An Extra Credit Class Assignment

I gave the following extra credit assignment to my classes.  I wonder whether Antifa, dumbed-down studies majors at universities around the country, Antifa's dumbed-down studies professors, and the dumbed-down New York news media will demand that I be fired for saying that socialism doesn't work. 

Dear Class:

At the beginning of the term, I said that you can raise your exam grade by five points by doing an optional extra credit assignment. The assignment requires that you read Friedrich von Hayek's article "The Use of Knowledge in Society" (available  here) and write a one- to two- page paper that develops a thesis about the article.  Your thesis can be pro or con.   You will need to read the paper thoroughly.   Adding additional readings is fine but not required. 

The paper needs to be one to two pages, double spaced, with 12-inch font, and with one-inch margins.  Your name and class section should be in the heading.  It needs to be emailed to me by December 16 because I will be submitting the final grades soon thereafter.

The background for Hayek's article is as follows:  In the 1920s Ludwig von Mises showed that socialist economic planning is necessarily inefficient because its information requirements are too great.  Later, Oskar Lange attempted to refute von Mises by claiming that firms can use survey data to equate economic marginal cost and revenue, so duplicating free markets.  However, Lange's claim that perfect competition can be duplicated with managerial survey techniques begs von Mises's original question.  

First, the burden of performing such surveys and coordinating them around the economy is too big and causes decision making to be too slow to be of any use. Second, even if such surveys are performed, a socialist economy--characterized by centralized planning, regulation, or control--violates a key premise of competition: ease of entry.  Since there is no quality competition, closed socialist economies are doomed to produce low-quality merchandise.  Moreover, because the central planning agency (Gosplan in the former USSR) cannot digest all of the information needed to coordinate a large economy, there will be inefficiencies. 

In "The Use of Knowledge in Society" Hayek provides an additional reason why socialism cannot work.  The most important knowledge in running a business is not theory. It is knowledge of specific time and place, practical coordination.  In order to coordinate economic decisions, an economic communication system is necessary. Although great advances have been made with respect to information technology since Hayek's article was published in the 1940s, the Internet, smart phones, and similar information technologies don't come close to being able to coordinate the massive, rapid fluctuations in information that must be communicated to entrepreneurs.  Only a free market PRICE system is capable of communicating such information rapidly.  Since socialism squashes, eliminates, or at a minimum distorts PRICES, information becomes garbled or disappears, and inefficiencies, shortages, and distortions occur.  

Von Mises and Hayek's ideas were transferred to smaller organization units by James March and Herbert Simon in their classic book on organization theory, Organizations.   March and Simon show that bounded rationality,--limits on the ability to plan--characterize business corporations, which are much smaller units than total states.  The information requirements to manage a state are orders of magnitude greater than the information requirements to manage a large corporation.  

Hence, the increasing trend toward socialism over the past sixty years in the United States has caused the real hourly wage to stagnate and has eliminated economic opportunities for millennials. Astonishingly, millennials now mostly support socialism, essentially favoring the system that has restricted their opportunities and likely reduced their lifetime incomes. 

The empirical evidence for the ideas of von Mises and Hayek, written in the 1920s to 1940s, supports their theories.  First, the Soviet Union fell in the 1980s for the reasons von Mises predicted in the 1920s. Second, large socialist countries like India and pre-reform China performed dismally. Third, countries that were largely democratic socialist in the 1960s, such as Denmark and Sweden, reformed their economies to eliminate much socialism because socialism performed badly there, even in smaller countries with smaller information demands than in large countries like the US or the USSR.  Denmark is now roughly as free market as the United States, and Sweden is almost as free market. 

Although scientific evidence overwhelmingly favors the failure of socialism, you probably have not been exposed to the ideas of von Mises and Hayek in your education or in the media.  The economic forces that favor socialism are the same that favored the large-scale bailouts of 2008-9.  To understand how special interests work (and make no mistake, your education has been the product of special interests), you need to understand public choice theory.  A good place to start is with Mancur Olson's Rise and Decline of Nations.  However, for this assignment you will need to focus on Hayek's essay.

Sincerely,

Oskar Lange RIP: "On the Economic Theory of Socialism" in Benjamin Lippincott, Editor, On the Economic Theory of Socialism

Oskar Lange, "On the Economic Theory of Socialism". Reprinted in Benjamin E. Lippincott, editor, On the Economic Theory of Socialism Volume 2: Government Control of the Economic Order. Minneapolis, Minn.: University of Minnesota Press. 1948. Original article in Review of Economic Studies, Volume IV, Nos. 1 and 2, October 1936 and November 1937. Used copies available from Amazon.com starting at $1.34.

I've had this article on the back of my back burner for roughly 30 years and I was inspired to read it, first, by Professor Danthine my microeconomics professor at Columbia Business School who reminded me of it in 1986 and second by Nicolai Foss's blog that I blogged about two weeks ago.

