How to Think about Economic Calculation
[Chapter 7 of Per Bylund's new book How to Think about the Economy: A Primer.]
Money, as we discussed in the previous chapter, makes lots of exchanges possible that are impractical or impossible under barter trade. We are better off as a result. But money has greater implications that are often overlooked or misunderstood. Chief among these is economic calculation, which is the process of determining how scarce resources should be used to produce the most valuable outcomes possible. Economic calculation is a core of any economy.
We can use technological knowledge to maximize a production process’ outcomes, given the inputs and outputs, and to reject inputs that are unsuitable for that type of production. But which input to use, which production process to undertake, which production technologies produce the better (higher-value) outcome, and which outcomes to strive for are fundamentally economic decisions.
For example, technological knowledge can tell us that gold is too soft to use for railroad tracks. But it cannot tell us which harder metal is best—most valuable—to use: iron, steel, or platinum? The answer requires knowing what else those metals can be used for, how valuable those uses are, and how much of each metal is available. Technological knowledge also cannot tell us when, how, or whether to build the railroad. Where should the railroad be built? Should it be built at all or should the resources go to building some other type of infrastructure—or something else altogether? Those are all economic questions—they are based on our calculation of the relative value outcome.
A metal that is far from technologically perfect may actually be the best choice, even if it means laying new rails from time to time. The best solution in terms of technology gives us little to no information on the value outcome of the cost of production. Without economic calculation, an economy is unable to economize on scarce resources.
Money facilitates economic calculation, an essential mechanism in a market economy, by serving as a common unit. In other words, it allows for monetary calculation.
The Nature of a Productive Economy
Economists have long known that productivity is closely related to specialization. We saw in chapter 5 that capital increases productivity and it does so by making labor more productive. We get more out of our labor efforts if we use appropriate tools and machines. Market exchange also makes labor more productive because people can focus on producing the things that create most value regardless of whether they personally value or use them. Instead of people being self-sufficient and producing everything they need for their everyday lives, markets allow them to develop their unique abilities and take advantage of economies of scale—of how average cost falls with higher production volumes—to increase their overall value output.
Specialization, or focusing our time and effort on a narrower set of productive activities, has two main effects.
First, when we specialize, we become better at carrying out specific productive activities. Adam Smith noted that specializing makes us many times more effective and productive because we (1) do not lose time shifting from one task to another, (2) develop and increase dexterity and workmanship, and (3) can more easily identify how to use simple machines or develop new tools to become even more effective.
Smith exemplified this “division of labor” with a pin factory in which the production of a pin takes eighteen distinct operations. In Smith’s example, “a workman … could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty.” But if ten workmen instead specialize in carrying out certain operations, they “could make among them upwards of forty-eight thousand pins in a day.” That’s an enormous difference—specializing increases the output of labor at least twenty-four hundred times.
The difference is not in the tools or operations, which are the same in both cases but in better organization of the production process. Or, specialization allows workers to be much more productive.
Second, when we specialize—and because we specialize—we become dependent on others doing their part of the production process—and they on us. The serial division of labor in a production process creates interdependence: the ten workmen in Smith’s example can produce an enormous number of pins together, but only as long as all of them carry out their tasks. If one worker, who is in the middle of the production process, does not show up for work, this creates a gap in the process. The workers in the earlier operations up to the point where the missing worker’s task begins will be able to do their part, but the workers requiring the input from the missing worker cannot carry out their operations, and so no pins will be produced. For the process to generate any pins at all, all tasks must be carried out. Simply put, the ten specialized workers stand and fall together. If the chain is broken, for whatever reason, they will revert from producing forty-eight thousand pins to a measly two hundred (the max for ten unspecialized workers in Smith’s example).
Such interdependence is risky and might sound like a bad idea, but it is not. Each of these workers has an interest in completing the process; otherwise there would be no pins to sell and no job. (As an unspecialized worker they could make no more than twenty pins each and have a lower standard of living.) So because their specialized productive efforts are interdependent, the workers share an interest in completing the production process.
Smith’s argument is more general and not just limited to factory production. The capital structure itself is the outcome of specialization: a division of resources that facilitates, strengthens, and enhances the division of labor.
