Economic calculation problem

Also known as the socialist calculation debate, this refers to an important academic debate on the question of whether centrally planned economies can allocate scarce resources efficiently. The debate was between the Austrian school economists Ludwig von Mises and Friedrich Hayek on the one side and socialist economists Oscar Lange and Abba Lerner on the other in the first half of the twentieth century.

The debate

The debate was kickstarted by Mises’ 1920 monograph “Economic Calculation in the Socialist Commonwealth” which argued that rational allocation of resources was impossible in a centrally planned socialist economy. Mises argued that in the absence of private property, as is the case in a centrally planned economy, there would be no market for resources and hence no rational resource allocation. Before Mises, many economists had argued that a socialist economy would be inefficient because it did not reward people according to their economic output. The logic was that people in general would have very little incentive to work hard when rewards are skewed. Mises, however, argued that even if a solution was found to the problem of incentives, a socialist economy would still not function efficiently. This, he argued, was because the group of central planners managing the economy would not have sufficient information to allocate the scarce resources under their control efficiently.

It should be remembered that resources in any economy are scarce when compared to the unlimited desires of human beings. So, these limited resources need to be allocated towards the most urgent needs of society in order to maximise social welfare. Take the case of a raw material like timber. It can be allocated for literally thousands of different uses, some a lot more urgent than others. In a market economy, in which resources are owned by private individuals who are free to exchange the resources that they own for resources owned by others, prices act as a crucial signal. When resource owners sell their resources to whoever is ready to pay the highest price, they thus ensure that the resource is allocated to those who need it the most. The implicit assumption here is that, generally speaking, people who are willing to pay the highest price for a resource also want it the most urgently.

In a centrally planned socialist economy, in which all resources are owned by the state, decisions regarding where to allocate resources are made by a group of central planners. No resource is owned by private individuals, and hence there is no possibility of exchange between individuals and the formation of market prices to guide the allocation of resources. Mises and Hayek argued that in the absence of prices which act as crucial signals to producers in a market economy, central planners would be left groping in the dark trying to figure out how to allocate resources. Central planners will, for instance, have to know by other means how much of the timber that is produced in a day need to be allocated towards each of the thousands of uses towards which it could possibly be allocated. In a market economy, this decision is made spontaneously together by millions of individuals through the market.

The socialist argument

Some socialist economists, however, retorted that markets were not essential for the rational allocation of resources. They argued that a central planning board can allocate resources according to a plan that takes into account the genuine needs of society. Other socialist economists such as Lange, however, acknowledged the importance of prices in resource allocation. They argued that a socialist economy can use the market mechanism to allocate resources even when all resources are owned by the state.