor uses to arrive at his goal. A recipe must be present at each stage of each production process from which the actor proceeds to a later stage. The actor must have a recipe for transforming iron into steel, wheat into flour, bread and ham into sandwiches, etc.

Our entrepreneur, with his new recipe for never-before-invented chocolate cake, must use the available factors and resources to produce the chocolate cake before he offers it to the consumers. All actions have costs—the foregone alternatives of a given action, or whatever is given up when a choice is made. These include time, energy, labor, and resources. Additionally, costs to the entrepreneur include what he might pay in money prices for factors of production. For example, he may purchase flour, milk, sugar, eggs, and other ingredients, as well as the use of tools like an oven and all the tools that come with a kitchen. He may even have costs in money prices by paying for labor.

All that said, with private property, freedom of exchange, and sound money, this entrepreneur can calculate the costs of these various resources in money prices and subtract the total from the future expected profit. (It would be a common fallacy, however, to conclude that costs determine prices, because it is the exact opposite.) The entrepreneur may also compare and contrast various costs of plans in money prices for how to make the cake.

Finally, the cake is offered to the consumer, who either accepts or rejects the cake depending on preference (the consumer subjectively may not even like chocolate cake) or on a given price point. The entrepreneur either realizes a profit or a loss.

Mises demonstrated that, under socialism, the factors of production would come under the ownership of the state. There would be no private property in the factors of production. Therefore, there would be no generation of meaningful market prices. Not only would this be the case under socialism, but it would also be the case if a market somehow moved toward one big firm. (For further illustration of the calculation problem, here is the best video that I have ever seen demonstrating it.) Thus, Mises demonstrated that economic calculation is impossible under socialism.

All that said, we can now return to the main point of the article—economic calculation is nonbinary.

When Mises described the necessary preconditions for economic calculation, it is easy to misunderstand his argument to mean that economic calculation is a binary either/or situation, an all or nothing choice. In other words, we might assume either an economy has the preconditions for economic calculation or it does not. Therefore, either unhampered calculation happens, or it cannot happen whatsoever. I believe to take Mises’s argument in this direction would be a bifurcation fallacy. It is instead a matter of degree depending on the presence or absence of intervention and distortion in the preconditions.

If we ask a simple question, we can see the issue with understanding economic calculation as a binary: Does the United States today possess the three preconditions for economic calculation (i.e., private property, freedom of exchange, and sound money)?

Thinking carefully, one would have to answer with some hesitation. This is sort of like when the reverend from The Simpsons answered that the short answer was a yes with an “if” but the long answer was a no with a “but.” The problem is that the question above concerning economic calculation is not a yes or no question; it is a matter of degree.

The modern United States has or has had these three preconditions imperfectly throughout time, but there have also been interventions that have caused distortions in private property, freedom of exchange, and sound money. Mises’s point, stated even more strongly by Rothbard, was that every intervention into the market necessarily impacts economic calculation because it creates distortions. Rothbard called this “calculational chaos” in Power and Market. Rothbard writes:

For each governmental firm introduces its own island of chaos into the economy; there is no need to wait for socialism for chaos to begin its work. No government enterprise can ever determine prices or costs or allocate factors or funds in a rational, welfare-maximizing manner. No government enterprise can be established on a “business basis” even if the desire were present. Thus, any government operation injects a point of chaos into the economy; and since all markets are interconnected in the economy, every governmental activity disrupts and distorts pricing, the allocation of factors, consumption/investment ratios, etc. Every government enterprise not only lowers the social utilities of the consumers by forcing the allocation of funds to ends other than those desired by the public; it also lowers the utility of everyone (including, perhaps, the utilities of government officials) by distorting the market and spreading calculational chaos. The greater the extent of government ownership, of course, the more pronounced will this impact become.

Note Rothbard’s discussion in matters of degree. This is extremely relevant for “mixed economies” because it entails that distortions of economic calculation do not just happen in socialist countries but occur whenever there are nonmarket distortions of private property, freedom of exchange, and sound money.

Hence, for example, when governments and central banks engage in the inflationary expansion of money and credit, this introduces what Mises called misleading calculations that lead to boom-bust cycles. We do not have to wait for socialism to experience calculational chaos because the distortions that result from interventions are not binary. They are present or absent as a matter of degree. All interventions will introduce what Rothbard called “islands of calculational chaos.”

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