When the flatbread baker builds an oven (see chapter 5), he not only increases his productivity as a baker but also develops the knowledge and skill to produce ovens. If there are other bakers interested in using his innovation, our baker could specialize in oven making instead of baking. He could supply other bakers, who can then specialize in producing oven-baked bread. The baker’s role has changed from baking bread to supplying ovens and his livelihood now depends on the availability of the resources needed to produce ovens and then sell them. It is an opportunity to create more value and increase his—and everybody else’s—living standards.
This simple example of the baker shows how a longer production process, through innovations and the resultant intensive division of labor and capital, is adopted because it produces more value. It is more productive than using scarce resources, especially labor, more effectively. The modern economy has extremely long production processes with such narrow specializations that most of us would not be able to survive without the rest of the economy. Think about everything you rely on and use in your daily life but that you did not produce yourself—and probably cannot produce. We depend on a lot of strangers doing their part in production.
On the flip side, an economy could never sustain the many people that live in the world today without specialization. And the smaller population it could support would not have the conveniences and number of goods available to us. Our modern prosperity is the result of the division of labor and capital, which is constantly enhanced and improved through innovation and competition in the market.
The market reduces the risks and potential downsides of interdependence in production and supply chains by influencing parallel production processes—redundancy. When a new and specialized production process earns profits, it will quickly be copied by entrepreneurs eager to share that profit. In other words, if the oven-maker earns high profits from his ovens, others will attempt to do the same. They will develop parallel production structures to capture a share of the market.
With this type of imitative competition, the risk that production will not be completed is greatly diminished. Imagine if the oven-maker had employed several workers to build the ovens through a specialized production process. The success of the whole undertaking depends on all of the workers doing their part. But when others imitate this process to capture some of the profits in the oven industry, they can use and complete a half-finished oven that another entrepreneur could not complete. Thus, failure due to interdependence is of little concern in markets, in contrast to centralized processes.
Is redundancy inefficient? Why have many producers offering the same goods instead of one factory producing on a larger scale? This overlooks the fact that the market is a process (more on this below)—that one firm is not enough to establish all the highly specialized processes. There are two main reasons for this. First, incompleteness: those highly specialized and unique processes would be high-risk because every specialized task would make or break them. It is not obvious that using economies of scale provides more benefits than lacking redundancy which also risks the whole process failing. Second, refinement: innovations in production are never perfect from the beginning but become better through competition, as new entrepreneurs figure out how to improve function. Without the market’s redundancy, we would never get production processes good enough to build economies of scale.
The second point requires some elaboration. Much refinement and progress happen as market competition divides production processes into ever smaller, more specialized tasks and processes. Entrepreneurs constantly try to outdo existing production by innovating and finding better ways of production. They replace parts of the existing processes with more highly specialized subprocesses that are expected to be more productive and could provide a competitive advantage. Entrepreneurs’ profit-driven innovation increasingly subdivides and decentralizes production processes. What used to be specialized parts of a novel production process become standardized capital goods and services traded in the market.
Consider this example. Early on, entrepreneurs implemented new ideas to keep track of and manage production, as well as to increase sales. These ideas expanded into accounting and marketing departments, whose specializations made these tasks more productive. Today accounting and marketing are separate businesses because entrepreneurs discovered that it was more productive to specialize in one or the other and sell these services to businesses as separate entities. This lets producers focus on production, accountants on accounting, and marketers on marketing. They can each specialize in their trade, improve their respective processes, and increase their overall output. It is the same reason that farmers do not build their own tractors, do not develop their own seeds, nor make their own fertilizers and pesticides.
Productive interdependence also comes with a positive social outcome. We noted in the previous discussion that our ability to demand—our purchasing power—comes from producing value for others. As the economy becomes ever more specialized, our personal contribution increasingly depends on the productive contributions of others. And vice versa. This also means that I, in this market setting, must serve others to serve myself, because my ability to demand is based on the value of my supply. Consequently, the more I interact with, learn about, and understand others, the better I can produce what they value most. This applies both to self-employed entrepreneurs, who seek to serve their customers and to employees in large corporations, who are paid wages for how well they serve their employers. Thus, market production is empathic—your ability to provide value for others ultimately determines the value you get in return for your efforts.
