Econ 101: Socialism, Part III

The Problems With Socialism

Socialism, in every form, and of any degree, produces three insoluble economic problems that the system is incapable of addressing satisfactorily: the incentive problem, the knowledge problem, and the calculation problem.

Almost everyone is familiar with these problems because they went to public school. But although you didn't learn about them explicitly as part of the curriculum, you experienced them firsthand when your teachers required you to complete the most hated and reviled task to ever infiltrate the education system:

THE GROUP PROJECT

Yes, if you've ever suffered through a group project you have experienced socialism in its most essential form.

In your modest group of only four or five students there resulted SLACKERS and MOOCHERS. These did no work at all. They did not brainstorm, they did not contribute to the buying of materials, they did not help to arrange the diorama, and they were never available outside of class. Their slacking was an example of the INCENTIVE problem.

When the time came to present your group project, the teacher judged everyone in the group by the finished product––not by their individual contributions. Everyone in the group gets the same grade because the teacher does not know the relative contributions of the group members. And she doesn't know because of the kind of assignment she gave them. Thus, the slackers are able to mooch off the efforts of the others, despite contributing nothing to the final result. This is the KNOWLEDGE problem. Because the teacher does not have the information required to measure students' contributions, she cannot calculate individual scores and is forced to give everyone the same grade. This is the CALCULATION problem.

So if you were ever curious what socialism would look like, or if you thought it might be preferable to capitalism (or even the mixed economy we have now), you now know exactly what that would entail....

Socialism is a group project at scale.

So let's address these three problems. The first problem––the incentive problem––is about how socialism rewards and punishes behaviors that are socially desirable or undesirable.

The second and third problems––the knowledge and calculation problems––are really the same problem looked at from different angles. With respect to these, no socialist system has ever, or can ever, resolve these issues.

The market, on the other hand, has mechanisms that deal with each of these problems.

The Market

In a market system everyone acts on their own behalf; free to do this or that, to make this good or provide that service. But everyone's actions always aim at serving other people. We do this because we wish to satisfy our own wants, so we cater to others who, in turn, cater to us.

This system is steered by consumers in the market. The prices they are willing to pay and the goods they are willing to buy tell everyone in the market what is desired, in what quantities, and of what quality. Each of us then integrate ourselves into this market, guided by the prices we face. We become farmers or truckers or tax accountants when consumers signal that our place in those roles create value for them. This value is communicated to us through the price system.

As workers, the wages we earn reflect the value our labor adds to the finished product. The consumer––through their buying and abstention from buying––moves wages up or down in accordance with the value this labor creates. As entrepreneurs, the profits or losses we bear are the result of consumers judging our use of resources as either desirable or undesirable. In the case of workers and entrepreneurs, wages and profit signal, respectively, that labor in this area is desirable or that the business is using resources in accordance with consumers' preferences. Low wages and losses, on the other hand, signal the opposite, and encourage workers and entrepreneurs to pursue more valuable activities.

All of this is determined by the consumer through his buying patterns and the prices he is willing to pay. Many believe, wrongly, that the entrepreneur––business––is in command of the market. But he is only a steward of the market's resources, and ultimately takes his orders from the king. In the market, it is the consumer who is king....

In a market system we see clearly how incentive, knowledge, and calculation problems are handled. The price system facilitates the solution of all these.

As incentives, prices reward labor in accordance with the value it creates for consumers. These prices are wages. Low wages are conferred by consumers who deem that work to be less valuable––like waitressing, Amazon delivery drivers, economists and other relatively low-value jobs that can be performed by lots of people, or which are in low demand. High wages are conferred to workers who create great value––physicians, welders, heavy machinery operators, and so on. These encourage capable, skilled or knowledgable people to direct their efforts toward higher-valued ends, rather than less-valued ends which could be fulfilled by less productive people. Whether high or low, wages reward workers in proportion to the value they create.

