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Austrian Economic Perspectives

The Impossibility of Economic Calculation under Socialism

Austrian School of Economics Fundamentals

The Impossibility of Economic Calculation under Socialism

  • The Impossibility of Economic Calculation under Socialism
  • The Economic Calculation Debate
  • Explaining the Impossibility of Economic Calculation
  • The Austrian Perspective and the Failures of Other Schools of Economics
  • The Austrian Business Cycle Theory as a Specific Case of the Impossibility of Economic Calculation under Socialism
  • Conclusion
“Where there are no market prices for the factors of production because they are neither bought nor sold, it is impossible to resort to calculation in planning future action and in determining the result of past action. A socialist management of production would simply not know whether or not what it plans and executes is the most appropriate means to attain the ends sought. It will operate in the dark, as it were. It will squander the scarce factors of production both material and human (labour). Chaos and poverty for all will unavoidably result” Ludwig von Mises, Planned Chaos

The Impossibility of Economic Calculation under Socialism

Despite the repeated failures of Marxist regimes over the last century, the economic calculation debate remains pertinent for two significant reasons:
  1. Comparable ideas are still advocated by progressives and other interventionists.
  2. Price-fixing, whether in capital markets through the actions of central bankers or in other markets through state-owned enterprises, decrees, and the intervention of regulatory committees, continues to be prevalent.

The Economic Calculation Debate

This debate was initially ignited by one of the most influential economic papers of the 20th century, "Economic Calculation in a Socialist Commonwealth," authored by Ludwig von Mises and published in 1920. During that era, socialism was on the rise, with the Bolsheviks seizing power in Russia, socialists taking office in the Weimar Republic (Germany), and socialist and communist parties gaining prominence across Europe.
Before Mises's article, debates on socialism and capitalism primarily revolved around moral arguments and the incentive problem. Even if one assumed that a society organized around the Marxist principle of "from each according to his ability, to each according to his needs" was morally superior, the practical question of "who will take out the garbage" still needed to be addressed. The common response was that socialism would produce individuals devoid of capitalist instincts, willingly serving their peers even in the absence of monetary incentives.
With his article, Mises introduced a new dimension to the debate. Setting aside utopian notions about the ability of a political economy to create a "new man," the Austrian economist pointed out that rational economic organization was impossible without prices for the intermediate factors of production. Even today, his argument remains poorly understood by his critics, and even by some liberal economists. Thus, it is worth explaining it in greater detail.

Explaining the Impossibility of Economic Calculation

Most misconceptions about Mises's arguments arise from a misunderstanding of the roles played by managerial and entrepreneurial classes in a capitalist economy. Mises never dismissed the ability of managers to devise efficient production plans within their own operations. Instead, he emphasized the significance of entrepreneurs and shareholders, who, as owners of the means of production, allocate capital across different industries, thereby forming prices that serve as inputs in the economic calculations of managers.
Without markets for capital and money, it becomes impossible to rationalize the use of resources across industries. This means that even if there is perfect organization within each firm or subpart of the economy, the entire economy cannot efficiently adjust to changes in resource availability, production conditions, and consumer preferences. In Mises's words:
"[...] the cardinal fallacy implied in [market socialist] proposals is that they look at the economic problem from the perspective of the subaltern clerk whose intellectual horizon does not extend beyond subordinate tasks. They consider the structure of industrial production and the allocation of capital to the various branches and production aggregates as rigid and do not take into account the necessity of altering this structure to adjust it to changes in conditions.... They fail to realize that the operations of corporate officers consist merely in the loyal execution of the tasks entrusted to them by their bosses, the shareholders.... The operations of managers, their buying and selling, are only a small segment of the totality of market operations. The market of the capitalist society also performs those operations which allocate the capital goods to the various branches of industry. The entrepreneurs and capitalists establish corporations and other firms, enlarge or reduce their size, dissolve them, or merge them with other enterprises; they buy and sell the shares and bonds of already existing and new corporations; they grant, withdraw, and recover credits; in short, they perform all those acts, the totality of which is called the capital and money market. It is these financial transactions of promoters and speculators that direct production into those channels in which it satisfies the most urgent wants of the consumers in the best possible way." Mises, Human Action, pp. 703-04
In essence, Mises argues that property rights, which place capital owners in a context of profits and losses, motivate them to allocate their resources to industries that are currently most in need of resources to satisfy consumer demands. When they succeed, they profit, but when they fail, they incur financial losses. Their "skin in the game" encourages them to speculate about the best allocation of capital for the current state of the economy. This creates a market-driven dynamic where the collective outcomes of their actions produce vital information about the most efficient use of resources.
Prior chapters have explained that values are subjective, economic actions reveal opportunity costs, and consumer prices express an ordinal hierarchy of consumer wants. Entrepreneurs compete for factors of production to construct production structures that maximize revenues over costs, satisfying consumer desires more effectively than alternative options. Therefore, prices of factors of production are derived from consumer prices: if a factor of production can generate greater monetary revenue (better satisfying consumer wants) in another industry or under a different plan, entrepreneurs will outbid its current owner, raising its price to its marginal productivity. This competition among entrepreneurs for factors of production, determining their highest marginal yield, is a process that generates relevant information about resource allocation.
This process is crucial because it validates or invalidates the efficiency of various activities, ensuring that factors of production are allocated to their most productive uses. The market performs this function as a continuous process. In a constantly changing world—where consumer preferences, production conditions, technology, regulations, demographics, and more are in flux—prices for intermediate factors of production continually change through the actions of entrepreneurs and capitalists adapting to shifting conditions. Since these changes are localized, information must be disseminated to economic agents who cannot possess complete knowledge of the entire world. This is the role of the market: it allows entrepreneurs to act on localized, often qualitative, and complex information by proposing economic production structures that are then validated or invalidated by the market. In this way, pertinent information generated by this bottom-up process is condensed and distributed throughout the entire economy via the price system. This process of information production and distribution is essential for resource allocation because it enables economic agents, who have limited knowledge of the world, to make economic calculations and devise coherent economic plans by relying on prices.
From this perspective, a centrally planned economy will inevitably experience capital misallocation. In the short to medium term, such misallocations might go unnoticed because there are no market prices or bankruptcies to reveal them. However, due to the absence of feedback (prices) and reallocation mechanisms (bankruptcies), errors will accumulate until the wastefulness becomes apparent through a significant decline in living conditions.