This means the market process is not only about production but is a civilizing process: it requires and augments social cooperation for our mutual and common benefit. There are no contradictions in open market production—there is only value and the pursuit of it through empathic production. Competition is in fact cooperation: it is not directed or designed but acted out through the price mechanism. And with it comes a better understanding and respect for other people’s points of view—because this makes us better. Ludwig von Mises was very clear:
Society is the outcome of conscious and purposeful behavior. This does not mean that individuals have concluded contracts by virtue of which they have founded human society. The actions which have brought about social cooperation and daily bring it about anew do not aim at anything else than cooperation and coadjuvancy with others for the attainment of definite singular ends. The total complex of the mutual relations created by such concerted actions is called society. It substitutes collaboration for the—at least conceivable—isolated life of individuals. Society is division of labor and combination of labor. In his capacity as an acting animal man becomes a social animal.1
The economy and society are two sides of the same coin. It is not possible to separate the market process from society and civilization.
The Driving Force
We have referred to the market economy as a process but have not yet discussed what makes it a process.
The market that we interact with and can observe is actually a number of production processes that generate the goods and services we can buy. These processes generate jobs that allow us to earn an income and with that income we can choose to buy goods.
But the market process is not merely the production of goods that is currently underway. Who decides what new goods should be produced? The simple answer is entrepreneurs. They think of new goods and new production processes that they think will benefit consumers and therefore earn them a profit. But entrepreneurs cannot know that what they produce and offer for sale will be fancied—or at what prices consumers are willing to spend. So entrepreneurs speculate—they bet that what they imagine is valuable will be valued by consumers. By doing this, entrepreneurs drive the market process forward. They constantly challenge the status quo in their quest for creating more value.
Entrepreneurs attempt to create new value and drive the evolution of production in the long term. For example, in the year 1900, the production of personal transportation centered around making horses and buggies available. But in the year 2000, it was about manufacturing automobiles. This change is what the market process is: constant change and refinement of what and how it is produced.
Entrepreneurship is the driving force of the market process. The great shift from horse and buggy to automobiles was a matter of entrepreneurial innovation, part of what economist Joseph A. Schumpeter famously called “creative destruction.” The creative aspect of the shift was the appearance of the automobile—a new type of personal transportation offered to consumers. Specifically, it was the introduction of Henry Ford’s Model T—an affordable, mass-produced automobile—that made the new automobiles accessible to so many consumers. People didn’t choose to do away with horses and buggies but rather chose automobiles because they provided more value. Therein lies the “destruction”—the market for horse-and-buggy transportation collapsed because consumers received greater value elsewhere.
To put this in different terms, automobiles provided greater value to consumers than their previously preferred means of transportation. Consequently, the people who had bred and trained horses and built buggies were no longer contributing sufficient value. Their businesses and professions were therefore soon replaced by ones that consumers valued more.
Businesses and professions that had emerged in support of horse-and-buggy transportation either disappeared or had to evolve into the production of other goods. So, today we have only a few stables but there are many iron mines, steel plants, and gas stations to support the automobile.
These shifts toward new value constantly occur in the market. Sometimes we are aware of them because they are swift and affect us personally. But often we are unaware of the changes. The latter is typically the case when major changes occur within production processes but do not affect consumers’ goods. The computer, for example, revolutionized both production processes and how firms operated. Although computers can make a production process more efficient—or completely restructure it—consumers often do not notice the difference in the goods offered in stores. But producers see it as new professions and specializations begin to appear. These new value-creating jobs offer higher wages and new types of careers. There were no computer professionals in 1900, but it was a common and respected career in 2000—and they earned a much higher standard of living than the most skilled carpenters producing top-of-the-line buggies in 1900.
The Production of Value
Entrepreneurs compete with both existing businesses and other entrepreneurs to produce new value for consumers. Entrepreneurs have a more important role. In speculating and betting on new value creation, entrepreneurs provide the means for economic calculation—they determine the money prices of the means of production. This is fundamentally important—it is what makes the economy possible. Without entrepreneurs providing this function, it would be impossible to economize resources and discover new innovative production processes.
