The Price System as Can Opener
The Economics Profession Needs a Paradigm Shift
JANUARY 01, 2002 by D.W. MACKENZIE
Both the subject matter and the choice between paradigms in economics contain interesting and perplexing problems. A key problem that we face in society, as F. A. Hayek pointed out as far back as 1945, is in making use of widely dispersed knowledge regarding available means in satisfying human wants. The key problem that we face as economists is in grasping the significance of economic problems such as I just mentioned. The interwar debate over socialism, begun by Ludwig von Mises in the 1920s and extended by Hayek in the 1930s, is perhaps the single best illustration of the importance of this problem in economics.
This debate centered attention both on the exact nature of the market system and on the particular understanding of this process by the two opposing sides. The critics of socialism thought of markets as an evolutionary and rivalrous process in which we continually learn about opportunities for trade in our complex world. The proponents of socialism thought of markets as an end state in a static world where we allocate resources to their most highly valued uses. The latter of these two visions enjoys popularity in the mainstream of the economics profession today. The former attracts more attention from other academics and laymen than from economists. Given the course of events in eastern Europe, this situation seems a little odd. Since the evolutionary/rivalrous paradigm pointed in the right direction in the real world, why does it not enjoy greater popularity in the professional economists’ world of ideas?
An easy way to understand this issue is to think of it in terms of this not-too-old joke:
An economist, a physicist, and a psychic find a can of food while they are stranded on a desert island. The physicist says that they should use their eyeglasses to focus the sun on the can to burn a hole in it. The psychic argues that they should focus their mental energy on the can to pry it open. The economist shakes his head and says, “Why don’t we just assume that we have a can opener?”
This is no mere joke; it strikes at the heart of modern economics. Many modern economists use assumptions much in the same way that speeding motorists use excuses after they get pulled over. Just as no excuse is too absurd for a motorist when trying to avoid a ticket, no assumption is too absurd for a socialist when trying to avoid certain conclusions about government and the market. The interwar debate illustrates the reality of this analogy in an interesting way.
Mises argued that socialism must fail in trying to satisfy consumer wants because it lacks means of economic calculation. Money provides a method by which individuals can calculate monetary profits. Profits and losses, in turn, work to motivate and regulate individuals as well as to inform them. Mises contended that without money as a guide to the calculation of profit, economic planners would be lost among a bewildering array of possibilities for producing goods that satisfy human wants.
Oskar Lange responded to Mises’s argument by insisting that central planners could use mathematical models of the market to simulate the results of markets in an “ideal” (that is, static) situation. Lange proposed using a system of equations created by Léon Walras for this purpose. With each equation representing a market, he insisted that central planners could calculate a set of prices that would lead to ideal resource allocation.
Hayek argued against the use of such models on the grounds that there was no possible way for central planners to know all they would need to know to solve the problem at hand. This was the crux of the debate. Each side saw the economic problem in a different way.
Through the Glass Walls
To Hayek and Mises the economic problem was one of trying to make sense out of a complex and ever-changing world. To Lange and Fred M. Taylor the economic problem was one of trying to calculate optimal values for the use of a given amount of well-known resources. Lange responded to Hayek’s challenge by arguing that central planners would see through the glass walls of socialism. This notion is both terrifying and absurd. It is terrifying because it implies a near-total lack of privacy. It is absurd because it takes for granted an ability to collect knowledge, in a usable form, that defies imagination. The absurdity of Lange’s argument points to the central issue of the debate—the issue of how we should conceive the problem we face. Should we accept the unreal assumptions of neoclassical economics or should we embrace the Austrian paradigm as we struggle with these issues?
Neither Mises and Hayek nor Lange and Taylor ever changed their views on the nature of the problem. Hayek and Mises held on to their paradigm, where time, uncertainty, and learning loom large as serious problems. Lange and Taylor pretended that these problems were inconsequential.
In other words, Hayek and Mises looked at the can in our joke and said, “We need a can opener.” Lange and Taylor looked at the same can and said, “Let’s assume we can open it and start planning how to use what’s inside.”
This story might seem strange enough as it is, but as it happens, there is another economist whose ability to ignore reality exceeded that of even Lange and Taylor. While the debate over socialism raged, Wassily Leontief set out to construct a model that social planners could use in practice.
The result of those efforts was his Nobel Prize-winning input-output model. In this model the ratios of inputs to outputs tells the planners how much of various inputs are needed to generate a given output. The interesting thing about Leontief’s model is that it assumes that all inputs are perfect complements. The reason for this points precisely at the problem Mises was getting at in his critique of socialism. Mises argued that without money prices for capital goods we would be lost in a bewildering array of possibilities for production, given that inputs are substitutes for each other. If all inputs to the productive process are perfect complements to one another, then choice between combinations of different inputs is needless. This approach to planning goes beyond the usual absurdities about a static world of perfect information where planners peer through “the glass walls of socialism” as they calculate their optimal price vectors. In this view, there are few choices for planners to make. If we know what people want and what the best available technologies and productive procedures are, and if inputs combine in fixed proportions, what is there left to choose about? Given all this, we do not need to solve the problem of economic calculation, for under these conditions the problem does not exist.
Rather than assuming that we have a can opener, Leontief simply assumed that the can in our joke was already open. Leontief dreamt of a world where planners would maximize consumer welfare by using his model to arrange production rationally. How it is that he came to believe that this dream could ever become a reality is truly baffling.
The price system is the can opener that we use to gain access to all the secrets that await us in our complex and ever-changing world. The competitive discovery procedure that is the market process enables us to learn about opportunities for satisfying our desires. The challenge to those academics who still believe in socialism is in finding a means by which they can penetrate the aluminum walls of dispersed knowledge without the aid of the market process.
The problem that we face at this time is twofold. As a practical matter, we need to address the deprivations that exist in the parts of the world that continue to labor under socialism. North Koreans have suffered from starvation in their workers’ paradise. Charitable organizations typically address these kinds of problems by sending actual cans of food when all that is really needed is our figurative can opener. The solution to this problem lies, in part, with the other problem that I mentioned at the beginning. The public at large needs to be made more aware of the importance of markets and the price system. This requires instruction in economics by individuals who understand how markets actually work. Academic economists are the ones whose job it is to instruct others in these matters. What is therefore needed is a paradigm shift in the economics profession, one that moves away from the static general-equilibrium theorizing of Walras, Lange, and Leontief in favor of the evolutionary approach of Mises and Hayek.