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Terminology: Socialism, Communism

Uses of the terms “socialism” and “communism”

1. Early vs. late stage of post-capitalist society.

2. Democratic and/or decentralized vs. authoritarian and/or centralized version.

3. Transition: legal/peaceful/evolutionary vs. extra-legal/violent/revolutionary.

4. Party that rejects Soviet model vs. party that accepts Soviet model.

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Early Approaches to Socialism

1. Utopian Socialists

2. Revolutionary/class struggle socialists

3. Gradualist Socialists

Main differences:

1. Strategy for getting to socialism

2. Nature of socialist institutions

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Early Approaches to Socialism (cont)

Agreement about basic features of socialism:

1. Social ownership of means of production replaces private ownership

2. Economic planning replaces the market

3. Production for use replaces production for profit

4. Cooperation replaces competition

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How Socialist Institutions would Achieve Socialist Goals

1. Social ownership º elimination of classes and exploitation

2. Economic planning º elimination of • unemployment• periodic depressions• waste due to ex-post market coordination• insecurity of life under capitalism

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How Socialist Institutions would Achieve Socialist Goals (cont)

3. Production for use º elimination of• trade secrets and monopolistic obstructions to

technical progress• treatment of workers as commodities

4. Cooperation º economy based on higher values than competition.

Believed system with above features would also• remove cause of war among nations• provide basis of true democracy by eliminating

classes and class power

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Economic Calculation Debate

Von Mises (1922)

1. No market in means of production º no market prices for means of production º no rational calculation is possible.

2. Market requires private property in MP.

3. Economic calculation is necessary for “dynamics”, not statics –actually meant comparative statics.

4. Key role of capitalist is risking own capital in uncertain ventures.

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Economic Calculation Debate (cont)

Barone (1908)

It was noticed that Barone had earlier demonstrated that there could be rational allocation of resources in principle, without any prices of means of production, by solving a set of equations.

Hayek (1935)

Accepted Barone’s argument in principle but said it would not be feasible due to information gathering and computational problems.

Concluded only a competitive market price mechanism could rationally allocate resources.

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Economic Calculation Debate (cont)

Lange (1938)

Offered market socialist solution.

Assume:

1) Means of production (and natural resources) are public property – no actual markets in them.

2) Actual markets in consumer goods and labor services

Substitute Central Planning Board (CPB) for Walrasian auctioneer.

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Lange Model (cont)

Process of reaching equilibrium

CPB sets accounting prices for means of production, natural resources, borrowed capital.

Enterprise managers told to follow two rules:1) For given output, minimize cost of production by following rule

that marginal revenue product divided by input price is equal for all inputs.

2) Choose output for which marginal cost = price.

CPB adjusts prices in light of shortages and surpluses at existing prices.

Iterative process leads to equilibrium set of prices for means of production, natural resources, and capital which provide basis for rational calculation necessary for Pareto optimal allocationof resources.

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Round 2 of Debate

Hayek and later Austrians redefined terms of debate:

1. Knowledge is local and tacit º cannot be written down and explicitly communicated.

This implies central planning cannot be effective -- but not a problem for the Lange model.

2. The economic problem is rapid adaptation to changes in circumstances.

This again implies a problem for central planning but not the Lange model, if information is contained in prices.

3. Only an entrepreneur/owner seeking profits can discover the most important kind of knowledge.

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Dobb 1930s-60s

Rejects market allocation, both capitalist and socialist.

Central planning has a key advantage: ex ante rather than ex post coordination.

Market system relies on short-sighted decision-making by atomized actors.

Planning overcomes narrow decision-making in the dark – crucial for rational investment decisions.

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Conclusions from Economic Calculation Debate

1. Given the terms of debate as of 1945 (neoclassical model of static equilibrium and its efficiency properties), the market socialists won.

2. Later Austrians and Dobb raised questions that are outside ofthe early debate:

a) How can a socialist economy effectively utilize tacit knowledge of the type that capitalist entrepreneurs allegedly uncover?

b) How can the advantages of central planning cited by Dobb be gained, given problems of informational and computational overload and tacit knowledge?

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The Neoclassical Model as a Basis for Evaluating Socialist Economic Performance

Key Claim: In centrally planned economies, economic allocation is not based on “rational” prices.

Question: Do market prices carry the information needed to make rational allocation decisions?

Pareto Optimum: A state in which no reallocation is possible that would make anyone better off without making someone else worse off.

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Competitive Markets and Pareto Optimality

Two theorems of welfare economics:

First Theorem: Every competitive market equilibrium is Pareto optimal.

