Economic Calculation in the Corporate Commonwealth: Part III
Mises argued that socialist governments directing nationalized economies were able to more or less approach economic rationality by setting their internal input prices with reference to foreign prices in countries where markets still prevailed. They would be able to function to some degree, despite the absence of market prices for producer goods, because
these were not isolated socialist systems. They were operating in an environment in which the price system still worked. They could resort to economic calculation on the ground of the prices established abroad. Without the aid of these prices their actions would have been aimless and planless. Only because they were able to refer to these foreign prices were they able to calculate, to keep books, and to prepare their much talked about plans. [Human Action, p. 703]
Murray Rothbard cited an actual example of the use of world market prices in communist planning. Economist Peter Wile reported his discussion with Polish economic planners:
What actually happens is that 'world prices,' i.e. capitalist world prices, are used in all intra-block trade. They are translated into rubles...and entered in bilateral clearing accounts. To the question, 'What would you do if there were no capitalist world?' came only the answer 'We'll cross that bridge when we come to it.' In the case of electricity the bridge is already under their feet: there has been great difficulty in pricing it since there is no world market.' [P. J. D. Wiles,"Changing Economic Thought in Poland,"Oxford Economic Papers 9 (June 1957): 202-3. In Rothbard, "Ludwig von Mises and Economic Calculation Under Socialism," Laurence S. Moss, ed., The Economics of Ludwig von Mises (Kansas City: Sheed and Ward, Inc., 1976), p. 72]
In Man, Economy, and State, Rothbard applied the calculation argument to the private sector firm in a market economy, raising the question of "the role of implicit earnings and calculation in a vertically integrated firm." [Man, Economy, and State, p. 545]
The firm buys labor and land factors at both the fifth and the fourth stages; it also makes the fourth-stage capital goods itself and uses them in another plant to make a lower-stage good....
Does such a firm employ calculation within itself, and if so, how? Yes. The firm assumes that it sells itself the fourth-rank capital good. It separates its net income as a producer of fourth-rank capital from its role as producer of third-rank capital. It calculates the net income for each separate division of its enterprise and allocates resources according to the profit or loss made in each division. It is able to make such an internal calculation only because it can refer to an existing explicit market price for the fourth-stage capital good. In other words, a firm can accurately estimate the profit or loss it makes in a stage of its enterprise only by finding out the implicit price of its internal product, and it can do this only if an external market price for that product is established elsewhere.
On the other hand, suppose that there is no external market, i.e., that the Jones Company is the only producer of the intermediate good. In that case, it would have no way of knowing which stage was being conducted profitably and which not. It would therefore have no way of knowing how to allocate factors to the various stages. There would be no way for it to estimate any implicit price or opportunity cost for the capital good at that particular stage. Any estimate would be completely arbitrary and have no meaningful relation to economic conditions.
In short, if there were no market for a product, and all of its exchanges were internal, there would be no way for a firm or for anyone else to determine a price for the good. A firm can estimate an implicit price when an external market exists; but when a market is absent, the good can have no price, whether implicit or explicit. Any figure could be only an arbitrary symbol. Not being able to calculate a price, the firm could not rationally allocate factors and resources from one stage to another.
Since the free market always tends to establish the most efficient and profitable type of production (whether for type of good, method of production, allocation of factors, or size of firm), we must conclude that complete vertical integration for a capital-good product can never be established on the free market (above the primitive level). For every capital good, there must be a definite market in which firms buy and sell that good. It is obvious that this economic law sets a definite maximum to the relative size of any particular firm on the free market. Because of this law, firms cannot merge or cartelize for complete vertical integration of stages or products. Because of this law, there can never be One Big Cartel over the whole economy or mergers until One Big Firm owns all the productive assets in the economy. The force of this law multiplies as the area of the economy increases and as islands of noncalculable chaos swell to the proportions of masses and continents. As the area of incalculability increases, the degrees of irrationality, misallocation, loss, impoverishment, etc., become greater. Under one owner or one cartel for the whole productive system, there would be no possible areas of calculation at all, and therefore complete economic chaos would prevail.
