Excerpts from
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downON THE ECONOMIC THEORY OF SOCIALISM

By OSKAR LANGE

 

I. THE PRESENT STATE OF THE DEBATE

 

 

 

 SOCIALISTS have certainly good reason to be grateful to Professor Mises, the great advocatus diaboli of their cause. For it was his powerful challenge that forced the socialists to recognize the importance of an adequate system of economic accounting to guide the allocation of resources in a socialist economy. Even more, it was chiefly due to Professor Mises’ challenge that many socialists became aware of the very existence of such a problem. …Both as an expression of recognition for the great service rendered by him and as a memento of the prime importance of sound economic accounting, a statue of  Professor Mises ought to occupy an honorable place in the great hall of the Ministry of Socialization or of the Central Planning Board of the socialist state…  As Professor Hayek has put it, to Professor Mises belongs “the distinction of having first formulated the central problem of socialist economics in such a form as to make it impossible that it should ever again disappear from the discussion.” 1

But, unfortunately, besides formulating the problem, Professor Mises has also claimed to have demonstrated that economic calculation is impossible in a socialist society. The economist will scarcely find it possible to accept this claim.  ... it was exactly Professor Mises’ denial of the possibility of economic accounting under socialism that provided his challenge with such force and power. ...  

 

A solution of the problem, different from that advanced by Professor Mises, was suggested by Pareto as early as 18972 and was later elaborated by Barone. 3  The further discussion of the problem, with one exception, which will be mentioned later, has scarcely gone beyond what is already contained in Barone’s paper. Professor Mises’ contention that a socialist economy cannot solve the problem of rational allocation of its resources is based on a confusion concerning the nature of prices. As Wicksteed has pointed out, the term “price” has two meanings. It may mean either price in the ordinary sense, i.e., the exchange ratio of two commodities on a market, or it may have the generalized meaning of “terms on which alternatives are offered.” …It is only prices in the generalized sense which are indispensable to solving the problem of allocation of resources. The economic problem is a problem of choice between alternatives. To solve the problem three data are needed: (1) a preference scale which guides the acts of choice; (2) knowledge of the “terms on which alternatives are offered”; and (3) knowledge of the amount of resources available. Those three data being given, the problem of choice is soluble.  

 

Now it is obvious that a socialist economy may regard the data under 1 and 3 as given, at least in as great a degree as they are given in a capitalist economy. ... The question remains whether the data under 2 are accessible to the administrators of a socialist economy. Professor Mises denies this. However, a careful study of price theory and of the theory of production convinces us that, the data under 1 and under 3 being given, the “terms on which alternatives are offered” are determined ultimately by the technical possibilities of transformation of one commodity into another, i.e., by the production functions. The administrators of a socialist economy will have exactly the same knowledge, or lack of knowledge, of the production functions as the capitalist entrepreneurs have.  

  As, in consequence of public ownership of the means of production, there is in a socialist economy no market on which capital goods are actually exchanged, there are obviously no prices of capital goods in the sense of exchange ratios on a market. And, hence Professor Mises argues, there is no “index of alternatives available in the sphere of capital goods. But this conclusion is based on a confusion of “price” in the narrower sense with “price” in the wider sense of an index of alternatives. It is only in the latter sense that “prices” are indispensable for the allocation of resources, and on the basis of the technical possibilities of transformation of one commodity into another they are also given in a socialist economy.  

 

Professor Mises argues that private ownership of the means of production is indispensable for a rational allocation of resources. Since, according to him, without private ownership of the means of production no determinate index of alternatives exists (at least in the sphere of capital goods), the economic principles of choice between different alternatives are applicable only to a special institutional set-up, i.e., to a society which recognizes private ownership of the means of production…  

Thus Professor Mises’ denial of the possibility of economic calculation in a socialist system must be rejected. However, Professor Mises’ argument has been taken up recently in a more refined form by Professor Hayek and Professor Robbins. They do not deny the theoretical possibility of a rational allocation of resources in a socialist economy; they only doubt the possibility of a satisfactory practical solution of the problem. Discussing the solution offered by Barone, Dickinson, and others, Professor Hayek says that “it must be admitted that this is not an impossibility in the sense that it is logically contradictory.” 7 But he denies that the problem is capable of a practical solution in a society without private ownership of the means of production. 8  

