Essays on Austrian Economics and Political Economy

By Karen I. Vaughn

In Essays on Austrian Economics and Political Economy, Karen I. Vaughn takes us through her intellectual journey and career. As a neoclassical economist by training and a specialist in the history of economic thought, Vaughn, although conversant with the Austrian school of economics, did not fully begin to grasp the fundamental differen

• Language: English
• Publisher: Mercatus Center at George Mason University
• Release date: Dec 1, 2021
• ISBN: 9781942951643

Karen I. Vaughn

Karen I. Vaughn is emerita professor of economics at George Mason University and emerita distinguished senior fellow with the F. A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center at George Mason University.

Book preview

Introduction

How I Became an Austrian Economist

My serious interest in Austrian economics began in June 1974 at the now famous Austrian conference at South Royalton, Vermont. During my Queens College days in the early 1960s, I had been introduced to both libertarianism and the writings of Ludwig von Mises by my longtime friend and colleague, Larry Moss. I had even attended two of Mises’s lectures with Larry, one at his New York University seminar and another at a weekend conference at the Foundation for Economic Education. I was also fortunate at that time to meet Murray Rothbard, and I spent many interesting evenings in his apartment discussing Austrian economics and libertarian philosophy with him and other likeminded young people. There were not many of us at the time. Murray would quip that the majority of libertarians in New York City fit easily into his living room. Having been prompted by a previous acquaintance with the writings of Ayn Rand, I became a convinced libertarian. However, I was not at all sure how Austrian economics differed substantially from the conventional microeconomic theory I had fully embraced in my undergraduate education. As far as I could tell at that time, both neoclassical microeconomic theory and Austrian economics were showing that a market economy was the best of all possible economic structures for allowing people to live free and prosperous lives.

During my graduate years at Duke University and into the early days of my teaching career at the University of Tennessee, Knoxville, I harbored fond feelings for the Austrians, but these feelings were based on no real understanding of what the Austrian tradition had to offer. At Tennessee, with a department dominated by Clarence Ayres’s version of Institutionalism, I thought of myself as a neoclassical microeconomist and taught the intermediate course with great enthusiasm. My primary research field of specialization was the history of economic thought, and my energies such as they were, were devoted to John Locke and the seventeenth century. But the truth was that I was getting bored with both. I realized that while I liked teaching micro, I had no ideas about how to contribute to the literature, and I was becoming increasingly impatient with Locke. I wrote a few desultory papers, none of which got published, and wondered if perhaps I was not cut out to be a professor of economics after all. Then, in the spring of 1974, I received the invitation to attend a week-long conference on Austrian economics held in South Royalton, Vermont, sponsored by the Institute for Humane Studies (IHS). Much has already been written about that conference, and elsewhere I have credited it with being the impetus for the Austrian Revival. For me, it was a life changer.

Initially, the prospect that most excited me was spending a week in early summer at an inn in Vermont in the company of interesting people. Having an opportunity to learn more about Austrian economics, of which I had only a cursory knowledge, was still important but perhaps only secondarily so. By the end of the week, that ordering changed.

The lectures by Israel Kirzner, Murray Rothbard, and Ludwig Lachmann, and the comments and discussions among participants, covered the full gamut of Austrian theory. I was most impressed by Israel Kirzner’s talks. His carefully constructed arguments and dispassionate presentation contrasted with what seemed to me to be the true believer approach of Rothbard. As for Lachmann, his talks about market process and capital theory were a foreign language to me. Nevertheless, I found the whole experience invigorating. While I still did not see how Austrian economics differed substantially from the economics I imbibed in my school years, I was completely convinced that the Austrian approach merited some serious investigation. I never suspected that I would soon have reason to take up that investigation with a vengeance.