Economic calculation becomes ever more important as the market economy develops and progresses, as the stages and the complexities of type and variety of capital goods increase. Ever more important for the maintenance of an advanced economy, then, is the preservation of markets for all the capital and other producers’ goods.
Our analysis serves to expand the famous discussion of the possibility of economic calculation under socialism, launched by Professor Ludwig von Mises over 40 years ago. Mises, who has had the last as well as the first word in this debate, has demonstrated irrefutably that a socialist economic system cannot calculate, since it lacks a market, and hence lacks prices for producers’ and especially for capital goods. Now we see that, paradoxically, the reason why a socialist economy cannot calculate is not specifically because it is socialist! Socialism is that system in which the State forcibly seizes control of all the means of production in the economy. The reason for the impossibility of calculation under socialism is that one agent owns or directs the use of all the resources in the economy. It should be clear that it does not make any difference whether that one agent is the State or one private individual or private cartel. Whichever occurs, there is no possibility of calculation anywhere in the production structure, since production processes would be only internal and without markets. There could be no calculation, and therefore complete economic irrationality and chaos would prevail, whether the single owner is the State or private persons.
The difference between the State and the private case is that our economic law debars people from ever establishing such a system in a free-market society. Far lesser evils prevent entrepreneurs from establishing even islands of incalculability, let alone infinitely compounding such errors by eliminating calculability altogether. [Man, Economy, and State, pp. 545-49]
Rothbard further elaborated on this argument in "Ludwig von Mises and Economic Calculation Under Socialism":
There is one vital but neglected area where the Mises analysis of economic calculation needs to be expanded. For in a profound sense, the theory is not about socialism at all! Instead, it applies to any situation where one group has acquired control of the means of production over a large area—or, in a strict sense, throughout the world. On this particular aspect of socialism, it doesn't matter whether this unitary control has come about through the coercive expropriation brought about by socialism or by voluntary processes on the free market. For what the Mises theory focuses on is not simply the numerous inefficiencies of the political as compared to the profit-making market process, but the fact that a market for capital goods has disappeared. This means that, just as Socialist central planning could not calculate economically, no One Big Firm could own or control the entire economy. The Mises analysis applies to ay situation where a market for capital goods has disappeared in a complex industrial economy, whether because of socialism or because of a giant merger into One Big Firm or One Big Cartel.
If this extension is correct, then the Mises analysis also supplies us the answer to the age-old criticism leveled at the unhampered, unregulated free-market economy: what if all firms banded together into one big firm that would exercise a monopoly over the economy equivalent to socialism? The answer would be that such a firm could not calculate because of the absence of a market, and therefore that it would suffer grave losses and dislocations. Hence, while a Socialist Planning Board need not worry about losses that would be made up by the taxpayer, One Big Firm would soon find itself suffering severe losses and would therefore disintegrate under this pressure. We might extend this analysis even further. For it seems to follow that, as we approach One Big Firm on the market, as mergers begin to eliminate capital goods markets in industry after industry, these calculation problems will begin to appear, albeit not as catastrophically as under full monopoly. In the same way the Soviet Union suffers calculation problems, albeit not so severe as would be the case were the entire world to be absorbed into the Soviet Union with the disappearance of the world market. If, then, calculation problems begin to arise as markets disappear, this places a free-market limit, not simply on One Big Firm, but even on partial monopolies that eradicate markets. Hence, the free market contains within itself a built-in mechanism limiting the relative size of firms in order to preserve markets throughout the economy. This point also serves to extend the notable analysis of Professor Coase on the market determinants of the size of the firm, or of the relative extent of corporate planning within the firm as against the use of exchange and the price mechanism. Coase pointed out that there are diminishing benefits and increasing costs to each of these two alternatives, resulting, as he put it, in an"'optimum' amount of planning"in the free market system." Our thesis adds that the costs of internal corporate planning become prohibitive as soon as markets for capital goods begin to disappear, so that the free-market optimum will always stop well short not only of One Big Firm throughout the world market but also of any disappearance of specific markets and hence of economic calculation in that product or resource. ["Ludwig von Mises and Economic Calculation under Socialism," pp. 75-76]
The main shortcoming of Rothbard's analysis is that, as Peter Klein characterized it,
Rothbard is making a claim only about the upper bound of the firm, not the incremental cost of expanding the firm's activities (as long as external market references are available). ["Economic Calculation and the Limits of Organization," The Review of Austrian Economics Vol. 9 No. 2 (1996).]