 

The issue has been put very clearly by Professor Robbins. “On paper,” he says, “we can conceive this problem to be solved by a series of mathematical calculations.... But in practice this solution is quite unworkable. It would necessitate the drawing up of millions of equations on the basis of millions of statistical data based on many more millions of individual computations. By the time the equations were solved, the information on which they were based would have become obsolete and they would need to be calculated anew. The suggestion that a practical solution of the problem of planning is possible on the basis of the Paretian equations simply indicates that those who put it forward have not grasped what these equations mean.” 9 …

Barone has already pointed to the fact that the equations of economic equilibrium must be solved also in a socialist society by trial and error. 10 He regarded such a solution as possible but failed to indicate how it would be achieved. However, the way in which a socialist economy would solve the problem by a method of trial and error has been indicated quite clearly by Fred M. Taylor in a paper published in 1929. 11 …It is, … the purpose of the present essay to elucidate the way in which the allocation of resources is effected by trial and error on a competitive market and to find out whether a similar trial and error procedure is not possible in a socialist economy.

 

downupII. THE DETERMINATION OF EQUILIBRIUM ON A COMPETITIVE MARKET

 

 

 

Let us see how economic equilibrium is established by trial and error on a competitive market. By a competitive market we mean a market in which (1) the number of individuals is so great that no one of them can influence prices appreciably by varying his demand or supply and, therefore, is forced to regard prices as constant parameters independent of his behavior; (2) there is free entry into and exodus from each trade or industry.  

The conditions of equilibrium are twofold: (A) All individuals participating in the economic system must attain their maximum positions on the basis of equilibrium prices; and (B) the equilibrium prices are determined by the condition that the demand for each commodity is equal to its supply. We may call the first the subjective, and the latter the objective, condition. These two conditions, however, do not determine equilibrium unless there is added a third condition which expresses the social organization of the economic system. In our case this condition states that: (C) the incomes of the consumers are equal to their receipts from selling the services of the productive resources they own, plus entrepreneurs’ profits (which are zero in equilibrium). l2 …  

 

The solution by trial and error is based on what may be called the parametric function of prices, i.e., on the fact that, although the prices are a resultant of the behavior of all individuals on the market, each individual separately regards the actual market prices as given data to which he has to adjust himself. Each individual tries to exploit the market situation confronting him which he cannot control. Market prices are thus parameters determining the behavior of the individuals. The equilibrium value of these parameters is determined by the objective equilibrium condition (B). As Walras has so brilliantly shown,l9 this is done by a series of successive trials (tatonnements).  

Let us start with a set of prices given at random (for instance, by drawing numbers from an urn). On the basis of this random set of prices (Walras’ prix cries par hasard ) the individuals fulfill their subjective equilibrium condition and attain their maximum positions. For each commodity a quantity demanded and a quantity supplied is established. Now the objective equilibrium condition comes into play. If the quantity demanded and the quantity supplied of each commodity happen to be equal, the entire situation is settled and the prices are the equilibrium prices. If, however, the quantities demanded and the quantities supplied diverge, the competition of the buyers and sellers will alter the prices. Prices of those commodities the demand for which exceeds the supply rise, while the prices of the commodities where the reverse is the case fall. As a result we get a new set of prices, which serves as a new basis for the individuals’ striving to satisfy their subjective equilibrium condition. … And so the process goes on until the objective equilibrium condition is satisfied and equilibrium finally reached.20 Actually it is the historically given prices which serve as a basis for the process of successive trials.

 

downupIII. THE TRIAL AND ERROR PROCEDURE IN  A SOCIALIST ECONOMY

 

 

 ...what kind of socialist society we have in mind?. …. Let us now assume that freedom of choice in consumption and freedom of choice of occupation are maintained and that the preferences of consumers, as expressed by their demand prices, are the guiding criteria in production and in the allocation of resources. Later we shall pass to the study of a more centralized socialist system.21

.. we have a genuine market ... for consumers' goods and for the services of labor. But there is no market for capital goods and productive resources outside of labor.22 The prices of capital goods and productive resources outside of labor are thus prices in the generalized sense, i.e., mere indices of alternatives available, fixed for accounting purposes.  

