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The idea of efficient planning in a socialist economy is plausible only if we assume that economic value is an objective feature of commodities, one that can be rationally ascertained apart from the give and take of market competition. Karl Marx (1818-1883) made precisely this assumption. Like David Ricardo and other economists in the classical school, Marx defended a labor theory of value. It is interesting to note that Marx finished only one volume of Capital (1867) during his lifetime, a book that was published as the theory of marginal utility was about to revolutionize economic thought. (The books by Menger and Jevons were published in 1871, that by Walras in 1874.) But this was one revolution that Marx failed to appreciate. By the time Friedrich Engels, using Marx’s notes, pieced together the second and third volumes of Capital (1885, 1894), the labor theory of value had ossified into a sacred relic for socialists and anarchists but found relatively few adherents outside those ranks.

Economic value, according to Mises and others in the Austrian School, is not an objective property of commodities. Rather, value is imputed to commodities according to their perceived utility in serving human wants. As Mises put it in Socialism: An Economic and Sociological Analysis:

Every man who, in the course of economic activity, chooses between the satisfaction of two needs, only one of which can be satisfied, makes judgments of value. Such judgments concern firstly and directly the satisfaction themselves; it is only from these that they are reflected back upon goods.

We compare our preferences by ranking them, not by measuring them. It makes sense, for example, to say that I like apples more than oranges, and oranges more than pears, and therefore that I like apples more than pears. But it makes no sense to say that I like apples twice as much as I like oranges, and oranges three times more than pears, and therefore that I like apples six times more than I like pears.

In other words, since economic value derives from estimates of personal satisfaction, and since there is no invariant unit of satisfaction that can serve as a standard of measurement, it is impossible to measure, compute, or add up the marginal utility of various commodities. We can rank values ordinally, but we cannot measure them cardinally. As Mises pointed out, this creates a problem when we need to make economic calculations:

Computation demands units. And there can be no unit of the subjective use-value of commodities. Marginal utility provides no unit of value…Judgments of value do not measure: they arrange, they grade.

Our subjective estimates of value may prove sufficient when dealing with simple situations, as when Crusoe, alone on his island, is calculating how to provide for his wants in the immediate future. But the problem of calculation becomes insurmountable in more complex situations, especially when a sophisticated division of labor is in place. When lengthy and complicated processes of production are involved, our estimates of subjective use value will fail to give us the information we need for long-range economic planning.

That which subjective use value cannot accomplish in a free market is accomplished instead by objective exchange value. By “objective exchange value,” Mises meant the money-price of a commodity, which serves as the required unit of economic calculation. Money, according to Mises, does not measure value, nor are prices somehow measured by money. Rather, prices are simply amounts of money. Mises called the price of a commodity its “objective exchange value” because that price—which arises from the interplay of the subjective valuations of those engaged in buying and selling—can serve as a practical means of economic calculation.

Calculations of this sort provide a control upon the appropriate use of the means of production. They enable those who desire to calculate the cost of complicated processes of production to see at once whether they are working as economically as others. If, under prevailing market prices, they cannot carry through the process at a profit, it is a clear proof that others are better able to turn to good account the instrumental goods in question. Finally, calculations based upon exchange values enable us to reduce values to a common unit. And since the higgling of the market establishes substitution relations between commodities, any commodity desired can be chosen for this purpose. In a money economy, money is the commodity chosen.

Money prices are necessary if we are to engage in long-range and complex calculations. They enable us to compare different production methods and determine which will produce the desired good at the lowest cost. Mises offered a concrete example of a problem that socialism is unable to solve, precisely because socialism, by prohibiting the private ownership of capital goods, also abolishes the market transactions that are required to generate prices for those capital goods.

Suppose…that the socialist commonwealth was contemplating a new railway line. Would a new railway line be a good thing? If so, which of many possible routes should it cover? Under a system of private ownership we could use money calculations to decide these questions. The new line would cheapen the transportation of certain articles, and, on this basis, we could estimate whether the reduction in transport charges would be great enough to counterweigh the expenditure which the building and running of the line would involve. Such a calculation could be made only in money….We can make systematic economic plans only when all the commodities which we have to take into account can be assimilated to money. True, money calculations are incomplete. True, they have profound deficiencies. But we have nothing better to put in their place. And under sound monetary conditions they suffice for practical purposes. If we abandon them, economic calculation becomes absolutely impossible.

This is why Mises predicted the inevitable failure of central planning. His portrayal of socialism, first made in 1920, proved remarkably accurate, especially in regard to the Soviet Union.

All transactions…will be subject to the control of a supreme authority. Recourse will be had to the senseless output of an absurd apparatus. The wheels will turn, but will run to no effect.

Socialism, far from being more scientific and rational than the free market, actually annihilates the possibility of rational planning.

[I]n the socialist commonwealth every economic change becomes an undertaking whose success can be neither appraised in advance nor later retrospectively determined. There is only groping in the dark. Socialism is the abolition of rational economy.