But the larger and more vertically integrated the corporation, even when outside markets continue to exist for all its inputs, the further removed are its internal conditions from the immediate conditions under which prices are formed moment to moment in the outside market. The external market prices are to some extent arbitrary, reflecting the situation of market actors outside the firm rather than the situation within the firm. Pricing based on the available supply and the valuation of purchasers under the spot conditions of the market may lead to irrational allocations given different conditions of supply and valuation within the firm. If nothing else, the fact that the firm is "exchanging" factors internally, rather than bidding in the outside market, distorts the price in the outside market so that it is different from what it would be if the firm were a participant in it. The outside market's prices are atypical or misleading precisely to the extent that they do not incorporate the valuations of the firm in question. Rothbard himself admitted as much, in a footnote to Man, Economy and State:
The implicit price, or opportunity cost of selling to oneself, might be less than the existing market price, since the entry of the Jones Company on the market might have lowered the price of the good, say to 102 ounces. [900-01, n56]
On this, Peter Klein comments:
Unlike Hirshleifer (1956), then, Rothbard does not require the external market to be perfectly competitive for a market-based transfer price to be economically meaningful. For Rothbard, "thin" markets are adequate: all that is necessary to have a genuine "external market" is the existence of at least one other producer (seller) of the intermediate good. ["Economic Calculation and the Limits of Organization," p. 14 n. 13; reference is to Jack Hirshleifer, "On the Economics of Transfer Pricing," Journal of Business 29 (1956): 172-89]
But this is unsatisfactory. The outside market price is as approximate and distorted, from the standpoint of the firm's internal planners, as market prices in the West were to Soviet state planners. Or at least, the unsatisfactoriness and approximateness are similar in kind, if not degree. If all that matters is that some external market continue to exist, no matter how unrepresentative of conditions within the firm, then a state-planned economy ought to work just fine on implicit pricing based on foreign markets, so long as some market continued to exist anywhere in the world.
On the other hand, Rothbard's size threshold in its practical effect might be quite low if, as he seemed to suggest, the requirement for "factor markets" applies to intermediate components or unfinished goods as well as basic raw materials. If the component parts of a complex consumer good are to some extent unique and differentiated from the components of competing versions of that good, in ways that prevent generic pricing of the components, the firm must set an internal transfer price for the component that is estimated on some cost-plus basis. In this case, Rothbard seems to argue, the more indirectly the transfer price is derived from the actual market prices of other producer goods, the further removed from reality are the firm's attempts at calculation. If this is taken as Rothbard's explicit doctrine, then most oligopoly manufacturing corporations probably exceed Rothbard's threshold; the majority of firms would fall within his threshold only where the predominant model of organization was to organize each stage of production as a separate firm and coordinate them by contract.
When no external market exists for intermediate products or components, the usual practice is to estimate the transfer price on a cost-plus basis, or perhaps to allow the buying and selling divisions to bargain in an internal "market." Rothbard (p. 547) dismissed such a transfer price as "only an arbitrary symbol." Peter Klein adds:
At the very least, any artificial or substitute transfer prices will contain less information than actual market prices... ["Economic Calculation and the Limits of Organization," p. 14]
The problem is complicated by the general distortion of prices under state capitalism. If prices for production inputs are necessary for economic calculation, then subsidies and other externalities caused by state intervention will distort the basic data on which coherent entrepreneurial decisionmaking will be based; the result is a tendency toward calculational chaos. [I'm indebted to Oisin O'Connell for making this connection, in his paper "The Green Star Idea" (unpublished course paper, 2007)]
Rothbard's assertion that "[f]ar lesser evils prevent entrepreneurs from establishing even islands of incalculability," under corporate capitalism, is quite doubtful. He neglects the extent to which the large corporation, as an island of incalculability, is insulated from the market penalties for calculational chaos.
