Real Prices and Ideal Prices - The Economic Calculation Problem and Prices

The Economic Calculation Problem and Prices

In the classic socialist calculation debate, the participants generally believed that economic calculation was a problem for centrally planned economies. Necessarily the central planners had to engage in price accounting, and had to use price information, but the volume and complexity of transactions was so great, that genuine central planning of the economy was often not really feasible in practice; often the state authority could only enforce the conditions of access to resources with the aid of extensive policing. An additional problem was, that much of the price information was actually false or inaccurate, because economic actors had no interest in providing truthful information, because the nominal price of goods did not reflect their value, or because goods changed hands informally in ways which could not be formally recorded and known. The effect was that the computed accounting information was often a mixture of fact and fiction.

However, on closer inspection market economies suffer from very similar defects, in the sense that much commercial price information is in practice deficient, false, distorted or inaccurate. This is not necessarily because trading parties intend to deceive - generally speaking, deception is bad for business, at least in the long run - but simply because it is technically impossible to provide fully exact price information. Official price estimates often fail to be accurate, rely on dubious valuation assumptions contrary to reality, or cannot be verified thoroughly, among other things because they rely on sample survey techniques or partial and infrequent information. Price signals are not intrinsically always clear; they can be deceptive, understating or overstating the real situation, or present a completely false picture of transactions and values. Jean-Claude Trichet for example remarked in 2008 that:

"The root cause of the crisis was a widespread undervaluation of risk. This included an underpricing of the unit of risk and an underassessment of the quantity of risk that financial operators took upon themselves."

A "unit of risk" does not really exist, but this category can nevertheless be thought of as the quantity of money which represents a "possible" financial loss. This can be formulated as a mathematical relationship between the magnitude of the value of an asset and the likelihood that a loss in its value of a certain size will occur, based on information from the past. We can then calculate an "average risk margin" for all kinds of assets, and obtain ratios (proportionalities) from which we can derive an "average risk price" (the cost of insuring for the risk - see also Margin (finance)). However, risk-pricing is intrinsically a problem-fraught process, since it relies on assumptions about unknowns, in advance of actual events, and these unknowns may include factors that were not previously anticipated or included in the mathematical models. Moreover, if people can make more money when they exaggerate the risks, they will do so, and they will also downplay the risk, if that makes more money.