Last week, I posted on looking at firms and government as alternative venues for exchange, or at least alternative means of resource allocation. On Sunday, the Quote of the Week was Oliver Williamson making the same point, much more succinctly. Some Austrians are hostile to this approach, because it seems to diminish the importance of markets. On the one hand, this shouldn’t really be an obstacle to accepting the institutional position, because if it reduces the importance of markets: so what? On the other, we can question whether alternative means of allocation are even possible (from an efficiency perspective) without competitive markets.

A theory frequently invoked on this blog is Mises’ theory of economic calculation. In 1920, Mises published “Economic Calculation in the Socialist Commonwealth.” He wanted to explore how we know the values of higher order goods, whose values are imputed from their final product. His answer is that these values can only be known through a competitive bidding process, where they are arrived at by owners trading with each other. In other words, market prices are an emergent phenomenon that cannot be known a priori. Without the market process, we can only allocate resources blindly.

Modern economists have internalized, for the most part, the ex ante role of prices: individuals (the representative agent, firm, et cetera) use prices to maximize some function. But, Mises’ theory also sheds light on the, arguably more important, ex post role of the pricing process as a disciplining mechanism. With the help of prices, individuals can account for profit and loss; they can use prices to compute whether their net return (revenue minus costs) are a net positive or negative. This ex post perspective also emphasizes the role of the market’s trial-and-error process, where entrepreneurs who do well are copied, and entrepreneurs who do poorly must learn from their mistake. The same is true for just about all market agents, including consumers: we may buy one brand of shampoo only to find out that we dislike it, and we usually never buy it again (unless the price is low enough to compensate for the loss in quality).

When we consider alternative institutions of exchange, the theory is that the individual has a choice between venues. There must be some calculus by which the individual compares alternative net benefits. In “The Nature of the Firm,” for example, Coase argues that the choice between organizing production within the firm or doing so through the decentralization of the market is ultimately a choice based on comparative transaction costs. If it’s cheaper to organize production within the firm than it is through the market, then the firm will arise. Similarly, allocation through government is only worth it if there are comparative net benefits (see, for instance, Buchanan and Tullock’s The Calculus of Consent): if there is some externality, government should only be used if private action is unable to solve it (opportunity cost), and if the benefits of collective action are greater than the costs.

But, if Mises’ theory is right, the only generally effective way of conducting a comparative analysis of costs is to use market prices. It follows that for alternative means of exchange and allocation to approach efficiency, there must already be markets, and most resources must already be traded through markets. In this fashion, society can attach prices to them, and these will reflect, to some extent or another (i.e. imperfectly), their value. This doesn’t mean that the market, to use a common theme, must have already provided roads, but at least the inputs to these roads must have market prices attached to them for alternative allocations to approach efficiency. Otherwise, we have no good way of accounting for benefits and/or losses, and therefore no basis for a comparative analysis.

This, though, was already understood at least as early as 1937 (see my post “Misunderstanding Coase“),

There is … point in [Evan F.M.] Durbin’s answer to those who emphasize the problems involved in economic planning that the same problems involved in economic planning have to be solved by business men in the competitive system. The important difference between these two cases is that economic planning is imposed on industry, while firms arise voluntarily because they represent a more efficient method of organizing production. In a competitive system, there is an “optimum” amount of planning!

— R.H. Coase, “The Nature of the Firm,” in The Firm, the Market, and the Law (Chicago: University of Chicago Press, 1988), p. 37, ftn. # 14.

Now, if someone were to devise a persuasive theory of alternative means of value estimation, that would be a significant breakthrough. So far, attempts have not passed the persuasion test (see the debates between early market socialists, such as Oskar Lange, and Hayek).