Why Centrally Planned Economies Fail?
As citizens, we are often frustrated by some aspects of the economy that don’t seem to work in our favor. We may be tempted to think that the government should step in to fix the problem, but is that really the best solution?
In this post, we will explore why centrally planned economies fail and why there may be a better answer than relying on a superior entity.
What Is a Centrally Planned Economy?
To better understand the pitfalls of a centrally planned economy, we should first define what it is. In a centrally planned economy, a central authority – usually the government – would control the market.
This means that prices of goods and services are fixed by the government, and it also dictates which companies are allowed to produce and how much they can produce.
While some people argue that a centrally planned economy is the most efficient way to benefit citizens, it’s important to examine the drawbacks of this system. So, let’s keep digging.
What is the Key to a Successful Business?
To evaluate the success of a centrally planned economy, we have to take a look at its economic performance, which is given by the success of its companies.
Any company that aims to stay in business and succeed has to answer only the following two fundamental questions:
1. How much does it cost them to produce whatever they sell?
2. How many goods will they be able to sell at a given price?
That’s the same as saying that the amount of sales revenue should exceed the production cost. If that weren’t the case, the business would go bankrupt.
Understanding these fundamental questions is crucial for evaluating the impact of introducing a third controlling party, which we will explore in the following sections.
What is The Cost of Production?
Every business has its inputs. Those are all the costs a business has to produce and deliver its final product. An efficient economy would reduce these at the bare minimum. There are four types:
- Land: All natural resources, commodities, land & real estate.
- Labor: The workers of a company.
- Capital: The required tools to do the job. Like a computer for a developer or an oven for a baker.
- Entrepreneurship: Those who steer the company.
Let’s comment on those.
The first thing to notice is that Land, Labor, and Capital change their cost over time. In particular, commodities or energy would change their price on a daily basis. For example, if a hurricane destroys the wheat fields, the next day, the price of wheat will skyrocket.
The second thing to notice is that entrepreneurship will differ from one business to the other. Because all people are different, their leadership and strategic thinking will also differ.
The third thing is that the amount to be produced affects the cost of the production. You could bake a cake in the oven, or you could bake two instead, using the same amount of energy. The latter would be cheaper.
The job of the business owner is to take all this information and summarize it in one figure, like dollars per Kg or Euros per service.
The nature of the inputs is variable, which forces the business owner to do this calculation on a regular basis to have the most updated figure.
Also, it is important to note that all this information is only available to them. The business owner is the one with insider information. No one else knows it unless it is purposely disclosed, but in that case, it would be outdated information.
Good Sales Forecast for an Efficient Business
Sales forecasting is key for businesses. It dictates how much a business should produce and at what price it should be sold.
Ideally, a producer would want to ask every potential customer in the market how much they will buy from them. So the producer would adjust their production accordingly. However, that would be impractical and costly.
Instead, business owners rely on previous experience and current market conditions to estimate sales. Unfortunately, this method cannot predict with 100% accuracy, which means there is always a margin of error.
If the error is too large, it can put the business at risk. For example, a baker might buy 1 ton of flour, thinking they will bake and sell it all, but if they only sell half, the remaining 500kg will go to waste, resulting in a significant loss.
Furthermore, each potential consumer has their own budget and requirements. They will only choose a provider that can fulfill those requirements at the price they are willing to pay. Customer needs and budgets evolve over time, so the producer must continuously update their sales forecast. This, in turn, affects their cost of production.
Can a Government Efficiently Control the Economy?
In a market economy, producers and consumers constantly make calculations based on their unique information to arrive at prices and quantities that meet their needs.
The success of a producer in this environment depends on how quickly they can uncover relevant information before their competitors.
However, in a centrally planned economy where the government seeks to control the market, the situation is entirely different.
The government assumes that it can find a price or quantity of goods that will satisfy the needs of all businesses and consumers, even in an environment where customers’ needs and input costs for businesses are constantly changing.
However, the government lacks the specific information possessed by each market participant, making it difficult to accurately calculate these values. As mentioned before, calculating those accurately is the key to a successful business.
Furthermore, the government may have little to no experience in the specific industries they are trying to regulate, and their political interests may not always align with finding the optimal solution.
This is exemplified in communist governments, which control the entire economy and inevitably make calculation errors. These errors can have devastating consequences, including wasted resources and an impoverished population.
Therefore, while it may seem efficient to have a central government controlling the economy, it is important to remember the flaws of this approach and be skeptical about it.
The Alternative
It is clear that a government cannot control the economy due to the missing information that is only available to businesses and consumers. Then the only viable option left is to leave businesses and consumers to operate freely.
Businesses should be able to decide how much to produce and at what price they will sell, while consumers should be able to decide whether to accept a deal or go elsewhere to do a purchase.
I leave you with one question: Who do you think will make a bigger calculation error?
1- A big government ruling over all businesses
2- Individual businesses making their own decisions.
How can this post improve your finances?
In the western world, economies operate relatively freely. However, I think we are losing track of the principles laid out in this post.
Lately, we are hearing proposals from our governments such as: Introducing price controls on oil and energy, raising taxes, prohibiting using gas stoves, reducing carbon emissions, energy transition, banning the manufacturing of combustion engine cars after 2035, etc.
So whenever you are offered a centrally planned measure, as the ones mentioned above, you should ask yourself the question, what is the economic inefficiency that this measure will introduce? Who will be affected by it? And does the benefit make up for the cost?
I believe that having a framework to distinguish a good economic policy from a bad one is the first step to making better financial decisions. If we want to live in an efficiently run economy, we citizens need to make good financial decisions and be efficient as well.
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