Why Socialism Does Not Work

Typical grocery store queue in Vilnius, Lithuania, USSR in 1990. Note the bare shelves.
Photo Credit: Reddit/HistoryPorn

Yesterday I published a post in which I viewed with alarm the rise of Bernie Sanders, a self-confessed “democratic socialist”, and the general movement of the Democratic Party toward socialism. A YouGov opinion poll indicates that an equal percentage of Democrats favors socialism as favor capitalism. This being the case, I thought it would be useful to spell out why socialism will not work.  

Before we get to that, let us review the basic task that an economy must perform, and then investigate what is required for the economy to accomplish it.

An economy’s most fundamental job is to coordinate the efforts of producers with the needs and desires of consumers so that, to the extent possible, the economy will produce what everyone wants and needs. Clearly, a real economy can not satisfy everything that everyone wants due to a large number of constraints, such as the availability of raw materials and labor, the capabilities of existing technology, and the demands on assets of the needs for operating the system, i.e. the costs of production. These costs of production are not totally determined by raw material and labor availability, and by the state of technology. This is because the type of economic system (laissez faire, mixed, or socialist) can impose different costs due to different efficiencies of operation. Also, if one is living in a world with multiple military threats, the cost of maintaining armed forces to preserve the nation and its economy is yet another cost of production for society. Therefore any economy will have definite limits to what it can produce at a given cost.

The greater the efficiency of an economy, the larger the amount of assets, raw material and labor, that can be used to satisfy the needs of consumers. All other factors of production being equal, the wealthiest country will be the most efficient and productive. As first noted by Adam Smith, one of the most important sources of efficiency is the division of labor because it generally increases the productivity (output per unit of labor) of an economic activity. This brings up the subject of the functions of money in an economy. Without the use of money, an individual could only obtain what he did not produce himself by bartering an exchange of what he produced for the produce of others. This greatly limits the scope of what one can obtain and therefore increases what he must produce for himself. Only those who needed what he produced would be willing to barter. In a primitive, bartering economy there would therefore be little division of labor. Once money was invented, a person could use money to buy the goods of people who had no need for his produce. Once that happened the division of labor was limited by very little until the complexity of the productive activity required more from the skill and knowledge of the workman. This gives the first major function of money as a medium of exchange.

Money’s second major function as a store of value is required by a society’s need for economic growth. An average worker can not consume all he produces if the economy is to grow, but some fraction of his production must be saved for investment in future growth. By saving some of the money that is his income, and  then either directly investing it or putting it in a bank account for investment lending, an individual frees up some of society’s output for future growth.

A third function of money, often called the role of money as a unit or standard of value, is indispensable for the smooth operation of any economy. In a modern economy money is the way by which we measure the relative values of different goods. A good that costs more in the marketplace than a second good is considered to be worth more. This is not due to the money itself, but to the relative utility or usefulness of the two goods to people in general. The average price for a good is merely a measuring device for its worth. Knowing the relative worth of goods and knowing his costs for producing them, a producer of a good can decide what quantity he would be willing to produce at the market price. If at a given price the producer finds he has made more of a good than customers will buy, i.e. he has made a surplus, then to decrease his costs and increase his profits, the producer will lower his prices until the surplus disappears. If he has set the price too low, his entire stock will quickly sell out and he will find customers begging for more, i.e. there is a shortage of the good. In that case he will raise his price until there is no shortage. Once he has found the price at which there is neither a shortage nor a surplus, he has found the “equilibrium” market price at which consumer demand is satisfied to the greatest extent possible without creating the waste of surpluses. This is generally also the price at which a producer maximizes his profit by selling the good at the highest prices possible without incurring the unproductive costs of surpluses. This particular mode of the operation of the law of supply and demand is precisely what is know as Adam Smith’s “invisible hand“. Another, more descriptive way of describing this third function of money is that money is a conduit of economic signals back-and-forth between producer and consumer to find the market price optimal for the economy.

Now, I have cheated a little bit in describing this third function of money, because it can operate fully only in a laissez faire free-market economy, and strictly speaking the description is not true for all economies. It can operate only partially in a mixed economy and not at all in a fully socialist economy. The reason for this is that the price signals I described above can only exist if the producer is free to fix the price and quantity of goods he sells, and if the buyer is not coerced into buying at any price. Only then will the price and quantities of goods be driven to the “equilibrium” market price point where Alfred Marshall’s supply and demand curves intersect. This fact constitutes one of socialism’s greatest drawbacks.

So what is a good socialist to do? If he could, a socialist would also sell a good at the quantity and price of the “equilibrium” price point. After all, just like the good capitalist, he wants neither shortages nor surpluses. Unfortunately for him he can not find it by using the “invisible hand” because he is dedicated to a system where the state dictates the prices. The socialist economist Oskar Lange made the only serious attempt by a socialist to emulate the “invisible hand” with his idea of “market socialism”. With his system, prices for goods would be set and then adjusted according to whether a surplus or a shortage was produced. Unfortunately for the Soviet Union and its empire,  it never worked, probably because the time-scales at which price-setting committees could reset prices were too long and the problem was too complicated. Many prices in a complicated economy are highly correlated, especially if some goods are used to make other goods. If the price of one good is changed, the price of all correlated goods would have to be adjusted in just the right way or the supply and demand of all the goods become even more imbalanced. It is well known in mathematics and engineering that solving a nonlinear optimization problem with a large number of variables with constraints is an extremely taxing problem. In the case of the socialist economic calculation problem, the function to be optimized, i.e. maximized, would be some aggregate like the GDP. The GDP would be a function of some hundreds of millions of variables, at least several for each human being in the country, many of the variables being connected by mostly unknown constraints. This is a problem that we do not even know how to pose, let alone solve. It is no wonder then that no socialist economy in the history of the last couple of centuries has worked very well.

These purely economic problems of socialism, together with the fascist tendencies of socialist countries to repress their citizens as described by Friedrich Hayek (see reference[E2]) and mentioned in our last post, make it hard to see how socialism could work well, or even survive over an extended period of time.

One last point must be made before I finish this post. If a socialist state can not solve the economic calculation problem, how is it that a capitalist state can solve it so handily? The answer is in the relative complexities of the problem in the two different economic systems. We have already noted the prohibitive complexity of the problem for the socialist state, which must solve the problem once for the entire economy. In a free-market system, the producers and consumers of a particular good do not solve the problem for the entire economy; they solve it only for their one little corner of the economy. The solutions for all the other pieces of the economy that matter to them are summarized and presented to them in the prices of all the inputs for their good. It is the signals of the price system to individual groups of buyers and sellers that make the solution for the entire problem possible.

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