Economics for Democratic
Socialism
Drexel University
Spring Quarter 2009
Economic Planning
• In the early twentieth century, many socialists
and others believed that market outcomes are
chaotic, irrational, and very inefficient.
• They called for government control of the
economy in order to implement a rational plan.
• However, neoclassical and Austrian economists
had shown that in ideal circumstances, market
equilibria could be rational (in a certain,
utilitarian sense) and, indeed, efficient, as we
have seen.
Rational Plan 1
•
•
However, it could be argued that there is more to
rational direction of the economy than efficient
allocation of resources.
Even in an ideal market economy, the outcome is
“irrational” in two ways:
i. Market prices depend on the distribution of
income from wealth, which has no rational
basis.
ii. The market makes no provision for distribution
according to need, while a rational plan would
rationally determine what needs are to be met,
and which left to individual decisions via
markets.
Rational Plan 2
•
Moreover, as we have learned since that time i. Markets are subject to inefficiency due to
externalities, and monopoly power, without
rational basis.
ii. A rational plan would efficiently curtail
externalities and offset monopoly power.
Market Rationality
• We need some details about the sense in which
market equilibrium is rational.
• Market equilibria reflect consumer demand.
• Consumer demand in turn is determined by the
subjective goals of consumers.
• In principles of economics, those subjective
goals are expressed as utility.
• In more advanced economic theory, preferences
are substituted for utility.
Planning: The Case Against 1
• Nevertheless, the Austrian case against planning
deserves attention.
• Von Mises drew on the Austrian representation of
production.
• First-order goods directly satisfy human wants.
• Second and higher-order goods do not directly
satisfy wants, can be used to produce first-order
goods when appropriately combined.
• How then can we “impute value” to hither-order
goods? Mises argues: only on the basis of
prices.
The Younger Austrian School
• Ludwig von Mises
1881-1973
• Born Lviv, Ukraine,
then part of AustriaHungary
• Friedrich von Hayek
1889-1982
• Born Vienna, Austria
• Nobel, 1974
From von Mises
• “It seems tempting to try to construct … a separate
estimation of the [economic success of] particular
production groups in the socialist state also. But it is
quite impossible. For each separate calculation of the
particular branches of one and the same enterprise
depends exclusively on the fact that is precisely in
market dealings that market prices to be taken as the
bases of calculation are formed for all kinds of goods
and labor employed. Where there is no free market,
there is no pricing mechanism; without a pricing
mechanism, there is no economic calculation.”
Lange
• In von Mises’ terminology,
socialism= planning, and a
system of worker
cooperatives would be
“syndicalism.”
• Oscar Lange, a Polish
Marxist, responded that a
socialist state could
nevertheless make use of
markets.
Oskar Lange, 1904-1965
Rejoinder 1
• Lange argued that a socialist state could use markets to
direct the allocation of resources.
• Lange drew partly on another tradition: Walras’ general
equilibrium theory.
– Only “equilibrium” prices impute values efficiently.
– That means supply=demand in every market.
– Walras envisioned an auction process to determine
those “general equilibrium” prices.
– But there is no such auctioneer in the actual world.
Rejoinder 2
• Lange proposed that the managers of socialized
enterprises be directed to maximize profits.
• Prices would be determined by the state, and adjusted by
trial and error to the equilibrium prices, as Walras had
envisioned the auctioneer doing.
• Probably Lange thought of this as only an accounting
procedure to support efficient planning.
• Nevertheless it was the origin of modern ideas of
“market socialism,” i.e. the combination of public
ownership with decentralized management and a market
mechanism.
The Case Against 2
• Hayek responded that planners could nevertheless never
have sufficient information to plan rationally.
• He stressed that much of the information needed for
economic calculation is not like scientific and
technological information.
– Scientific information is true regardless of time and
place.
– Much economically relevant information is specific to
time and place.
– For example: such and such resources are available at
such and such time and place.
The Case Against 3
• The people who have this information specific to time
and place may not reveal it unless they profit by doing
so.
• For this to happen, there has to be actual trading in the
markets for second and higher-order goods -- that is,
(Hayek asserts) capitalism.
• This probably is the first discussion of “asymmetric
information” in economics, and has been much extended
in late twentieth century economics -- but mostly in a
direction critical of free markets!
Asymmetric Information
• Hayek’s point is that such information cannot -even in principle -- be known to central planners.