As sources of knowledge, prices tell consumers what they must forego to acquire a good, and which producers are better stewards of resources. If Piggly Wiggly is selling ground beef for $8, and Walmart for $7, the consumer "knows" that Walmart has found a less resource-intensive way of providing beef. By using fewer resources, Walmart enables consumers to satisfy more of their wants. For entrepreneurs, the spot prices for steel and iron tell him how available these resources are, and whether there are opportunities to increase their supply. They also inform him about whether his current plan should be modified to account for certain resource constraints.

As tools for calculation, prices mean that entrepreneurs and businesses can assess whether their uses of resources have created value for consumers––if they have provided goods which have used resources in ways that are better than their alternatives. If a sandwich shop incurs losses, it may decide that it is better to make fancy bagels instead. Despite using the same resources––dough, spreads, meats, vegetables and ovens––if fancy bagels yield a profit then the entrepreneur learns what consumers do not want (sandwiches) and what they do want (fancy bagels). Through his calculation of profit and loss, he discovers a better way to combine his resources.

However, under socialism the market's price system is distorted. In the presence of wage controls, price controls, subsidies, taxes and public ownership of the means of production (raw resources), prices no longer reflect the preferences of consumers or the underlying economic reality. By interfering with the price system through controls and other interventions, and by removing raw resources from the control of the market, incentives are changed, knowledge is lost, and people's ability to calculate the cost and benefits of a particular course of action is destroyed.

Because of this distortion, socialism results in raw resources and labor being misallocated, resulting in fewer goods and services, increased scarcity, and greater levels of poverty. Contrary to the belief of the socialists, the problem of poverty is not money. Prices in the form of wages and retail costs have no bearing on people's quality of life insofar as their absolute levels reflect the relative scarcity of resources. No, the problem of poverty is that there isn't enough stuff to satisfy all our wants––poverty is the result of scarcity, and money prices are the measure of that. As will be shown, socialism only compounds the problem of scarcity by destroying the system that makes abundance possible.

The Incentive Problem

The incentive problem is the problem of how to encourage socially desirable behaviors while discouraging undesirable ones.

Back in the classroom we saw how the group project changed the incentives of students such that they became slackers. Because the final grade is given to everyone in the group, those who are content with a low grade are able to sit back and do nothing. The group member who is only satisfied with a high grade, however, is left doing the lion's share of the work. Because of this arrangement, the group project isn't as good as it could be, and students are able to free-ride on the efforts of the other group members.

But the group project could be improved by assigning each member a different task and grading them individually. Rey could focus on the rise of the Roman Empire, Sarah on the fall, and Angelo could build the diorama. Now, each member is incentivized to contribute to the project because their grade depends on their effort alone. When Rey must spread his efforts across all three tasks, he cannot concentrate on producing a singular excellent "product." This is why the market process results in a division of labor and specialization. A woman who is self-employed may be able to run a bakery by herself, but if she wants to run a restaurant, she hasn't the time nor the skill to seat patrons, take orders, cook meals, serve food, clean tables, and handle the finances.

To make up for this, she hires employees who divide their labor among specific tasks, and then provides them with specialized tools (i.e. capital or producers' goods) to increase their output. The exceptional effort she must exert incentivizes her to hire employees who she then incentivizes with wages, which results in a better product yielding greater profits.

Wages As Incentives

In the market, this dividing of tasks and individual reward is precisely what is done, and is incentivized by prices. Pickers at a mushroom farm are paid piecemeal because the boxes they fill are tied to their effort alone. Pizza delivery boys are paid per box delivered to encourage them to deliver more pizzas. Salesmen are paid commission to encourage them to sell more product. Garbagemen receive higher wages because the work is especially unpleasant, and they are salaried because they have a fixed amount of work each day. In each of these jobs, workers respond to the incentive structure imposed. Pickers pick quickly, drivers drive faster, and garbagemen collect waste more efficiently. All of this is accomplished because their wages incentivize them to do the work, and to do it in a certain way.

When jobs are incentivized in a way that encourages bad behavior, other incentives come into play to mitigate those bad behaviors. If a pizza boy gets in an accident, runs red lights or peels out in a customer's driveway, he is fired or has his pay docked. Alternatively, the shop could require him to wear a car topper so other drivers can report his reckless driving to the store. A trucker who drives too fast and burns too much company fuel can be given dual incentives regarding time bonuses and fuel efficiency. He gets merit pay for taking time-efficient routes, but is penalized for speeding.

