Consumer Information and the Calculation Debate
Government Cannot Determine the Most Appropriate Amount of Information
DECEMBER 01, 1996 by E.C. PASOUR
Filed Under : Socialism, Regulation, Government Intervention, Central Planning, Free Markets, Knowledge Problem, Market Failure, Ludwig von Mises, Collectivism, F. A. Hayek, Socialist Calculation Debate
Dr. Pasour is professor of agricultural and resource economics at North Carolina State University, Raleigh.
Government intervention has been common throughout the world over the past half century, whatever the type of political and economic system. In socialist countries such as the former Soviet Union and its satellites, government assumed primary responsibility for all economic activity, making major decisions about what and how to produce. Piecemeal regulation is widespread even in the United States and other democratic societies. Heavily regulated areas include agriculture, education, employment, medicine and health care, and the environment.
Market failure is the stated rationale for the pervasive role of government in piecemeal regulation. In this view, the unfettered market economy is unrivaled in its ability to produce goods and services for private consumption but falls short in producing things for the common good. Thus, according to conventional wisdom, government should intervene to improve consumer information and to cope with other problems, including pollution, monopoly, poverty, and unsafe working conditions. The market-failure approach assumes away the problems of information and incentive that hamper all government activity.
The lure of classical socialism has largely disappeared following the breakup of the Soviet Union. There is an emerging consensus that comprehensive central planning is inconsistent with both economic progress and individual liberty. However, the death of the socialist dream has not affected public attitudes about government regulation of particular areas of economic activity.
Using insights from the socialist calculation debate, we can show that information problems are just as important in piecemeal intervention as in comprehensive central planning. The analysis here challenges the common assumption that government can improve on the information provided through markets and other voluntary arrangements. Problems arise in government efforts to supplement information available to consumers through normal market channels.
Government and the Use of Knowledge in Society—An Evolving View
Public attitudes about the appropriate role of government in economic planning have changed dramatically since the end of World War II. During most of the period since 1945, economists throughout the world argued that central planning was indispensable for the development of poor countries. Indeed, according to Nobel Laureate economist Gunnar Myrdal, in the mid-1950s all competent economic development advisers recommended central planning as the first condition of progress. This approach presumes that government planners can determine the pattern of production most consistent with consumer preferences and successfully implement the plan.
The rosy view of government’s ability to coordinate economic activity through central planning grew out of the economic or socialist calculation debate. The calculation debate among economists, continuing from 1920 until the late 1930s, had to do with the feasibility of socialism. Ludwig von Mises started the debate in an article published in 1920, arguing that socialism was incompatible with rational economic planning. Mises was responding to various socialist theorists who had argued that central planning was superior to the market system in coordinating economic activity.
A fellow Austrian economist, F. A. Hayek, soon joined Mises in arguing that alternatives to a private-property market order cannot succeed. He showed that the structure of production under socialism cannot reflect consumer desires effectively because government planners cannot acquire the knowledge necessary for economic calculation. Hayek stressed that the knowledge needed to achieve a rational economic order consists of dispersed bits of knowledge held by individuals. This knowledge is highly specialized: only individuals involved in deciding resource use know the relative importance of the various ends or purposes for which resources might be used. Thus, the crucial problem confronting society is how to use the specialized knowledge of different people in the production of goods and services to satisfy consumers.
The debate inspired attempts by socialists to duplicate the efficiency of markets. Oskar Lange was the best known socialist theorist. In the mid-1930s, he argued that a socialist economy could establish a market-type mechanism that would eliminate the need for private property and market prices. Lange demonstrated that a socialist system could be more efficient than a real-world market economy if the central planning board were given the necessary information. The required information includes data on available resources, production alternatives, and consumer preferences.
In 1945 Hayek published a classic paper, “The Use of Knowledge in Society.” There he showed that while central planning, as proposed by Lange and other socialists, may not be logically contradictory, information problems make it impractical. To assume all the knowledge to be given to a single mind in the same manner in which we assume it to be given to us as the explaining economists is to assume the problem away and to disregard everything that is important and significant in the real world.
No Workable Substitute for the Market Order
Economic planning in a socialist system must necessarily founder on the rocks of ignorance. First, the data necessary to find out the pattern of production that best fits consumer preferences are never given, as often assumed by planning proponents. Second, and even more important, the central planner cannot obtain the necessary data. Much of the data on available resources, production alternatives, and consumer demand constantly changes as economic conditions change. Thus, decentralization is the only means of coordinating economic activity through which the specialized knowledge of individuals can be taken into account and used promptly. In short, Hayek and Mises showed that in the production and marketing of goods and services the market order has no workable substitute. Without price and profit signals based on private property, there is no way to use resources productively or to preserve a society based on extensive division of labor.
