Tuesday, 5 July 2016

Economic calculation and the theory of the firm

Ludwig von Mises is famous for pointing out that even in theory socialism cannot work. Checkout the current state of the Soviet Union and Eastern Europe or Cuba or Venezuela for empirical evidence on this matter, if you need it. Mises’s argument on ‘economic calculation’ can be summarised as follows (Boettke 1998):
“1 Without private property in the means of production, there will be no market for the means of production.
2 Without a market for a means of production, there will be no monetary prices established for the means of production.
3 Without monetary prices, reflecting the relative scarcity of capital goods, economic decision-makers will be unable to rationally calculate the alternative use of capital goods.”
In short, to be able to rationally decide on how to allocate scare capital resources among the many possible uses they can be put to, market prices are a necessary informational input. That is, entrepreneurs need prices to decide what to produce and how to produce it. Without prices an entrepreneur cannot compare the many possible goods to produce and the multitude of ways to produce them.

This shows us that any institutional regime, eg socialism, which attempts to abolish private ownership of the means of production cannot work. While it is clear that this is so for the economy as a whole, it is not so clear that the argument has important implications for institutions that are just part of the economy, in particular firms. Or it has at least two important implications for the theory of the firm.

First it highlights the need to include the entrepreneur into models of the firm. A point to keep in mind is that the neoclassical model is one in which Mises’s argument is effectively sidestepped. The model has market prices but without (real) ownership of the means of production. This is why the market socialists could use the model in response to Mises. This point is particularly relevant for the textbook, neoclassical, theory of the firm. An implication of Mises’s argument is that models that without genuine markets for the means of production, the model has no role for the entrepreneur. The entrepreneur is the one who carries out the economic calculations, she is the one who combines the factors of production together in such a way as to satisfy consumers’ current or future demands. It is also the entrepreneur who forms firms (and via them markets (Spulber 2009)). In models with ‘passive’ markets for inputs there is no genuine role for an entrepreneur. The neoclassical model in such a framework. In it the firms (and markets) are simply assumed into existence, there is no explanation for where it comes from or who forms it or why it is necessary to have it. There is no consideration of the role of the entrepreneur since there is no need of one. Inputs are simply combined via the market by the owners of the means of production responding to market prices and interaction via elaborate complete contracts.

More than 40 years ago William Baumol noted that the entrepreneur has no place in formal neoclassical theory.
“Contrast all this with the entrepreneur’s place in the formal theory. Look for him in the index of some of the most noted of recent writings on value theory, in neoclassical or activity analysis models of the firm. The references are scanty and more often they are totally absent. The theoretical firm is entrepreneurless−the Prince of Denmark has been expunged from the discussion of Hamlet” (Baumol 1968: 66).
Baumol notes that the reasons for this are not hard to find. Within the formal model the ‘firm’ is a production function or production possibilities set, it is simply a means of creating outputs from inputs. Given input prices, technology and demand, the firm maximises profits subject to its production plan being technologically feasible. The firm is modelled as a single agent who faces a set of relatively uncomplicated decisions, e.g. what level of output to produce, how much of each input to utilise etc. Such ‘decisions’ are not decisions at all, they are simple mathematical calculations, implicit in the given conditions. The ‘firm’ can be seen as a set of cost curves and the ‘theory of the firm’ as little more than a calculus problem. In such a world there is a role for a ‘decision maker’ (manager) but no role for an entrepreneur.

Market socialists could utilise this model when responding to Mises’s attack since in the neoclassical model, given it is a zero transaction cost world of complete contracts, there is no role for ownership as contracts cover every state of the world. There is no situation to be faced or decision to be made that is not included in the terms of the contract and thus there is nothing for an owner to do, the contract does it all. This is as true of the markets for the factors of production as for output markets and so such markets react passively to prices without the need of serious decision making by an entrepreneur. The manager just sets marginal benefits equal to marginal costs in both input and output markets. In fact, the model can be seen as one without entrepreneurs or firms.

As there is no role for ownership in such a world and any organisational structure can mimic any other, it’s not hard to see that a centrally planned economy can mimic a market economy, which was basically the market socialists’ claim. The market socialist argument works, in part, because the neoclassical model suppresses the role of the entrepreneur.

What this highlights is the need for the inclusion of the entrepreneur into economic theory and, in particular, the integration of the entrepreneur with the theory of the firm. This is a process that has started within mainstream economics with works such as Spulber (2009) and Foss and Klein (2012).
In his essay “Ludwig von Mises and Economic Calculation Under Socialism” Murray N. Rothbard make a second point about how Mises’s argument is relevant to the theory of the firm. Rothbard argues that Mises's point about the impossibility of socialism can be applied to the problem of the size of firms. Rothbard writes that
“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”.
In other words, it can apply to a firm.

Rothbard continues
“[ … ] 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”.
Rothbard then notes that this argument is related to Coase's argument about the size of firms.
“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 ah " '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. Coase stated that the important difference between planning under socialism and within business firms on the free market is that the former "is imposed on industry while firms arise voluntarily because they represent a more efficient method of organizing production." if our view is correct, then, this optimal free-market degree of planning also contains within itself a built-in safeguard against eliminating markets, which are so vital to economic calculation”.
So we can think of Mises’s argument as giving an upper bound to the size of firms.

  • Baumol, William J. (1968). ‘Entrepreneurship in Economic Theory’, American Economic Review, 58(2) May: 64–71.
  • Boettke, P. J. (1998). “Economic Calculation: The Austrian Contribution to Political Economy,” Advances in Austrian Economics 5: 131–58.
  • Foss, Nicolai J. and Peter G. Klein (2012). Organizing Entrepreneurial Judgment: A New Approach to the Firm, Cambridge: Cambridge University Press.
  • Rothbard, Murray N. (1976). "Ludwig von Mises and Economic Calculation Under Socialism," in Lawrence Moss, The Economics of Ludwig won Mises, pp. 67–77.
  • Spulber, Daniel F. (2009). The Theory of the Firm: Microeconomics with Endogenous Entrepreneurs, Firms, Markets, and Organizations, Cambridge: Cambridge University Press.

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