 Just as in a competitive individualist regime, the determination of equilibrium consists of two parts. (A) On the basis of given indices of alternatives (which are market prices in the case of consumers' goods and the services of labor and accounting prices in all other cases) both the individuals participating in the economic system as consumers and as owners of the services of labor and the managers of production and of the ultimate resources outside of labor (i.e., of capital and of natural resources) make decisions according to certain principles. These managers are assumed to be public officials. (B) The prices (whether market or accounting) are determined by the condition that the quantity of each commodity demanded is equal to the quantity supplied. …. Finally, we have also a condition C, expressing the social organization of the economic system. As the productive resources outside of labor are public property, the incomes of the consumers are divorced from the ownership of those resources and the form of condition C (social organization) is determined by the principles of income formation adopted.  

The possibility of determining condition C in different ways gives to a socialist society considerable freedom in matters of distribution of income. But the necessity of maintaining freedom in the choice of occupation limits the arbitrary use of this freedom, for there must be some con­nection between the income of a consumer and the services of labor performed by him. It seems, therefore, convenient to regard the income of consumers as composed of two parts: one part being the receipts for the labor services performed and the other part being a social dividend constituting the individual's share in the income derived from the capital and the natural resources owned by society. … Thus condition C is determinate and determines the incomes of the consumers in terms of prices of the services of labor and social dividend, which, in turn, may be regarded as determined by the total yield of capital and of the natural resources and by the principles adopted in distributing this yield.23

A.            Let us consider the subjective equilibrium condition in a socialist economy:

1.            Freedom of choice in consumption being assumed,24 this part of the subjective equilibrium condition of a competitive market applies also to the market for consumers goods in a socialist economy. The incomes of the consumers and the prices of consumers' goods being given, the demand for consumers' goods is determined.

2. The decisions of the managers of production are no longer guided by the aim of maximizing profit. Instead, certain rules are imposed on them by the Central Planning Board which aim at satisfying consumers' preferences in the best way possible. These rules determine the combination of factors of production and the scale of output.

One rule must impose the choice of the combination of factors which minimizes the average cost of production. This rule leads to the factors being combined in such proportion that the marginal productivity of that amount of each factor which is worth a unit of money is the same for all factors.25 This rule is addressed to whoever makes decisions involving the problem of the optimum combina­tion of factors, i.e., to managers responsible for running existing plants and to those engaged in building new plants. A second rule determines the scale of output by stating that output has to be fixed so that marginal cost is equal to the price of the product. This rule is addressed to two kinds of persons. First of all, it is addressed to the managers of plants and thus determines the scale of output of each plant and, together with the first rule, its demand for factors of production. The first rule, to whomever addressed, and the second rule when addressed to the managers of plants perform the same function that in a competitive system is carried out by the private producer's aiming to maximize his profit, when the prices of factors and of the product are independent of the amount of each factor used by him and of his scale of output.

The total output of an industry has yet to be determined. This is done by addressing the second rule also to the managers of a whole industry (e.g., to the directors of the National Coal Trust) as a principle to guide them in deciding whether an industry ought to be expanded (by building new plants or enlarging old ones) or contracted (by not replacing plants which are wearing out). Thus each industry has to produce exactly as much of a commodity as can be sold or "accounted for" to other industries at a price which equals the marginal cost incurred by the industry in producing this amount. The marginal cost incurred by an industry is the cost to that industry (not to a particular plant) of doing whatever is necessary to produce an additional unit of output, the optimum combination of factors being used. This may include the cost of building new plants or enlarging old ones.26

Addressed to the managers of an industry, the second rule performs the function which under free competition is' carried out by the free entry of firms into an industry or their exodus from it: i.e., it determines the output of an industry.27 The second rule, however, has to be carried out irrespective of whether average cost is covered or not, even if it should involve plants or whole industries in losses.