Despite the merits of the Austrians’ challenge to collectivism, the socialists won the calculation debate—at least for a time. The Hayek-Mises insights about the uniqueness of the market in generating and communicating information did not find a place in mainstream economic theory. Instead, these insights remained largely unrecognized and were nearly lost in the aftermath of the Keynesian revolution that occurred during the late 1930s. Socialists and nonsocialists alike continued to discount the importance of Hayekian information problems until the breakup of the Soviet Union in the early 1990s. In 1967, some 30 years after the publication of his original essay on the theory of socialism, Lange argued that the computer revolution had made the market obsolete!
Were I to rewrite my essay today my task would be much simpler. My answer to Hayek . . . would be: so what’s the trouble? Let us put the simultaneous equations on an electronic computer and we shall obtain the solution in less than a second. The market process . . . appears old-fashioned. Indeed, it may be considered as a computing device of the pre-electronic age.
In 1989 Leonid V. Kantorovich, a Nobel Laureate Soviet economist, echoed Lange’s fascination with the use of mathematical optimization techniques, even as the death knell sounded for Soviet collectivism: I am looking optimistically on the prospects of wide spread of mathematical methods . . . in all-level economic control. It can give us a significant improvement of planning activity, better use of resources, increment of national income and living standards.
Failure to recognize the importance of the market system in generating and using information was not limited to socialist theorists. In the 1989 edition of his famous textbook, Economics, American Nobel Laureate economist Paul Samuelson defended the efficiency of socialism, remarking that the Soviet economy is proof that contrary to what many skeptics had earlier believed, a socialist command economy can function and even thrive.
The crumbling of collectivism has vindicated Hayek and Mises in their contention that information is the Achilles’ heel of socialism. Nearly everyone agrees that successful planning is impossible without private property and the associated market prices. Without these signals, as Mises emphasized, no one can calculate costs or determine the most highly valued products.
Ironically, the economic crisis that led to the breakdown of collectivism was directly associated with the revolution in communications technology involving electronic computers, fax machines, and modems. But this revolution in the generation, processing, and transmission of information has increased the relative importance of and dependence on market signals.
Nobel Laureate economist James Buchanan observes that the death of socialism has discredited politics in the large in the sense of central planning at the national level but has not reduced the appeal of politics in the small. Government efforts in the United States to cope with alleged market failure, including inadequate consumer information, reflect the appeal of piecemeal socialism. The economic calculation debate has implications for piecemeal regulation of consumer activity, too.
Problems in Regulating Consumer Information
The efficient coordination of economic activity hinges on the discovery and use of information by individual decision-makers. Individuals seek more information only if the expected benefits exceed the costs. Thus, it would be uneconomic for a person to get complete information, even if it were possible to do so. In the words of Nobel Laureate economist George Stigler, information costs are the costs of transportation from ignorance to omniscience and seldom can a trader afford to take the entire trip. The most appropriate amount of information will vary from person to person because expectations are subjective. Consequently, government officials have no standard to determine whether consumers have too little or too much information. Individuals may often regret not having acquired more information before making a decision, but such hindsight regret is beside the point.
The conventional wisdom holds that individuals relying solely on market-based data have inadequate information. But supposing that government intervention can correct this market failure is a heroic assumption. It assumes that public officials can determine when individuals have too little knowledge and that officials then will act in a way that improves welfare. But one has little basis for thinking that individuals will use knowledge more effectively if government intervenes to second-guess market decisions. People acquire different amounts of information because of individual differences in knowledge, risk preference, and so on. Thus, the knowledge problems that plague government efforts to improve on the amount of information provided through markets are similar to those in central planning. Therefore, government efforts to improve consumer knowledge through piecemeal regulation are likely to be futile or counterproductive.
Consider nutritional information. The rationale for government efforts to improve consumers’ nutritional knowledge is inadequate response by food manufacturers and consumers to medical evidence showing links between diet and health. Individual consumers face formidable obstacles in obtaining the desired amount of information about the nutritional contents of prepared food and food products. It is difficult and costly for food manufacturers to provide information to consumers willing to pay without providing it also to those who haven’t paid. This difficulty limits the availability of nutritional information. Moreover, the costs to the individual consumer of obtaining nutritional data on various food products are likely to be prohibitively high.