But under socialism, where wages are manipulated or set by the state, the incentives change drastically.

As is often the case, socialist societies impose wage controls on different lines of work. If the minimum wage was $10/hr but is raised to $25/hr, everyone who was earning close to $25/hr will attempt to get minimum wage jobs. The wage price has changed their incentives.

When you understand that the market pays wages based on the value created for consumers, those making $25/hr were engaged in more valuable work that probably required more skill. Those making $10/hr were not capable of such work, which is why they filled the $10/hr roles. But now, because of the higher minimum wage, employers of minimum wage workers now have the choice between highly-trained and experienced workers or lower-skilled workers. Many will choose to replace their workforce with the higher-skilled workers because they cost the same but are more productive. Meanwhile, the jobs they left will remain vacant.

Then, there's also the problem of unemployment that the minimum wage creates. Employers which pay a minimum wage typically don't have large margins to be able to pay the same number of workers the higher wage, so to protect their profits and remain in business they fire employees. When all is said and done, jobs in the minimum wage sector have been lost, and higher-skilled jobs in the $25-30/hr sector have been lost. This leads to less output for consumers, which subsequently raises the prices consumers pay. All of this "looks good" because wages are now higher, but the wages no longer reflect the economic facts. In fact, real physical resources have been transferred to fewer minimum wage workers from consumers who must now pay more money for fewer goods. The wage control has increased scarcity and exasperated poverty.

Profit & Loss As Incentives

One of the greatest misconceptions about capitalism is that it is a for-profit system. Wrong. "It's a profit and loss system, and the loss part is even more important than the profit." Related to this misconception is the Marxist conception that profit is the result of the employer "extracting surplus value" from laborers. This is also incorrect.

Profit is not "extracted" or "taken," it is given to businesses by consumers who deem the value of their products to be greater than the cost of acquiring them. Profit is a sign that entrepreneurs have literally created value by using resources in a way that is better than the alternative way in which consumers would have them used. This profit works as an incentive that rewards entrepreneurs for their good judgement, and further incentivizes them to think of new or better ways to use resources.

Profits entice. Profits reward.

When losses are incurred these punish businesses and incentivize them to change their behavior. As the opposite of profits, losses signal that entrepreneurs have destroyed value––those resources would've been put to better use elsewhere. If the losses are not too large, a business can continue to operate at a loss until it loses the ability to purchases resources entirely. Often new businesses incur losses for months or years before they become profitable. While these losses are ongoing they are wasting resources, but they still have the opportunity to discover ways of becoming efficient stewards of resources. Perhaps a restaurant needs better marketing, shorter hours, fewer employees, or should switch to less expensive non-organic ingredients. Whatever the case, the threat of closure incentivizes creativity in the use of resources, and actual closure removes resources from the control of wasteful businesses.

Additionally, the threat of future losses incentivizes entrepreneurs to avoid starting businesses in risky new markets, or when market research shows that expansion would yield insufficient demand. The threat of future losses incentivizes caution and tempers ambitions, which in turn prevent resources from being wasted in the first place.

Losses deter. Losses punish.

But under socialism, the incentives that profit and loss create are distorted by intervention in the market. The state may subsidize business and boost demand to give the appearance of profitability––the appearance of value. For example, subsidies for higher education result in more people attending college who believe better job prospects will be available to them in the future. So, because the cost of education was reduced by grants and low-interest rate loans, degrees in Lesbian Dance Theory appeared to be profitable entrepreneurial ventures. But because college was subsidized, thousands of others got the same degree which made jobs in the Lesbian Dance Theory industry more competitive, thus lowering the wages and making LDT degrees un-profitable. As a result, resources like time and labor were employed in attaining unprofitable degrees which could have been employed elsewhere.

