Smith explains the theory of value provided the foundation for the argument that rational economic calculation is impossible in a socialistic economy.


George H. Smith was formerly Senior Research Fellow for the Institute for Humane Studies, a lecturer on American History for Cato Summer Seminars, and Executive Editor of Knowledge Products. Smith’s fourth and most recent book, The System of Liberty, was published by Cambridge University Press in 2013.

Ludwig von Mises (1881–1973) was a brilliant economist, a leading proponent of the Austrian School of economics, but he was more. He was an interdisciplinary thinker of remarkable breadth who was conversant in history, social theory, and philosophy. His greatest book, Human Action, is a masterful exposition of praxeology (the science of human action); and throughout his many other books–such as Theory and History, The Epistemological Problems of Economics, and The Theory of Money and Credit–we see an original, first‐​rate mind at work.

Mises is perhaps best known for his early critique of socialism, which convinced many economists, including a young socialist named Friedrich Hayek, that rational economic calculation is impossible in a socialist system. Optimal economic coordination requires a free market in which prices transmit crucial information about the supply and demand of capital goods.

Mises drew on the Austrian theory of value to argue that socialism cannot solve the problem of economic calculation. Thus, before presenting the Misesian argument, I will present some relevant background information on this theory of value.

Central to all economic analysis is the concept of value. In classical economics–whose major exponents included Adam Smith, David Ricardo, and John Stuart Mill–two kinds of value were often distinguished, namely value in use and value in exchange. “Use value” signifies the usefulness, or utility, of a given commodity, such as water. Because water is essential to human life, it was said to have a high use value. “Exchange value,” in contrast, refers to what a given commodity can fetch in the market when it is exchanged for something else. Because diamonds will command a good deal in return, they were said to have a high exchange value.

As Adam Smith put it in The Wealth of Nations, the word value “has two different meanings, and sometimes expresses the utility of some particular object, and sometimes the power of purchasing other goods which the possession of that object conveys.” After distinguishing “value in use” from “value in exchange,” Smith continued:

The things which have the greatest value in use have frequently little or no value in exchange; and, on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.

Although modern economists sometimes refer to this distinction as “the paradox of value”(or “the water‐​diamond paradox”), this was not how it was viewed by Smith and his many predecessors (going back to Aristotle). Smith was not puzzled by this “paradox,” which he explained in the same manner as it had been explained many times before, i.e., in terms of relative scarcity. As he put it in his Lectures on Jurisprudence, the market price of a commodity depends on three things: first, “the demand or need for it (whether this be real or capricious)”; second, “the abundance of it in proportion to this demand”; third, “the wealth of the…demanders.”

Something for which there is no demand, such as a lump of clay, will not command a market price. But if something is perceived as useful and thereby generates a demand, then “the price will be regulated according to the demand.” Thus even a good which has little use value will command a high price “if the quantity be not sufficient to supply the demand; hence the price of diamonds.” On the other hand, a highly useful good like water, if it exists in superabundance and is able to “more than supply all possible demands, renders water of no price at all.”

Although Smith’s explanation is valid so far as it goes, the positing of two different types of “value” generated some problems for classical economists that they were unable to resolve. A unified theory of value did not emerge until the 1870s, when there occurred what is known as the “marginal utility revolution” in economic thought. This important innovation was arrived at independently by three men: William Stanley Jevons in England, Leon Walras in Switzerland, and Carl Menger in Austria. Although these men differed somewhat in their treatments of marginal utility, their central insights were essentially the same. (The term “marginal utility” was coined by the Austrian economist Friedrich von Wieser.)

As these economists pointed out, when we choose one commodity over another, we do not consider the general usefulness of that commodity. We do not, for example, consider the general utility of water–its role in supporting human life–when deciding how much we are willing to exchange for a specific amount of water. True, if we had to choose between all the water in the world and all the diamonds in the world, then we would choose water over diamonds, but rarely are we faced with this all‐​or‐​nothing situation. Instead, we confront commodities as they exist in specific quantities, or units, and how much we subjectively value a given unit of a given commodity depends on how we plan to use it.

