2. Background for China and Russia

3.  Markets are institutions of buying and selling on the basis of voluntary exchange.  Can you draw one? Market in Istanbul, Turkey

4. Supply shows what sellers wish to do, Demand shows what buyers wish to do, and both express the freedom of economic agents to pursue their own interests. Prices and quantities reflect social forces and leave no need for government planning or intervention except where citizens vote their desires to limit certain markets, such as vice markets. This is the portrait of a free society.

5.  Hierarchies are institutions designed to allocate resources without the use of markets.  They use strict lines of authority – Like a corporation or  The Soviet Union, Inc.

6. Economic Systems  An economic system, e.g., capitalist or socialist, must allocate scarce resources through markets or through a central planning agency.

7.  Who was the spiritual father of this mentality? Karl Marx.  Lenin’s . Contrast to bargaining mentality or to a western sales mentality.  Who gains in the normal transaction?  Do both gain, or is one party always the sucker, the exploited participant?

8.  Business and Economics students and most Americans generally, tend to think of engaging in market transactions as beneficial for both buyer and seller.  Social studies majors from other disciplines are often taught anti-market, anti-multis thinking and sometimes fall into the trap of thinking someone is always “ripped off.”

9.  The fundamental planning problem: destroy markets so the property and power (to set prices and gain monopoly profit and other forms of exploitation) is taken away from the capitalists (see p. 5 and p. 6, Reluctant Retreat.)

10.  A moral hazard problem exists when the principle (the owner of the assets in question) and the agent (the manager or “steward” of such assets (whether a firm, a farm, or other assets) have divergent interests.  If he cannot be monitored, the agent pursues his own interests rather than those of the principle. This often involves “slacking” or using the principles resources for personal gain. The Principle/Agent Problem, or Moral Hazard

11.  When the center makes all the decisions, there is insufficient information for planners to make appropriate choices. If there were enough information, planners would then have to deal with the tremendous complexity of the economy.  How do you get necessary planning information in Moscow?  From the enterprises!

12.  Planning and the principle/agent problem.  If the people are the “principle,” and the Communist Party is the agent of the proletariat, there is moral hazard. The proletariat cannot monitor or control the agent, or the Communist Party. So the latter, the “vanguard of the working classes,” can do what it wants. Its main objective is retaining its own power.

13.  Planning and the principle/agent problem.  If the central planning agencies are conceived of as the principle, the individual enterprises are the agents. The center is unable to monitor all the individual enterprises, so there is moral hazard. The enterprises seek their own self- interest and pursue soft production targets to secure their own bonuses.

14.  Incentive compatibility problems are that the center and the enterprises seek different goals. These are at the core of principle/agent problems.

15.  To reach its objective of overtaking the west in production, the Soviet central government establishes quotas for each producing enterprise:  The gross output target.  Meet it and you get a bonus,  Exceed it and it will be ratcheted upward.  Fail to meet it and you may be managing next year in Siberia, or worse.

16. The objective of the enterprise, the Center’s agent is to secure soft targets.  Don’t manage in Siberia.  Make the target, but never exceed it (so that it gets ratcheted up).  Find reasons why your target should be small, probably smaller than last year’s.  Never, never let the center discover your real output capacity!

17. The Gross Output Target  The primary objective: “bury” the capitalists.  Frenetic pursuit of growth results in:  No quality dimension,  No innovation,  Environmental degradation.

18. The Gross Output Target Quality is costly. It means producing a smaller quantity. We want more, not better, to defeat capitalism.  Neither the ministry (the center) nor industry wants to fuss with improving or updating a product, both of which take time and money. That may mean managing in Siberia next year.

19. The Gross Output Target No innovation,  Innovation is also costly. One must wait for new machinery and techniques, retrain workers, and miss the production goals for this year and maybe beyond.

20. The Gross Output Target No innovation,  The great dilemma of socialism (according to Brezhnev) was that the only way output could increase under central planning was through the use of more inputs.

21. The Gross Output Target Environmental degradation.  Cleanup is costly. If efforts are made to avoid spoiling the air and water, they will cost time and money. Gross output can be greater if such efforts are avoided.

22. The Information Problem in Central Planning  This is the worst of the world’s forms of economic bureaucracy. The main method is that of “Material Balances,” the committee approach to allocation.

23. The Information Problem in Central Planning  The sources subcommittee must send letters to all suppliers and buyers for an estimate of the quantities they expect they can produce in the coming year.  Enterprises understate their capacity, of course, in their efforts to secure a soft target. It is a problem to meet the target when workers are either absent or malingering all month except for the last few days of “storming” where the monthly quota is actually met.

24. The Information Problem in Central Planning  The center takes these deflated estimate and makes the first draft of a plan. It informs all enterprises of the inputs that will be assigned to them from their supply-chain partners.  Enterprise hear these results and realize they will not have their padded requests met. The requests for output (padded) are much greater than the estimates of production.

25. The Information Problem in Central Planning  Enterprises review the problems and revise. Another round of planning must then begin. Each time they go through a round, they hope to draw closer to a consistent plan.  7-13 iterations should do. How many iterations do you suppose there are time for before the new year’s production must begin.  Two would be a rare treat!

26. The Information Solution  A now-famous Russian saw this planning problem and sought a mathematical method to do all the planning in one iteration.  Input-Output Analysis was developed by Wassily Leontief who won the Nobel Prize in 1973.

27. The Information Solution  In a matrix of inputs (columns) and outputs (rows) all industries were to be listed.  Reading across, you could see where all an industry’s outputs were to be used through the entire economy

28. The Information Solution  Reading down, you could see all an industry’s suppliers of inputs through the entire economy.  Invert the matrix to solve for precise planning quantities.  There were only two problems with this analysis. What were the problems that kept it from being used?

29. The Information Solution  First, the matrix was too highly aggregated. A matrix of several million commodities and outputs would be unmanageable even on super computers. It could only provide general planning parameters.  Second, Leontief was promoting bourgeois doctrine. By the time he invented input- output analysis he was Professor of Economics at the bourgeois Harvard University in Massachusetts.

30. The Information Solution  As a result, it was necessary for the Soviet Union to wait for their great scientist, Kantorovich to develop another tool, linear programming, which likewise could solve the information problem mathematically.  But the Soviet Union never achieved consistent planning and the absence of markets resulted in severe distortions and shortages throughout the economy.