The same logic applies to businesses that receive subsidies. Because residential solar panels, for example, are subsidized in so many states (like California), the cost to the homeowner is reduced. Instead of paying $10,000 out-of-pocket he need only spend $1,000––and sometimes nothing at all. This gives the appearance that solar panels are a good investment––and for the homeowner it is––but it doesn't change the fact that the real cost of the resources to build and install solar panels is $10,000. This subsidy winds-up in the hands of the solar company who appears profitable, but who in reality would be bankrupt if homeowners had to pay the full price. This distortion of consumer demand causes resources like silicon, silver, gold, tempered glass, copper, iron and labor to flow into the solar industry where they are not being used economically.

Consequently, the subsidy increases the number of solar panels, redistributes wealth to solar companies from taxpayers, increases the demand for solar panel materials which raises their price, and raises the price of all other goods which use those materials. In short, the consumer, who is also the taxpayer, is spending money to build solar panels he would not build himself in exchange for higher prices on a now smaller stock of goods he actually wants.

The Knowledge & Calculation Problem

The knowledge problem is the problem of how to make best use of all the available knowledge in society. The calculation problem is the problem of how to engage in rational economic calculation when prices for the means of production are non-existent or distorted by interventionism.

The knowledge and calculation problems are intimately related. They are essentially the same problem looked at from different angles, but treating them separately is crucial to understanding why autarkic socialism, democratic socialism, and every other kind of socialism are never preferable or superior to capitalism.

In the history of the modern debate over socialism, the calculation problem––formally the economic calculation problem––came first when it was proposed in 1920 by Ludwig von Mises in his essay Economic Calculation in the Socialist Commonwealth. This paper sparked a decades-long debate over the feasibility of a socialist planned economy which was not resolved until 1991 when the Soviet Union collapsed.

Well before that occurred however, a pupil of Mises had observed that something else was at the heart of the calculation problem. That pupil was Nobel Laureate F.A. Hayek who, in 1936, first articulated the knowledge problem in a speech given to the London Economic Club called Economics and Knowledge. By 1945, Hayek had fully fleshed-out his argument and published The Use of Knowledge in Society in The American Economic Review.

The work of these two men and the problems they identified are largely credited with the intellectual shift away from absolute command economies and toward "mixed" economies or modified forms of socialism like market socialism and democratic socialism. But what today's critics fail to recognize is that these problems are not unique to despotic governments, but features of every form of socialism––and even capitalism. The difference, we shall see, is in capitalism's ability to deal with these problems through the institutions of private property, freedom of action and contract, and money prices––institutions whose functioning are all impaired by socialism.

So, if we are to understand each of these problems and their bearing on society's ability to alleviate scarcity, we must first attempt to answer the following questions:

The Knowledge Question:

#1 How do you ride a bike without falling over?

The Calculation Question:

#2 Why do we make toilets out of porcelain instead of gold?

How did you fare on question #1? Did you say "to keep peddling?" "Look where you want to go?" "Just keep practicing until you figure it out?" All of these are helpful tips for those learning to ride a bike, but they're not really what keep you from falling over. The correct answer is counter-intuitive, but all of you will realize it's truth once you hear it:

If you want to keep from falling over on a bike, you turn your handlebar in the direction you're falling.

Falling right? Turn right. Falling left? Turn left. Peddling isn't actually required, which is why skilled cyclists can stay upright even while stationary. Like this guy. Watch how he turns in the direction of his fall.

How did you fare on question #2?

Did you say the reason toilets are made of porcelain is "Because gold is more expensive?" "Porcelain is easier to work with?" "There's more porcelain available?" These are wrong, too. Gold may be more expensive, but if price were the deciding factor we would make toilets from pure clay. Porcelain may also be a more workable material, but is it more workable than wood? After all, wooden toilets do not need to be fired in massive kilns, and anyone can whittle a bowl. And what about abundance? Yes, there is more porcelain than gold, but there is much more plastic than porcelain. And yet, plastic toilets only make an appearance in motor homes.