To understand this we need to consider what entrepreneurs do. Specifically, we must consider what their actions as a whole mean. As with so many things in the economy, observable phenomena emerge from people’s actions but are not created by any one person. Instead, they are patterns (order) that emerge from people’s actions. To put this differently, if I drive on one side of the road but not on the other, that is no big issue. The same for other drivers. But if all drivers drive on the right-hand side of the road, then this creates an order to traffic (in the aggregate) that is beneficial to all: fewer accidents and faster travel. This order also affects individual drivers’ decisions—it makes more sense to drive on the same side as everybody else, because doing otherwise would be unsafe and highly inefficient.
Similarly, what one entrepreneur does is important and might even be disruptive, as we saw with Henry Ford’s Model T. But disruptive of what? Of the previously existing market order, which is the aggregate of producers’ and consumers actions. Thus, entrepreneurs can individually act in certain ways (the corollary of individually driving on one side of the road) and in the aggregate create an order (right-lane driving) that benefits us all.
Let’s elaborate for clarity. The entrepreneur imagines a new good or process that has not yet been tried. Henry Ford imagined an automobile using assembly line production, Johannes Gutenberg a printing press, and Thomas Edison a light bulb. The entrepreneur is convinced that the new good will bring more value to consumers than existing goods do. He believes that the potential value is so high that consumers will be willing to pay for his new good. In other words, he expects to make a profit.
The entrepreneur’s profit calculation is based on the costs of available resources: salaries for workers, a production facility, materials and machines, electricity, etc. These costs are easy to estimate because the resources are available on the market—their prices have already been determined (this is important, and we’ll come back to it). For resources that are hard to come by, an entrepreneur can estimate how much it will take to outbid other producers. The cost of building a new type of machine can also be estimated because everything that is needed is already available for purchase. Practically all the costs can be estimated in money prices, so an entrepreneur can easily estimate the cost of producing this new good.
Will it be worth it? Will the undertaking generate sufficient profit? To figure this out, the entrepreneur must estimate the new good’s value to consumers. That value gives a rough idea of what prices consumers will be willing to pay and quantity sold at those prices. This price—derived from value—is the basis for an entrepreneur’s decisions for how, when, and where to produce. Expected revenue in money prices constitutes the maximum an entrepreneur would be willing to pay workers, sellers of capital, etc. Subtracting the costs from the expected revenue gives the entrepreneur an idea of a product’s profitability and its expected rate of return. This monetary calculation is possible because both cost and benefit are expressed in money—they can be compared and an outcome, even though it is in part based on guesses and estimates, albeit a predicted one, can be calculated. Based on the expected profit, the entrepreneur can then decide whether the investment is worthwhile. Monetary calculation allows for economizing on the market level!
This may sound obvious, but it is not. Many overlook the fact that it is the value outcome that guides entrepreneurs and informs their choices of how to run the business. Entrepreneurs are motivated by profits, which can be made when consumers value the good. Value is out of the entrepreneur’s hands, in other words, but cost is a choice.
Consider the combined effect of all entrepreneurs making choices about costs based on their best guesses of the value they will provide consumers. They constantly bid for resources and reconsider their costs—in competition with each other. Just like the entrepreneur above, they might have to motivate workers or entice sellers of materials or services by offering a higher price. Even if they already have a business, they still need to choose whether to renew previous contracts, renegotiate them, revise production, etc. These choices and decisions are based on the expected value outcome: for entrepreneurs trying something new, this is their best guess of how much value consumers might see in their goods; for entrepreneurs continuing to produce an existing good, it might be their assumption that things will continue as before (or not!).
Those entrepreneurs who expect to produce more value can bid higher prices for inputs—and will find it easier to get the inputs they want. Those who expect to produce less value cannot afford to buy the most expensive inputs and will need to consider other, likely inferior, ones. This means the most useful and value-contributing resources will be sold at the highest prices and, therefore, be used where they are expected to create most value for consumers. Entrepreneurs thereby indirectly direct resources toward their “best” uses.