The free-rider incentive also may stymie action by a group of consumers willing to pay for additional information. Consider the problem of supplementing currently available nutritional information through voluntary group action. If it is not feasible to keep the information from those who don’t pay, everyone has an incentive to free ride on those who pay. Therefore, one might argue, government should force food manufacturers to provide nutritional information to all consumers. This commonly cited justification for government intervention is based on high transactions costs and the incentive of individuals to free ride. Trouble is, similar problems plague the political process.
In nutritional information, and in other areas, the relevant question is who is to decide, and on what basis, that consumers are not adequately informed. The fact that individuals appear to have too little information does not necessarily mean that they would benefit from additional information or that government intervention would be beneficial. Information problems are inherent in the political process because of the separation of power and knowledge, as revealed in the economic calculation debate. Political decision-makers do not have and cannot find out the relevant costs and benefits of nutritional data to individual consumers.
Perverse incentives also distort actions of political decision-makers because of the separation of power and responsibility. In politics, those who make decisions do not bear responsibility for their actions to the same extent as decision-makers in the market. In markets, entrepreneurial decisions depend on perceptions of profit opportunities and only the firms that best anticipate market conditions survive. In contrast, there is no bottom line in government, where political decisions replace the discipline of the market.
The market process may appear to provide too little of some goods and services, including information. Market outcomes, however, must be compared with outcomes of the political process. A government agency has an incentive to price its services below cost. Thus, government agencies tend to produce too much. For example, information provided by the publicly funded Cooperative Extension Service typically is free to U.S. farmers. The tendency of government agencies to price below cost is no accident, as lower prices lead to more clients, larger budgets, more jobs, and more political influence.
Consider again the example of government attempts to improve consumers’ nutrition knowledge. The U.S. Food and Drug Administration (FDA) recently imposed an additional labeling requirement on manufacturers of food products. The FDA now requires that food manufacturers provide nutritional data, including amounts (per serving) of calories, fats, cholesterol, carbohydrates, protein, and sodium on product labels. This information presumably enables consumers to make more informed dietary choices. The nutritional labeling mandate ostensibly solves the free-rider and high-transactions-cost problems that hinder consumers’ attempts to obtain more nutritional information. However, the political action creates a new class of free riders. The labeling mandate enables those who use the information to benefit at the expense of those who pay and do not use it. It is likely that a minority of consumers benefits from the required (costly) information. Moreover, government action also creates a new class of forced riders. In the example, forced riders are consumers paying higher prices for food who consider the benefit of the additional information to be less than the cost.
Government efforts to increase public awareness of the links between diet and heart disease or cancer illustrate the difficulties encountered when government intervenes to improve market outcomes. The scientific evidence linking diet to heart disease was well established by the early 1960s. Articles stressing the relationship between diet and heart disease appeared regularly in Reader’s Digest and the general press. The American Heart Association issued a major public health advisory in 1964. Articles in the popular press on the increased incidence of cancer associated with high-fat diets began to appear in the 1970s. Following this publicity, food manufacturers began promoting their products’ fat and cholesterol profiles. Thus, the market responded, as expected, to the increased demand for nutritional information.
Government has played an important role in providing diet-disease information, but these efforts lagged private manufacturers’ actions by at least ten years. Moreover, government actually banned food manufacturers’ advertisements of their products’ fat and cholesterol profiles in the 1960s. Although the ban was lifted in 1973, government did not allow manufacturers to explain the health reasons to be concerned with fat and cholesterol! The policy prohibited any claim that directly linked a dietary component such as fat or cholesterol to disease risks. Government regulators argued that such claims were inherently misleading because diet-disease issues were too complex for advertisers to deal with.
What is the lesson from government’s attempt to correct the alleged failure of the market to provide consumers adequate nutritional information? Implementation problems stymie government planners’ attempts to improve consumers’ dietary knowledge. These problems are even more formidable than the information problem faced by the individual. In short, when government intervened to improve nutrition information, government failure appears to have been worse than market failure—as it is generally. Thus, it is unwise to concede monopoly power to government in the provision of nutrition information.
Implications and Challenges
The primary challenge in achieving a productive economy is to overcome the knowledge problem created by dispersed information. Widely held information can be most effectively used through the discovery process of a decentralized private-property market system. Hayek stressed that because much of the information is highly specialized to time and place, the man on the spot makes the best decisions. The explosion in communications technology heightens the advantage of decentralization. Consider the ongoing revolution in the transmission of information in industrial societies. The use of fax machines, computers, and modems has significantly eroded the effects of government’s traditional monopoly of first-class mail.