This is the article in which Lange writes that a statue should be erected to Ludwig von Mises in the hall of the ministry of socialism for his arguments about the impossibility of price in a socialist economy. Lange claims that he has disproven von Mises's arguments based on elementary economics (the second section of the article is a review of microeconomic theory) but history has proven von Mises right and Lange wrong. The socialist economy of the Soviet Union fell because of the very kind of pricing inefficiency that von Mises identified. Hence, a statue might be erected to Lange in the hall of failed academic theories.

Lange's argument is elegant but there are several flaws that stand out and should have stood out even prior to the passage of the historical record.

First the part that Lange could not have known in advance. Lange overlooks the realities of bureaucratic and political decision making in organizations. He assumes that central planners are rational actors who will equilibrate marginal cost and price. History did not prove him right. Central planning was largely political, and political actors are influenced, as were the Soviet planners of Gosplan, by political considerations rather than considerations of pure rationality. Thus, the history of Soviet socialism is riddled with examples of price-setting on the basis of political concerns. For instance, bread was priced at a low level because the citizenry expected cheap bread. However, farmers had earlier supply-chain access to the bread than did retailers, and because the bread was set at a price that was cheaper than animal feed, they would purchase the bread from the distributers and feed it to their cattle while there were bread shortages in the cities. There were many examples of this type as Berliner's book Soviet Socialism from Stalin to Gorbachev illustrates.

Second and related to the first point, much of Lange's argument is based on the theory that economic planners will be able to reach optimal, market clearing prices through trial and error. He assumes away Hayek's argument that it is impossible to acquire the necessary information for the myriad products in an economy. However, Hayek was right. The trial and error process is too difficult to accomplish because product variations are too complex for planners to anticipate. No amount of theorizing about the possibility of equating marginal cost and price will change the transactions cost impediments to doing so.

Third, there were several points that should have stood out as far fetched even in the 1930s. Many of Lange's arguments make assumptions that have a tautological quality. That is, to prove pricing is possible he assumes that price information is available, and then deduces that pricing is possible because the information is available. His argument begins with a model in which socialist firms have the ability to determine price and production levels, but this is the very problem that impeded socialist central planning. Central planners want to determine price and production levels centrally and so cannot make use of imbalances between supply and demand in each region and firm. For instance, Lange writes (p. 71):

"If demand and supply are not equal for each commmodity, prices change again and we have another set of prices, which again serves as a basis for individual rearranging of choices."

But this assumes either local price determination or the ability of the central planning authority to flexibly change price. It is precisely the absence of such flexibility that caused socialist planning to fail. Trial and error are impossible because the information constraints are too severe and because the political and bureaucratic processes are too inflexible.

The tautological quality of Lange's argument is especially seen on page 75 where he writes that:

"The decisions of the managers of production are no longer guided by the aim of maximization of profit. Instead, certain rules are imposed on them by the Central Planning Board which aim at satisfying consumers' preferences in the best way possible."

But it is the absence of price that inhibits the Central Planning Board from figuring out consumers' preferences. The entire problem is that the central planners do not know consumer preferences. This is related to their inability to judge product quality because of transactions costs constraints. The complex and subtle art of quality management could not be done by a central planning board. Even competitive American firms have had trouble in this area.

Similarly, on page 76 Lange argues that the central planners can combine factors:

"in such proportion that the marginal productivity of that amount of each factor which is worth a unit of money is the same for all factors".

The problem, though, is that determination of productivity is not independent of understanding consumer demand. You cannot know the productivity of the factors unless you know whether customers view the outputs as desirable in comparison with competitive products.

Perhaps most importantly, Lange's model omits one of the key assumptions of perfect competition: ease of entry. Because there is no flexibility as to competition to the governmentally controlled firms, they can all reflect arbitrary or bureaucratic decision criteria and fail to evolve or experiment simply because consumers are forced to purchase their product, which, to put it politely, will be garbage.

It is entirely possible that the central planning board produces garbage and since there is no entry of entrepreneurial firms, there are no competitors to produce alternative products. As it turned out, this was the rule in the Soviet economy, a rule which Lange's argument simply assumes away. If all existing firms produce garbage and there is no ease of entry, then consumers are forced to choose among an array of undesirable products and prices can be set by the trial and error method that Lange outlines but they will be market clearing prices for garbage.

Lange also omits the importants of dynamic change. Without entrepreneurship there is no process for quality improvement. Hence, he outlines a static economy that can produce garbage where, if there are no transactions costs, firms can disobey the central planners at risk of their necks and experiment to find optimal prices.

Price and marginal productivity are then equilibrated, but customers remain unsatisfied. Nor could the firms that produce the garbage be closed because doing so would be too complicated politically. You would have to shut down the entire economy.

It is puzzling that Lange's argument had any influence in the first place. Now that history has proven him wrong, let us resell our copy of this book for $.85.