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Thursday, June 14, 2012

Monetary Calculation: Looking Forward and Backward

Indispensable prices.

I have written before about the importance of monetary calculation for the market economy. In that earlier column I discussed the ways in which the prices that result from exchanges of money for goods and services in a genuine market process serve as the basis for the calculations of entrepreneurs. I specifically noted how these calculations are what enable entrepreneurs to answer the hard question: How should I produce the goods that consumers want. Even if producers know consumers want cars, the producers have to figure out which technologically possible way of making the cars will be the most economically efficient way. Comparing the prices of inputs helps them decide.

The ability to compare input costs is what enables producers to engage in what I call the forward- and backward-looking aspects of monetary calculation. Having money prices at their disposal allows producers to project into the future and imagine what costs and revenues will look like in order to decide what to do and how to do it. In the business world this is conventionally referred to as budgeting.

Appraising the Market

Having decided what she might like to produce (the decision itself is based to some degree on money prices), the entrepreneur has to figure out how to produce it by estimating what the likely revenues will be and what the costs of various methods of production will be. In estimating costs the entrepreneur must start with current prices, or more precisely, the prices of the immediate past. She must then, to use Mises’s word, “appraise” the economic landscape and formulate her best estimate of what those prices will do during the budget period. Finally she must further appraise the likely market for her product and estimate the quantity she can sell and at what prices. The budget she settles on will guide production for the period (subject to some ongoing change of course).

All this is forward-looking.

At the end of the period the entrepreneur then uses the backward-looking services of monetary calculation to figure the profits or losses from the period. By looking at the costs incurred and the revenues earned during the production process, the entrepreneur can determine if she created value. Suppose she made lemon bars. If the total cost of the ingredients, labor, machinery, and real estate is less than the revenue earned, she will show a profit. If it is greater, she will show a loss.

What profit and loss indicate is whether value was created during the period. Profit demonstrates that the final product was worth more than the separate inputs (accounting for time as well); losses indicate that the inputs were more valuable separately than in the form of the final output. Profit and loss are, therefore, backward-looking. They inform us of the results of past action.

Attractive to New Producers

Profit and loss also signal what other entrepreneurs might do in the future. Signs of past success will often attract new producers to an industry. If lemon bars seem especially profitable, other producers might shift from what they are selling (perhaps chocolate chip cookies) and begin to produce lemon bars instead. Losses, by contrast, signal other firms to stay away. Past performance is no guarantee of future success or failure, but profit and loss signals are a starting point for potential entrants.

Finally, the original entrepreneur does not stop calculating. The backward look informs her next moves. She now has to decide whether her combination of inputs was the right one and whether she picked the right output and priced it right. Prices and profits are not marching orders; rather entrepreneurs have to interpret them and decide how to proceed.

This cycle continues on endlessly as entrepreneurs look forward and backward trying to anticipate and adjust to ever-changing consumer demands and input costs. This is the essence of entrepreneurship in a market economy characterized by consumer sovereignty. Entrepreneurs are servants of consumers, and monetary calculation allows entrepreneurs both to peer into an uncertain future and determine their past successes and failures. The result is that free markets do far better for consumers than any alternative.

  • Steven Horwitz was the Distinguished Professor of Free Enterprise in the Department of Economics at Ball State University, where he was also Director of the Institute for the Study of Political Economy. He is the author of Austrian Economics: An Introduction.