Of all the possible answers, the one regarding price is the closest. The real reason toilets are made of porcelain rather than gold is because of all the technologically possible ways to fashion a toilet, only a subset of those are acceptable to consumers, and it happens to be the case that porcelain's benefits and costs confer the greatest value to consumers. The prices for porcelain, gold, wood, plastic and clay are relevant because they enable the calculation of profit and loss. This calculation then reveals that porcelain toilets yield the greatest profit in most situations, hence their prevalence. So like staying upright on a bicycle, this result is counter-intuitive. We might think that toilets would be made of the least-cost material or the technologically superior material, but consumers are not interested in minimizing costs per se, else they'd use their yard as a restroom. And they're not interested in technically superior materials either, else they'd opt for gold––what with its anti-bacterial properties and quality as a soft metal which makes it immune to shattering.

A golden toilet or a hole in the yard both would have prevented tragedies like this from occurring....

The Use of Knowledge

The economic problem is the problem of how to make best use of the resources available to us to satisfy our wants. To do this, we must know what resources there are, how they can be used, and which of those uses are most important. Crucially, the knowledge of what resources exist is distributed among millions of people, as is the knowledge of how they can be used and the relative importance of our various wants.

In addition to this knowledge being dispersed among individuals, it is also imperfect and contradictory. What people know is imperfect because they do not know everything, and because they often do not even know what they know––their knowledge is limited and tacit. People's knowledge is contradictory because individuals can know different ways of doing the same thing, and because their wants can conflict with the satisfaction of others'––their knowledge is specific and rivalrous.

Because knowledge is dispersed, limited, tacit, specific and rivalrous, the problem of discovering the best use of the resources available to us rests on our ability to utilize the knowledge held by individuals:

Because of the nature of this dispersed knowledge, the task of central planning under socialism must involve the gathering and assimilation of this knowledge without the aid of market prices. The planner must instead resort to the use of reports like surveys or inventory levels. With these, he can devise an economic plan which creates production quotas for certain raw resources like steel and lumber, and quotas for certain consumers' goods like bread and housing. But in what amounts should he require them?

A central planner could collect mountains of data to attempt to affect a coherent plan, but the question is whether "the data that it is feasible to collect correspond to the knowledge that really guides economic decisions" (Don Lavoie, National Economic Planning, p. 56).

Has the information he's attained included the reasons for why there is not already more steel, lumber, bread or housing? Does it convey whether these industries are even capable of producing more output, and whether they have the requisite machines, manpower, and technical know-how to tap as of yet untapped resources? Does his information include the tacit knowledge which is, by definition, incapable of being conveyed? Do his reports measure all the individuals' subjective preferences––preferences which are incapable of being objectively measured and compared, and which only reveal themselves at the moment of choice? How will he decide which resources to use, in what amounts, and to what ends?

The answer to all of these questions cannot be found in whatever data the central planner collects because "The truly relevant 'data' that a planning organization would need...resides deeply embedded in and dispersed among the separate minds of millions of people" (Lavoie, p. 56). The "relevant" data in this regard is that tacit knowledge which we are incapable of articulating. For example, the knowledge of what we want––what we really want––often isn't even known to us until we make a choice at the checkout line. We say we want to lose weight but we pick up a fork rather than a dumbbell. We know how to win a client's business but cannot learn how from a textbook. A skilled author knows how to write gripping prose, but his knowledge of grammar alone does not make for compelling stories. This sort of knowledge is relied upon daily in the workplace by managers who artfully craft shift schedules, entrepreneurs with great "intuition", and mechanics who can diagnose a problem based on a clk-clk-pheww sound.

The sheer volume of knowledge required to perform any of these tasks, let alone to coordinate them in a coherent plan, is what led Leonard Read to declare that no one knows how to make something even as simple as a pencil. We know that they consist of wood, paint, graphite, metal, glue and rubber, but as Read explains, knowing the recipe for pencils isn't actually sufficient to produce a pencil. In addition to needing to know how to produce each of these materials, a central planner must also know how to produce the goods used to produce those, and the goods to produce those, and so on....

Read continues by analyzing the complexity involved in producing the other parts of the pencil—the lacquer, the metal, the eraser, the paint. As he shows, the complexity of the production process involved in creating a very simple pencil virtually precludes a central planner from organizing the production of even more complex goods like CNC machines, motherboards, cars and other goods with extensive input trees because a planner would have to direct the production of all the requisite materials and goods.

