Economic Calculation The Role of the Price System

An Introduction to Austrian Economics

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Thomas C. Taylor

3.
Economic Calculation

The Role of the Price System

It has been shown that the essence of social cooperation is specialization and the division of both labor and knowledge. This fact has two significant implications for the purposes of this study. The first is that social cooperation results in the production of such a wide range of intermediate and final products that calculations in kind will not allocate scarce resources effectively. A common denominator is indispensable. The second is that the concomitance of decentralized decision-making and social cooperation requires a means of coordinating individual plans that are based upon imperfect knowledge and information. These two requirements are fulfilled simultaneously through the price system of the market economy. Detailed treatment of the workings of the price system will be postponed until later. At this point it will be sufficient to discuss the price system in general terms in order to demonstrate its dual function as a means of economic calculation and as a means of coordinative communication. Actually, as will be shown, these two functions are really of a piece; that is, they relate the same problem of resource allocation under an arrangement of social cooperation and a system of market prices.

Economic Calculation vs. Technological Calculation

Economic calculation is not a technological problem. Technology can establish quantitatively the causal relations between a particular set of external things that can be used in various combinations to produce a particular result. The nature of technological calculation is that 6a + 4b + 3c + ...xn will likely create the result 8p. But technology cannot say whether the resulting 8p is the most desirable use of those particular quantities of resources a, b, c, etc., as compared with their possible alternative uses as means to the production of other ends. By the same token, technology is not able to say whether that particular formula for the production of 8p is the preferable one when 8p is also producible by means of other formulae or combinations of different resources. Mises has illustrated the problem as follows:

The art of engineering can establish how a bridge must be built in order to span a river at a given point and to carry definite loads. But it cannot answer the question whether or not the construction of such a bridge would withdraw material factors of production and labor from an employment in which they could satisfy needs more urgently felt. It cannot tell whether or not the bridge should be built at all, where it should be built, what capacity for bearing burdens it should have, and which of the many possibilities for its construction should be chosen. [1]

Max Weber made the same point in the following statement:

The question of what, in comparative terms, is the cost of the use of the various possible technical means for a single technical end depends in the last analysis on their potential usefulness as a means to other ends. [2]

Technical calculations can only be calculations in kind. They are not sufficient for human decisions and actions because they are devoid of any preferential quality. The ivory-tower theorist may be right in claiming that an excellent tunnel can be built of platinum. But monetary calculation makes the issue an economic one, and the practical engineer is thereby discouraged from disembarking upon such a scheme as long as platinum has uses deemed more important than the construction of tunnels. Technology is neutral to human valuation; it has nothing to say about the subjective use-value of the various objective uses for resources. As Mises has said, "It ignores the economic problem: to employ the available means in such a way that no want more urgently felt should remain unsatisfied because the means suitable for its attainment were employed--wasted--for the attainment of a want less urgently felt. [3]

Subjectivity of Value

The task of resource allocation is to satisfy urgently felt human wants, and therefore resources must be devoted to their most important employments. Yet the question must be raised as to how these most important wants or usages are to be determined. It would appear that some means of measuring the value of things is necessary to make these determinations, but this is not the case. There is no such thing as a measuring unit of value, and this fact means that measuring the value of a thing is impossible. Value is a subjective phenomenon that eludes cardinal quantification. A thing's value is in the mind of the person who is doing the valuing, and this process of evaluating is not a matter of measurement. Because valuation is always a matter of individual preference, ordinal numbers are the only type of numerical treatment that can be accorded the problem of valuation. This is the subjective theory of value which did not enter economic science until Menger, Jevons, and Walras introduced it in their analysis around 1871. Until that time, economists had searched for a source of value for all goods as if value were intrinsic in each good.

The problem of value measurement is indicated by the fact that not only do different people often value the same thing differently, but the same person might value a certain thing differently at different times. And under the operation of the law of diminishing marginal utility, a person will always value each additional unit of a given good less than the prior unit's value. If value were quantifiable and measurable, there would exist a standard unit of measure that would be unchanging. It is clear that there is no such immutable unit of measure of the value of a good when different people at the same time and the same person at different times often have divergent valuations of the same good.

Valuation necessarily is manifested in the act of choosing or preferring. One is able to say he values A more than either B or C, but he is unable to say quantifiably how much more he prefers A over B or C. He may qualitatively indicate that his preference of A over B is far more intense than his preference of A over C. In that case, he would be ranking his preferences from first to last in the order of A, C, and B. But this ranking is strictly an ordinal, and not a cardinal, use of numbers. The allocation of scarce resources cannot be based upon any alleged method of measuring their values; employment of particular increments of resources can be decided only through ranking one incremental choice over alternative incremental uses of the same or different resources. Resources, since they are means to consumer goods, derive their ranking from the relative importance of their ultimate products. A more detailed look at the subjective theory of value is presented in chapter 3.

Economic Calculation Through Money Prices

It is through the pricing process of the market that the relative importance of the various resources and consumer goods is translated into common terms in the form of money prices. Money enables people to make economic calculations because it is the common medium of exchange. All goods and services that are bought and sold on the market are exchanged for sums of money. These money prices are not measurements of value. Money prices are exchange ratios that are expressive of the ranking of the valuations placed upon increments of goods at a given moment by the participants in market exchanges. Money prices are subject to continuous change because of the changeability of people's subjective valuations and because of changes in the supply of the particular goods and services. The propensity of humans to conceive of changes they deem improvements in their ways of doing things and in the means of attaining satisfaction prevents the emergence of permanently stable prices in the market economy.

