Physics and the Economic Calculation Problem

by | Feb 27, 2020

Physics and the Economic Calculation Problem

by | Feb 27, 2020

Screen Shot 2020 02 27 At 7.07.14 Am

Throughout the nineteenth century, economic socialism was given its intellectual foundations by the Utopian Socialists such as Charles Fourier and Robert Owen, and by the ‘Scientific’ Socialists Karl Marx and Friedrich Engels. Austrian economics was only founded in 1873, with the publication of Carl Menger’s Principles of Economics. So while the greatest economic theory was still finding its legs, the task of refuting socialism fell into the laps of the classical economists. 

These economists argued that under centralized control of the means of production and provision of consumer goods to each person “according to his needs,” workers would have no incentive to be productive. Absent the dangling carrot that is the profit motive, no one would put effort into his duties. John Stuart Mill wrote: “Competition may not be the best conceivable stimulus, but it is at present a necessary one, and no one can foresee the time when it will not be indispensable to progress.” The socialists responded that there would be a “New Socialist Man” who would work to the benefit of the community and hence would not require monetary profit in the first place. 

These classical economists implicitly conceded that if the so-called incentive problem could be solved, then a socialist economy could be as productive and allow as much wealth creation as could a capitalist one. There was no principled argument against coercive government takeover of vast swathes of the economy. The best that the intellectual descendants of Adam Smith could do was argue that such a society would be ‘unrealistic’. But unrealistic is a far stretch from impossible, especially to the socialist, we’ll-mold-man-according-to-our-vision, thinker.

Exactly one-hundred years ago, the Austrian economist Ludwig von Mises went beyond those classical rebuttals to socialism and shattered the very foundations on which socialism rested (that an Austrian economist took the baton from his classical forebears and peered deeper into the nature of economics is rather common in the history of ideas). In a 1920 article, Economic Calculation in the Socialist Commonwealth, Mises explained the so-called economic calculation problem, one of the greatest intellectual achievements of the twentieth century.

In a monetary economy, consumers bid for various goods, the prices of which are determined by the consumers’ demand for and the producers’ (entrepreneurs or their associates) supply of them. These producers don’t necessarily transform raw materials into their final consumer products: a restaurant owner might purchase utensils from a firm that specializes in the production of forks and knives. This firm, in turn, might buy the raw materials that are required in order to create utensils in the first place. For example, maybe they buy stainless steel from an owner of land who mines minerals solely in order to sell them. Physically, the production process of this example runs according to the following recipe: minerals are extracted from the earth by the landowner, then the fork-and-knife firm transforms the minerals into utensils, then the restaurant owner ‘transforms’ them into a presentable meal, and finally the patron of the restaurant ‘consumes’ the presentable meal (part of which is the utensils). Economically, however, this entire production process flows backwards from the consumers’ demand for consumer goods: the more patrons the restaurant owner serves, the more he, in turn, demands utensils from the fork-and-knife firm, which then demands more minerals from the landowner. This is what is meant when economists say that ‘consumer is king’.

But the restaurant owner is not the only entrepreneur bidding for utensils—he is competing with homeowners, collectors, other restaurant owners, and speculators. Just as prices emerge on the consumer goods market between consumers and the entrepreneurs selling such goods, so too does a producer goods market between entrepreneurs and sellers of producer goods generate prices of producer goods. This is true for all stages of production, and again, this entire network of prices is ultimately driven by the consumers’ demand for consumer goods.

When the entrepreneur sells a good to a consumer, the price of that consumer good is his revenue. In our example, this would be the restaurant owner selling a steak dinner to a patron for twenty dollars. But entrepreneurs do not pursue revenue, but rather profit. In order to calculate whether or not he’s earned a profit, the restaurant owner must subtract the cost of producing the meal from the price at which he sold the meal. But what is that cost? It is the price of the producer goods that he purchased in order to create the meal in the first place—in our example, this includes not only the abovementioned utensils, but also whatever other producer goods went into the production of the meal. So, if the price of the sum of the producer goods exceeds the price of the final consumer good, the entrepreneur has incurred a loss. If the reverse is true, he’s earned a profit.

Under voluntary conditions (a free market), profits and losses are signals—a profit indicates that the entrepreneur is satisfying consumers in transforming producer goods into consumer good that they demand. A loss indicates consumer dissatisfaction with that particular line of production*. In either case, the entrepreneur may adjust his activities. In the first, he might demand more producer goods in order to try to earn even greater profits, while in the second, he might abandon his project in order to cut his losses. No matter what the entrepreneur does next, his decision will take in knowledge about what consumers want, and then transmit this knowledge ‘backwards’ to owners of producer goods. Without the ability to calculate his profit/loss, the entrepreneur cannot know what to do next in order to better satisfy consumers. 

