Socialist Economies Impoverish People: Basic Economics Explains Why

THE LAST PREMIER OF THE SOVIET UNION, Mikhail Gorbachev, is said to have asked British Prime Minister Margaret Thatcher: How do you see to it that people get food? The answer was that she didn’t. Prices did that. And the British people were better fed than those in the Soviet Union, even though the British have never grown enough food to feed themselves in more than a century. Prices bring them food from other countries.

Prices play a crucial role in determining how much of each resource gets used where. Yet this role is seldom understood by the public and it is often disregarded entirely by politicians.

Many people see prices as simply obstacles to their getting the things they want. Those who would like to live in a beach-front home, for example, may abandon such plans when they discover how expensive beach-front property is. But high prices are not the reason we cannot all live on the beach front. On the contrary, the inherent reality is that there are not nearly enough beach-front homes to go around and prices simply convey that underlying reality. When many people bid for a relatively few homes, those homes become very expensive because of supply and demand. But it is not the prices that cause the scarcity, which would exist under whatever other economic or social arrangements might be used instead of prices.

High prices are not the reason we cannot all live on the beach front. On the contrary, the inherent reality is that there are not nearly enough beach-front homes to go around and prices simply convey that underlying reality.

If the government were to come up with a “plan” for “universal access” to beach-front homes and put “caps” on the prices that could be charged for such property, that would not change the underlying reality of the high ratio of people to beach-front land. With a given population and a given amount of beach-front property, rationing without prices would now have to take place by bureaucratic fiat, political favoritism or random chance—but the rationing would still have to take place. Even if the government were to decree that beach-front homes were a “basic right” of all citizens, that would still not change the underlying reality in the slightest.

Prices are like messengers conveying news—sometimes bad news, in the case of beach-front property desired by far more people than can possibly live at the beach, but often also good news. For example, computers have been getting both cheaper and better at a very rapid rate, as a result of the development of technological ingenuity. Yet the vast majority of beneficiaries of these high-tech advances, insights, and talents have not the foggiest idea of what these technical changes are specifically. But prices convey to them the end results—which are all that matter for their own decision-making and their own enhanced productivity and well-being from using computers.

Similarly, if vast new rich iron ore deposits were discovered, perhaps no more than one percent of the population would be likely to be aware of it, but everyone would discover that things made of steel were becoming cheaper. People thinking of buying desks, for example, would discover that steel desks had become more of a bargain compared to wooden desks and some would undoubtedly change their minds as to which kind of desk to purchase because of that. The same would be true when comparing various other products made of steel to competing products made of wood, aluminum, plastic or other materials. In short, price changes would enable a whole society—indeed, consumers around the world—to adjust automatically to a greater abundance of iron ore, even if 99 percent of those consumers were wholly unaware of the new discovery.

Prices not only guide consumers, they guide producers as well. When all is said and done, producers cannot possibly know what millions of different consumers want. All that automobile manufacturers, for example, know is that when they produce cars with a certain combination of features they can sell those cars for a price that covers their production costs and leaves them a profit, but when they manufacture cars with a different combination of features, they don’t sell as well. In order to get rid of the unsold cars, they must cut the prices to whatever level is necessary to get them off the dealers’ lots, even if that means taking a loss. The alternative would be to take a bigger loss by not selling them at all.

While a free market economic system is sometimes called a profit system, it is really a profit-and-loss system—and the losses are equally important for the efficiency of the economy, because they tell the manufacturers what to stop producing. Without really knowing why consumers like one set of features rather than another, producers automatically produce more of what earns a profit and less of what is losing money. That amounts to producing what the consumers want and stopping the production of what they don’t want. Although the producers are only looking out for themselves and their companies’ bottom line, nevertheless from the standpoint of the economy as a whole the society is using its scarce resources more efficiently because decisions are guided by prices.

From the standpoint of society as a whole, the “cost” of anything is the value that it has in alternative uses. That cost is reflected in the market when the price that one individual is willing to pay becomes a cost that others are forced to pay, in order to get a share of the same scarce resource or the products made from it. But, no matter whether a particular society has a capitalist price system or a socialist economy or a feudal or other system, the real cost of anything is still its value in alternative uses. The real cost of building a bridge are the other things that could have been built with that same labor and material. This is also true at the level of a given individual, even when no money is involved. The cost of watching a television sitcom or soap opera is the value of the other things that could have been done with that same time.

