Tuesday, April 15, 2014

The possibility of economic calculation under capitalism

I picked up several books at the local AAUW's book sale last Friday, including Lange and Taylor's "On the Economic Theory of Socialism".  I was flipping through it and found a great passage on economic calculation. I think Lange understands a point that is a stumbling block for many people grappling with "mainstream" economic models. If you get frustrated by the beginning, please note the frequent and deliberate use of scare quotes and hold on until the end:
"The only 'equations' which would have to be 'solved' [under socialism] would be those of the consumers and the managers of production. These are exactly the same 'equations' which are 'solved' in the present economic system and the persons who do the 'solving' are the same also. Consumers 'solve' them by spending their income so as to get out of it the maximum total utility; and the managers of production 'solve' them by finding the combination of factors that minimizes average cost and the scale of output that equalizes marginal cost and the price of the product. They 'solve' them by a method of trial and error, making (or imagining) small variations at the margin, as Marshall used to say, and watching what effect those variations have either on the total utility or on the cost of production. And only a few of them have been graduated in higher mathematics. Professor Hayek and Professor Robbins themselves 'solve' at least hundreds of equations daily, for instance, in buying a newspaper or in deciding to take a meal in a restaurant, and presumably they do not use determinants or Jacobians for that purpose." (page 88).
The title of this post is meant to highlight that I find more to agree with with Lange on capitalism here than I have to agree with him about socialism, but I've conveniently cut off the quote before he got into socialism.

This is an issue I posed to my students in my history of economic thought class when we went over Walras, Jevons, and Menger (and it is perhaps easiest to see with Jevons and Menger precisely because they are not presenting the problem so formally as Walras). Do you need to know and use calculus to make decisions for the theory of the marginalists to be useful? If not, why not?

Well if you do then surely marginalism is not useful, because even those of us proficient in calculus don't use it in the vast majority of our decision making. My view is that you don't need calculus and marginalism is nevertheless very useful for modeling human decision making (and "modeling" here is the key). In the end, all the constrained optimization framework says is "keep doing X until doing more X makes you worse off". It requires very little behaviorally. The greatest burden imposed by marginalism is not in the area of behavior, it's in assumptions about the structure of preferences. We usually impose a few rules here. I've argued elsewhere that they are not very burdensome and fine as an approximation in the absence of anything better. Furthermore, there's no indication that loosening these assumptions qualitatively changes the results. Its only apparent effect is to make the math harder.

As Lange points out, we don't care about the math in everyday life. The purpose of the math is to generate models to study.


  1. We don't calculate. We usually just use simple heuristics to make such decisions. Using simple heuristics is way more robust that calculating equations. No one ever actually calculates any equations and such methods are extremely fragile to error of all kinds; heuristics are not.

    1. Right... I don't know if you're missing the point of the post or just trying to restate it. I agree.

      Some heuristics are certainly fragile - I think you need to put a little more meat on that claim before advocating it too strongly.

    2. The advantages of heuristics is that their flaws are obvious and in the open. The flaws of methodologies using complex calculation are much easier to ignore, especially when dealing with issues like model error or measurement error. Most of those errors don't really exist in heuristics. Heuristics are simple and the flaws are out in the open, which makes them way more robust than complex calculations.

  2. You did a very good job of excerpting, Daniel Kuehn. And I agree with Suvy - in practice, much of "economic calculation" really is the use of heuristics. Heuristics aren't completely invulnerable to fallacious reasoning, however...but that's another topic. On a somewhat related note, I think you might want to take a look at this article - even if it was published a long time ago.


  3. The way I view it is, economists understand that first order conditions are not being calculated in the human brain while undergoing economic transactions. We just model their decision making processes using mathematical tools, which some feel, is the "best fit" to modeling these transactions. I am reminded of the famous billiard player analogy by Dr. Friedman, the player does not use physics to line up the shot, but we may use physics to determine the outcome, given certain conditions are met.

    Where I think this is related to the article above, is that economic agents do no need to perform these mathematical optimizations in order to get the best out of their economic decisions, if left to their own free will. But if a social planner wishes to modify these decisions made by agents/firms, then they have the great challenge of knowing the mathematical models that best fit the economy. If the planner does not have this information, then social efficiency is very difficult to obtain, especially without unintended consequences.


    1. I agree completely, and this is getting more specifically at why I say I agree with Lange more on capitalism than I do on socialism.

      I don't think non-market action is doomed. In narrow cases we can think of some useful public action heuristics as well that are - if not perfect - good. But these are case specific and it is not a claim that I think maps over to generating an entire matrix of exchange values.

    2. Daniel Kuehn: I wouldn't say that "non-market actin is doomed"...but I do think if one wants to be more accurate, Suvy is correct to say that people really use "heuristics" rather than literal calculation to choose things on the market.

  4. "In the end, all the constrained optimization framework says is "keep doing X until doing more X makes you worse off". It requires very little behaviorally."

    I think this is pretty reasonable in a partial equilibrium context. Where I think some of the mainstream stuff is lacking is in a general equilibrium context. It's not straightforward that the plans of agents whose behavior is guided by a basic heuristic will over time become consistent. This isn't a knock on the assumption of constrained optimization per se, but on the set of assumptions that characterize a typical general equilibrium model. There's been some work on the subject (Alchian,1952, is one of my favorites), but it's definitely something that's under-emphasized. A more recent paper is from Gintis, "The Dynamics of General Equilibrium":


  5. Two quick points:

    The Lester-Machlup debate is relevant here, won by Alchian. "Economic calculation" isn't simply a matter of adaption to the environment, but of the environment 'adopting' those firms that best act like they're aiming for efficiency (though they may be doing nothing of the sort). If a thousand cars leave Chicago at random, and only one road has gas stations, we can ex-post anoint the car driving on the road with the gas stations as 'rational,' but it's the environment, not the decision-making process, that has made it so.

    And, of course, minimizing the 'cost of production' without market prices is a somewhat problematic concept.


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