All Commentary
Thursday, January 12, 2012

Not Just What, But How

The indispensability of free-market prices.

There are a variety of ways to look at the fundamental problem that all economies must solve. One way is to talk about the responsiveness of producers to consumers. In this view, the problem the economy solves is figuring out what consumers want and then giving it to them. The challenge here is how producers are to know what consumers want. This view is embraced by some defenders of markets, who argue that they do the job quite well, and by many critics, who deny that proposition. But both groups generally agree that the problem is figuring out what to produce. Faced with stacks of potential inputs, what outputs should we produce that consumers want and value?

Although this perspective has much truth to it, it leaves aside an even more fundamental question that is frequently overlooked in discussions about the efficacy of market economies. Knowing what to produce is one problem, but figuring out how best to produce it is perhaps an even bigger one.

To Build a Bridge

Suppose we know that people would value a bridge over a nearby river. Suppose we even know the location they prefer (and suppose they’re unanimous about it). For some, the hard economic problem has been solved. But that leaves unanswered the question: How we are going to build that bridge? And by “how,” I mean not the engineering question, but the economic ones: With what inputs? How much of each? And are we going to build that bridge with the least valuable resources possible, leaving the most valuable ones for other wants?

We could perhaps build it out of wood, or stone, or steel. We could build it in a labor-intensive way, using lots of workers doing things by hand, or we could go more capital-intensive by using lots of heavy machinery and less labor. If we care at all about the economic well-being of our citizens, getting these questions right matters a great deal. If we could avoid it, we would not want to build the bridge with resources that had more highly valued alternative uses, since that would reduce the total wealth we were capable of creating. Ideally, we’d like to use the least valuable set of resources possible consistent with having a functioning bridge. How are we to figure that out?

Almost a hundred years ago, in one of the social sciences’ most important articles (“Economic Calculation in the Socialist Commonwealth”), Ludwig von Mises gave us the answer. He argued that such comparisons require a common standard of value and that the only standard that would permit rational resource allocation consists of prices generated by a genuinely free market in capital and labor. Market prices, Mises argued, require exchange against money, and exchange requires private property. Only in a free-market economy, characterized by the private ownership of capital, could we figure out not just what to produce, but how best to produce it.

“Groping in the Dark”

Imagine a dark room with stacks and stacks of potential inputs lying around and all kinds of potential consumers trying to find the outputs they want. Free-market prices provide us with a series of lights that allow us to navigate that room and begin to get a sense of how we might answer those questions. Profits and losses tell us after the fact whether or not we got it right. Hence Mises referred to socialism as just so much “groping in the dark.”

No matter how much we know about people’s desire to cross that river, or how much engineering knowledge we have, we cannot figure out the best way to build the bridge unless we can compare the values of the relevant inputs. That is why the prices that emerge from the exchange of privately owned of capital are an irreplaceable feature of an advanced society.

  • 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.