A Machine That Turns To No Effect
You won't run into economic proofs very often in your life. Here's one:
The Economic Calculation Problem
Let's start with a scenario that keeps statists awake at night, checking under their bed for Walmart demons: because of an unregulated, untaxed free market, one company achieved such tremendous economies of scale and such a tremendous competitive advantage that it has driven out all competition in all areas of production. Basically this company now has a monopoly on every factor of production in the world, they have disregarded the Law of Comparative Advantage by refusing to enter into business agreements with anyone else, and no one can possibly compete with them. This scenario was depicted in the popular animated movie Wall-E. A megacorporation named Buy N Large has used every conceivable economic and political manipulation to control every resource on the planet. We'll discuss at another time whether a free market could produce such an entity.
Quick note: for the purposes of this proof, it does not matter if our company owns all the resources available or that it uses the strong arm of the State to direct all of the resources. The method is irrelevant to the proof. As you are about to see, the fact that there is no exchange in the factors of production is the integral aspect.
Choosing to Produce
Let's pause for a moment and consider the following question: how does a company (or an entrepreneur) decide what to produce and how to produce it? In a market economy, there are literally millions of ways that the factors of production can be combined to produce a good. For example, there are thousands of different types of labor (unskilled, skilled, managerial, robotic, and each of those categories are broad brush strokes) and many different natural resources, different types of capital goods (i.e. machines), land, etc..
To simplfiy, a company has to do two main things when it embarks on a project. First, it must attempt to anticipate future prices for the goods it plans to produce. Second, it has to determine the costs of producing those goods. If the company correctly anticipates future prices, it will profit. If it is wrong, it will fail. We know this. But what if the company had absolutely no idea what the costs of producing a particular product were? How would it know if it made the right product in the right way? What type of feedback would it receive to know that it was heading down the right path or the wrong path? In a normal market economy, company X may produce a good at $2,500 knowing that the cost of production is $1,500 and that it makes a $1,000 profit. But what if it didn't know the cost of production? How would it know that $2,500 marked a success or a failure?
Now let's go back to Buy N Large. In our scenario, they own or direct all the factors of production. There is no exchange. You can't exchange with yourself. Since there is no exchange, there are no prices - certainly not a price system that in any way reflects the value of alternative uses of the factors of production.
Prices arise from exchange. Not only are consumer goods exchanged in a market economy, but producer inputs are exchanged as well. The latter can be grouped into four broad catagories: labor, land, natural resources, and machinery. Each of those categories is a broad aggregation of many hundreds and thousands of categories. The prices of these factors of production is imputed back from the value of the goods that are produced. I can't stress that last sentence enough. If you don't grasp that concept, you can never have a full understanding of how a market economy works. I'd be happy to explain it further in the comment section if you desire.
Know-How, No Matter
So Buy N Large has no costs of production at its disposal. We can assume that it has all the technical and scientific know-how to produce any item. It still won't matter. The question the company has to ask itself and answer is should they produce this good or that good? Should they? And how should they produce it?
Should they produce new computers or new cars? Should they use a robotic plant or a plant that relies on more unskilled labor? Should they close a plant or expand a plant? Should they cease producing an item altogether or double production? It depends. It depends on scarcities of labor, scarcities of related goods, scarcities of other factors. They don't know these things. They can't know. They don't know the value of the alternative uses of their factors of production because they don't have a unitary measure, a price system, that tells them what it costs to produce them!
So there is absolutely no way that Buy N Large can make production decisions that reflect the output of a market economy - the wants and needs of consumers. The result would be total chaos and the destruction of capital. Buy N Large's situation is impossible. Even if they were to be incredibly lucky and they correctly anticipated the value of a good they produced, they wouldn't know if the endeavor was the best use of the factors of production, since they don't know what it cost them to produce it in the first place. Likewise, they have no idea if the good they produced was a flop.
Though the situation I have descirbed is based on fiction, it is exactly the scenario that would play out in an entirely Socialist economy, where one entity: the collective, which is really just a State monopoly, owns every resource.
This proof is the Economic Calculation Problem or Economic Calculation in the Socialist Commonwealth. It proves that a Socialist economy is impossible. The proof was delivered by a student of Carl Menger named Ludwig Von Mises in 1920. For 90 years, it has either been ignored or dismissed by academic economists, who have longed for the day when their State masters will ask them to centrally plan the glorious new world economy.
The Machine That Turns to No Effect
The Soviets had a few methods for dealing with the Economic Calculation problem, and it was by no means ever dismissed in Russia. Their economists had to eventually concede that Mises was right even as Western "intellectuals" were still fawning over Soviet production numbers. The CIA, for example, thought that Russia was an economic powerhouse because of its constantly rising GDP. In the end, all that waste accomplished was turning Russia into "Bangladesh with missiles."