It is important to distinguish between knowledge and information. Individual action is based on knowledge, which consists of information plus judgment. Knowledge is always scarce, but information constantly bombards people in industrialized societies. Print and electronic information sources include newspapers and magazines, radio, television and, increasingly, E-mail. Thus, the individual decision-maker must assess the accuracy and relevance of new information to decide whether it effectively contributes to knowledge useful in decision-making. Both the current knowledge base and the cost and benefit of getting additional information are subjective and vary from person to person. Consequently, any attempt by government to second-guess a consumer’s decision concerning the most appropriate amount of information is problematic.
Government’s attempts to correct perceived problems in consumers’ nutritional choices through a mandated food-labeling requirement highlights the distinction between information and knowledge useful in decision-making. Information provided through the FDA-mandated nutrition profile on labels of food products has little significance for consumers lacking a stock of nutrition knowledge. Consider a food product that has 20 grams of fat in a standard serving that contains 360 calories. The food label would show that 50 percent of the product’s calories are from fat. Without a stock of nutrition knowledge, however, the consumer would not know whether the indicated fat content is high or low. Thus, the nutritional data standing alone, although costly to provide, has little meaning for the typical consumer.
In compensating for consumers’ lack of nutritional knowledge, the FDA requires that food manufacturers also provide information on recommended daily allowances. The FDA dietary guidelines, for example, recommend that fat consumption be no more than 30 percent of total energy intake. However, many nutrition experts believe that this recommendation constitutes misinformation. The medical evidence suggests that a much lower rate of fat consumption would be safer. The government’s recommendations apparently arose from what authorities setting the guidelines thought the public would accept instead of epidemiological evidence! If so, the legally required nutritional data are misleading consumers who would reduce fat consumption further if informed of the lower risks associated with a lower-fat diet. The tentative nature of knowledge on diet-disease issues makes futile all attempts to regulate nutrition information in the public interest. Furthermore, the FDA nutrition-labeling example illustrates the pitfalls of conceding monopoly power to government in regulating information.
What is the alternative? When quality has aspects that are hard for consumers to detect, a market for information is likely to arise in the absence of government regulation. For example, Best Western is a private regulatory agency for motels that enables travelers to identify easily the motels that meet the quality standards specified by Best Western. Similarly, Underwriters Laboratories establishes standards for electrical equipment and then tests it to see if it meets those standards. The use of brand names is another market contribution to the efficient use of knowledge in society. Finally, some firms independently test and evaluate products and report results to their subscribers in publications such as Consumer Reports. Market-generated information undoubtedly would be more common were it not for the current widespread government regulation. Government regulatory activity, as shown by the food-labeling example, may both crowd out and legally restrict privately produced consumer information.
Individuals’ actions necessarily rest on imperfect knowledge, and people often appear to act without sufficient information. However, intractable problems of knowledge and incentives impede government officials’ attempts to improve on market-generated knowledge. Knowledge, consisting of information plus judgment, is highly subjective. Therefore, the optimal amount of information varies from person to person, depending on the expected costs and benefits. It should not be surprising that government attempts to improve consumer knowledge frequently are disappointing. Hayek labels as the fatal conceit the idea that human beings can determine what is best for society and use the political process to shape the world according to their wishes.
The economic calculation debate showed that central planners cannot overcome the knowledge problem. Knowledge is highly specialized to time and place and much of it is unavailable to the planner. Thus, successful planning hinges on private property and the information and incentives conveyed by market prices. Moreover, knowledge problems encountered in piecemeal intervention resemble those that stymie central planning. Thus, the implications of the calculation debate are just as important for politics in the small (piecemeal regulation) as for politics in the large (socialism). Recent dramatic advances in technology heighten the importance of keeping decisions decentralized. Consequently, central control of information, whatever the application, in a way that promotes rather than impedes effective decision-making is highly dubious.
Government cannot determine the most appropriate amount of information. Thus, the use of knowledge in society is unlikely to be improved by government action that overrides outcomes of decentralized information markets. Government can, however, encourage the development of private institutional arrangements that enable decision-makers to obtain the information necessary to act in their own interests. Brand names and private regulatory agencies like Best Western, Underwriters Laboratories, and Consumer Reports show that markets can, and do, cope with information problems. Why are such institutions not more widespread? Privately supplied consumer information, as shown by the food-labeling example, is not more common because government regulation is so widespread. It will be a major challenge in the twenty-first century, as during the twentieth, to foster private institutions for providing consumer information.
4. Ludwig von Mises, Economic Calculation in the Socialist Commonwealth, Part III in F.A. Hayek, ed., Collectivist Economic Planning (London: Routledge, 1935), pp. 87-130. Reprinted by Augustus M. Kelley Publishers, 1975.