The arguments of Mises caused some socialists to re-examine the plausibility of their own theories, and even caused some to embrace the free-market principles of classical liberalism. Among those former socialists was a young Friedrich Hayek, who would go on to become one of the twentieth century’s most influential advocates of free markets and limited government. As Hayek said of his generation in Vienna after WWI:

We felt that the civilization in which we had grown up had collapsed. We were determined to build a better world, and it was this desire to reconstruct society that led many of us to the study of economics. Socialism promised to fulfill our hopes for a more rational, more just world.

When Socialism first appeared in 1922, its impact was profound. It gradually, but fundamentally, altered the outlook of many of the young idealists returning to their studies after the First World War. I know, for I was one of them.

Hayek later expanded on the ideas of Mises, applying them in ways that enhanced our understanding not only of why socialism fails but of why capitalism succeeds. Hayek is perhaps best known for his argument that free markets are able to coordinate the dispersed knowledge of millions of people in a way that maximizes economic efficiency. As Hayek wrote in his 1945 essay, “The Use of Knowledge in Society,”

The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate ‘given’ resources—if ‘given’ is taken to mean given to a single mind which deliberately solves the problem set by these ‘data.’ It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality.

Thus prices in a free market, in addition to enabling us to make economic calculations, are also a sophisticated method for communicating knowledge. As Hayek put it, “We must look at the price system as such a mechanism for communicating information if we want to understand its real function.” (I would argue that this Hayekian insight is implicit in the Misesian argument about economic calculation.)

When governments forcibly intervene in market transactions, they reduce or distort the information that would otherwise flow through market channels. This will generate various problems, depending on the severity of the interventions, and those problems, in turn, will typically generate demands for even more intervention. Thus as interventions multiply, and despite the best intentions of planners, a country will become trapped in a downward economic spiral that will terminate in a highly regimented economy. This is the Road to Serfdom that Hayek described in his best-selling book. Or, as the title of a book by Mises put it, this is the way to Planned Chaos.

I have presented only a barebones summary of some arguments by Mises and Hayek against a command economy—arguments that will already be familiar to many libertarians. But I know that some libertarians have an allergic reaction to economic theory, so I wrote this two-part series in the hope that it will encourage such people to investigate the ideas and writings of Mises and Hayek in more detail.

Ludwig von Mises (1881-1973) was a brilliant economist, a leading proponent of the Austrian School of economics, but he was more. He was an interdisciplinary thinker of remarkable breadth who was conversant in history, social theory, and philosophy. His greatest book, Human Action, is a masterful exposition of praxeology (the science of human action); and throughout his many other books—such as Theory and History, The Epistemological Problems of Economics, and The Theory of Money and Credit—we see an original, first-rate mind at work.

Mises is perhaps best known for his early critique of socialism, which convinced many economists, including a young socialist named Friedrich Hayek, that rational economic calculation is impossible in a socialist system. Optimal economic coordination requires a free market in which prices transmit crucial information about the supply and demand of capital goods.

Mises drew on the Austrian theory of value to argue that socialism cannot solve the problem of economic calculation. Thus, before presenting the Misesian argument, I will present some relevant background information on this theory of value.

Central to all economic analysis is the concept of value. In classical economics—whose major exponents included Adam Smith, David Ricardo, and John Stuart Mill—two kinds of value were often distinguished, namely value in use and value in exchange. “Use value” signifies the usefulness, or utility, of a given commodity, such as water. Because water is essential to human life, it was said to have a high use value. “Exchange value,” in contrast, refers to what a given commodity can fetch in the market when it is exchanged for something else. Because diamonds will command a good deal in return, they were said to have a high exchange value.

As Adam Smith put it in The Wealth of Nations, the word value “has two different meanings, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys.” After distinguishing “value in use” from “value in exchange,” Smith continued:

The things which have the greatest value in use have frequently little or no value in exchange; and, on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.

Although modern economists sometimes refer to this distinction as “the paradox of value”(or “the water-diamond paradox”), this was not how it was viewed by Smith and his many predecessors (going back to Aristotle). Smith was not puzzled by this “paradox,” which he explained in the same manner as it had been explained many times before, i.e., in terms of relative scarcity. As he put it in his Lectures on Jurisprudence, the market price of a commodity depends on three things: first, “the demand or need for it (whether this be real or capricious)”; second, “the abundance of it in proportion to this demand”; third, “the wealth of the…demanders.”

Something for which there is no demand, such as a lump of clay, will not command a market price. But if something is perceived as useful and thereby generates a demand, then “the price will be regulated according to the demand.” Thus even a good which has little use value will command a high price “if the quantity be not sufficient to supply the demand; hence the price of diamonds.” On the other hand, a highly useful good like water, if it exists in superabundance and is able to “more than supply all possible demands, renders water of no price at all.”

