• Economic Calculation in the Academy

    pdficon2Garrett M. Petersen[1]
    Simon Fraser University
    Email: gpeterse@sfu.ca

     

     

    Skills, knowledge, and abilities are valued for their potential to produce valuable output. Such skills allow labourers to produce a greater output, or the same output with less time, effort, or waste, in any given production process. They are collectively called human capital, and understandably so, as human capital bears many similarities to capital goods. However, this analogy does not hold everywhere. Importantly, human capital cannot be allocated according to monetary calculation in the same way that capital goods are allocated, as it cannot be directly exchanged against money.

    The analogy between human capital and capital goods holds well when considering their contributions to production processes. To illustrate, suppose that Robinson Crusoe, an unskilled fisherman, and Friday, an expert, spend their days fishing. Friday could teach Crusoe his fishing skills, but both of them would need to forego fishing for a day. Crusoe will request Friday’s training if the fish foregone, both those Crusoe could have caught and those he must pay Friday in compensation for his training services, are valued less than the additional fish he can catch in the future given superior training.

    Suppose now that two days’ schooling, with the first day spent learning the intellectual tools to grasp the concepts of the second day, can develop Crusoe’s fishing ability to a greater extent than a single day’s schooling. Then two days’ schooling will be preferred to one day’s schooling only if Crusoe’s time preference is sufficiently low to justify the loss of the extra day’s product and the delay of an additional day before he can begin fishing.

    Thus, we see a familiar pattern. Crusoe’s choice of whether to sacrifice present consumption to be trained in fishing is essentially similar to the choice of whether to sacrifice present consumption to construct a capital good such as a net. In either case, he trades off present consumption against the potential for increased future production.

    As with capital goods, human capital can be part of a more or less roundabout production process. The first day’s schooling in the two-day process produces human capital that only has value in that Crusoe expects it to allow the creation of further human capital (developed on the second day) that will allow the production of a greater product in consumption goods (fish).

    Capital accumulation increases the diversity of tasks that labourers may perform in the production process. An economy based on net fishing requires labourers with fishing skills and with net-making skills. A complex, modern economy requires labourers with a vast array of different skills applicable at all stages of production.

    As the structure of production becomes more roundabout and complex with capital accumulation, so too do the processes of developing human capital. Learning by doing is present in any activity that humans perform repeatedly; it is present in all economies. Learning through a roundabout and indirect process is characteristic of more advanced economies. While these more roundabout production processes are more productive, they also increase the complexity of the allocation problem, the problem of directing scarce resources to some processes over others. The means of confronting this problem are essentially different for human capital than they are for exchangeable factors of production.

    Human Capital and Calculation

    Given the tight analogy between capital goods and human capital, one might be tempted to drop the distinction entirely and consider them as different manifestations of the same economic phenomenon. As we shall see, this would be an error.

    Human capital is woven into the structure of production at every point where labour is present. Any given element of human capital can be useful in the performance of some tasks but not others. Human capital is normally developed with an aim to improve an individual’s (present-valued) earnings. The relevant data for directing the development of an individual’s human capital are the wages paid to differently skilled labourers over the course of his working life. In a static economy, these would be the same wages paid to such workers in the present, so calculation would be no problem. The worker could simply measure the benefits in terms of these wages, and the costs in terms of the direct costs of human capital development and of wages foregone, to choose his best course of action. However, as the economy is not static, choosing how to develop one’s human capital always requires forecasting unrealized future prices.

    Ludwig von Mises’ great insight was to recognize the vital role exchange plays in facilitating economic calculation. Mises gives three reasons why calculation based on exchange values (i.e. market prices) is superior to calculation without the aid of exchange values. First, “it renders it possible to base the calculation upon the valuations of all participants in trade.’’ Second, it provides immediate feedback to the calculating individuals, so each “will immediately notice whether he has worked more economically than others or not.’’ Third, “calculation by exchange-value makes it possible to refer values back to a unit’’ ([1920] 1935, 97-98). In a monetary economy, money serves as that unit.

    Capital goods and land can be bought, sold, or rented. The market price of a capital good or a piece of land corresponds to the capitalized value of the stream of rents market participants expect it to produce. Rothbard ([1964] 2009) argues that “[t]he wage…is the only source of rent that cannot be capitalized on the free market, since every man is necessarily a self-owner with an inalienable will’’ [emphasis in the original] (559). Man’s will is inalienable in the sense that it cannot be granted to another person for any future period. Human capital enters into production only by augmenting labour prior to its use in production; it earns rent only in the sense that it allows the worker to earn a wage premium. Thus, it too cannot be capitalized on the free market.

    To what extent, then, can human capital be allocated according to monetary calculation? For human capital directly useful in production, the wage premium paid to workers possessing such capital allows it to be allocated according to monetary calculation. However, for the factors required to create this human capital, which include capital goods (e.g. textbooks or technical manuals, classrooms, pens, computers) and labour, contributed both by students and instructors, the relevant price is not the wage premium at any given time but the present value of the human capital. As I have established, this is not expressed as a market price, so it must be estimated without the aid of monetary calculation.

    The problem is compounded by the fact that the labour used in the production of human capital itself depends on human capital. For an instructor to teach a student calculus, the instructor should understand calculus and have pedagogical skills. The student should understand algebra and have note-taking and study skills. The instructor’s labour is priced through his wage, but the student’s labour is not priced, as he works only for himself to produce his own inalienable human capital.

