Among the most important articles ever written in economics is Ludwig von Mises’s 1920 paper “Die Wirtschaftsrechnung im sozialistischen Gemeinwesen” – which is normally translated as “Economic Calculation in the Socialist Commonwealth.” In this paper Mises argued that socialism will not only fail to achieve improved living standards for ordinary people, it will impoverish them. Inevitably. Socialism that is meant to outperform markets at raising living standards is destined to fail.
Mises’s reasoning is not what you might expect. His argument doesn’t rest on the reality that socialism dampens people’s incentives to work, dims businesses’ incentives to produce the array, quantity, and quality of outputs most desired by consumers, and provides poor incentives for central planners to take responsibility for their decisions. Although Mises agreed that incentives under socialism are perverse, his explanation of why socialism will fail digs deeper. The validity of this explanation stands even if the perversity of socialism’s incentives is miraculously cured.
Mises’s argument is that, under socialism, there is no workable means of determining how to produce outputs in ways that don’t waste vast amounts of resources. And by wasting vast amounts of resources to produce some outputs – even outputs that genuinely satisfy some consumer demands – the economy loses the capacity to satisfy as many consumer demands as it would absent such waste.
The reason socialism inevitably wastes resources is rooted in the fact that, under such a regime, the state owns all means of production (or what Mises called “goods of higher order”). Without private ownership of the means of production, there is no genuine exchange of the means of production. There is no transfer of ownership of plots of land, of factories, of commercial lathes, or of stockpiles of iron ore and bauxite. With no exchange of the means of production, there are no prices of the means of production. (Each price, after all, is among the terms on which one thing is exchanged for another.) And with no prices of the means of production, the manager of a factory that produces, say, lawn mower blades can’t possibly know whether the lowest-cost method of producing these blades involves the use of steel or of aluminum or of carbon fiber.
Without prices in the means of production, this factory manager must fly blind. Her decision on which material to use is a wild guess. Suppose she decides to produce blades using steel. She requisitions some quantity of steel from the central planning bureau, and the bureau complies. A few hours later, however, the bureau receives another requisition for steel, this time from a comrade charged with the responsibility for manufacturing automobile engines. But because the bureau already shipped steel to the blade factory, there’s not enough steel now to ship to the engine factory.
How is anyone to know if this quantity of steel is better used to produce blades or engines? Without market-determined prices, such knowledge is impossible.
In a market economy, blade producers and engine producers compete against each other for steel. The factory owner who offers the highest price for some amount of steel is the one who gets that steel. And the factory owner who offers the highest price for that steel is the one who expects to use that steel in the highest-valued manner – that is, to produce outputs for which consumers are willing to pay higher prices. Also in a market economy, producers of other outputs – outputs from bird feeders to I-beams – observe the price of steel as it compares to the prices of aluminum, carbon fiber, and other materials. These other producers make their own production plans based on these prices. Producers for whom the price of steel is attractive buy steel for use; producers for whom the price of steel is unattractive buy aluminum or some substitute input for use.
Socialism, however – by eliminating prices of each of the countless different means of production – eliminates this method of determining the allocation of steel and other inputs. Steel and other inputs, not being priced, are allocated without any knowledge of which particular outputs are produced at lowest cost using steel and which outputs are produced at lowest cost using some other material.
The result is a massive waste of resources. Many outputs are produced using inputs that would have produced more output – measured in terms of economic value – had those inputs been used otherwise. The result is a systemwide, gargantuan failure to get as much output as possible from available inputs.
As Mises summarized the fate of a fully socialized economy, “As soon as one gives up the conception of a freely established monetary price for goods of a higher order, rational production becomes completely impossible.”
It’s Not All or Nothing
In the 1930s, Mises’s most famous protégé, F.A. Hayek, entered the debate that pitted Mises against the socialists. Hayek produced a series of brilliant essays (most of which are now contained in Socialism and War) explaining in greater detail the indispensable role of market prices in allocating resources in ways that promote human betterment. The culmination of Hayek’s work on this front is his most famous article, first appearing in the September 1945 issue of the American Economic Review, “The Use of Knowledge in Society.”
Since the collapse of Soviet-style communism three decades ago, many people today who are skeptical of free markets concede the validity of Mises and Hayek’s demonstration of the inevitability of failure of full-on socialism – that is, the inevitability of failure of state ownership of all means of production and of comprehensive economic planning. Yet it’s not uncommon for such people nevertheless to propose that a great deal of resource allocation be carried out by government, and that government often interferes with the operation of the competitive price system.
As I’ll explain in my next column, to insist that Mises and Hayek’s case against socialism applies only to full-on socialism, and is thus irrelevant in discussions of piecemeal economic intervention, is to miss the foundational lessons in these economists’ virtuoso explanation of the formation of, and role played, by market prices.