Prices emerge on the producer goods market precisely because 1) these producer goods are privately owned, 2) entrepreneurs bid for them according to what they think consumers demand of their (the entrepreneurs’) final consumer products, and 3) money is sound**. Under centralized control of the means of production, there is no producer goods market. So the socialist institution has no idea what the prices of these producer goods are, and therefore has no profit/loss mechanism. Economic waste, such as shortages, surpluses, inefficient choices of which particular producer goods to employ in the creation of consumer goods, and reduction in total wealth (called economic regression) are all inevitable under a socialist order.

No matter how superhuman the “New Socialist Man” might be, no matter how selfless and communitarian, he will never overcome this calculation problem. The knowledge encoded in the profit/loss system that emerges in a free market cannot be recovered by a socialist Leviathan. Counterintuitively, it is centralized, coercive planning that causes destructive economic chaos, rather than an unplanned, voluntary system.

But is that really true? Had Mises shown that, following deductively from first principles, collective ownership of producer goods forces the socialist institution to provide consumer goods in wildly erroneous proportions relative to its decentralized, free market counterpart? The socialistic institution could always get lucky, and provide exactly what would’ve been provided in a free market. But then, a cow could similarly ‘get lucky’ and appear spontaneously in deep space. In neither case would we have a good explanation for why these seem to be regularities of nature.

A physical transformation is impossible if, no matter how much knowledge is brought to bear, it cannot be achieved. For example, building a generic spaceship out of raw materials is evidently possible, given that it has happened. However, building a particular spaceship that can travel faster than the speed of light is impossible in principle, since the laws of Einstein’s special relativity forbid any massive object from traveling at such a speed. No matter how much more knowledge civilization acquires, we will never be able to violate the laws of nature.

The converse is also true—if no law of nature explicitly forbids a particular transformation from being achievable, then people are capable of causing said transformation, given the requisite knowledge. This implies that what we intuitively think of as wealth is more fundamentally about knowledge than about the particular resources a person owns. For example, a farmer who owns the raw materials of land and seeds is capable of transforming them into edible crops, while a professor of history may not know what to do with those same resources. Furthermore, a person can grow wealthier without acquiring any new resources by instead acquiring more knowledge. The value of land with oil reserves only shot up in value after people learned how they could employ oil to their advantage, and not a moment before that. So the set of all possible transformations that the same scarce resources may undergo depends on what their owner knows what to do with them.  

An economy is a particular way that knowledge is arranged in the universe, distributed across the minds of creative people. As we’ve seen, this knowledge can grow (or shrink, as when civilization regresses), causing a concomitant increase in economic wealth. Can we express this more exactly? Are there laws of nature that govern, constrain, and explain changes in the growth of knowledge and wealth?

A new fundamental theory in physics, constructor theory, seems to be able to express all other laws of physics in terms of possible and impossible transformations. This is a deeper mode of explanation than the so-called prevailing conception of physics, which had held that theories are to be expressed in terms of ‘initial conditions plus laws of motion’. That mode of explanation worked in explaining domains of reality in which exact predictions of what will happen is possible, such as when Newton accurately predicted the future speed and position of moving objects with his theory of classical mechanics. 

But there are aspects of reality that are unpredictable, even in principle. One of those is the growth of knowledge, and therefore all economic phenomena. Despite the mockery they’ve received, Austrian economists have long understood that predictions cannot help in understanding, or criticizing, the principles of economics. The theorems and explanations of Austrian economics are not expressed in terms of predicting exactly what will happen, as would be required by the prevailing conception, but what can possibly happen, and what cannot happen in principle***. At long last, physics has caught up to them.

If socialism is truly impossible in principle, then it must be forbidden by some law of nature. Specifically, the impossibility of economic calculation under socialism should be manifest in (or be deducible from) physical laws that govern the possible ways knowledge can be arranged and its relationship to the growth of wealth. Constructor theory provides the mathematical formalism necessary for precisely these kinds of laws—principles of nature that don’t predict what will happen, but that express what can be caused to happen, and what cannot be caused to happen. 

Here, we reach the boundary of present scientific understanding, and so I have reached the limits of my precision. I don’t know what transformations, exactly, will be shown to be impossible, nor do I know how the arguments will even be stated in their constructor theoretic form. While constructor theory has solved some problems in physics and elsewhere already, a constructor theory of knowledge has not yet been created, and hence a constructor theory of economics is even further from our present vantage point. But I am optimistic. If laws of nature come to show, via the formalism of constructor theory, that economic calculation is physically impossible in principle under socialism, then denial of what Mises had shown one-hundred years ago will carry the same logic as denial of the existence of dinosaurs, or of the roundness of the earth. 

*More technically, a profit signals that the entrepreneur is engaged in a line of production of which consumers approve, and a loss signals a corresponding disapproval.

**I won’t expound on sound money in this essay.

***Many of these theorems are counterfactual in nature (so-called ceteris paribus arguments), and constructor theory has already demonstrated an ability to handle other regularities that require reference to counterfactuals, such as those of information

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