Both rules can be put in the form of the simple request to use always the method of production (i.e., combination of factors) which minimizes average cost and to produce as much of each service or commodity as will equalize marginal cost and the price of the product, this request being addressed to whoever is responsible for the particular decision to be taken. Thus the output of each plant and industry and the total demand for factors of production by each industry are determined. To enable the managers of production to follow these rules the prices of the factors and of the products must, of course, be given. In the case of consumers' goods and services of labor they are deter­mined on a market; in all other cases they are fixed by the Central Planning Board. Those prices being given, the supply of products and the demand for factors are determined.

B. The subjective equilibrium condition can be carried out only when prices are given. This is also true of the decisions of the managers of production and of the productive resources in public ownership. Only when prices are given can the combination of factors which minimizes average cost, the output which equalizes marginal cost and the price of the product, and the best allocation of the ultimate productive resources be determined. But if there is no market (in the institutional sense of the word) for capital goods or for the ultimate productive resource outside of labor, can their prices be determined objectively? Must not the prices fixed by the Central Planning Board necessarily be quite arbitrary….?

… the Central Planning Board has to fix prices and see to it that all managers of plants, industries, and resources do their accounting on the basis of the prices fixed by the Central Planning Board, and not tolerate any use of other account­ing. Once the parametric function of prices is adopted as an accounting rule, the price structure is established by the objective equilibrium condition. For each set of prices and consumers' incomes a definite amount of each commodity is supplied and demanded. ….

The condition that the quantity demanded and supplied has to be equal for each commodity serves to select the equilibrium prices which alone assure the compatibility of all decisions taken. Any price different from the equilibrium price would show at the end of the accounting period a surplus or a shortage of the commodity in question. Thus the accounting prices in a socialist economy, far from being arbitrary, have quite the same objective char­acter as the market prices in a regime of competition. Any mistake made by the Central Planning Board in fixing prices would announce itself in a very objective way-by a physical shortage or surplus of the quantity of the commodity or resources in question-and would have to be corrected in order to keep production running smoothly. As there is generally only one set of prices which satisfies the objective equilibrium condition, both the prices of products and costs30 are uniquely determined.31

Our study of the determination of equilibrium prices in a socialist economy has shown that the process of price determination is quite analogous to that in a competitive market. The Central Planning Board performs the func­tions of the market. It establishes the rules for combining factors of production and choosing the scale of output of a plant, for determining the output of an industry, for the allocation of resources, and for the parametric use of prices in accounting. Finally, it fixes the prices so as to balance the quantity supplied and demanded of each commodity. It follows that a substitution of planning for the functions of the market is quite possible and workable.

Having treated the theoretical determination of eco­nomic equilibrium in a socialist society, let us see how equilibrium can be determined by a method of trial and error similar to that in a competitive market. This method of trial and error is based on the parametric function of prices. Let the Central Planning Board start with a given set of prices chosen at random. All decisions of the man­agers of production and of the productive resources in public ownership and also all decisions of individuals as consumers and as suppliers of labor are made on the basis of these prices. As a result of these decisions the quantity demanded and supplied of each commodity is determined. If the quantity demanded of a commodity is not equal to the quantity supplied, the price of that commodity has to be changed. It has to be raised if demand exceeds supply and lowered if the reverse is the case. Thus the Central Planning Board fixes a new set of prices which serves as a basis for new decisions, and which results in a new set of quantities demanded and supplied. Through this process of trial and error equilibrium prices are finally determined. Actually the process of trial and error would, of course, proceed on the basis of the prices historically given. Rela­tively small adjustments of those prices would constantly be made, and there would be no necessity of building up an entirely new price system.

Thus the accounting prices in a socialist economy can be determined by the same process of trial and error by which prices on a competitive market are determined. To deter­mine the prices the Central Planning Board does not need to have "complete lists of the different quantities of all commodities which would be bought at any possible combi­nation of prices of the different commodities which might be available.40 Neither would the Central Planning Board have to solve hundreds of thousands (as Professor Hayek expects41) or millions (as Professor Robbins thinks42) of equations. The only "equations" which would have to be "solved" would be those of the consumers and the man­agers of production. These are exactly the same "equations" which are "solved" in the present economic system and the persons who do the "solving" are the same also. Consumers "solve" them by spending their income so as to get out of it the maximum total utility; and the managers of produc­tion "solve" them by finding the combination of factors that minimizes average cost and the scale of output that equalizes marginal cost and the price of the product.