In November of that same year, Larry Moss organized a session at the Southern Economic Association meetings on the subject of The Economics of Ludwig von Mises: Toward a Critical Reappraisal (Moss 1976). The speakers were to be Murray Rothbard, Israel Kirzner, Larry Moss, and William Baumgarten, each speaking on a different aspect of Mises’s work. Fritz Machlup was to be chair of the session. Moss asked me to serve as the sole discussant of all four papers in the session, a daunting prospect for an Austrian neophyte. Nevertheless, I accepted the challenge and spent months in the library giving myself a crash course in most aspects of Austrian theory. Of the four papers, one in particular engaged my interest: Rothbard’s (1976) paper on the economic calculation debate. I had never before heard of that debate, but the more research I did into the Austrian response to the economics of socialism, the more I came to realize that the debate was the key to understanding the important theoretical differences between the then standard neoclassical economics and the view of the market process presented by Mises and Hayek. I cannot claim to have immediately grasped all of the implications of the debate, but it is no exaggeration to say that my research into the economic calculation debate sparked the development of my ideas for most of the rest of my career.

A word about why I was so intrigued by the calculation debate: When I first learned micro theory as an undergraduate, I felt that I had learned the secret of the universe. I loved the notions of market clearing, efficiency, and the apparent fairness that seemed to flow from people acting in their own interests in a market economy. Even before I read Adam Smith, the benefits of economic liberty seemed apparent to me. Microeconomics provided the organizing principle that helped me understand a complicated world, and it reinforced my youthful libertarianism. Imagine my chagrin, then, when in my graduate micro theory class, after a lecture on general equilibrium, I was told that general equilibrium theory proved that a socialist economy could be just as efficient as a market economy—and this from an otherwise conservative economist! I really did not believe it, but I had no tools to prove otherwise, so I just tucked it away for future reference. Learning about the economic calculation debate was a revelation. There really was something wrong, not only with socialist economics but possibly with neoclassical economics as well. The next twenty-five years of my career, more or less, consisted of an exercise in figuring out exactly what was wrong with both, a project greatly helped by my reading of Friedrich Hayek.

Hayek was, of course, a major force in the Austrian Revival, especially after winning the Nobel Prize in Economics in 1974. At first, I really only knew his work on the calculation debate and his knowledge essays. I admired the knowledge essays and incorporated The Use of Knowledge in Society (Hayek 1945) and The Meaning of Competition (Hayek [1946] 1948) into my micro theory course, but I was still thinking like a micro theorist—though with embellishments about knowledge problems. As far as I was concerned, market clearing was the important concept and as long as the market got there, that was all that mattered. Clearly, I still did not grasp the rudiments of market processes. Not surprisingly, I found Economics and Knowledge, Hayek’s (1937) most profound critique of equilibrium theory, elusive at best. I had yet to read The Constitution of Liberty (Hayek 1960) or the first volume of Law, Legislation and Liberty (Hayek 1973). Surprisingly, it was reading the third volume of Law, Legislation and Liberty (Hayek 1979) that helped me understand how to think about market processes—but more on that later.

The 1970s and into the 1980s were exciting times to be a neophyte Austrian. Economists outside the Mises-Rothbard-Kirzner nexus were starting to take the Austrians—or at least Austrian ideas—seriously, despite not always agreeing with them. I was fortunate to meet some of them, scholars such as Axel Leijunhufvud, Robert Clower, Leland Yeager, and above all, James Buchanan, at a succession of Liberty Fund conferences held in the late 1970s. I was first introduced to Buchanan’s work through a footnote reference to L.S.E. Essays on Cost (Buchanan and Thirlby 1981) in Rothbard’s (1976) paper on the calculation debate. This in turn led me to read Cost and Choice (Buchanan [1969] 1999), a book that took Austrian arguments seriously. Because Cost and Choice was a difficult book for me to grasp, I had to read it several times before I finally thought I understood Buchanan’s central arguments. However, what I immediately understood was that Buchanan, too, thought that the Austrians had important ideas. That may not seem like much all these many years later, but at the time it was enough to keep me studying the Austrian tradition. Austrian economics was clearly at the fringe of the economics profession. I was greatly attracted to its theories, but I was not sure I could trust my instincts. Was I right to think that there was real substance to the Austrian critiques of neoclassical theory? For me, reading Buchanan gave me confidence to follow my instincts.