The Austrian Perspective and the Failures of Other Schools of Economics

One could argue that painting such a panorama in hindsight is easy. After all, we are all aware of the empty shelves in the USSR, Venezuela's hardships, and the humanitarian catastrophe in Cambodia. But Mises foresaw these events as early as 1920. Yet, until the collapse of the USSR in 1989, many economists, including numerous Nobel laureates, were praising the Soviet economic miracle and predicting that the Soviet economy would soon surpass that of the USA.
Despite this impressive forecasting and numerous empirical demonstrations of the impossibility of economic calculation under socialism, political leaders worldwide are more eager than ever to set prices, nationalize entire industries, and propose five-year plans, often applauded by economically uninformed populations. The consequences of such interventionism are acutely felt by people in formerly prosperous Western countries who are slowly witnessing the decline of their living standards.

The Austrian Business Cycle Theory as a Specific Case of the Impossibility of Economic Calculation under Socialism

In a previous chapter, we elucidated the dynamics of overinvestment and capital misallocation resulting from interest rate manipulation by central banks. Essentially, what we explained can be viewed as a specific case of the impossibility of economic calculation under socialism, applied to the realm of money markets. When prices are fixed outside their market values, entrepreneurs and capital allocators are incentivized to engage in investments that cannot be sustained in the long term due to a lack of savings. By interfering with the price system, central planners (in this case, central bankers) create a miscoordination between economic agents. In this instance, the intertemporal miscoordination entails overinvestment in higher-order investment goods and underinvestment in lower-order investment goods, which represents a specific manifestation of capital misallocation across industries.
The consequences of such misallocation include financial and economic crises, reduced economic activity, and debt deflation. These macroeconomic effects stem from an imbalance between savings and investments resulting from credit expansion. In the USSR and other communist regimes, price fixing led to similar miscoordination, resulting in shortages of some goods and overproduction of others. In both cases, prices fail to reflect the true preferences of consumers, whether in terms of time preferences or consumption preferences, leading entrepreneurs or central planners responsible for resource allocation to invest capital in the "wrong industries."
Today, the economic calculation debate resurfaces primarily in discussions about energy, where malinvestments driven by a green agenda are becoming increasingly evident. It also arises in discussions about money markets, with Austrian economists pointing out that the 2008 crisis, which mainstream economists failed to predict, was a classic boom and bust cycle characterized by overinvestment in the housing market due to prolonged periods of low interest rates. Furthermore, neo-Marxists and other socialist factions propagate the notion that the emergence of AI could resolve the economic calculation problem. However, this perspective stems from a flawed understanding of the issue; the economic calculation problem is not a matter of computing power but rather a matter of generating and distributing information related to production and resource allocation. This information can only be generated locally by agents with specialized knowledge and a vested interest in the outcome. AI cannot replace this bottom-up process and, therefore, cannot help central planners address the resource allocation problem. Unfortunately, due to a century of misunderstanding, we anticipate a proliferation of claims that AI will usher in a new era of economic prosperity led by enlightened central planners who, with the aid of AI, can correct the failures of free markets.
For a concrete application of the problem of economic calculation to a contemporary situation, you may refer to this article addressing the allocation of resources in modern China: The Road to Financial Repression: China the Paper Tiger, by Théo Mogenet.

Conclusion

In this final chapter, we have explored the impossibility of economic calculation under socialism, a central tenet of the Austrian school of economics. The Austrian perspective presented in this course culminates in this conclusion and provides a strong case for non-interventionist policies. At its core, all Austrian thinking revolves around the importance of prices in economic coordination. By emphasizing the significance of opportunity costs and economic calculation for rational resource utilization, Austrian economists demonstrate the complexity and subtlety of human action in an ever-changing world.
Mainstream economists and central planners often dislike Austrian economists because they highlight the uncertainty of the future, the fallacy of quantitative economic prediction, and the detrimental effects of economic intervention. In short, Austrian economics underscore the ineffectiveness and harmful consequences of interventionist actions.
The Austrian tradition embodies a humble approach to human action, drawing profound implications from the concepts of subjective value, uncertainty, free will, and complexity. It explains how the market order, despite not being a product of human design, stands as the central institution for our development and prosperity. If there's one key takeaway from this course, it is that capitalism became the dominant economic system because of its ability to adapt to change in a dynamic and uncertain world populated by free individuals.
Quiz
Quiz1/5
Why do mainstream economists and central planners often dislike Austrian economists?