But even more important for the central planner than knowing how to make a pencil is knowing why it ought to be made a certain way. In addition to a central planner needing to have command of all the relevant production goods, he must know why pencils should be made of cedar rather than pine; why erasers should be made of rubber rather than a synthetic; why the "lead" should be made of graphite rather than actual lead; and why the metal ferrule should be made of brass rather than aluminum.

The knowledge of the best way to craft a pencil is not a fact given to Dixon Ticonderoga by its engineers and machinists. Nor is it a given that pencils ought to continue to be made in the way they currently are. Technological knowledge cannot solve the economic problem.

As Mises noted in Human Action:

A great irony of the market is that most producers do not even know why they must use certain materials rather than others––only that they must. The knowledge of how and why pencils and everything else should be made the way they are is the result of a discovery process carried out daily by various participants in the market. Through their bidding for resources producers speculate that their particular plans will satisfy consumers' preferences, which are then proven either correct or incorrect.

This speculation on the part of producers (capitalists) is what Marx lamented as the "anarchy of production"––if only producers could be made to produce in accordance with what consumers say they want then the speculative failures of capitalism could be avoided.

As John O'Sullivan states in the video below, the premise of Marx and the socialists is that "because the problems of society are so difficult, they require planning," when in actual fact, "because they're so complex, they make planning impossible."

In the market the problem of how best to use the resources available to us (the economic problem) is complicated by the fact that the knowledge required to determine the best use of these resources isn't immediately available to us (the knowledge problem). But despite this, the market has a mechanism by which this knowledge––which is dispersed, limited, tacit––is communicated to everyone in an accessible and efficient form––prices.

Prices facilitate the coordination between individuals that makes decentralized economic planning possible and rational. When a resource has become more scarce, for example, the knowledge of those individuals aware of its greater scarcity results in their bidding up the price. In response, those far removed from the situation can adjust their consumption of this resource in accordance with the new economic reality simply by referring to the price, and without ever knowing why it has become more scarce. Everyone in the market thus adjusts their behavior to account for this change in the economic data without ever being told to do so.

In the absence of a price mechanism, a central planner would need to be told that a resource has become more scarce, the extent of that scarcity, and then issue orders to all the users of that resource with new guidance on what and how to produce. In the time it takes to do all that, the resource has continued to be used in ways that are no longer economic when the information regarding its scarcity could have been conveyed in mere seconds by a simple change in the spot price on the commodities market.

The Need for Calculation

The calculation problem is the problem of how to engage in rational economic calculation when prices for the means of production are non-existent or distorted by interventionism.

When Mises put forth this problem in 1920 he was trying to explain that socialist economies could not be prosperous regardless of how intelligent, dedicated or moral they were because none of them would be able to engage in rational economic calculation. Socialism calls for the abolition of private ownership of the means of production and proposes as a substitute "collective" ownership of the economy's production goods. But in eliminating private ownership of the means of production the socialist economy also eliminates the only mechanism that allows planners to determine whether a plan is economically viable. That determination depends on having access to the knowledge of a thing's costs and benefits which, we know, is only communicated to us through the price system.

In the absence of private ownership of the means of production there can be no market for production goods. If there is no market then there is no rivalry (competition) among producers for control of these goods. If there is no rivalry, then prices for these resources will not emerge. If there are no prices, there can be no knowledge of resources' relative scarcities. And if we do not know what their relative scarcities are, then there is no way to determine whether a particular plan is profitable––if it is a plan which creates more value than it consumes in resources.

When we think back to the question of "why do we make toilets out of porcelain instead of gold?" the importance of prices becomes apparent. A central planner would be at a total loss to determine which material confers the greatest net benefit and would have to rely on their personal value judgments. While they may be able to avoid "absurd" misallocations such as this (which begs the question of how they know it's absurd), the problem still applies to other more ambiguous situations. For example, should houses be made of wood or stone? Should floors be hardwood or vinyl? Should the bodies of automobiles be steel or aluminum?

