Thursday, October 28, 2010

Planned versus Market Economies




Two weeks ago, I published a post about a conversation I had with an entrepreneur based in New Jersey. As I often do, I published this piece in the discussion section of the MIT Alumni site on Linked-in. In the comments section a few started a discussion that has been raging ever since.

Among the comments, Roger White wrote a lengthy piece that discusses the merits of both planned and markets economies and identifies under which conditions each is working better.

Here is his insights:

"I think planned economies are at their best when heavy industries are at the mainstream of progress. Those are complex, but in predictable ways, and require organizing a lot of capital and infrastructure, once again in predictable ways. Think steel-making, road-making and moon shots.

"Planned economies don't work as well when the mainstream is in medium or light industries and there are lots of technology and social surprises in the offing -- think the rise of personal computers and Facebook. Key to advancement in these areas is lots and lots of experimenting, not planning.

"China is in the middle of big infrastructure building, so planning is working well there. But... they did give up on collectivization, that apparently was going too far towards the comprehensive planning side to work well.

"Where the US is these days is hard to tell. I'm still watching for the next big thing to appear and become the mainstream of our growth. I don't think it's going to be clean technologies because those are too expensive -- no positive feedback in those.

"So, I think we should be doing lots and lots of experimenting, and that's what government policies at all levels should be encouraging.

"This is where Hayek's discussion on rule of law comes back into this picture. He points out that the strength of rule of law is that governing powers can be surprised without being threatened and without having to make changes. Unlike in the planning environment, in the rule of law environment it's OK for those governing to be hit with surprises. They can simply check with how those surprises relate to existing laws."


I have always held a similar position but I expressed it in different terms. Planned economies are good at completely reallocating resources but can't deliver the continuous adjustments that are needed to adapt to the small incremental changes that occur everyday in an economy that by definition is continuously evolving. Only a market economy is successful at this. Through the price mechanism, markets send the right incentives (signals) to reallocate resources optimally.

On the other hand, in the short-run at least, markets tend to only deliver small incremental changes and are thus enable to deliver the jolt necessary to switch from one equilibrium to another more optimal one (assuming that such equilibrium exists).

In practice it means that, using planning, China has been able to rapidly jump ahead; from one bad equilibrium (where it was stuck for decades) to a much better one. However, I suspect that once it reaches full employment (that may still be far into the future in certain regions but closer to reality for coastal areas), the planning exercise will not deliver such fast growth as it has in the past. Remember that the Soviets were able to "plan" the production of televisions. However, they got stuck with a black & white, 4 channel 1950 model until about 1990 when they introduced radical reforms.

Most of the problems of planned economies can be traced back to the absence of a functioning price mechanism to allocate resources properly. They succeed at first and then fail to adapt and fall miserably behind. In a communist society, the problem is compounded by collectivism which essentially kills individual incentives.

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