Power & Market

# Explaining the Economic Calculation Problem in a Principles Class

Jim Cox

A microeconomics principles class presents professors with the opportunity to at least briefly explain the economic calculation problem. Almost every text spends a page or two on the production function — the relationship between inputs and outputs by a firm.

Here is the relevant data and graphs from one such text.

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The professor can ask the students, “at what output should the firm produce?”— which is a central issue in microeconomics. Looking at the figures and the graphs the students will likely answer, “at the peak of Total Product”, or “at the highest Marginal Product”, or “at the highest Average Product”.

None of these responses is correct, as there is no rational way to answer based on the limited information given. There is no rational way to answer because the data only include quantities of inputs and quantities of outputs. There is no value in the form of prices attached to either the inputs or the outputs. Until the prices of these are included there is no answer.

Here’s an example to illustrate this point:

If the outputs are valued by consumers in the market at a price of \$1.00 while each input costs the firm \$100.00 it is obvious that to produce any of these outputs would be a financial disaster for the firm in the way of major losses (and thus the firm will be destroying value in the world). Conversely, if the consumers in the market value the outputs at a price of \$50 each and the input costs are \$2 for each, the firm can make major profits (and thus the firm can be adding value in the world).

Socialists had proposed abolishing both money and prices leaving them in the same position as our students in trying to determine which output quantity would be best. Pointing this out allows the professor to recount Ludwig von Mises’s highlighting this problem in his 1920 article, “Economic Calculation in the Socialist Commonwealth“ and the resulting debate over the issue in the 1920s through the 1930s.

While Mises — and Hayek who also participated in this debate — maintained their views, the socialist critics retired from the debate self-satisfied that they had answered the challenge by claiming that the socialist authorities could direct the managers to adjust production by simulating markets, that is non-existent markets! They would just be “playing market”.

As Mises pointed out, even the best intentioned socialist manager would be lost in trying to discover just what the best output would be.

I also like to make the point in my classes that playing market with assets one does not own is far removed from risking personal assets one does own! When one owns the assets, such decisions will have a major impact on the owner’s personal financial well-being.

(By the way, I have never in my many years of teaching principles classes seen a text that raises the economic calculation issue at all.)