• The people who have the information can be
induced to put it into effect only in response to
profit motives (in a very general sense).
• This can occur, he argues, only with a capitalist
market system.
Does Hayek’s Argument Hold
Water?
• Paul Rosenstein-Rodan, who
had studied with Mises, made
similar assumptions the basis
for a call for planning.
• This illustrates a shortcoming
of the Austrian economics.
Their verbal “plausible
reasoning” often is not
conclusive.
P. N. Rosenstein-Rodan
(1902-1985)
Coordination Failure 1
This is
RosensteinRodan’s “Shoe
factory example.
The managers of
the shoe factory
assume that
growth in
demand will be
slow, so …
Coordination Failure 2
• Believing the growth of demand for shoes will be
slow, the managers of the shoe factory decide not to
expand.
• Believing the growth of demand for shirts will be
slow, the managers of the shirt factory decide not to
expand.
•
•
•
• As a consequence, they are all right -- demand
growth is slow.
Coordination Failure 3
• Rosenstein-Rodan argues that central planning is
the only way out of this trap.
• Notice the role that asymmetric information plays
in this example:
 None of the managers knows what the plans
of the other managers are.
 If they did know, then the problem would not
arise.
 Not knowing, they must base their plans on
conjecture, rather than fact.
 However, a common conjecture becomes a
self-fulfilling prophesy.
A Zigzag of Progress?
• Of course, this discussion had no impact on the practice
of planning in the Soviet Union.
• Consequently it had relatively little impact on the
discussion of economic planning after World War II.
• Neoclassical economists developed a rudimentary theory
of planning as a means of understanding Soviet planning
-- but mostly by contrast.
• Perhaps it is ironic that neither side in the earlier
controversies influenced this theory.
Simple Economy
Let us return to
the simple
example of
“Economia,” and
economy that
produces only
two goods.
How to plan for
this tiny
economy?
Planner’s Preferences
• The first step for Economia's planning bureau is to
determine what its objectives are, and to express those in
terms of quantities of food and machinery produced.
• Recall, in neoclassical market theory, consumers’
preferences determine demand.
• The neoclassical theory of planning supposes that the
planners have preferences over the outputs of the
national economy.
• The Planners' preferences are expressed in neoclassical
thinking by a set of indifference curves.
Optimal Planning
The “optimal
plan” in terms of
the planners’
preferences is at
point * But, of
course, it isn’t
that easy!
http://faculty.lebow.drexel.edu/mccainr/
top/prin/txt/comsysf/cs5.html
Information
• If the planning bureau had unlimited information aqnd
computational capacity, they could just compute the plan
and instruct the enterprises as to what they should produce.
• How can the planners get the information they need? One
possibility is to ask the enterprise managers how much
they can produce. Let's make the optimistic assumption
that the enterprise managers will tell the truth -- either
because they are nice guys or because the planning bureau
has found some costless way of giving them an incentive
to tell the truth.
Iteration
• The bureau starts out
optimistically with a
tentative plan at A. But the
enterprises' resource
requirements will add up
to more resources than are
available -- A is
infeasible. Adjusting, the
planning bureau follows
up with B.
Next Step …
• B is infeasible, too -- but
with the information they
have gotten from the
enterprises on these two
attempts, the plan bureau
makes its third iteration C.
That is an improvement -C is feasible -- but it is
inefficient, since
enterprises are capable of
producing more than C
with available resources.
Further Steps
• The planning bureau
scales up the production
amounts to D. This is
better still -- D is efficient,
that is, on the production
possibility frontier -- but it
is not optimal. With the
available resources, the
planning bureau would
prefer to see more
machines and less food
produced.
Optimal Plan
• By now, however, the
planning bureau has
gotten the information
they need, and on the next
iteration they move up the
production possibility
frontier to *, the optimal
plan. This is the plan they
direct the enterprises to
carry out.
Problems
• This is a very optimistic story.
• Even if the enterprise managers tell the truth, it might take
many costly iterations of the plan to get to the optimum at *.
• Worse, the enterprise managers have strong incentives to lie.
• Even if the plan is “optimal” the consumers may not be very
happy with it. If the planning bureau tells the enterprises to
produce one finger brush per person.
• In practice, Soviet planners struggled even to produce a
feasible plan and probably never approached efficiency or
optimality.
Nevertheless …
• Economic planning is very difficult, and the
problems have never been solved in practice.
• However, market systems are not efficient
either, if externalities are important.
• A real planning system might do better than a
real market system, taking account of
externalities.
• Indeed, planning may yet be necessary in order
for us to survive.
Two Problems
• In principle, planning can be thought of as two stages:
• Framing the plan, that is, putting it down in specific
numbers on paper.
• Implementing the plan, that is, arranging for the
numbers to be realized in actual production and
distribution.
• As we have seen, they are interrelated. Our ability to
frame an efficient plan may depend on how the plan is
to be implemented.
• For now, we focus on framing.
Rational Distribution of Wealth
• So far the discussion is only in terms of efficiency -- on
which markets can do well, at least in ideal
circumstances.
• What about rational -- equitable -- distribution of income
and wealth?
• There is a neoclassical theory of equity, which arises
from work by Duncan Foley.
• This, with externalities and considerations of need, could
explain the “planners’ preferences.”
Equity Example
• We consider a very small economy consisting of
two persons, Grasshopper and Ant, two jobs, a
hard job and an easy job, and an income that can
come in two sizes: large and small.
• The institutions of the society (the "rules of the
game") link the large income to the hard job and
the small income to the easy job.
Grasshopper’s Preferences
income
large small
job
easy
hard
1
3
2
4
• We suppose that
Grasshopper is a
bit of a
lazybones.
Grasshopper's
preferences
among jobs and
incomes is
shown by the
Table.
Ant’s Preferences
income
large small
job
easy
hard
1
2
3
4
• Ant's
preferences are
different and are
shown by this
Table.
“Envy”
• Suppose that by accident Ant had been assigned
the easy job and Grasshopper the hard job.
• Grasshopper has his own third choice, but Ant has
Grasshopper's second choice:
– Grasshopper "envies" Ant.
• Conversely, Ant has his own third choice, but
Grasshopper has Ant's second choice:
– Ant "envies" Grasshopper.
Inequity
• This could be considered “inequitable” or “unfair.”
• But the inequity is easily remedied by a market transaction:
given the opportunity, Ant and Grasshopper will
voluntarily exchange jobs.
• Then Ant has his second preference, while Grasshopper's
allocation is Ant's third preference.
• Conversely, what Ant has is Grasshopper's third
preference, and Grasshopper has his own second
preference.
• Since each insect has a job-and-income package he
positively prefers over the package the other insect has, the
allocation between the two insects is said to be superfair.
No Equity
• Suppose instead that there are two Ants, Adam and
Hillary.
• One of the Ants will have to be assigned the easy
job/small income bundle. Let us suppose it is Adam.
• Adam finds that he is stuck with his own third
preference, while Hillary has Adam's second
preference. Adam "envies" Hillary and the allocation
between them is inequitable.
• Switching the Ants will not help -- one or the other of
them will "envy" the other. Inequity is unavoidable in
this example.
Lottery
• Suppose the planner decides at random which
ant will have the hard job and large income, with
equal probability.
• This is fair in a sense -- neither ant prefers the
other ant’s lottery ticket.
• But the outcome, after the draw, is still not fair.
• The lottery is said to be fair ex ante, but not ex
post.
• Is ex ante fairness good enough?
Back to Equity
• Suppose that the "rules of the game" assign income of $8
to a hard job and $4 to an easy job, but we have to allocate
jobs between two Ants.
• Suppose that an Ant will accept a hard job rather than an
easy job only on the condition that the hard job pays $3
more.
• Now, our planner assigns Hillary to the easy job and Adam
to the hard job, the redistributes $0.50 of Adam's income to
Hillary. Now Hillary has the easy job and $4.50 while
Adam has the hard job and $7.50. This makes both Ants
indifferent between the hard job and the easy job with their
associated incomes. The result is a fair (not superfair)
allocation.
A Further Complication
• I would prefer to be a professional basketball player or a
jazz pianist rather than an economist. Unfortunately, I have
no talent for either of those professions. According to the
strictest neoclassical conception of equity, my exclusion
from those professions is inequitable: I “envy” those who
do work in those occupations. But we may be satisfied
with a less generous concept of equity in the allocation of
occupations: the allocation of goods and occupations is
inequitable if one person would prefer the occupation and
standard of living of another, and is capable of doing the
work that the other person does.