If houses are made of wood there will be less available for hardwood floors. If houses are made of stone there will be fewer miles of high speed rail. If floors are made of vinyl there will be fewer pipes plumbed with PVC. If automobiles are made of steel there will be fewer miles of rail, fewer cars and trucks, and shorter skyscrapers. If aluminum is used instead, there will be less available for canned beverages and an increase in the use of plastic bottles. A socialist will inevitably call for a "mixture" of all these but that does not answer the question of what that mixture ought to be, nor does it propose a mechanism for how a socialist economy would respond to the changes in consumer preferences and resource availabilities that would require a different "mixture" to prevail.

In contrast, the potential to refer to prices for the purpose of economic calculation under a system of private ownership of the means of production, does reveal what mixture of resources is desirable, while also enabling market participants to respond to changing economic conditions.

What makes this possible, as Mises explains, are the three benefits of economic calculation that result from private ownership of the means of production:

First, Mises says that calculation in terms of prices makes it:

"...possible to base the calculation upon the valuations of all participants in trade. The subjective use value of each is not immediately comparable....It only becomes so in exchange value, which arises out of the interplay of the subjective valuations of all who take part in exchange."

The prices that result from exchange thus reflect, to a degree, people's valuations of these goods. These prices then inform us as to what people want, which is required to achieve the ultimate goal of the economic problem. As Lavoie says, when someone uses prices to engage in calculation,

"...he is unconsciously taking into account the entire complex of consumer and producer evaluations that resulted in that price being what it is" (Rivalry and Central Planning, p. 54).

Second, Mises says that:

"Anyone who wishes to make calculations in regard to a complicated process of production will immediately notice whether he has worked more economically than others...."

In other words, calculation in terms of prices means that accounting can be done to determine if a plan has been profitable. The profit or loss incurred is "a signal wrapped in an incentive" that urges resources toward more valuable ends. Prices, profit and loss thus reveal the desirable uses of resources and impel people to change their behavior in the face of changing economic conditions––precisely the issues which socialism cannot address.

The last benefit of economic calculation is that:

"...calculation by exchange value makes it possible to refer values back to a unit."

Since all exchanges are expressed in the same unit––money––profit and loss can be calculated after the fact. But just as important as this, the fact that resources' values are expressed in terms of the same unit enables entrepreneurs to engage in forecasting––there is a technique available to them to judge, before any production takes place, whether a particular production plan is more or less likely to be profitable. This technique is not a guarantee of profitability, but it does provide decision-makers with valuable information that aids them in the formulation of their plans.

So, to summarize: because prices enable economic calculation on the basis of other people's valuations, and because this calculation makes it possible to determine profit and loss, and because calculation in terms of a common unit guides future planning, private ownership of the means of production results in rational economic calculation.

What makes it rational is the fact that production in an economy organized under the division of labor (people producing different things) and based on indirect exchange (the use of money) always aims at serving other people whose wants are only ever conveyed to us through prices––the record of their actual preferences––which are then used to determine the course of production. In the absence of economic calculation, we do not know what other people want or how much they want it.

When we produce for ourselves––such as in the cases of Robinson Crusoe, the Swiss Family Robinson, or Tom Hanks's Chuck Noland in Cast Away––economic calculation only ever needs to consider our own valuations. Since we know what we want and what is most important to us, our calculations of cost and benefit are always rational. But an economy which exists to serve others precludes the possibility of getting inside the minds of others to truly know what they want, so an indirect exchange economy must rely on prices to calculate the costs and benefits of a course of action as judged by other people.

Under socialism, where the prices of the means of production do not correspond to or even approximate the costs and benefits of employing a resource in a particular mode of production because prices do not exist, or are otherwise artificially manipulated by interventionism, rational economic calculation is impossible. Whatever the degree of socialization, so long as prices for the means of production are not the result of a rivalrous process of competition guided by the calculation of profit and loss, socialism will always result in resources being squandered in pursuit of ends which are less urgently felt by society. This fact explains why socialism always result in mass poverty and suffering, and why socialism is never preferable to private ownership of the means of production under capitalism: