Friday, March 16, 2012

Risk and Uncertainty - An Introduction to Austrian Economics - Thomas C. Taylor

An Introduction to Austrian Economics

Thomas C. Taylor

Economic Calculation

Risk and Uncertainty

There is no precision in economic calculation because of the uncertain future that pervades all activities in the market economy. Predicted future costs and revenues are anticipations on the part of the entrepreneur-producer, who possesses no superhuman ability to know the future. This uncertainty no less affects the retrospective calculation of profit and loss because the most recent calculation of capital is tenuously based on a money equivalence that the future may not uphold. An individual decision maker is unable to know precisely the future preferences of consumers, the future changes in technology, the future plans and actions of other producers, and the infinite number of other external events that will occur in the future. The gathering of empirical data as is done in establishing actuarial tables is not sufficient for the purposes of entrepreneurial activities in the market economy. Actuarial science is predicated on determining classes of homogeneous events. Each class is made up of a large number of past similar events that are subject to a statistical analysis that reveals the percentage of instances in which a given event has transpired. But the preponderance of the entrepreneur's dealings is not with matters of a homogeneous nature. To the extent that he does concern himself with actuarially describable events, he resorts to insurance in order to recognize the probable cost of detrimental happenings. But most of his concerns are of such a comparatively rare nature that the grouping or categorizing of them into classes for the purposes of computing class probabilities is impossible.
Frank Knight developed this idea in distinguishing between risk and uncertainty. [8] Risk is subject to numerical computation based on statistical data pertaining to a large number of similar events that are expected to recur. This is the nature of actuarial probabilities. Uncertainty relates to situations that are unique; each situation is a case in itself as opposed to being a member of a class or large number of homogeneous events or circumstances. Uncertainty is not numerically calculable because of the lack of sufficient past experiences relating to the particular set of circumstances being considered. [9]Comprehensive empirical data are not available in the varied classifications necessary to permit calculating the probability of success for each of the innumerable ventures that are underway. Knight explains the problem this way:
The liability of opinion or estimate to error must be radically distinguished from the probability or chance of either type (a priori and statistical), for there is no possibility of forming in any way groups of instances of sufficient homogeneity to make possible a quantitative determination of true probability. Business decisions, for example, deal with situations which are far too unique, generally speaking, for any sort of statistical tabulation to have any value for guidance. The conception of an objectively measurable probability or chance is simply inapplicable.... [10]
Uncertainty is the overwhelming obstacle that each entrepreneur-producer faces in the market economy, and his attempt to foresee the future is a subjective matter that escapes mathematical equations and formulae. The businessman is not dealing with objects whose behavior is predictable as is a physicist or engineer. The object of the producer's attention are the wants of other people and the plans of other producers; it is not possible to know what changes they will undergo. The unexpected innovations and applied inventions on the part of competing producers have often spelled the downfall of less enterprising businesses. The changeability of customers' preferences and of resource availabilities are persistent problems confronting the producer. The uncertainty is primarily due to the unpredictability of the actions of other people. This is the central theme of the following remarks by Mises:
In the real world acting man is faced with the fact that there are fellow men acting on their own behalf as he himself acts. The necessity to adjust his actions to other people's actions makes him a speculator for whom success and failure depend on his greater or lesser ability to understand the future. Every action is speculation. There is in the course of human events no stability and consequently no safety. [11]
This does not mean that the future is so uncertain that every business action is a gamble or that each situation is so unusual that there exists no basis for planned action. Experience provides an invaluable guide to action. Past prices are the starting point for predicting future prices. However, for the problems of the entrepreneur-producer, experience is too diverse and complex to enable him to quantify the probability of the success of alternative actions. In the market economy there are no fixed relations. The producer's reliance on past experience is necessarily judgmental and qualitative.

The Tenuousness of Economic Calculation

Since all anticipatory economic calculation deals with an uncertain future, all such calculations are tenuous and indefinite. Because no entrepreneur can know the future, errors in anticipations are inevitable, and success or profit comes to those whose foresight is the least erroneous or most nearly correct. Even the capital arising from the results of past events and transactions and used in determining past profits is but an interim level of wealth since its permanence is not assured in an uncertain future. Mises describes the tenuousness of the figures reported in business financial statements:
The main thing in balance sheets and in profit-and-loss statements is the evaluation of assets and liabilities not embodied in cash. All such balances and statements are virtually interim balances and interim statements. They describe as well as possible the state of affairs at an arbitrarily chosen instant while life and action go on and do not stop.... [12]
Monetary calculation may lack preciseness and certainty, but that does not mean it does not fulfill its task of guiding future actions according to a producer's view of what the future want-satisfactions of other people will be. It is not the fault of the system of economic calculation that uncertain calculations exist. They arise necessarily because human action always occurs in the face of an uncertain future. Under a social organization with an extensive division of labor, producers require a means of calculation on the basis of a common denominator. Monetary calculation affords this means, although it is not definite or certain. Resources are directed to those used that the owner deems the most promising and remunerative as indicated by his money calculations. Monetary calculation is possible only in a market economy in which the factors of production can be related to money prices. There can be no monetary calculation in a barter economy or on Robinson Crusoe's island. Even socialist theorists have admitted that the allocation of productive resources in a socialized economy would require the establishment of money prices by the central authorities in order to correct discrepancies between supply and demand.

The Rationalizing Effect of Monetary Calculation

The recognition of the significance of economic calculation has not been restricted to Austrian economists. Max Weber attributed to the tool of monetary calculation or capital accounting the dominant rationalizing influence in the technological development of western capitalism: is one of the fundamental characteristics of an individualistic capitalistic economy that it is rationalized on the basis of rigorous calculation, directed with foresight and caution toward the economic success which is sought in sharp contrast to the hand-to-mouth existence of the peasant, and to the privileged traditionalism of the guild craftsman and of the adventurers' capitalism, oriented to the exploitation of political opportunities and irrational speculation. [13]
The instruments of money and monetary calculation are the means by which versatile and diversified resources can be rationally allocated to the satisfaction of urgent wants. The advances of technology are dependent on the guidance offered by such means. The great advantages of the division of labor could not have been realized without the calculations made possible in common terms by a common medium of exchange and its correlative, money prices. As Mises states: "Economic calculation is the fundamental issue in the comprehension of all problems called economic." [14]
And yet economic calculation is not without its limitations. Those things that cannot be bought and sold are outside the realm of monetary calculation. A man's devotion to good character or to another person may not be subject to compromise at any price. In a society that forbids slavery, human life has no money price. A person may own something that he so cherishes for its beauty or for sentimental reasons that he would not exchange it for any amount of money. Such matters cannot be related to money prices. But the existence of these exceptions does not hinder the effectiveness of money prices in guiding the utilization of the vast amount of goods and services that do not fall outside the pale of market activities.

Coordinative Communication Through Market Prices

In addition to the need for a common denominator for calculation purposes, we have seen that another requirement of social cooperation based on specialization and division of labor and knowledge is for a means by which the multitude of individual plans and actions can be coordinated into a consistent pattern. The interrelationship of specialized activities demands a system of apprising decision makers of changes relevant to their activities. Each decentralized planner cannot make decisions strictly on the basis of his awareness of his immediate surroundings. His decisions need to be harmonized with those of other planners so that the larger economic system operates as smoothly and effectively as possible.
Money prices are the medium through which the communication of necessary information is made to coordinate effectively the actions of individual planners. As Hayek has pointed out, each particular decision maker does not need to know all the facts pertaining to the changes in resource usage. What is relevant to each is "how much more or less urgently wanted are the alternative things he produces or uses." [15] The economic question is always a question of the relative importance of specific things available for the satisfaction of human wants. Each planner does not usually need to know why the relative importance of the things that he uses or produces has changed. What he does need is some indication of the extent to which its relative importance has been altered. The crucial objective of such information is to see that each individual planner acts in the light of changes in the relative importance of the things with which he is concerned. Market prices at any moment reflect the relative importance most recently ascribed at the margin to goods and services exchanged on the market. Thus changes in the relative importance of goods and services are reflected in changes in their money prices.
The coordinating function performed by the price system can be illustrated by assuming a sudden shortage of some resource. Those people who will eventually solve the problem of the shortage do not need to understand its cause. The price of a unit of the resource will be driven upward as those who employ it in the most important usages, i.e., use it for the generation of products promising the highest return, outbid those producers who plan to use it in less remunerative products. The shortage has meant that the marginal uses of the resources that could be supplied before the advent of the shortage cannot be provided for as long as the shortage persists. The higher price successfully causes the curtailment of the employment of the resource in its marginal uses. Hayek has poignantly articulated the role of the price system:
...the marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; that is, they move in the right direction....I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind. Its misfortune is the double one that it is not the product of human design and that the people guided by it usually do not know why they are made to do what they do. [16]
People far removed from the origin of the shortage are thereby led to plan and act in accordance with the fact that the supply of a particular factor of production has diminished. The higher price not only signals for adjustments in the quantities demanded; it also induces a search on the part of suppliers to increase the available supply of the resource. And to the extent this search is successful, the price of the good will fall accordingly, thereby indicating that the good is now available for employment in less remunerative lines. The price system operates in the same way to guide the actions of consumers in their acquisition of consumer goods and services. Hayek's further description of the effectiveness of the price system as a means of communicating information to dispersed decision makers is useful:
...The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned...a system of telecommunications which enables individual producers to watch merely the movement of a few order to adjust their activities to changes of which they may never know more than is reflected in the price movement. [17]
Let us not fail to recognize that the effective operation of the price system can be thwarted by political interferences. Thus, past problems in oil and gasoline stemmed from the refusal on the part of those in power to allow the market system to function openly. The prices set by OPEC and by the Department of Energy were not prices freely set in the open market, and the distortions in supply and the gasoline lines were not the outcome of open-market decisions. Price controls hold prices down at points that cause frustration on the part of buyers, who are misled into thinking their demands at those prices can be met. These same price controls preclude the adequate search by oil producers to discover and market additional supplies of petroleum. Interferences with the price system perpetuate the problem of a "shortage" of fuel.
Money prices simultaneously fulfill the needs for a common denominator for calculation purposes and a process by which the individual decisions of dispersed people can be coordinated. Prices established on the market are coordinative precisely because they are a major factor taken into consideration in the economic calculations underlying the actions taken by various decision makers. Past prices are useful guides to the anticipation of prices expected to exist in the immediate future. Perceptions of opportunities for profitable alterations in economic activities engender actions that influence the eventual configuration of future prices. Through such changes in prices additional information is communicated to other market participants. The knowledge problem is further alleviated as such price signals now reflect the new decisions and induce others to plan their affairs in ways consistent with the new market data. The tendency for separate decisions to be consistent with one another was the natural outcome of establishing a medium of exchange that furnished to everyone a common denominator to be used for their economic calculations. Without a common denominator the need for coordinating the plans of various people would not be so great. The reliance on calculations in kind would significantly restrict the development of specialization and division of labor. Exchanges would be limited to pure barter relations. The rational allocation of scarce resources in a system of fruitful and extensive social cooperation is the great advantage emanating from a market economy and its counterpart, monetary calculation.

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