In 1978, I accepted a position at George Mason University. Again, there were no Austrians on the faculty, but the work environment was congenial, and the names Mises and Hayek were at least familiar to a few. I still felt intellectually isolated—but not for long. In 1980, Richard Fink, director of the Austrian program at Rutgers University, Newark, accepted a position in our department and brought with him both his plan for an Austrian program and several of his Austrian students from Rutgers University, most notably undergraduates Daniel Klein and Tyler Cowen. Together that first year, Fink and I received permission from George Mason University to officially form the Center for the Study of Market Processes. We then persuaded the faculty to hire Don Lavoie and Jack High to become members of the center. If South Royalton had been a life changer for me, forming the Center for the Study of Market Processes was the event that made that change the guiding force of the rest of my career. We now had weekly seminars in Austrian topics and funds to bring in outside speakers, including such Austrian luminaries as Israel Kirzner, Ludwig Lachmann, Friedrich Hayek, and James Buchanan. I was immersed in discussions about the future of Austrian theory. Yet, while the Center for the Study of Market Processes was flourishing, it was doing so within an unknown and unremarkable university. The economics department was just starting to offer a PhD program. We were excited to admit our first graduate students, but we were also concerned for their future careers. No matter how good our program was, the future of our graduate students would be compromised by the status of the university as a whole. That worry disappeared when, much to everyone’s amazement, James Buchanan and the entire Center for the Study of Public Choice moved to George Mason University. All of a sudden, our department went from being unknown to being the home of a prestigious academic center. The spillover benefits to the department, and especially to the Center for the Study of Market Processes, in both recognition and scholarly achievement were immeasurable. For me, however, the arrival of the Center for the Study of Public Choice was something of a mixed blessing. On the one hand, the intellectual stimulation that came from bringing Buchanan, who was a fount of ideas and greatly sympathetic to the Austrians, was enormous. But since I had been instrumental in negotiating the arrival of the Center for the Study of Public Choice, I was asked to serve as department chair, a position I held for seven long years. With all the administrative duties I had to assume, finding time to write was a challenge.

Before I became the department chair, I had published Economic Calculation under Socialism: the Austrian Contribution (chapter 1) and Does It Matter That Costs Are Subjective? (chapter 2), the two articles that provided the theoretical background to my understanding of Austrian economics. During my tenure as chair, I managed to publish several papers in Austrian economics: I co-authored Hayek’s Ricardo Effect: A Second Look (chapter 3) with Larry Moss, as well as several papers on Public Choice themes, often from an Austrian perspective. The most significant Austrian piece that I wrote during those seven years was the entry on Menger in the New Palgrave Dictionary of Economics (Vaughn [1987] 2008), a piece that gives an historical account of the aspects of Carl Menger’s writings, rather than an evaluation of them, from a contemporary perspective. When I was finally liberated from my seven years of indentured servitude as the department chair, I could then start thinking about contemporary Austrian economics more systematically. Since I was trained as an historian of economic thought, I naturally approached the subject historically.

Since I had recently written the Palgrave entry on Menger, it is not surprising that my first post-administrative effort was The Mengerian Roots of the Austrian Revival (chapter 5). Writing that paper helped me to clarify the central issues of contemporary Austrian theory and brought me back to a question that had dominated Austrian debates in the mid-1970s and throughout much of the 1980s: the role of equilibrium constructs in Austrian theory.

Shortly after the South Royalton conference, Israel Kirzner arranged for Ludwig Lachmann to visit New York University each spring semester for the better part of a decade, where Kirzner and Lachmann ran a colloquium on Austrian economics. A recurrent theme of their discussions was the nature of equilibrium theory and whether it had a role to play in Austrian economics. Kirzner argued that some notion of equilibrium was essential to explaining the order that emerges from economic action; without that, he believed, there was no defense of a market economy. The choice was between equilibrium explanations of the market and nihilism. Lachmann, on the other hand, emphasized the ongoing nature of market activity that never settles because of the subjectivism of not only preferences and costs, but also of expectations. He also talked about institutions as points of orientation, but in a rather nonsystematic way. In the beginning, I thought it was obvious that Kirzner was correct. Some notion of equilibrium was necessary to capture the orderly process of the market. One could explain the essentials of the market order by showing how price changes induced actors to move from one equilibrium to another. But after almost a decade of closer study of Menger, Hayek, and Lachmann, I was no longer so sure.