Different economic systems deal with this underlying reality in different ways and with different degrees of efficiency, but the underlying reality exists independently of whatever particular economic system is used. Once we recognize that, we can then compare how economic systems which use prices to force people to share scarce resources among themselves differ in efficiency from economic systems which determine such things by having kings, politicians or bureaucrats issue orders saying who can get how much of what.

During the brief era of glasnost (openness) and perestroika (restructuring) in the last years of the Soviet Union, two Soviet economists named Nikolai Shmelev and Vladimir Popov wrote a book giving a very candid account of how their economy worked and this book was later translated into English. As Shmelev and Popov put it, production enterprises in the U.S.S.R. “always ask for more than they need” in the way of raw materials, equipment, and other resources used in production. “They take everything they can get, regardless of how much they actually need, and don’t worry about economizing on materials,” according to these economists. “After all, nobody ‘at the top’ knows exactly what the real requirements are,” so “squandering” makes sense. Among the resources that get squandered are workers. These economists reported that “from 5 to 15 percent of the workers in the majority of enterprises are surplus and are kept ‘just in case.’”

The consequence was that far more resources were used to produce a given amount of output in the Soviet economy as compared to a price-coordinated economic system, such as that in the United States. Citing official Soviet statistics, the Soviet economists lamented:

According to the calculations of the Soviet Institute of World Economy and International Relations, we use 1.5 times more materials and 2.1 times more energy per unit of national income than the United States … . We use 2.4 times more metal per unit of national income than the U.S. This correlation is apparent even without special calculations: we produce and consume 1.5 to 2 times more steel and cement than the United States, but we lag behind by at least half in production of items derived from them … Recently, in Soviet industry the consumption of electrical energy exceeded the American level, but the volume of industrial output in the U.S.S.R is—by the most generous estimates—only 80 percent of the American level.

The Soviet Union did not lack for resources, but was in fact one of the most richly endowed nations on earth—if not the most richly endowed. What it lacked was an economic system that made efficient use of scarce resources. Because Soviet enterprises were not under the same financial constraints as capitalist enterprises, they acquired more machines than they needed, “which then gather dust in warehouses or rust out of doors,” as the Soviet economists put it. In short, Soviet enterprises were not forced to economize—that is, to treat their resources as both scarce and valuable in alternative uses. While such waste cost these enterprises little or nothing, they cost the Soviet people dearly, in the form of a lower standard of living than their resources and technology were capable of producing.

The Soviet Union did not lack for resources, but was in fact one of the most richly endowed nations on earth—if not the most richly endowed. What it lacked was an economic system that made efficient use of scarce resources.

Such a waste of inputs as these economists described could not of course continue in the kind of economy where these inputs would have to be chased and where the enterprise itself could survive only by keeping its costs lower than its sales receipts.In such a price-coordinated capitalist system, the amount of inputs ordered would be based on the enterprise’s most accurate estimate of what was really needed, not on how much its managers could make sound plausible to higher government officials, who cannot possibly be experts on all the wide range of industries and products they oversee.

The contrast between the American and the Soviet economies is just one of many that can be made between economic systems which use prices to allocate resources and those which have relied on government control. In other regions of the world as well, and in other political systems, there have been similar contrasts between places that used prices to ration goods and allocate resources versus places that have relied on hereditary rulers, elected officials or appointed planning commissions.

When many African nations achieved independence in the 1960s, a famous bet was made between the president of Ghana and the president of the neighboring Ivory Coast as to which country would be more prosperous in the years ahead. At that time, Ghana was not only more prosperous than the Ivory Coast, it had more natural resources, so the bet might have seemed reckless on the part of the president of the Ivory Coast. However, he knew that Ghana was committed to a government-run economy and the Ivory Coast to a freer market. By 1982, the Ivory Coast had so surpassed Ghana that the poorest 20 percent of its people had a higher real income per capita than most of the people of Ghana.

