Economic Calculation

Mr. Summers is a member of the staff of The Foundation for Economic Education.

Which economic system produces what society wants in the manner society deems most efficient?

As with all economic questions, the answer is found by focusing one’s attention on the actions of individuals. When one understands the actions of individuals, then one understands the actions of society, for society moves only as its individual members move.

The movement of rational beings is purposeful. People choose those courses of action they think will better their own situations from their own points of view. Of course, people make mistakes. Sometimes, due to a lack of understanding, they choose the wrong courses of action. The purpose of economics is to provide understanding that reduces such wrong choices by men seeking to maximize prosperity. That is, economics helps men to be efficient.

To be efficient one must have a means of comparing possible courses of action. To cite an example, consider the proverbial widget manufacturer. Should his product be made of resource A or resource B? Should he use manufacturing process X or process Y? The only way to decide these questions in the manner society considers most efficient is to know the price society places on resource A, resource B, process X, process Y, and the final manufactured widget.

How does society determine prices? Most people seem to think that free market prices are determined by merchants. It is true that the merchant is the one who actually writes down a specific price. However, in a free market the merchant’s hand is guided by society.

The widget manufacturer is well aware that he cannot arbitrarily set his price. He must constantly take into account the prices being charged by competing widget manufacturers, manufacturers of substitute products, and all other merchants competing for the consumer’s dollar. As the manufacturer raises his price, customers take their business elsewhere. As he lowers his price, customers return. Free market prices of consumers’ goods are determined by the merchant’s anticipation of the consumer’s reaction to his price.

Pricing the Factors of Production

In a free market, consumers also indirectly determine prices of the factors of production: labor, natural resources, and capital goods. Businessmen, anticipating future prices of consumers’ goods, bid among themselves for factors of production. Thus businessmen, in the role of competing buyers, determine the prices of the factors of production in the same way consumers set the prices of consumers’ goods. However, the businessman is merely acting as an agent for the consumer, for he is guided by his estimation of the future prices of consumers’ goods.

Using free market prices, the businessman attempts to calculate the manufacturing procedure that will maximize the difference between his final selling price and total production costs. That is, he uses society’s prices to try to maximize his profits. Because his final selling price is set by competition, this means that the businessman tries to maximize profits by minimizing costs of production. This, from the point of view of society, is what it means to be efficient. That is, in the free market the most efficient producer is the one earning the greatest profits.

Of course, many businessmen do not earn profits. Those businessmen whose balance sheets show losses are soon driven from the market and forced, by economic necessity, to try their hands at something else. This is how society, acting through the market, discourages the inefficient use of labor, natural resources, and capital goods.

Those businessmen who do earn profits are encouraged by their profits to continue in business and use their profits to expand their operations. This is how society encourages the efficient use of factors of production.

Interfering with Trade

The system of economic calculation just described presupposes that the market is free from governmental interference. When the government does intervene in the economy, inefficiencies are the inevitable result. The government can only influence the prices of consumers’ goods and of the factors of production by overriding the prices determined by society through the market. When the government does this, then the economy produces what the government wants in the manner the government considers best, rather than what society wants in the manner society deems most efficient.

In the United States today, the government influences prices in innumerable ways. Wage and price controls, minimum wage laws, laws discouraging the hiring of nonunion workers, rent controls, interest rate regulations, tariffs, and zoning laws are just a few of the ways the government contravenes free market pricing and thus distorts and disrupts economic calculation. Such laws, from the point of view of society, can only result in misallocations of scarce resources.

The farther an economy moves from free enterprise, the more wasteful it becomes. In a completely socialized economy, consumers have no influence over "prices" of consumers’ goods. The government widget manufacturer can arbitrarily set his "price" because the government is the only manufacturer of widgets. Customers have nowhere else to turn. In a completely socialized economy, consumers also have no influence over the "prices" of labor, natural resources, and capital goods. These factors of production are controlled by the government, and the government decides their "prices."

How does a completely socialized government decide these "prices"? Well, it can guess. This is apparently a common procedure in communist countries. Another procedure communists often use is to charge whatever the going rate is in the relatively free markets of the West. Of course, free market prices vary from place to place, so the communists are at best approximating the prices that would prevail in their countries were their markets free. Should we ever completely lose our Western markets, no one anywhere in the world will know what to charge for anything.

Lacking a means of economic calculation, socialism is bound to fail.  

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