By 1992, the Kirzner-Lachmann debates were over, but as far as I was concerned, the issue had never been resolved. Kirzner was correct that the core of economics was explaining the spontaneous order that emerged from the unintended consequences of purposeful human action. But was the equilibrium metaphor really the best way to capture that order? Lachmann’s arguments about the radical subjectivism of knowledge and the ongoing nature of economic action seemed to argue against any metaphor that was grounded in a state of rest, but unfortunately, he never specified an alternative construct. The Problem of Order in Austrian Economics: Kirzner vs. Lachmann (chapter 6) was my attempt to clarify the two viewpoints in my own mind. I had hoped it would allow me to come up with a way of explaining economic order without resorting to equilibrium notions. Unfortunately, I was successful in neither that essay nor in my larger work, Austrian Economics in America (Vaughn 1994). My voilà moment didn’t come until several years later when, thanks to Hayek, I finally figured out what I thought about the whole equilibrium matter.

While my first acquaintance with Hayek in the late 1970s came from my study of the calculation debate, I soon started delving into his more philosophical works. I first read Law, Legislation and Liberty and The Constitution of Liberty. Then soon I was reading his books of published essays: Studies in Philosophy, Politics and Economics (Hayek 1967) and New Studies in Philosophy, Politics, Economics and the History of Ideas (Hayek 1978). I became a huge fan of Hayek. I was especially drawn to Competition as a Discovery Procedure (Hayek [1968] 1978), because it seemed to mark a real break from conventional economics. Market economies are about learning and change, not about achieving some equilibrium state. But still, how do we explain the orderly process that allows economically progressive learning and change to take place? I found my tentative answer in, of all places, Hayek’s theory of social evolution. I had been reading a great deal about biological evolution during my years as the department chair. Austrians and some other nonmainstream economists were beginning to argue for an evolutionary account of market processes. I became convinced that an evolutionary framework was appropriate for Austrian economics, but I did not try to systematically explore my ideas. I wrote several papers examining Hayek’s account of the evolution of rules from the perspective of constitutional economics, but nothing about the evolution of market economies.

After writing Austrian Economics in America (Vaughn 1994) and struggling with the problem of explaining order without equilibrium, I turned again to Hayek’s social evolution. It then occurred to me that while, according to his critics, Hayek’s account of the evolution of formal and informal social rules might be problematic, Hayek’s evolutionary logic was a better fit when applied to a market order than to political and social interactions. Markets are indeed discovery procedures. Actors are driven by competition to learn and experiment with new ways to satisfy consumer demands. Profit and loss are indicators of whether they are successful, and thus whether the innovation will persist. Hence, economic discovery leads to the growth of market institutions that codify the results of market discovery. Hayek ([1968] 1978) alluded to these market characteristics in his essay by that name, but he never attempted to develop a systematic economic theory that followed from his insights. Hayek’s Implicit Economics: Rules and the Problem of Order (chapter 8) was my attempt to begin developing an evolutionary theory of markets from a Hayekian perspective, where equilibrium constructs were irrelevant to understanding the market order.

That article was a verbal account of market evolution from a Hayekian perspective, but in a profession that regards itself as scientific, verbal theory is more easily accepted when there is a systematic model that underlies it. So, when I began reading about the theory of complex adaptive systems, I believed I had found the appropriate model for Hayek’s economics. After all, Hayek had been greatly interested in early cybernetic work and systems theory. He never directly applied systems theory to economics, but it seemed obvious to me that this is exactly what Hayek should have done. Hayek’s Theory of the Market Order as an Instance of the Theory of Complex, Adaptive Systems (chapter 9) was my attempt to argue exactly that point. This article, along with Hayek’s Implicit Economics (chapter 8), ended my search for the proper theoretical framework for Austrian economics. All that was left was to flesh out my arguments—or so I thought. To that end, I had hoped to write a book developing my ideas in more detail. Alas, life got in the way of my project, and I retired before I could finish it. Still, I regard these two papers as my most important contributions to Austrian economic theory.

