Mises fired the opening salvo in the socialist calculation debate in 1922 by questioning whether socialism was possible at all—whether modern industrialized society could continue to exist if organized along socialist lines. Mises attacked the basic premise of socialist theorists that the economy could be planned and directed efficiently after a socialist state had abolished money, markets, and the price system. He argued that money prices determined in a market context were necessary for rational economic calculation. The price system allows resources to freely flow to their most highly valued uses, indeed, directs resources to their highest valued use. For example, it is technically feasible to construct subway rails out of platinum rather than steel, but to use platinum would be inefficient in the face of less expensive substitutes. Only the price system, representing the competing bids of all potential users of platinum, guarantees that such judgments are made. Without the price system, Mises argued, resources could not be allocated efficiently and the economy would function at a primitive level.
Socialist economists took Mises' challenge seriously, with some of the most prominent socialist writers, particularly Oskar Lange and Abba Lerner, acknowledging that Mises had uncovered an important weakness in the socialist theory. Lange even half-seriously proposed that in the future socialist commonwealth a statue be erected to Mises so that no one would forget that prices and markets are essential under socialism too. But of course, the socialists launched a counterattack. Partially retreating from the theory of pure socialism, Lange claimed that socialism would work if socialist planning were substituted for the market mechanism. In other words, the state would set prices for goods and factors of production instead of the market. Managers of state-owned firms would then produce until the marginal cost of their output equaled the "shadow" price of the good. Resources needed to produce finished goods would be requisitioned in accordance with this rule, and the state would stand ready to adjust prices in response to any shortages or surpluses that might result.
As clever as this response appears on the surface, Mises and Hayek now responded with an even more devastating critique. The problem with the state "imitating" the market, they argued, is that the ex ante prices established by government functionaries could never convey accurate information regarding the true opportunity costs associated with resource use. The enormous amount of detailed, specific information required for state-determined prices to match market prices, if it could be made available to government bureaucrats, would only be forthcoming at huge transaction costs. In addition, for socialism to approximate market performance, individual incentives would have to be structured to ensure that people within the system would use information and resources efficiently. This could only happen if property were privately owned, a circumstance that clashed directly with socialism.
At its most fundamental level, the socialist calculation debate was a contest over theoretical models. Socialist economic theory is based on Walrasian general-equilibrium models within which the central planning board substitutes for the Walrasian auctioneer. Lange proposed that a central planning board administer resource prices and allow consumer goods to be priced in free markets in order to provide accurate information for factor evaluation. Factor prices would then respond to market eventualities, and the whole process would, by trial and error, simulate the Walrasian tdtonnement process. For their part, Mises and Hayek rejected the Walrasian model as unrealistic and inappropriate. In either its pure form or its socialist guise it could not capture enough important features of the real world to make it applicable. In particular, Hayek argued that the information required by the socialist calculation theory was not given, but is the subject of continuous discovery. The Austrian criticism was essentially the same as that leveled at the neoclassical model, namely that the proponents of socialism did not understand the nonparametric function of prices. Somewhere along the way in the evolution of economic theory, neoclassical economists had forgotten or ignored Cantillon's original vision of the market as an arena in which market participants (i.e., entrepreneurs) nudge prices in the direction of equilibrium by exploiting profit opportunities offered by disequilibrium prices. This vision has been more consistently grasped and maintained by Austrian economists than by any other group. Consequently, they attributed the socialists' myopia to a perception of the market's operation primarily in terms of perfect competition.
As usual, Hayek gave the most forceful counterargument to the socialist position. In a nutshell, he argued as follows. The information that individuals use to guide their economic activity is vast, detailed, fragmented, and often idiosyncratic. It is not neatly captured in objective demand and supply functions that are at the ready command of the central planners. The major reason Hayek gave was that such information is the subject of continuous discovery through entrepreneurial action and counteraction. Neoclassical economics stresses only one kind of knowledge—the "engineering knowledge" of technical input-output relations. Austrian economics also spotlights the specific knowledge of "time and place," which leads to the perception of profit opportunities in advance of the crowd, and the kind of knowledge that enables an individual to conceptualize new methods and new products that may bring large rewards. Market prices in this framework are not parameters. They are the unique and timely results of numerous transactions by individuals possessed of these various bits and forms of knowledge. In turn these prices serve as the signals by which decentralized knowledge is collected and coordinated into a systematic whole. In the words of Karen Vaughn, "To try to summarize all this information into a set of simultaneous equations would be quixotic at best" ("Economic Calculation under Socialism," p. 546).
The problem that Mises and Hayek were attacking at base was the effects of different specifications of property rights on individual economic decision making. This is a wide-ranging issue that does not confine itself to the dichotomy between socialism and capitalism. It also pervades the issue of economic regulation.
Seven decades after the socialist calculation debate began, we may well ask how relevant was the debate in retrospect. Among existing socialist economies, only Yugoslavia resembles the "market socialist" proposals of Lange and Lerner. Several of the socialist countries, particularly Hungary and Poland, but including also the largest, China and the Soviet Union, have introduced reforms enlarging the role of the private sector, even though large segments of these economies remain directed from the center. Before we conclude, however, that the "workability" of nonmarket socialist economies belies the Austrian critique of socialism, we must take into account two established facts about centrally planned economies. First, their economic performance is poor by comparison with capitalist market economies, in some cases, disastrously so. Second, the private sector in socialist economies, usually existing in the form of illegal underground economies, is typically large and important. These facts offer at least a partial vindication of the Austrian critique of socialism.