Economic or monetary calculation is essentially a matter of providing a comparison between input and output, between sacrifice and result, for past or contemplated lines of resource utilization. It has been shown that calculations in kind, which must necessarily characterize technological computations, will not suffice for the task of economic allocations. Money prices related to particular quantities of goods and services permit the determination of money costs and money revenues, thereby shedding light on the desirability of specific resource employments.

Economic calculation includes both retrospective and prospective monetary calculations. Retrospective calculation is the determination of past monetary profit or loss, i.e., income, resulting from actions already taken and serves two purposes: (1) to the extent that the past is assumed to be indicative of the future, it has instructive value, and (2) the determination of monetary income reveals the extent to which the future capacity to produce can be maintained after current income is withdrawn. The latter function derives from the complementary concepts of capital and income, the ultimate mental tools of economic calculation, which are discussed in the next section. Prospective calculation, which might well be influenced by retrospective calculations of capital and income, is a matter of anticipating the money profit or loss expected to result from specific actions being contemplated. Note that all economic calculation deals with the future. As all action is meant to cause a beneficial change, all action is directed to the future, whether to the next hour, day, year, or longer. Every step along the path of resource utilization has a prospective orientation.

The Concepts of Capital and Income

The essence of modern economic activities is the devotion of resources to the process of production leading to the output of consumer goods and services. The entrepreneur-producer invests funds to acquire productive means by which he hopes to increase his monetary wealth. Through money prices the producer is able to ascertain numerically the economic significance of the factors employed for future production. The determinable amount of money equivalent devoted toward productive activities is called capital, and the aim to keep at least this amount intact is called capital maintenance. Mises defines capital in the following way:

Capital is the sum of the money equivalent of all assets minus the sum of the money equivalent of all liabilities as dedicated at a definite date to the conduct of the operations of a definite business unit. It does not matter in what these assets may consist, whether they are pieces of land, buildings, equipment, tools of any kind and order, claims, receivables, cash or whatever. [4]

When productive efforts result in net assets whose money equivalent exceeds the capital devoted to such efforts, the business unit is said to have earned an income equal to that excess. The concept of income is the correlative of the concept of capital. Income is the amount that can be consumed without lowering the capital below the sum of the amount dedicated to the business at the start of a given period and any additional investments paid in during that period. If consumption is restricted to the amount of income, capital is maintained. If, on the other hand, consumption exceeds income, capital is not maintained; this difference is referred to as capital consumption. Capital accumulation takes place when consumption is less than the available income, that is, when a portion or all of income is saved. If the business fails to earn income and instead suffers a monetary loss, there is capital consumption, and capital it not maintained unless new funds are invested by the producer. Additional investments, in combination with income and consumption effects, make for either capital maintenance, capital accumulation, or a reduction in capital consumption. As Mises states, "Among the main tasks of economic calculation are those of establishing the magnitudes of income, saving, and capital consumption."

Although capital may be embodied in produced factors of production (often called capital goods), the idea of capital refers to a concept existing only in the minds of individuals. Man is mentally aware of the monetary significance of the means to which he resorts for productive purposes. This concept is an element in economic calculation and provides a basis for appraising the results of future actions and for ordering subsequent steps of consumption and production through capital maintenance. The concrete capital goods are doomed to eventual dissipation; it is only the value of the capital fund that can be constantly preserved or maintained through a proper arrangement of consumption. [5]

The establishment of the outcome of past actions involves the calculation of capital both prior to and after the actions. The comparison of these two calculations yields the determination of profit (income) or loss. This retrospective form of economic calculation provides a starting point in the planning of future actions to the extent that the actor deems the past an indicator of future developments. This point illustrates how the knowledge problem previously discussed is partly resolved.

In addition to serving instructive aims, the determination of profit or loss resulting from past actions provides the only means by which the actor or actors can ascertain whether or not the capacity of the business unit to produce in the future has been impaired. Like anyone else, producers are interested in attaining the satisfaction of their personal wants, and the calculation of profit or loss reveals the extent to which they can enjoy consumption expenditures without encroaching on the capital base necessary to continue productive operations at a level comparable to that of the past. This calculation may show that additional investment is required in order to offset the dissipation of capital as a result of unprofitable operations or to achieve desired capital accumulation. And the most recent determination of capital affords a point of comparison for the calculation of profit or loss resulting from actions taken in the succeeding period. Thus retrospective economic calculation is significant only because it facilitates the planning of future actions; without this use it would be merely dead history.

Every productive undertaking is guided by the calculation of anticipated future costs and proceeds expected to result from the project or activity. The determination of past revenues and costs may be of substantial assistance in the projection of these results. For most entrepreneur-producers, only those actions will be pursued that promise a monetary output that sufficiently exceeds the expected monetary input, including capital dissipation, necessary to carry them out. [6] Resources then are directed into their most profitable uses by means of anticipatory calculations built on expected prices for various goods and services. Mises has made clear the overriding significance of monetary calculation:

Monetary calculation is the guiding star of action under the social system of division of labor. It is the compass of the man embarking upon production, He calculates in order to distinguish to remunerative lines of production from the unprofitable ones, those of which the sovereign consumers are likely to approve from those of which they are likely to disapprove. Every single step of entrepreneurial activities is subject to scrutiny by monetary calculation. The premeditation of planned action becomes commercial precalculation of expected costs and expected proceeds. The retrospective establishment of the outcome of past action becomes accounting of profit and loss. [7]

It warrants reiteration at this point that economic or monetary calculation is not a process of measurement. Monetary numbers provide no standard unit of value. The infinite possible uses of productive resources dictate that choices or preferences, not value measurement, characterize the nature of the economic problem. Monetary calculations, through past and anticipated market prices, indicate preferences or the relative importance of alternative undertakings.

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