The debates over the role of equilibrium in the 1980s and 1990s have long been over. Despite some initial skepticism on the part of some of my colleagues, it is now commonplace among Austrians and others who share many views with Austrians to think of the economy as a complex adaptive system. My specific emphasis on the nature and evolution of market institutions, however, initially did not seem to arouse much enthusiasm. Perhaps I was just writing what other Austrians already believed. I was disappointed but still, for me, these two essays were a personal achievement, the culmination of my twenty-five years of searching for the distinctiveness of contemporary Austrian theory.

Becoming an Austrian economist was a gradual process for me. At first, I was reluctant to be labeled by a set of ideas that I only partially understood. Besides, I greatly admired other economists, such as Milton Friedman, Armen Alchian, Douglas North, and Ronald Coase, all of whom did not exactly fit the Austrian mode. Indeed, Friedman and North were distinctly hostile to the Austrians. I continued to teach microeconomics in full confidence that I was imparting the core of economic theory. But each time I grappled with more of the contemporary Austrian literature, attended one of the frequent Austrian conferences that were being held at that time, or listened to contemporary Austrians explore various facets of Austrian theory, my neoclassical shell cracked a little more. When the Center for the Study of Market Processes was up and running at George Mason University, I finally realized that the aspects of the work of my non-Austrian heroes that I found attractive were exactly those aspects that were most reminiscent of Austrian theory. When I realized several years later that I could no longer teach intermediate micro with a clear conscience because I ceased to find the identification of equilibrium conditions to be a useful means of understanding market order, it occurred to me that I truly was an Austrian economist. I still do not particularly like the label, Austrian. I would prefer Austrians highlight the substantive core of the tradition (such as market process economics) rather than their ancestry, but once given, labels are nearly impossible to change. Yet, despite the label, far from being a set of dogmas inherited from Menger and Mises as some early critics believed, Austrian economics is—to use an old-fashioned term—a progressive research program, a framework for developing an increasing understanding of the nature of the market order.

During a brief visit to the South Royalton conference, Milton Friedman provocatively quipped, There is no such thing as Austrian economics, only good economics and bad economics. On the face of it, his claim was indisputable, but unlike Friedman, who clearly thought the Chicago version of neoclassical economics was the real good economics, it seems clear to me now that Austrian economics is in fact good economics. Indeed, I have come to realize that the Austrian approach to economics is far superior in its ability to understand and explain the consequences of human action in the marketplace than the neoclassical economics that so entranced me early in my career. The essays in this volume chronicle my transformative journey.

REFERENCES

Buchanan, James. M. (1969) 1999. Cost and Choice: An Inquiry in Economic Theory. Vol. 6 of The Collected Works of James M. Buchanan. Indianapolis, IN: Liberty Fund.

Buchanan, James M., and G. F. Thirlby, eds. 1981. L.S.E. Essays on Cost. New York: New York University Press.

Hayek, F. A. 1937. Economics and Knowledge. Economica 4 (13): 33–54.

________. 1945. The Use of Knowledge in Society. The American Economic Review 35 (4): 519–30.

________. (1946) 1948. The Meaning of Competition. In F. A. Hayek, Individualism and Economic Order, 92–106. Chicago: The University of Chicago Press.

________. 1960. The Constitution of Liberty. Chicago: University of Chicago Press.

________. 1967. Studies in Philosophy, Politics and Economics. Abingdon, UK: Taylor & Francis.

________. 1973. Law, Legislation and Liberty. Vol. 1: Rules and Order. Chicago: University of Chicago Press.

________. 1978. New Studies in Philosophy, Politics, Economics, and the History of Ideas. Chicago: University of Chicago Press.

________. (1968) 1978. Competition as a Discovery Procedure. In F. A. Hayek, New Studies in Philosophy, Politics, Economics, and the History of Ideas, 179–90. Chicago: University of Chicago Press.

________. 1979. Law, Legislation and Liberty. Vol. 3: The Political Order of a Free People. Chicago: University of Chicago Press.

Moss, Laurence S., ed. 1976. The Economics of Ludwig von Mises: Toward a Critical Reappraisal. Kansas City, MO: Sheed and Ward.