The Soviet production agency, GOSPLAN, attempted to set production targets for the various industries, and then each industry's planner would set targets for each firm. The targets were quantitative measurements, as in x tons of steel, or x tons of nails. If you exceeded the target, you got a bonus. If you failed.... well you didn't want to fail. But you didn't want to succeed by too much either, because your target would be raised and you'd have an even tougher task ahead of you. So it built in a system of mutual lying, where everyone exceeded their targets by just a little bit. Hence the steadily rising Soviet GDP. But, and this is the crucial point, the Soviets had no way of knowing the value of anything they produced. During a famine in the 1980's, silos sat empty and tractors rusted while laborers were stuck in factories... making more tractors. The wheel was turning but to no effect. A popular Russian cartoon joke goes as follows: a Russian nail factory manager is meeting with his central planner. In the backround are a train and a giant nail that takes up the entire train. The factory manager exclaims, "we have met our production target, Comrade!"
Note: a fuller discussion of Soviet calculation would include the bartering between industries, allowing black markets to thrive to help determine costs, copying prices from Western manufacturers, and global exchange of Russian resources - but we'll cut it short here. The Soviet economy was only fully Socialist during the War Communism period under Lenin. After that, it mixed in as much Western pricing as possible and more resembled the Post Office in a Capitalist country rather than a Socialist utopia. Had it remained fully Socialistic, it would have collapsed far sooner than 70 years.
Finally, I'll address some of the criticisms of Mises' proof.
The first people to attack Mises were the German economists of the Historical School. These guys weren't very bright and they rejected theoretical approaches to economic problems. Their solution was that the State could just add all of the factors of production up, without a unitary measure. Mises asked, how can you add tons of steel to thousands of hours of unskilled labor to x square feet of plant space etc etc? You can't add apples and oranges. So Mises dismissed them rather easily. This method ended up being similar to GOSPLAN's approach, but in practice was completely useless, as Mises predicted.
The Marxists came next, claiming that they had a unitary measure: labor hours. We'll just take labor hours as the measure of a good's cost and determine our profits and losses from there. But, Mises said, labor hours is purely semantical. The proper term is labor hours of an engineer, labor hours of a janitor, labor hours of an accountant, etc. There are thousands upon thousands of different types of labor in a market economy, each with their own market, and even within each category of employment you can't say that Engineer X and Engineer Y have the same skills and experience and hence the same market value. Calling it all Labor Hours is a semantic trick and nothing more. Besides, Mises pointed out, in a market economy value does not come from mere work, but from the marginal utility that a good provides to consumers. This is the core discovery of the Marginalist Revolution that refuted Marx's Labor Theory of Value in the first place. So again, Mises smashed this objection.
In the 1930's, Mises' argument was translated to English and the next opposition came from the Neo-Classical school. Their solution was more nuanced, but ultimately just as flawed. They proposed a trial and error method, known as the Lange-Lerner-Taylor solution. The idea would be to leave everyone in place in their current capacity in the market economy, and have the central planners estimate price changes through trial-and-error. If there is a surplus of an item, lower the price. If there is a shortage, raise the price. This child's game, and that is what Mises called it, actually became the Orthodox defense of central planning in American universities until the fall of the Soviet Union temporarily shook the academic world. Mises' objection was very fundamental and insightful (and roundly ignored or dismissed.) Mises said, you are completely ignoring three important facts:
First, as I talked about above, prices are imputed back. Just because there is a shortage in laptop computers, that doesn't tell the central planner the best way to produce them at a lower the cost or whether lowering the cost or producing them at all is the best use of resources. You still don't have any costs of production to measure the alternative uses.
Second, even if you could collect and process the level of shortages and surpluses throughout the entire market economy (consider that in an American grocery store alone there 70,000 products on average), using super computers to calculate all of these factors, and imputing all of these values back to the producer goods, you are missing a key point. Many plants and machines in existence today shouldn't be in existence. How do you account for capital depreciation, and the current wasteful production processes that would otherwise be replaced when the market no longer values those resources.
And finally, these economists fail to understand the impact of the entrepreneur in a market economy. The best way to explain this is through an example. In the early 1980's, IBM had the technology to produce personal computers. At the time, their CEO said we're not going to do it because we don't think businesses will use them. They are just going to be a game platform for bored rich consumers. They were clearly wrong. Steve Jobs disagreed, manufactured the Mac, then Microsoft came in, and the rest is history. Imagine Steve Jobs trying to explain to a central planner why the factors of production in his plant should be used to produce a technology that no one is certain will be useful. And imagine the plant manager and the planners trying to determine if the costs of production justify the demand they discovered if they actually went through with it.
Yet, thse objections were ignored. To this day, every country, including the United States, engages in some level of central planning. Every country employs central planning of the money supply. Mises himself was barred from teaching in America, land of the free and the greatest market economy of his day, because of his economic theory. Central planning continues to charm the ruling class despite Mises' work.
So I hope this post enlightened you and stimulates thought for your weekend. I'd be happy to engage any questions or objections in the comment section.
Have a great weekend!
David in Qatar
(p.s. a debt of gratitude is owed to Professor Joseph Salerno for his excellent explanation of economic calculation at Mises U 2009.)
Sources and some further reading:
Economic Calculation in the Socialist Economy by Ludwig Von Mises
The End of Socialism and the Calculation Debate Revisited by Murray N. Rothbard
Intellectuals and Socialism by F.A. Hayek
An Interview with Yuri Maltsev by LvMI
The Decline and Fall of Gorbachev and the Soviet State by Yuri Maltsev
Why A Socialist Economy is Impossible by Joseph Salerno