The bidding process is not only a way to direct resources to where they are expected to be most valuable, although this is very important. It also determines the market prices of those resources. There are already determined prices that entrepreneurs can use in their profitability calculations. To avoid losses, entrepreneurs will stay away from resources that are too expensive (which is a sign that the market expects someone else to create more value from them) and instead choose more affordable resources that can generate profit.
Thus, entrepreneurs’ competitive bidding directs resources and determines their prices—and by extension which projects should be pursued. Only the projects with the highest expected value can be expected to earn a profit (and will therefore be pursued). An entrepreneur who anticipates creating new value can afford to outbid existing production.2 This is why large corporations have little sway over entrepreneurs. What matters is the expected value contribution, not organizational size.
This curious process of market pricing of the means of production, in which entrepreneurs make decisions based on prices that they are also involved in determining, is what allows a market to use scarce resources rationally—that is economically from the perspective of future value outcome. This process does not create a perfect outcome, which is impossible because production decisions, including what costs to assume, always precede consumers’ valuations. The outcome of any production is uncertain and ultimately depends on what consumers choose to buy. Remember, it is a process—it cannot be maximizing because the outcome is not and cannot be known, but it can be improved.
The uncertainty of the future explains why so many entrepreneurs fail. Without knowing the future, many of them will miscalculate, perhaps overestimate the consumer value of what they set out to produce. Nevertheless failed entrepreneurs make an important contribution because their failure both makes clear to other entrepreneurs what does not work and makes their resources available to other entrepreneurs.
This system works because it is based on private property: entrepreneurs personally gain or lose. If they did not risk losing their own money and property, many of them would be less careful in choosing which costs to bear, and prices would as a result not be rational value estimations. If entrepreneurs did not stand to gain from their uncertain undertakings, they would have little reason to try them—and even less reason to choose their costs wisely.
In sum, the market process rationally distributes scarce resources because entrepreneurs risk their own personal property and therefore do their best to make the right choices. If they fail, they are mercilessly weeded out and have less capital to try again. Those entrepreneurs who are successful, who chose their costs wisely and produced goods that consumers valued highly, are rewarded with profits. This entrepreneurial dynamic creates a “division of intellectual labor” where the best and brightest can try their ideas—and benefit consumers.
Entrepreneurship and Management
The market process, as outlined here, is so much more than what we can observe at any moment. Because it is a process, everything that exists at any given time is the result of what came before—and will be challenged by what will come after. In other words, the firms that exist today are the outcome of the market’s weeding-out process—they “won” the entrepreneurial bidding for resources. Had consumers chosen differently or entrepreneurs had other ideas, there would be other businesses producing other goods.
Similarly, some of the entrepreneurs that are currently in the process of securing funding, starting up their businesses, or experimenting with production processes are creating tomorrow’s businesses. Existing producers will only stay in business if they continue to create value—and create more value than tomorrow’s businesses. This is why existing businesses, even the very big ones, cannot sit back and relax but must innovate. They have a place in the market process only as long as no one else offers consumers more value.
In other words, if we were to analyze the economy and focus only on the businesses that exist, we would miss most of the process! We would not be able to understand why these businesses (and the goods they produce) exist, and we would not understand how or why entrepreneurs with better ideas might soon replace them. Looking only at the status quo—the economy that we can observe in the present—or the changes that have happened in the recent past, we could easily conclude that the economy is a fairly static system that is far from maximizing the use of resources. It would be easy to find inefficiencies and come up with other potential solutions. But this would be an enormous mistake. The market process is primarily about figuring out how to create new value for consumers—it is not about maximizing output in current production.
It is an entrepreneurial process. The status quo is merely the most recent expression of the process—it’s yesterday’s winners before they are replaced by tomorrow’s. The market process is in constant flux and is characterized by renewal and progress.
The market process goes well beyond simple production management. We should want businesses to have good management that streamline production, cut costs, and tweak and improve the goods they produce. But management is what takes place in production after the entrepreneur has been proven right. As Mises put it, the manager is the “junior partner” of the entrepreneur.
Simply put, management solves an entirely different problem than entrepreneurship. It is about maximizing the outcome of a production process (typically in terms of profit). It is a fundamental error to misconstrue the market process as mere production management.