Rothbard, Murray. 1976. Ludwig von Mises and Economic Calculation under Socialism. In The Economics of Ludwig von Mises: Toward a Critical Reappraisal, edited by Laurence S. Moss, 67–78. Kansas City, MO: Sheed and Ward.

Vaughn, Karen I. 1994. Austrian Economics in America: The Migration of a Tradition. Cambridge: Cambridge University Press.

________. (1987) 2008. Menger, Carl (1840–1921). In The New Palgrave Dictionary of Economics. London: Palgrave Macmillan.

Chapter 1

Economic Calculation under Socialism

The Austrian Contribution

Between 1920 and 1940, a body of economic literature developed which became known as the debate over economic calculation under socialism. It began with the publication of Ludwig von Mises’s article, Economic Calculation in the Socialist Commonwealth (Mises 1920); it took form first primarily in the German literature and then reached full flower in English language journals and books during the 1930s. The ostensible subject of the debate was whether it was possible for a real economy to operate efficiently without free markets and without private ownership of capital and land, but at the core of the debate were issues that were far-reaching and profound in their implications for economic theory in general. That the issues involved are still some of the most difficult in contemporary economic theory and remain unresolved almost forty years after the conclusion of the debate makes the identification of the differences between the two sides of more than historical interest.

It is indicative of the nature of the controversy that those who argued most effectively in favor of socialism were not advocates of a labor theory of value but were economists operating within the dominant neoclassical paradigm.¹ A few took their inspiration from Marshall, more from Walras, but all agreed that given some just initial wealth distribution, equilibrium in the perfectly competitive model represented the maximization of human welfare, and all their programs for socialism were designed to reproduce the conclusions of perfect competition in a centrally directed economy.² They preferred socialism to capitalism because they believed under socialism it would be possible to eliminate the imperfections that they found existing simultaneously with free markets: monopolies, externalities, business cycles, and unjust income and wealth distributions.³ Thus, they believed that capitalism was undesirable because it did not measure up to the ideal of perfect competition.

Those most closely associated with the theoretical defense of capitalism,⁴ on the other hand, were Ludwig von Mises, Friedrich Hayek and Lionel Robbins.⁵ Of the three, Mises and Hayek were both Austrian economists, and Robbins, although English, was much influenced by Carl Menger and was, therefore, at least partly in the Austrian tradition. As Austrians, they worked with a perception of economic activity that differed markedly from that of mainstream economists. Primarily, they questioned the relevance and applicability of static equilibrium models in which all information is given and emphasized instead the process by which decentralized economic actors operating in a world of uncertainty and constant change bring about the coordination of production and consumption plans. Consequently, the debate was a contest of theoretical models in which a mutually satisfactory resolution was precluded from the outset.

Although it is conventional to treat the economic calculation controversy as a debate between those who favored socialism and those who opposed it, this is not descriptive of the actual course of events. During the 1920s there was a genuine debate between Mises and the German and Austrian socialists, but by the 1930s Mises had finished with the issue and it was Friedrich Hayek who took upon himself the role of critic of socialism in England. However, by that time, the real debate, in so far as one took place in the journals, was among the socialists themselves⁶ who were busy hammering out a complete economic theory of socialism based on neoclassical static equilibrium analysis. Occasionally, Hayek’s criticisms were noted in scholarly articles, but rarely for any purpose other than refutation. Mostly, Mises was ridiculed; and Hayek, on this issue seen as little more than Mises’ apologist, was ignored. The unhappy result of this failure to see more than warmed-over Mises in Hayek’s work was an almost total lack of recognition of the subtleties of the issues Hayek raised in criticism of market socialism. If I had to offer a crude synopsis of the economic calculation debate, it would be this: Mises wrote an article claiming that rational economic calculation was impossible under socialism. This prompted those who favored socialism to try to refute him and thus forced them to construct a model of rationally administered, centrally directed economy. Meanwhile, Hayek wrote two sophisticated and penetrating critiques of the socialist schemes, which were in the main ignored. Mises seemed easy to refute, and so for twenty years, socialists continued to refute the same arguments, thereby avoiding consideration of the more difficult issues raised by Hayek.