Consider a society in which -• i. Everyone consumes the same goods and services.
• ii. Jobs are allocated by a lottery, in such a way that
– 1.
Everyone is assigned to a job he is capable
of doing,
– 2.
Everyone has the same chance of being
assigned to a particular job, given that he is capable
of doing it.
• This would be “fair” ex ante but very inefficient.
Trade and Fairness 1
• Suppose that from the beginning point with equal
consumption, people are allowed to enter into exchange.
• The ski enthusiast can offer her opera tickets to the opera
fan in return for the ski lift tickets allocated to the opera
fan.
• This will generate no inequity, since each will prefer the
services she enjoys after the exchange to the different
services the other enjoys.
• Let this process of exchanging goods, services, and job
probabilities continue until there is no pair that can
mutually increase their well-being by exchanging.
Trade and Fairness 2
• We will then have arrived at an “efficient” allocation of
resources. Efficiency, in neoclassical economics, means
that no person can be better off without making someone
else better off.
• But the result is also equitable, since we have begun from
an equitable situation, and in each exchange, each person
gives up what he less prefers to obtain what he more
prefers.
• Moreover, this allocation is a market equilibrium. This
follows from the fact that there is no pair that wants to
trade.
Trade and Fairness 3
• Corresponding to a market equilibrium, we have a
system of prices.
• All trading takes place before the lottery takes place, and
so the equity and efficiency are ex ante, not ex post.
• The trading is also a mind experiment. In practice, the
prices would have to be estimated.
• An ideal plan then would be based on costs and benefits
in terms of these estimated prices, reflecting value
judgments both for equity and efficiency.
• Let us call them “planning prices.”
Aufhebung
• The general idea is: we begin from a situation that is
generally acknowledged to be equitable, but inefficient.
• An all-knowing central planner would then propose a
transition from this equitable but inefficient allocation to
one that is efficient.
• In the terms of benefit-cost analysis, this transition will
generate a certain quantity of net benefits.
• Let the net benefits be divided equally among all the
members of society.
• This allocation corresponds, conceptually at least, to a
market equilibrium with a particular distribution of
wealth.
Externalities and Needs
• Thus far, we have not taken account of
externalities and needs.
• Externalities have been included in models of
this kind, and planning prices with efficient
abatement of externalities is no problem in
theory.
• Needs have not been considered, but can be
introduced as lower constraints on quantities of
needed goods consumed by each agent.
Framing and Implementation 1
• We have come to think of a plan that could be
expressed (from one point of view) as a set of
prices for goods and services.
• How can such a plan be implemented?
Framing and Implementation 2
• One possibility would be as follows: revenues from the
sale of consumer goods flow, not to the worker
cooperatives that produce the goods, but into a central
fund.
• The operations of the social enterprises producing
consumer goods would then be financed by grants from
the same fund, in such a way that the outputs would be
valued at planning prices.
• In effect, there would be a national marketing board, a
public monopolist/monopsonist for consumer goods.
Framing and Implementation 3
• This is equivalent to a 100% tax on consumer goods
used that to finance subsidies that would pay wages and
other costs of production consistent with the plan.
• It would seem more reasonable instead to impose a
schedule of net taxes and subsidies. Thus, for example,
consumer good production that generates externalities
would pay a higher than average tax, while production
of coarse grains consumed by poor people, and without
externalities, would receive a positive subsidy.
Framing and Implementation 4
• This is equivalent to a 100% tax on consumer goods
used that to finance subsidies that would pay wages and
other costs of production consistent with the plan.
• It would seem more reasonable instead to impose a
schedule of net taxes and subsidies. Thus, for example,
consumer good production that generates externalities
would pay a higher than average tax, while production
of coarse grains consumed by poor people, and without
externalities, would receive a positive subsidy.
Framing and Implementation 5
• This would be no different from a system of
excise taxes and subsidies already found in
most capitalist market economies. Indeed, so far
as externalities are concerned, the taxes would
be Pigovian taxes. Such taxes – or some other,
equivalent “correction” of market prices – is in
any case necessary to attain a rational allocation
of resources under capitalism.
Conclusion
• In principle we can put neoclassical economics
to work and frame and implement a plan for
efficient, equitable allocation of resources,
using policy tools already widely deployed in
capitalist economies.
• Of course, the step from principle to action is
the largest step of all.