….As we have seen, there is not the slightest reason why a trial and error procedure, similar to that in a competitive market, could not work in a socialist economy to determine the accounting prices of capital goods and of the pro­ductive resources in public ownership. Indeed, it seems that this trial and error procedure would, or at least could, work much better in a socialist economy than it does in a com­petitive market. For the Central Planning Board has a much wider knowledge of what is going on in the whole economic system than any private entrepreneur can ever have, and, consequently, may be able to reach the right equilibrium prices by a much shorter series of successive trials than a competitive market actually does.4 …

downupIV. THE GENERAL APPLICABILITY OF THE TRIAL AND ERROR METHOD

 

 

The procedure of trial and error described is also app cable to a socialist system where freedom of choice in Consumption and freedom of choice of occupation are not existent and where the allocation of resources, instead being directed by the preferences of consumers, is directed by the aims and valuations of the bureaucracy in charge of the administration of the economic system. In such a system the Central Planning Board decides which com­modities are to be produced and in what quantities, the consumers' goods produced being distributed to the citi­zens by rationing and the various occupations being filled by assignment. In such a system also rational economic accounting is possible, only that the accounting reflects the preferences of the bureaucrats in the Central Planning Board, instead of those of the consumers, The Central Planning Board has to fix a scale of preferences which serves as the basis of valuation of consumers' goods.

 Finally, the Central Planning Board has to impose the parametric function of the accounting prices fixed by itself and to fix them so as to balance the quantity supplied and the quantity demanded for each commodity. The price fixing can be done by trial and error, exactly as in the case studied above; the equilibrium prices thus fixed have a definite objective meaning. The prices are "planned" in so far as the preference scale is fixed by the Central Plan­ning Board; but once the scale is fixed, they are quite determinate. Any price different from the equilibrium price would leave at the end of the accounting period a surplus or a shortage of the commodity in question and thus impair the smooth running of the production process. …

 

By demonstrating the economic Consistency and worka­bility of a socialist economy with free choice neither in consumption nor in occupation, but directed rather by a preference scale imposed by the bureaucrats in the Central Planning Board, we do not mean, of course, to recommend such a system. Mr. Lerner has sufficiently shown the un­democratic character of such a system and its incompati­bility with the ideals of the socialist movement.47 Such a system would scarcely be tolerated by any civilized people. A distribution of consumers' goods by rationing was pos­sible in the Soviet Union at a time when the standard of living was at a physiological minimum and an increase of the ration of any food, clothing, or housing accommoda­tion was welcome, no matter what it was. But as soon as the national income increased sufficiently, rationing was given up, to be replaced to a large extent by a market for consumers' goods. And, outside of certain exceptions, there has always been freedom of choice of occupation in the Soviet Union. A distribution of consumers' goods by rationing is quite unimaginable in the countries of Western Europe or in the United States.

But freedom of choice in Consumption does not imply that production is actually guided by the choices of the consumers. One may well imagine a system in which production and the allocation of resources are guided by preference scale fixed by the Central Planning Boar' while the price system is used to distribute the consumer goods produced. In such a system there is freedom of choice in consumption, but the consumers have no influence whatever on the decisions of the managers of production and of the productive resources.48 There would be two sets of prices of consumers' goods. One would be the market prices at which the goods are sold to the consumers; the other, the accounting prices derived from the preference scale fixed by the Central Planning Board The latter set of prices would be those on the basis of which the managers of production would make their decisions.

However, it does not seem very probable that such a system would be tolerated by the citizens of a socialist Community. The dual system of prices of consumers' goods would reveal to the people that the bureaucrats in the Central Planning Board allocate the community's pro­ductive resources according to a preference scale different from that of the citizens. The existence of a dual price system of consumers' goods could scarcely be concealed from the people, especially if there existed an institution (like the Workers' and Peasants' Inspection in the Soviet Union49) giving to the rank and file citizen the right to pry into the bookkeeping and into the management of the community's upresources.

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