This could not be attributed to any superiority of the country or its people. In fact, in later years, when Ivory Coast politicians eventually succumbed to the temptation to have the government control more of their country’s economy, while Ghana finally learned from its mistakes and began to loosen government controls, these two countries’ roles reversed—and now Ghana’s economy began to grow, while that of the Ivory Coast declined.

Similar comparisons could be made between Burma and Thailand, the former having had the higher standard of living before instituting socialism and the latter a much higher standard of living afterwards. Other countries—India, Germany, China, New Zealand, South Korea, Sri Lanka—have experienced sharp upturns in their economies when they freed those economies from many government controls and relied more on prices to allocate resources.

In a society of millions of consumers, no given individual or set of government decision-makers sitting around a table can possibly know just how much these millions of consumers prefer one product to another, much less thousands of products to thousands of other products—quite aside from the problem of knowing how much of each of thousands of resources should be used to produce which products. In an economy coordinated by prices, no one has to know. Each producer is simply guided by what price that producer’s product can sell for and by how much must be paid for the ingredients that go into making that product.

Knowledge is one of the most scarce of all resources and a pricing system economizes on its use by forcing those with the most knowledge of their own particular situation to make bids for goods and resources based on that knowledge, rather than on their ability to influence other people. However much articulation may be valued by intellectuals, it is not nearly as efficient a way of conveying accurate information as confronting people with a need to “put your money where your mouth is.”

Human beings are going to make mistakes in any kind of economic system. In a price-coordinated economy, any producer who uses ingredients that are more valuable elsewhere is likely to discover that the costs of those ingredients cannot be repaid from what the consumers are willing to pay for the product. After all, he has had to bid these resources away from alternative users, paying more than these resources are worth to some of those alternative users. If it turns out that these resources are not more valuable in the uses to which he puts them, then he is going to lose money. There will be no choice but to discontinue making that product with those ingredients. For those producers who are too blind or too stubborn to change, continuing losses will force their business into bankruptcy, so that the waste of society’s resources will be stopped that way.

In a price-coordinated economy, employees and creditors insist on being paid, regardless of whether the managers and owners have made mistakes. This means that capitalist businesses can make only so many mistakes for so long before they have to either stop or get stopped—whether by an inability to get the labor and supplies they need or by bankruptcy. In a feudal economy or a socialist economy, leaders can continue to make the same mistakes indefinitely. The consequences are paid by others in the form of a standard of living lower than it would be if there were greater efficiency in the use of scarce resources.

In a feudal economy or a socialist economy, leaders can continue to make the same mistakes indefinitely. The consequences are paid by others in the form of a standard of living lower than it would be if there were greater efficiency in the use of scarce resources.

As already noted, there were many products which remained unsold in stores or in warehouses in the Soviet Union, while there were desperate shortages of other things. But, in a price-coordinated economy, the labor management, and physical resources that went into producing unwanted products would have had to go into producing something that could pay its own way from sales. That means producing something that the consumers wanted more than they wanted what was actually produced. In the absence of compelling price signals and the threat of financial losses to the producers that they convey, inefficiency and waste in the Soviet Union could continue until such time as each waste reached proportions big enough and blatant enough to attract the attention of central planners in Moscow, who were preoccupied with thousands of other decisions.

Ironically, the problems caused by trying to run an economy by fiat or by arbitrarily-imposed prices created by government dictates were foreseen by Karl Marx and Friedrich Engels, whose ideas the Soviet Union claimed to be following. Engels pointed out that price fluctuations have “forcibly brought home to the commodity producers what things and what quantity of them society requires or does not require.” Without such a mechanism, he demanded to know “what guarantee we have that necessary quantity and not more of each product will be produced, that we shall not go hungry in regard to corn and meat while we are choked in beet sugar and drowned in potato spirit, that we shall not lack trousers to cover our nakedness while trouser buttons flood us in the millions.” Marx and Engels apparently understood economics much better than their latter-day followers. Or perhaps Marx and Engels were more concerned with economic efficiency than with maintaining political control from the top.

Prof. Sowell is a senior fellow at the Hoover Institution. This article is adapted from Basic Economics: A Citizen’s Guide to the Economy by Thomas Sowell. Copyright © 2004. Available from Basic Books, an imprint of Perseus Books, a division of PBG Publishing, LLC, a subsidiary of Hachette Book Group, Inc.