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Economics for Democratic Socialism Drexel University Spring Quarter 2009.

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1 Economics for Democratic Socialism Drexel University Spring Quarter 2009

2 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.

3 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.

4 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.

5 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.

6 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.

7 The Younger Austrian School Ludwig von Mises 1881-1973 Born Lviv, Ukraine, then part of Austria- Hungary Friedrich von Hayek 1889-1982 Born Vienna, Austria Nobel, 1974

8 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.

9 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

10 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.

11 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.

12 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.

13 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!

14 Asymmetric Information Hayeks 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.

15 Does Hayeks 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)

16 Coordination Failure 1 This is Rosenstein- Rodans Shoe factory example. The managers of the shoe factory assume that growth in demand will be slow, so …

17 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.

18 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.

19 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.

20 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?

21 Planners 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.

22 Optimal Planning top/prin/txt/comsysf/cs5.html The optimal plan in terms of the planners preferences is at point * But, of course, it isnt that easy!

23 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.

24 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.

25 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.

26 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.

27 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.

28 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.

29 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.

30 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.

31 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.

32 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.

33 Grasshoppers Preferences We suppose that Grasshopper is a bit of a lazybones. Grasshopper's preferences among jobs and incomes is shown by the Table.

34 Ants Preferences Ant's preferences are different and are shown by this Table.

35 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.

36 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.

37 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.

38 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 ants 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?

39 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.

40 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.

41 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.

42 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.

43 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.

44 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.

45 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.

46 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.

47 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?

48 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.

49 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.

50 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.

51 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.

52 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.

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