Although Smith’s explanation is valid so far as it goes, the positing of two different types of “value” generated some problems for classical economists that they were unable to resolve. A unified theory of value did not emerge until the 1870s, when there occurred what is known as the “marginal utility revolution” in economic thought. This important innovation was arrived at independently by three men: William Stanley Jevons in England, Leon Walras in Switzerland, and Carl Menger in Austria. Although these men differed somewhat in their treatments of marginal utility, their central insights were essentially the same. (The term “marginal utility” was coined by the Austrian economist Friedrich von Wieser.)

As these economists pointed out, when we choose one commodity over another, we do not consider the general usefulness of that commodity. We do not, for example, consider the general utility of water—its role in supporting human life—when deciding how much we are willing to exchange for a specific amount of water. True, if we had to choose between all the water in the world and all the diamonds in the world, then we would choose water over diamonds, but rarely are we faced with this all-or-nothing situation. Instead, we confront commodities as they exist in specific quantities, or units, and how much we subjectively value a given unit of a given commodity depends on how we plan to use it.

Suppose we are deciding whether or not to purchase a gallon of water. How much we are willing to pay will be based not on the general usefulness of water but on the contribution that the additional gallon of water will make to satisfying our “marginal” wants. And this, of course, depends on how much water we already have. A man dying of thirst in a desert will value a gallon of water more highly than he would in normal circumstances, because he will use that gallon to sustain his life—rather than using it, say, to wash his car, which is what he might do in circumstances in which water is more plentiful.

Thus economic value ultimately depends not on the general usefulness of a commodity but on the specific usefulness—or marginal utility—of a given unit of that commodity in satisfying our most pressing desires. If water is abundant—that is, if most of our important wants are easily satisfied by the available water—then we will place a relatively low value on each additional unit of water, because that unit will be used to fulfill a want that we consider relatively unimportant. And if diamonds, while greatly prized, are normally scarce, then we will place a relatively high value on each additional unit of diamonds, because that unit will be used to satisfy a want that ranks high on our scale of preferences.

As I noted before, the classical economists were able to explain the water-diamond paradox fairly well in terms of relative scarcity, but their dualistic theory of value, which distinguished between use value and exchange value, created more problems than it solved. The theory of marginal utility was a significant theoretical advance because it was able to dispense with this dichotomy in favor of a unified theory of value. It was now understood that exchange value can ultimately be explained in terms of use value—provided that we correctly understand the meaning of “use value” as referring to the marginal use of a specific quantity of an economic good.

This is where the discussion of marginal utility by Carl Menger (1840-1921) is especially important if we are to appreciate what Ludwig von Mises had to say about economic calculation. Menger, who is generally acknowledged as the founder of the Austrian School, stressed the subjective nature of use value. The economic value of a commodity, argued Menger, depends ultimately on our subjective valuations, specifically, on how we assess the usefulness of a good in furthering our subjective goals. Economic science does not pass judgment on the true worth, or objective value, of an economic good. It does not, for instance, evaluate the “true” worth of water in relation to diamonds. Rather, economics takes as its starting point what people do in fact value, and it then analyzes the economic phenomena that emerge from this pursuit of subjective goals.

Menger’s distinctive contribution to marginal utility was his extension of this theory to what he called “goods of a higher order”—or what are sometimes called “capital goods” or “the means of production,” in contrast to “consumer goods.” Many economists had contrasted supply (or the factors of production) with consumer demand, as if these elements operated according to different principles of value. But this is incorrect, said Menger; ultimately the value of all higher-order goods depends on their role in producing consumer goods, those things that people use directly to satisfy their desires. “Goods of a higher order”—so-called because they fall higher than consumer goods on the scale of production—are indirect means of satisfying human wants. A steel factory may not produce anything that is directly used by the consumer, but it does satisfy consumer demand indirectly by providing the material for the building of cars and other goods that are directly used by the consumer.

Menger’s discussion of higher-order goods allowed him to apply the notion of marginal utility not only to consumer goods but to the factors of production as well. This insight proved essential to the Misesian argument that planners in a socialist economy will be unable to engage in rational economic calculation. Mises first advanced his argument in a 1920 essay, “Economic Calculation in the Socialist Commonwealth,” and he expanded upon it two years later in his seminal book, Socialism: An Economic and Sociological Analysis.

Pure socialism is a system in which there is no private ownership of the means of production; all production decisions are made by a central planning authority. Unlike a market system, in which capitalists and entrepreneurs can base their production decisions on the market prices of higher-order goods, the planners in a socialist economy have no such prices to guide them. What, then, can these planners substitute for market prices? What rational criteria can they use in determining which higher order goods are needed, and in what amount, in order to produce the desired consumer goods?

Without market prices to guide production, argued Mises, no rational calculation is possible. Thus the supposed rational economic planning of socialism (or any kind of planned economy) leads to economic chaos, to inefficiency and waste on a massive scale.

To be continued…