In order to understand the principal issues raised in the literature on socialist economic calculation, it will be convenient to divide my discussion into four parts. The first part of this paper examines Mises’s 1920 article to identify the sources of controversy; the second part briefly outlines the major developments in the economic theory of socialism during the 1930s; the third part presents Hayek’s criticisms of socialist economic programs; and the fourth and final part attempts to summarize the theoretical problems raised during the debate in order to appreciate the relevance of the Austrian contribution to current problems in economic theory.

I.

The literature on the economics of socialism before 1920 is sparse. While there was no lack of scholarly (and not so scholarly) discussion of socialism as a social theory, Marxists, following the lead of Marx himself, paid little attention to the actual workings of a socialist economy. It was assumed that after the revolution was time enough to worry about the economic problem, assuming that one still existed after the demise of capitalism.⁷ A few attempts were made to describe a theory of a centrally directed economy, but these attempts were significantly made by non-Marxist economists interested in a purely theoretical problem. F. von Wieser often made use of the construct of a centrally directed economy in explicating his economic theories, as did Pareto in his exposition of general equilibrium theory. Enrico Barone developed the most complete exploration into the economics of socialism, applying neoclassical tools to the problem of a centrally directed economy in an article written in 1908 (Wieser 1893, especially 60–64; Pareto 1906, especially 267–271; Barone 1908). None of these writers, however, were socialists and none were attempting to prescribe a formula for running a real socialist economy. More significantly, none of these efforts had any influence on socialists and Marxists prior to 1920.

What all these early attempts to construct a theoretical model of a centrally directed economy had in common was the realization that the same economic logic can be applied both to capitalism and socialism. Therefore, if socialist economic planners want to allocate resources efficiently, they must be able to calculate correct resource and product values, including those two much despised by Marxists, interest and profits. Hence in 1920, in a manner which suggested growing impatience with economically naive Marxists (some of whom were advocating a moneyless economy without exchange and denying the existence of resource scarcity), Mises wrote his famous article, Economic Calculation in the Socialist Commonwealth.

Mises’s article was concerned with establishing two principal propositions. The first was a restatement of the Wieser-Pareto-Barone argument that all the same economic variables that guide resource use in a capitalist economy must also necessarily be taken account of under socialism. He argued specifically that it was naive to expect money and prices to disappear for very long under socialism; that as long as people have differing preferences (and as long as socialist leaders strive to satisfy consumer preferences), the allocation of consumer goods would present problems which could only be solved by resorting to some system of money and prices. In fact, since consumer goods presumably would be owned by consumers themselves, the development of prices and markets in consumer goods was inevitable (Mises 1920, 90–93). The real problem, according to Mises, was in the allocation of capital goods—the means of production. Since these would not be privately owned, markets could not be utilized to determine resource prices, and hence there would be no way to evaluate relative resource scarcities (104–109). He conceded that while socialism may be possible in a static state where knowledge of unchanging economic parameters is universal and where the imputation problem, once solved, would remain solved forever, he emphasized that such a static state itself is only a theoretical assumption corresponding to no real state of affairs (104). In any real socialist world, the impediments to rational economic calculation are legion: the inevitability of change, the uncertainties that this implies in all economic decision-making (111), the problem of initiative without private property (116), and the necessary elimination of the promoter and man of affairs (119) who makes the market work to establish relevant prices. Mises’s second proposition, then, was that without free markets based on private resource ownership, economic calculation would be totally impossible. It was this second proposition that infuriated socialists, challenged conventional economists, and became the focus of attempts to refute Mises.⁸

II.

Although there was much discussion of the problems Mises raised during the 1920s in the German literature,⁹ the creation of an economic model of socialism along neoclassical lines was a product of English-speaking economists in the 1930s. Three men especially stand out as originators of socialist economics: H. D. Dickinson, Oskar Lange, and Abba Lerner. Of the three, Dickinson was first in print with his preliminary model, Lange’s work came to represent the economic theory of socialism (and incidentally was credited with offering the definitive refutation of Mises), and Lerner’s marginal cost rule made a significant contribution to the work of the other two.¹⁰