Suppose we are deciding whether or not to purchase a gallon of water. How much we are willing to pay will be based not on the general usefulness of water but on the contribution that the additional gallon of water will make to satisfying our “marginal” wants. And this, of course, depends on how much water we already have. A man dying of thirst in a desert will value a gallon of water more highly than he would in normal circumstances, because he will use that gallon to sustain his life–rather than using it, say, to wash his car, which is what he might do in circumstances in which water is more plentiful.

Thus economic value ultimately depends not on the general usefulness of a commodity but on the specific usefulness–or marginal utility–of a given unit of that commodity in satisfying our most pressing desires. If water is abundant–that is, if most of our important wants are easily satisfied by the available water–then we will place a relatively low value on each additional unit of water, because that unit will be used to fulfill a want that we consider relatively unimportant. And if diamonds, while greatly prized, are normally scarce, then we will place a relatively high value on each additional unit of diamonds, because that unit will be used to satisfy a want that ranks high on our scale of preferences.

As I noted before, the classical economists were able to explain the water‐​diamond paradox fairly well in terms of relative scarcity, but their dualistic theory of value, which distinguished between use value and exchange value, created more problems than it solved. The theory of marginal utility was a significant theoretical advance because it was able to dispense with this dichotomy in favor of a unified theory of value. It was now understood that exchange value can ultimately be explained in terms of use value–provided that we correctly understand the meaning of “use value” as referring to the marginal use of a specific quantity of an economic good.

This is where the discussion of marginal utility by Carl Menger (1840–1921) is especially important if we are to appreciate what Ludwig von Mises had to say about economic calculation. Menger, who is generally acknowledged as the founder of the Austrian School, stressed the subjective nature of use value. The economic value of a commodity, argued Menger, depends ultimately on our subjective valuations, specifically, on how we assess the usefulness of a good in furthering our subjective goals. Economic science does not pass judgment on the true worth, or objective value, of an economic good. It does not, for instance, evaluate the “true” worth of water in relation to diamonds. Rather, economics takes as its starting point what people do in fact value, and it then analyzes the economic phenomena that emerge from this pursuit of subjective goals.

Menger’s distinctive contribution to marginal utility was his extension of this theory to what he called “goods of a higher order”–or what are sometimes called “capital goods” or “the means of production,” in contrast to “consumer goods.” Many economists had contrasted supply (or the factors of production) with consumer demand, as if these elements operated according to different principles of value. But this is incorrect, said Menger; ultimately the value of all higher‐​order goods depends on their role in producing consumer goods, those things that people use directly to satisfy their desires. “Goods of a higher order”–so-called because they fall higher than consumer goods on the scale of production–are indirect means of satisfying human wants. A steel factory may not produce anything that is directly used by the consumer, but it does satisfy consumer demand indirectly by providing the material for the building of cars and other goods that are directly used by the consumer.

Menger’s discussion of higher‐​order goods allowed him to apply the notion of marginal utility not only to consumer goods but to the factors of production as well. This insight proved essential to the Misesian argument that planners in a socialist economy will be unable to engage in rational economic calculation. Mises first advanced his argument in a 1920 essay, “Economic Calculation in the Socialist Commonwealth,” and he expanded upon it two years later in his seminal book, Socialism: An Economic and Sociological Analysis.

Pure socialism is a system in which there is no private ownership of the means of production; all production decisions are made by a central planning authority. Unlike a market system, in which capitalists and entrepreneurs can base their production decisions on the market prices of higher‐​order goods, the planners in a socialist economy have no such prices to guide them. What, then, can these planners substitute for market prices? What rational criteria can they use in determining which higher order goods are needed, and in what amount, in order to produce the desired consumer goods?

Without market prices to guide production, argued Mises, no rational calculation is possible. Thus the supposed rational economic planning of socialism (or any kind of planned economy) leads to economic chaos, to inefficiency and waste on a massive scale.