How to Think about Economic Calculation
[Chapter 7 of Per Bylund’s new book How to Think about the Economy: A Primer.]
Money, as we discussed in the previous chapter, makes lots of exchanges possible that are impractical or impossible under barter trade. We are better off as a result. But money has greater implications that are often overlooked or misunderstood. Chief among these is economic calculation, which is the process of determining how scarce resources should be used to produce the most valuable outcomes possible. Economic calculation is a core of any economy.
We can use technological knowledge to maximize a production process’ outcomes, given the inputs and outputs, and to reject inputs that are unsuitable for that type of production. But which input to use, which production process to undertake, which production technologies produce the better (higher-value) outcome, and which outcomes to strive for are fundamentally economic decisions.
For example, technological knowledge can tell us that gold is too soft to use for railroad tracks. But it cannot tell us which harder metal is best—most valuable—to use: iron, steel, or platinum? The answer requires knowing what else those metals can be used for, how valuable those uses are, and how much of each metal is available. Technological knowledge also cannot tell us when, how, or whether to build the railroad. Where should the railroad be built? Should it be built at all or should the resources go to building some other type of infrastructure—or something else altogether? Those are all economic questions—they are based on our calculation of the relative value outcome.
A metal that is far from technologically perfect may actually be the best choice, even if it means laying new rails from time to time. The best solution in terms of technology gives us little to no information on the value outcome of the cost of production. Without economic calculation, an economy is unable to economize on scarce resources.
Money facilitates economic calculation, an essential mechanism in a market economy, by serving as a common unit. In other words, it allows for monetary calculation.
The Nature of a Productive Economy
Economists have long known that productivity is closely related to specialization. We saw in chapter 5 that capital increases productivity and it does so by making labor more productive. We get more out of our labor efforts if we use appropriate tools and machines. Market exchange also makes labor more productive because people can focus on producing the things that create most value regardless of whether they personally value or use them. Instead of people being self-sufficient and producing everything they need for their everyday lives, markets allow them to develop their unique abilities and take advantage of economies of scale—of how average cost falls with higher production volumes—to increase their overall value output.
Specialization, or focusing our time and effort on a narrower set of productive activities, has two main effects.
First, when we specialize, we become better at carrying out specific productive activities. Adam Smith noted that specializing makes us many times more effective and productive because we (1) do not lose time shifting from one task to another, (2) develop and increase dexterity and workmanship, and (3) can more easily identify how to use simple machines or develop new tools to become even more effective.
Smith exemplified this “division of labor” with a pin factory in which the production of a pin takes eighteen distinct operations. In Smith’s example, “a workman … could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty.” But if ten workmen instead specialize in carrying out certain operations, they “could make among them upwards of forty-eight thousand pins in a day.” That’s an enormous difference—specializing increases the output of labor at least twenty-four hundred times.
The difference is not in the tools or operations, which are the same in both cases but in better organization of the production process. Or, specialization allows workers to be much more productive.
Second, when we specialize—and because we specialize—we become dependent on others doing their part of the production process—and they on us. The serial division of labor in a production process creates interdependence: the ten workmen in Smith’s example can produce an enormous number of pins together, but only as long as all of them carry out their tasks. If one worker, who is in the middle of the production process, does not show up for work, this creates a gap in the process. The workers in the earlier operations up to the point where the missing worker’s task begins will be able to do their part, but the workers requiring the input from the missing worker cannot carry out their operations, and so no pins will be produced. For the process to generate any pins at all, all tasks must be carried out. Simply put, the ten specialized workers stand and fall together. If the chain is broken, for whatever reason, they will revert from producing forty-eight thousand pins to a measly two hundred (the max for ten unspecialized workers in Smith’s example).
Such interdependence is risky and might sound like a bad idea, but it is not. Each of these workers has an interest in completing the process; otherwise there would be no pins to sell and no job. (As an unspecialized worker they could make no more than twenty pins each and have a lower standard of living.) So because their specialized productive efforts are interdependent, the workers share an interest in completing the production process.
Smith’s argument is more general and not just limited to factory production. The capital structure itself is the outcome of specialization: a division of resources that facilitates, strengthens, and enhances the division of labor.
When the flatbread baker builds an oven (see chapter 5), he not only increases his productivity as a baker but also develops the knowledge and skill to produce ovens. If there are other bakers interested in using his innovation, our baker could specialize in oven making instead of baking. He could supply other bakers, who can then specialize in producing oven-baked bread. The baker’s role has changed from baking bread to supplying ovens and his livelihood now depends on the availability of the resources needed to produce ovens and then sell them. It is an opportunity to create more value and increase his—and everybody else’s—living standards.
This simple example of the baker shows how a longer production process, through innovations and the resultant intensive division of labor and capital, is adopted because it produces more value. It is more productive than using scarce resources, especially labor, more effectively. The modern economy has extremely long production processes with such narrow specializations that most of us would not be able to survive without the rest of the economy. Think about everything you rely on and use in your daily life but that you did not produce yourself—and probably cannot produce. We depend on a lot of strangers doing their part in production.
On the flip side, an economy could never sustain the many people that live in the world today without specialization. And the smaller population it could support would not have the conveniences and number of goods available to us. Our modern prosperity is the result of the division of labor and capital, which is constantly enhanced and improved through innovation and competition in the market.
The market reduces the risks and potential downsides of interdependence in production and supply chains by influencing parallel production
Article from Mises Wire