Dickinson and Lange developed very similar models of socialist economy in which there would be private ownership of consumer goods and freedom of choice in occupation, but public ownership of all capital goods and nonhuman productive resources. Where their models differed most significantly, at least initially, was in the methods suggested for obtaining relative values to guide resource allocation. Dickinson’s solution to the pricing problem was to set up selling agencies which would determine the prices of all goods by a combination of several methods: The prices for consumer goods would be set according to what the market would bear, the agencies raising (prices) when stocks fell short, lowering when they accumulate (1933, 239). In this way they would be able to determine statistically all the demand functions for all goods which, when combined with technologically determined production functions and a given supply of resources, would enable the central planning board to impute factor valuations (240). Dickinson also seemed to propose that the planning agency, operating within the glass walls of socialism (where all demand functions, production functions, and resource supplies are known to planners) would be able to construct a mathematical model of the economy which would be solved for resource prices using a system of simultaneous equations á la Barone (245).

Lange’s solution to the pricing problem was simpler. He too, proposed setting up a central planning board to administer prices, but only resource prices. Consumer goods would be priced in free markets in order to provide accurate information for factor valuation (1938, 72–73). Factor prices would then be determined by a system of trial and error exclusively, the process partially adopted by Dickinson but originally proposed by F. M. Taylor in 1928. Lange’s use of trial and error was a conscious attempt to overcome the myriad difficulties inherent in an attempt to solve for prices using statistical demand curves and econometric models, difficulties stressed by both Robbins and Hayek (Robbins 1933, 149; Hayek 1935, 212). In response to the critics, Lange argued forcefully that there was no need to set up systems of simultaneous equations to find factor prices as long as the planning board fixes the prices so as to balance the quantity supplied and the quantity demanded of each commodity (Lange 1938, 83). Lange believed that trial and error described the process by which prices are formed in real markets, and he patterned his method after a Walrasian tâtonnement with the central planning board acting the part of the auctioneer (1938, 70, 82–83).

After Lange’s work appeared in print, the socialists, as well as many nonsocialists, agreed that the problem of pricing under socialism had been solved by the trial-and-error process, and what remained to be explored was how these prices should be used in the actual production of goods and services. Hence, after the publication of Lange’s article, the problem of what set of rules would induce managers of socialist firms to make decisions that would lead to appropriate resource allocation replaced the problem of pricing in the literature on socialist economics.

Lange’s contribution to the question of managerial rules had been to point out that in pure competition, profit maximization and the freedom of entry and exit are the mechanisms which assure allocative efficiency. Thus, to duplicate the results of perfect competition, it was necessary to force socialist managers to behave like perfect competitors by imposing two rules of behavior on them: As an alternative to profit maximization, they would be instructed to minimize factor costs for the given set of resource prices, and to equate marginal cost to product price in the production of output. The first would guarantee efficient use of resources and the second, appropriate plant size. When applied to the industry as a whole, the second rule would also control the size of the industry (Lange 1938, 75–79). As long as socialist managers observed the parametric function of price, that is, as long as they, like perfect competitors in genuine markets, treated resource and product prices as parameters rather than dependent variables, his rules would lead to the same resource allocation as perfect competition (81).¹¹

By the end of the decade, the outline of a neoclassical economic theory of market socialism was complete. Consumer goods are priced in genuine markets, communally owned resource prices are determined by a central planning board through the trial-and-error process, and managers at both firms and industries are told to produce where the marginal cost of output equals the price of the product produced and the price of any resource employed equals the marginal contribution of that resource to output. Any change in parameters will manifest itself as a change in price, which will cause managers to alter firm production and industry size accordingly. Clearly, these neoclassical socialists believed they had shown that economic calculation was just as possible under socialism as it was under capitalism. That in order to do so they had to create a socialism that bore no resemblance to any existing political states, and which had nothing to do with Marxist economics, was irrelevant. Their economic model was still within the spirit of socialism although it retained many important features of capitalism.¹² In addition, they believed their brand of socialism was both economically and morally superior to free market capitalism. With a system of market socialism, one could more rationally direct economic growth through appropriate manipulation of the rate of interest, and production in general would increase because of the elimination of monopoly power and the waste associated with business cycles and inappropriate coordination of private production plans. Furthermore, income distribution under socialism would be morally superior to capitalism because