    The problem of evaluating human capital becomes more difficult with each step it is removed from exchange. Suppose someone intends to learn algebra in order to learn calculus, in order to learn physics, in order to learn engineering, in order to work as an engineer. Then he must form his valuation of his engineering knowledge by anticipating the stream of rents from the wage premium paid to qualified engineers. He must form his valuation of his physics knowledge by estimating its contribution to his grasp of engineering. He must form his valuation of his calculus knowledge by estimating its contribution to his grasp of physics. His valuation of his algebra knowledge, at last, depends on his estimate of its contribution to his grasp of calculus, and on every other valuation in the logical chain.

    Someone must choose how each student is to allocate his time and funds. In a free economy, each person decides for himself, or delegates the decision as he sees fit. More typically, early educational choices are imposed through the political process, in public schools or regulated private schools. In any case, someone must choose how to allocate each student’s time and funds, where these funds may come from the student himself, his family, or from the government’s budget.

    The decision of whether a young student should learn a little more English, a little more algebra, or deliver newspapers to earn a small income while learning basic job skills requires that the human capital gained in any of these activities be evaluated. A precise evaluation would require the decision-maker to anticipate the eventual market value of the student’s potential future skill set and to evaluate each element contributing to this skill set, tracing the logic back step by step to find the marginal contributions of English, algebra, or basic job skills learned in the present. Such precise evaluations are rarely (if ever) attempted, perhaps because the uncertainty introduced at every stage of the process would make the result wildly inaccurate. Most people can give qualitative reasons why it’s important to learn algebra; few would attempt to give a precise estimate of the marginal return to an hour spent learning algebra.

    Limited Calculation through Credit Markets

    Monetary calculation can enter the production of human capital through credit. Education is a long-term investment, and like other investments it can be financed through credit. In that case, the person whose human capital is being developed shares the entrepreneurial gains or losses with his creditors. In a standard loan contract, the most the creditor can hope to gain is full repayment. However, if the debtor is unable or unwilling to repay in full, the creditor takes a loss. To evaluate a debtor’s potential to repay a loan, the creditor must account for the value of his human capital investment. Creditors must be particularly alert to human capital investments that will lead to such low incomes as to jeopardize debtors’ ability to repay. However, in this sort of contract, creditors need not concern themselves with the distribution of potential incomes above the point where full repayment is maximally likely. If someone with a $150,000 salary is just as likely to repay his student loans in full as he would with a $200,000 salary, creditors face no incentive to consider the differences between salaries in this high range in allocating credit. Thus, these creditors’ role is to limit the supply of loans to the least remunerative human capital investments.

    Another, though less common, loan contract allows the creditor to claim some portion of the debtor’s income over a certain period. Then the creditor has incentive to extend loans to people who he anticipates will earn high incomes, of which the returns on human capital form a significant part. However, such contracts face a moral hazard problem: By taking a portion of the person’s earnings, they disincentivize earning, thus reducing the human capital’s total value. This would prevent any creditor from getting the entire entrepreneurial return to a human capital investment, and thus this sort of debt contract cannot serve to completely reintroduce monetary calculation into human capital. Furthermore, even if a creditor could overcome the moral hazard problem, creditors lack the private knowledge possessed by each student about his abilities.

    Credit markets are entirely amenable to monetary calculation. When debts are traded and priced in both primary and secondary markets, they are subject to the process of monetary calculation described by Mises. The choice of whether to extend credit to a student can be based on the valuations of all participants in the market for debt, as they express these valuations in their willingness to trade at various prices. Market prices provide continuous feedback on the quality of past lending decisions. A creditor can immediately recognize a loss or gain when the market prices of his assets, priced in the secondary markets for student debt, rise or fall in response to new information. Finally, debts can be valued in terms of money: the money value that such debts can be exchanged for at the present moment.

    However, for creditors to introduce monetary calculation into human capital investments, even indirectly and incompletely, requires the existence of a basically unhampered market in student debt. Such a market does not exist in reality. The prevailing ideology extols the slogan “education for all.’’ Yet for creditors to serve their role, they must restrict credit to some people seeking to be educated. This would horrify those who see education as a human right. Rather than allow this to occur, governments subsidize or socialize both student debt and educational institutions. The goal of guaranteeing access to education for all who want it cannot be achieved without removing the market discipline introduced by private creditors facing profit and loss.

    Conclusion

    The issue of calculation and human capital is of increasing importance as capital accumulation makes more roundabout production processes economical. As human capital is developed through longer processes with more intermediate stages, this increases the scope of potential errors. While error is always present in human affairs, it can be mitigated.

    Human capital is unlike capital goods in that it is inalienable from the person to whom it is attached. This means it can never be priced directly through exchange and thus cannot be subject to monetary calculation. This implies a problem for anyone seeking to allocate his time and funds towards education or other human capital investments. Without exchange and monetary calculation, each student finds himself in the position of a socialist planner with respect to his own education: He must solve a complex allocation problem, accounting for uncertain future states of the world, and he must do so without the aid of the cognitive tools provided by markets and exchange.

    His creditors on the other hand, to the extent that they operate in an unhampered market where the prices of loans are undistorted by government intervention, can calculate with respect to prices. Empowered to expand or restrict credit to different students with different educational plans, private creditors could mitigate the worst misallocations in educational investments.

     

    References

    Mises, Ludwig von. (1920) 1935. “Economic Calculation in the Socialist Commonwealth.’’ In Collectivist Economic Planning, edited by F. A. Hayek, 87-130. London: Routledge & Kegan Paul.

    Rothbard, Murray N. (1962) 2009. Man Economy and State with Power and Market, Scholar’s edition, 2nd ed. Auburn, AL: Ludwig von Mises Institute.


    [1] I would like to thank Glenn Fox for helpful comments on an earlier draft of this paper.