Second Theorem: Every feasible Pareto optimal state is associated with a

competitive market equilibrium, with suitable arrangement of initial endowments.

Why is a competitive equilibrium Pareto optimal?

The key reason is the information that is believed to be carried by prices.

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Competitive Markets and Pareto Optimality

Assumptions required for proof of theorems of welfare economics:

1. No increasing returns to scale.

2. Convex indifference curves

3. No interdependence of utility functions

4. Information: Households know the characteristics and prices of all consumer

goods.Producers know the characteristics of all technologies and inputs

and the prices of inputs.

5. No price discrimination.

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Competitive Markets and Pareto Optimality

Three aspects of Pareto Optimality:

1. Efficient allocation of consumer goods among consumers

In equilibrium, MRSA,N = PA/PN for all consumers.

Hence, MRSA,N is the same for all consumers.

2. Efficient allocation of inputs among producers

In equilibrium, MRTSL,K = PL/PK

Hence, MRTSL,K is the same for all producers.

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Competitive Markets and Pareto Optimality

3. Efficient matching of production with preferences

MRTA,N = MCA/MCN by definition of MRT.

In equilibrium, profit maximization º P = MC for all products.

Therefore, MRTA,N = PA/PN

For all consumers, MRSA,N = PA/PN

Therefore, MRTA,N = MRSA,N

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Critique of Pareto Optimality

1. Efficiency cannot be defined in a value-free way.

2. Virtually every economic act makes someone worse off.

3. Growth is more important than efficiency in the long-run.

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Critique of Optimality of Competitive Market Equilibrium

1. Economies of scale are widespread º can’t prove existence of equilibrium.

2. Information about consumer goods is often largely possessed by producers º invalidates proof of optimality. (“Asymmetric information”)

3. Information requirements for theorems are of same order of magnitude as information requirements for efficient central planning!

4. When is incomplete contracting, a market may not clear – labor, capital º invalidates optimality proof.

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Critique of Optimality of Competitive Market Equilibrium (cont)

5. External effects are pervasive º invalidates proof, since price does not reflect full benefit or cost from consumption or production.

6. Public goods invalidate the proof:

a) Collectively consumed goods cannot be sold due to free rider problem. (National defense, highway beautification)

b) Zero MC goods (TV signal, lighthouse) cannot be produced for profit.

7. Problem of designing reallocation of initial endowments in way that does not interfere with market incentives.

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Dynamic Problems

General equilibrium is not dynamically stable under any reasonable assumptions.

Stability requires infinite information requirements.

Implications:

a) Actual relative stability of market systems must be due to institutional features of the system, which violates the model.

b) The equilibrium properties of a market system are irrelevant.

c) The actual prices in a market economy do not have the information properties claimed for market prices.

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Other Problems

1. Prevalence of monopoly (market) power Market power means that the price carries the wrong information.

Prevalence of price discrimination (a form of monopoly power)Invalidates proof of Pareto optimality

2. Wage determination and bargaining powerLabor costs are the main determinant of relative market prices.If wages are determined mainly based on relative bargaining

power, rather than by the marginal product of labor and the marginal disutility of labor, then prices reflect the relative bargaining power of the workers who directly and indirectly produce a product, not any “true cost of production.”

Conclusion: Prices send signals but they are arbitrary signals.

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Comparing Socialism and Capitalism

Realistic picture of the strengths of capitalism.

1. Profit motive and competition º effort to keep costs down and produce what consumers want or can be persuaded to want.

2. The institutions of capitalism º rapid technological innovation, capital accumulation, increase in consumption of commodities over time.

3. Capitalism historically brought a certain kind of individualfreedom, bourgeois rights, bourgeois democracy.

Key question: Can a socialist system provide economic, political, and cultural outcomes that masses of people would regard as superior to capitalism?

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Comparing Socialism and Capitalism (cont)

Some advantages of socialism involve qualitative differences in kind of economy and society:

cooperationmeaningful labornon-commodity societyhuman control over social evolution

But are some areas in which it is possible to make an economic performance comparison with capitalism:

1) average living standard2) growth of living standard over time3) income distribution4) security and stability5) full employment6) technical progress7) environmental protection

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Comparing Socialism and Capitalism (cont)

Efficiency is not one of the areas of comparison between socialism and capitalism.

Each system has characteristic forms of waste.

Ask whether a socialist economy can use resources to produce what is valued at a cost that society finds reasonable.

Comparing Alternative Designs of a Socialist Economy:

Judge alternative designs of socialist economy based on performance relative to the goals and values of a socialist system.