The existing state capitalist system has promoted economic centralization and large scale to the extent that it is impossible for any decisionmaker to aggregate the distributed knowledge necessary to take both entrepreneurial and technical questions into account in making a rational decision. But the large corporate firm operates in an enviroment of restraints on competition, shared cultures of inefficiency with other firms in the same industry, and push distribution models, so that it is insulated to a considerable degree from the consequences of irrational decisions.
In fact, the parallels between the kinds of uneven development and misallocation that exist under state socialism, and the equivalent phenomena under state capitalism, are striking. The corporate economy, as a whole, operates in nearly the same atmosphere of calculational chaos as the Soviet planned economy. Like the Soviet planned economy, it is able to stagger on because it does at least translate production inputs into real use-value. But like the Soviet planned economy, its managers have little idea whether the use-value produced came at the expense of some other, greater use-value that might otherwise have resulted from the same inputs. Like the Soviet economy, it has little idea of the comparative efficiency or inefficiency with productive inputs have been used. Like the Soviet planned economy, although to a lesser extent, it is insulated from competition by those who might more accurately assess the needs of consumers or organize resources more efficiently in meeting those needs.
The problem with a state economy, as Mises pictured it, was not that it would be incapable of technical sophistication. A state socialist economy might produce use-value. The problem is that the planners would have absolutely no idea whether the use-value created was worth the cost: did it absorb inputs that might have been used for some greater use value? "All economic change... would involve operations the value of which could neither be predicted beforehand nor ascertained after they had taken place. Everything would be a leap in the dark." [Socialism: An Economic and Sociological Analysis. Translated by J. Kahane. New edtion, enlarged with an Epilogue (New Haven: Yale University Press, 1951).
Richard Ericson remarked on the ability of communist systems to achieve great feats of engineering without regard to cost:
When the system pursues a few priority objectives, regardless of sacrifices or losses in lower priority aras, those ultimately responsible cannot know whether the success was worth achieving." ["The Classical Soviet-Type Economy: Nature of the System and Implications for Reform." Journal of Economic Perspectives 5:4 (1991), p. 21]
Consider also Hayek's prediction of the uneven development, irrationality, and misallocation of resources within a planned economy:
There is no reason to expect that production would stop, or that the authorities would find difficulty in using all the available resources somehow, or even that output would be permanently lower than it had been before planning started.... [We should expect] the excessive development of some lines of production at the expense of others and the use of methods which are inappropriate under the circumstances. We should expect to find overdevelopment of some industries at a cost which was not justified by the importance of their increased output and see unchecked the ambition of the engineer to apply the latest development elsewhere, without considering whether they were economically suited in the situation. In many cases the use of the latest methods of production, which could not have been applied without central planning, would then be a symptom of a misuse of resources rather than a proof of success.
As an example he cited "the excellence, from a technological point of view, of some parts of the Russian industrial equipment, which often strikes the casual observer and which is commonly regarded as evidence of success...." [F. A. Hayek. "Socialist Calculation II: The State of the Debate (1935)," in Hayek, Individualism and Economic Order (Chicago: University of Chicago Press, 1948), pp. 149-50]
To anyone observing the uneven development of the corporate economy under state capitalism, this should inspire a sense of deja vu. Entire categories of goods and production methods have been developed at enormous expense, either within military industry or by state-subsidized R&D in the civilian economy, without regard to cost. [Two of David Noble's works, Forces of Production: A Social History of Industrial Automation (New York: Alfred A. Knopf, 1984), and America by Design: Science, Technology, and the Rise of Corporate Capitalism (New York: Alfred A. Knopf, 1977) are a good starting point on this subject. Miniaturized circuitry, digital control systems for machine tools, cybernetics, and quality control systems--just to name a few examples--were all direct spillovers from the military economy.] Subsidies to capital accumulation, R&D, and technical education radically distort the forms taken by production. Blockbuster factories and economic centralization become artificially profitable, thanks to the Interstate Highway System and other means of externalizing distribution costs.
