The Austrian contribution, Austrian Contributions

The essential question of the technical debate is how resources will be allocated under socialism. Ludwig von Mises (1881-1973) became the writer who most significantly influenced subsequent developments on this issue, possibly in part because of the force of his attack on socialism, and in part because he concentrated on these issues for much of his life. He was later joined in his study of this question by his student Friedrich von Hayek (1889-1992).
In 1920 Mises published an article in which he contended that a rational allocation of resources was not possible under socialism.4 Mises observed the operation of markets under capitalism, pointing particularly to the key role played by factor markets. In these markets owners of land, labor, and capital supply the factors of production to firms demanding them. Prices emerge, and on the basis of these prices and the available technology, firms make decisions on the most economical way to combine factors to produce final products. Under socialism the factors of production are, for the most part, not individually owned; they are owned by the community. Mises contended that because there are no independent owners of the factors of production, there would be no factor markets and no set of prices emerging from these markets. Rational decision making for resource allocation is not possible without factor prices:-"As soon as one gives up the conception of a freely established monetary price for goods of a higher order [factors of production], rational production becomes completely impossible. Every step that takes us away from private ownership of the means of production also takes us away from rational economics."5
Although the earlier work of Pareto and Barone had already allegedly dem­onstrated that Mises' argument was erroneous, his position was challenged by F. M. Taylor in his presidential address to the American Economic Association in 1928.6 Taylor claimed that the problem of allocating resources could be ration­ally solved under socialism. He suggested that income be distributed by the state in accordance with whatever objectives were accepted and that the household be permitted to spend its income in free markets. State-owned firms would plan pro­duction to meet consumer demand so that price equaled cost of production. The prices of factors of production would be determined by a process of imputation. Trial and error would disclose to the planners equilibrium prices for the factors. Thus, no fundamental resource-allocation problem existed under socialism.

The debate grew as F. A. Hayek, later a Nobel Prize winner, and Lionel Robbins (1898-1984) started a new argument. They contended that although the solution to the allocation problem under socialism was theoretically possible, it was practically impossible. To appreciate their argument, think of the economy as a giant computer. For each commodity demanded by a household, there is an equation; for each commodity supplied by a firm, there is an equation; and so forth. Hayek and Robbins insisted that it would be impossible for socialist planners to collect the mass of data necessary for rational allocation, let alone solve the equations simultaneously.

This phase of the debate was effectively closed by Oskar Lange (1904-1965) in two essays published in 1936-1937, which were revised and published under the title On the Economic Theory of Socialism.7 Lange, like many other writers on these issues, also made important contributions to welfare economics. He was a socialist who taught in the United States at the University of Chicago and then returned to Poland following World War II. In responding to the argument of Mises, Hayek, and Robbins, Lange claimed that once it is recognized that factor prices can be used for rational allocation whether the factor prices emerge from competitive markets or are set by state planners, their arguments fail. Market prices are really just indexes of the alternatives offered to buyers and sellers. In competitive markets under capitalism, the households selling factors and the firms buying factors have no real knowledge of the forces determining these prices. But that lack of knowledge does not influence their actions. They take the prices as parameters and act accordingly. By trial and error the planners will find the prices that will make quantity supplied equal to quantity demanded and thus clear the markets.

Lange went on to point out that under competitive capitalism, neoclassical theory has found that three conditions obtain in equilibrium. (1) Both consumers and producers are in maximizing positions; (a) consumers are spending their limited income so as to maximize satisfaction, and (b) producers are maximizing profits. (2) Every price is such that quantity supplied equals quantity demanded, so that all markets are cleared. (3) Incomes from consumers will be equal to their receipts from the factors sold plus profits. Under planned socialism equilibrium (la) is unchanged. Thus, Lange argued that consumers would be able to spend their income to maximize satisfaction. Condition (lb) no longer holds under socialism, because state-owned firms are not interested in profit maximization. Lange would replace condition (lb) by requiring producers to follow two rules: first, that they produce every output at the lowest possible cost; second, that they choose the scale of output so that price equals marginal cost. Condition (2) is brought about in capitalism by free-market forces. Lange contended that the clearing of markets under socialism would be brought about by state planners adjusting prices on a trial-and-error basis. A price that is too high would bring about surpluses and indicate to the planners the necessity of lowering prices. Too low a price would result in shortages. Condition (3) would hold under socialism, except that there would be no profits.

Lange recognized that his essay was just an extension and elucidation of Taylor's argument. There is no more need to have a huge computer solving supply-and-demapd equations under socialism than under capitalism. The Pareto-Barone-Taylor-Lange-Lerner argument essentially states that a socialist economy would allocate resources most efficiently if, by planning and direction, it brought about the same results as would exist under perfectly competitive markets. Thus, the state firm would meet consumer demands by operating at the minimum point of its long-run average cost curve, where marginal cost would equal price.

By 1940 there was agreement in the profession that Mises and Hayek had been wrong and that socialism could rationally allocate resources. This accep­tance is manifested by an article written in 1948 by Abram Bergson (1914- ) in a two-volume collection of survey articles under the sponsorship of the American Economic Association, which was designed to be used by economists to bring them up to date with accepted thought in various fields.

In his survey of socialist economic theory, Bergson notes that "by now it seems generally agreed that the argument on those questions advanced by Mises ... is without much force."9 He goes on to suggest that some of Hayek's contributions to the debate concerning the monitoring of state firms and the knowledge necessary for planners to acquire to give efficiency "exaggerate the difficulties of the problems."

One of the reasons why Mises, Hayek, and others were unable to effectively communicate their criticisms of theoretical and practical socialism as worked out by Lange and others was the state of the economic model in the 193 0s and 1940s. It was essentially an equilibrium model. There was little discussion of how disequilibrium adjustments would come about and individual entrepreneurial action was not part of the formal model. Because that disequilibrium adjustment was not part of the formal model, criticism of an argument based on the need for such actions was not acceptable.

To have accepted the Austrian argument would have damaged the theoretical case for socialism; it also would have undermined the formal theoretical case for capitalism, because that too was based on the static general equilibrium model and did not have any explicit role for individual entrepreneurial actions. From the 1930s to the 1970s, the central argument that socialism was theoretically and practically able to rationally allocate resources was accepted by the economics profession, nonsocialists and socialists, with few exceptions.

By the last quarter of the twentieth century, however, that view began to change. Some argued that it was rather naive to hold that managers of firms in a socialist system could be expected to follow rules aimed at operating plants efficiently and equating marginal cost to marginal revenue. Without the penalties existing in competitive private property societies, these critics held, managers of firms will behave in ways that will engender much inefficiency. Others in the economics profession followed the lead of F. A. Hayek, whose views on the question appeared in two seminal articles published in 1937 and 1945.n Hayek pointed out that the neoclassical model's assumption that consumers and pro­ducers have perfect knowledge is false, and that, in fact, one of the functions of markets and the process of competition is the discovery of such knowledge. Planners cannot acquire the needed knowledge except as it is revealed through the operation of markets.

In the 1980s Don Lavoie and Israel Kirzner raised these issues again, arguing that the knowledge problems raised by Hayek were more serious than neoclas­sical economics had previously thought. This time economists were more open to the argument, for two reasons: first, communist economies were crumbling, in part because of poor resource allocation; and second, neoclassical economics had evolved into a more eclectic modern economics in which there was not the certainty that had marked earlier neoclassical economics.