Economics for Democratic Socialism

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
• Market prices depend on the distribution of
  income from wealth, which has no rational basis.
• 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 --
• Markets are subject to inefficiency due to
  externalities, and monopoly power, without
  rational basis.
• 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.

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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
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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 supplydemand in every market.
• Walras envisioned an auction process to determine
  those general equilibrium prices.
• But there is no such auctioneer in the actual
  world.

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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.

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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.

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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.

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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.

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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?
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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
The optimal plan in terms of the planners
preferences is at point But, of course, it
isnt that easy!
http//faculty.lebow.drexel.edu/mccainr/ top/prin/
txt/comsysf/cs5.html
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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.