These quotes on communist central planning also describe quite well the environment of pervasive irrationality within the large corporation: management featherbedding and self-dealing; "cost-cutting" measures that decimate productive resources while leaving management's petty empires intact; and the tendency to extend bureaucratic domain while cutting maintenance and support for existing obligations. Management's allocation of resources no doubt creates use value of a sort--but with no reliable way to assess opportunity cost or determine whether the benefit was worth it.
In this article we have examined the inefficiencies of the large corporation, resulting directly from the internal diseconomies of scale: the separation of economic from technical knowledge; the informational problems of aggregating distributed knowledge in a hierarchy; the agency problems of divorcing the benefits of increased productivity from the knowledge of how to improve the process; and the calculational chaos created by removing internal transfer pricing from its proper basis in the market.
The solution is to avoid hierarchy as much as possible, and to internalize the costs and benefits of organizing production in the same decisionmakers.
Insofar as the production process involves a series of discrete, severable steps, the best way of circumventing informational and incentive problems may be to relate the separate steps to one another by contract--especially if each step, organized under a separate firm, takes the internal form of a producer cooperative.
Each step, although a black box to those outside, from an inside perspective is ideally suited to aggregating all relevant information for consideration by a single group of decision-makers. In a self-managed enterprise, the same elected management that considers the relative prices of different productive inputs, and the price of the finished product, is also experienced in the actual production process in which the inputs are used. They are most qualified, of all people, to decide not only the relative priority by which productive inputs ought to be economized, but the most effective technical methods of organizing production in order to economize those inputs.
From an outside perspective, on the other hand, other contracting firms are able to make a virtue of necessity in treating a particular stage of production--organized as a separate firm--as a black box. The outside contractor and the internal hierarchy are equally ignorant of goings-on inside the black box. The difference is that an outside contractor, unlike a hierarchy, has no need to know what's happening in the internal production process, and no power to interfere with what he doesn't understand. So long as the inputs (likely in money terms) are specified by contract, and the outputs are verifiable and enforceable, what goes on inside the box isn't the outside contractor's problem.
The mainstream of the transaction cost school, the progeny of Coase and Williamson, greatly underestimates the internal agency costs of organizing transactions within a corporate hierarchy. The ideal contract, after all, is "sharp ins by clear agreement, sharp outs by clear performance." It is far simpler and less costly to simply monitor the contractually specified "ins" and "outs" going to and from a contracting firm, than to monitor the internal use of inputs within the production process: the "in" usually consisting simply of an amount of money established by contract, perhaps along with some intermediate goods for processing, and the "out" a finished product of specified quality and quantity. So long as the ins and outs (the money price and the quality and quantity of finished goods) can be effectively monitored, the contracting party has no need to worry about the internal efficiency of the production process. It has effectively outsourced the responsibility for decisions on how best to organize production to those engaged in production.
The contracting firm, if cooperatively owned by self-managed workers, is uniquely qualified to organize production most efficiently given the specified ins and outs. Just as important, unlike a production unit within a corporate hierarchy, the production workers within the contracting producers' co-op fully internalize all the costs and benefits of their production decisions. Unlike the case within a corporate hierarchy, there is no conflict of interests resulting from the making of decisions by managers who stand to reap the benefits of increased productivity while workers suffer only the costs. For a self-managed production unit, any decision concerning production methods will be a tradeoff of costs and benefits, all of which are fully internalized by the decisionmakers.