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Are Corporations Islands of “Calculational Chaos”?

According to Kevin Carson (“Hierarchy or the Market,” The Freeman, April 2008), a private business corporation is in effect “an island of calculational chaos in the market economy.” . . . Carson writes, “Those at the top make decisions concerning a production process about which they likely know as little as did, say, the chief of an old Soviet industrial ministry.” But that is not true with respect to modern corporations. They operate in an economy with private property, privately owned businesses, and a market for goods and services in which prices develop. Thus a corporation is not similar to a socialist state; it has market prices to guide it.

Carson mentions F. A. Hayek’s “The Use of Knowledge in Society,” which explains that the knowledge corporations need to plan their operations is widely dispersed among countless individuals. But Carson fails to note that Hayek explained how this information becomes available to businessmen through market prices. . . .

Businessmen make calculations on the basis of market prices not only when exchanging with other businesses but also when shifting goods and workers internally from one department to another. Almost every day, newspapers report some example of entrepreneurs making plans on the basis of market prices and using bookkeeping to determine income and outgo. . . .

It is true, as Carson points out, that government interventions—regulations, taxes, and subsidies—distort prices and the pattern of production, so that today’s prices are not truly free-market prices. Nevertheless, even such not-truly-free-market prices . . . make available to businessmen widely dispersed information and enable them to calculate fairly accurately, formulate plans, estimate costs and income, and anticipate profits and losses. Thanks to market prices and modern bookkeeping methods, our corporations do not yet operate “in a manner quite similar to the bureaucracy of a socialist state.”

—Bettina Bien Greaves
Hickory, North Carolina

Kevin Carson replies:

Most of the issues Mrs. Greaves raises were addressed in my June 2007 Freeman article, “Economic Calculation in the Corporate Commonwealth.” I refer her to it, since I cannot do her arguments justice in the constraints of a letter.

I would dispute Mrs. Greaves’s contention that a genuine price system operates within the large corporation, either as an effective mechanism for assigning values to production inputs or for aggregating dispersed knowledge. Corporate internal-transfer pricing, in the case of goods for which there is no external market, are essentially what Murray Rothbard denounced, in Man, Economy and State, as play-acting, directly comparable to the pricing Oskar Lange proposed under his market socialism. Peter Klein expounded on this at much greater length in “Economic Calculation and the Limits of Organization” (The Review of Austrian Economics, vol. 9, no. 2, 1996). Rothbard and Klein probably underestimated the extent of the problem. The majority of intermediate goods to which internal-transfer prices are assigned are product-specific components for which no external market exists.

The phenomenon Mrs. Greaves describes, of corporate management using external market prices as a guide to internal-transfer pricing, is just the kind of estimation Ludwig von Mises argued state-socialist central planners would have to resort to in assigning prices to inputs in their domestic economies. Mises, it goes without saying, regarded this as highly unsatisfactory.

Pricing based on the available supply and the valuation of purchasers under the spot conditions of the market may lead to irrational allocations given different conditions of supply and valuation within the firm. . . . But if all that matters is that some external market continue to exist, no matter how unrepresentative of conditions within the firm, then a state-planned economy ought also to work just fine with implicit pricing based on foreign markets, so long as some market exists anywhere in the world.

To address Mrs. Greaves’s other major point, on distributed knowledge, the source of the trouble is the moral hazard resulting from the separation of “ownership” from control, and of labor from management. Management’s attempts to aggregate knowledge in a hierarchy are limited by the agent’s unique knowledge. Unless the agent is a residual claimant, who fully internalizes the costs and benefits of his own actions, he has every reason (and opportunity) to take advantage of his private knowledge to the disadvantage of the principal. Management is insulated from effective external control by its use of retained earnings for most new investment and its ability to rig the internal rules of corporate governance to thwart hostile takeovers and proxy fights.

In American corporate culture, despite management’s ostensible role as agent, its normal practice is that of an Ottoman tax farmer: gutting long-term productive capabilities in order to maximize short-term profits and game its own bonuses and stock options. . . . Double-entry bookkeeping is a doubtful instrument for controlling an agent when the agent is keeping the books.