we're now going to look at the issue of
profit and loss calculation the point of
this unit is to help try to explain why
government planning doesn't always
succeed the core ideas here were first
presented during the socialist
calculation debate which took place in
the first part of the 20th century after
the Communists took over the Soviet
Union there was a claim that planning or
central planning would be more efficient
than capitalism but to all economists
from Austria the first named Ludwig
nesis and the second named Friedrich von
Hayek who later won a Nobel Prize they
both argued that central planning would
not be nearly as efficient as capitalism
with its system of market prices and
profit and loss the Mises Hayek argument
was that businesses need access to
market prices to determine which courses
of action are profitable and which
courses of action are not profitable and
that should not be pursued to put this
in the context of a concrete example
imagine a business which is considering
investing in a new computer system this
new computer system will make the
factory safer but there's still the
question of whether this new computer
system is at all worth the money let's
say that to develop the new computer
system what's needed are 20 computers
five additional programmers three
marketers to help sell the system to
factories and five engineers to hold the
whole thing together when combined these
inputs will produce exactly one more
system to monitor factors factory safety
but should this investment in fact be
undertaken well here's what the
socialist calculation debate comes in if
all you do is list the inputs and the
outputs and you have no access to market
prices we really don't have a very good
idea whether this new system is
cost-effective maybe it's costing us a
lot more resources than we're going to
get back in return now let's consider
that same estimation when market prices
are present imagine for instance that
each computer costs a thousand dollars
that means the computers run to about
twenty thousand dollars each programmer
costs about $80,000 five of them runs to
about four hundred thousand dollars the
marketers at 60 ka year 180 k total and
for engineers at a hundred thousand
times for means four hundred thousand
and you add up all those costs and what
you get is something about 1 million
dollars so those are prices on the cost
side and you then want to compare that
to your total revenue and you can ask is
the total revenue more or less than 1
million dollars and if the revenue is a
lot more than a million well maybe it's
a good idea if the total revenue is say
much less than a million only 200,000
then probably the project is a very bad
idea and this process of calculation
with market prices it's highly imperfect
and highly prone to error but still it
gives you some basic starting point for
trying to figure out how should
resources be allocated and when is a new
investment a good idea centrally planned
economies don't have access to these
kinds of market prices and the central
planning generally tends not to work of
course not all forms of government
intervention take this extreme path of
using central planning and abolishing
markets and prices altogether what's
more common is that government activity
is in some ways embedded within a system
of prices and wages and the government
in some manner tries to improve on the
operation of private capital markets so
let's say for instance that we're back
to our computer system that will make
the factory safer and this costs 1
million dollars in terms of investments
and what we see is that in the first
year yields two hundred thousand dollars
in revenue and there's then the question
of well might the higher revenue come in
the second year the third year the
fourth year and so on and the government
government may feel it can do a better
job of forecasting that future revenue
then can private capital markets there
are still major problems however with
government intervention in a lot of
these cases private capital markets
really are trying to forecast future
profits and losses when politics is
being superimposed on private capital
markets very often a company or investor
feels it cannot so easily go out of
business or that its future prospects
depend upon its ability to get more
money out of the government rather than
by producing a product that will satisfy
consumers there's also a tendency to run
with projects which maybe don't make
economic sense because they support jobs
or because they bring money to a
politically favored district for these
reasons when a political process has
some access to market prices it's still
the case that process will experience a
lot of difficulty in trying to calculate
future profits and future losses
sometimes when a political process sets
the price of a good or service which is
being sold it tends to set that price
too low so to view this in terms of a
supply and demand diagram here's price
and here's quantity here's a demand
curve here's a supply curve here's the
level of market clearing well the
political incentive often is to put
price somewhere down here and that means
demand will be quite high relative to
supply and there will be a shortage in
the market but what the political
process tends to do is to hand out that
good or service in accordance with
political favoritism this was common in
the Soviet Union most prices were set to
low there were extreme shortages say of
meat but if you are well connected with
the Communist Party you would have a
relatively easy time getting meat
because you would get it through your
political connections and the price was
held artificially low precisely to
create that shortage so the people who
are controlling the allocation of meat
could trade that meat for favors so part
of the problem with the socialist
calculation debate isn't just that
governments face difficulties when
trying to calculate the right prices but
that very often for Public Choice
reasons governments aren't even trying
to calculate the right price in fact
they're trying on purpose to get the
price wrong and perhaps set it too low
for political reasons the argument here
is to explain why governments face such
difficulties and trying to get
investment decisions right but the
argument is not that governments always
get such decisions wrong in fact you can
find cases in histories where
governments have done a pretty good job
getting
investment decisions right consider for
instance the industrial policies of the
nation of South Korea during the time of
south korea's most rapid economic
development government played a
significant role in allocating capital
and overall you can debate how good a
job they did but they certainly did not
hold back the economic growth of South
Korean given the socialist calculation
debate well how is this possible one way
to think about what happened is to think
that perhaps South Korea had a lot of
market prices especially wages which
initially were at the wrong level that
is South Korean workers were going to be
extremely productive and do very well
educating themselves and producing
things and these productivities were not
really adequately reflected in market
prices so South Korean labor was
extremely cheap so if the government
then charged ahead and supported a bunch
of investments even though the
government really isn't generally good
at calculating exact estimates of profit
and loss the government was dealing with
a lot of underpriced factors in this
case labor and so a lot of investment
decisions which maybe were simply thrown
forward ended up being very good ones
and they ended up being investment
decisions which supported economic
growth when some key factors in your
economy such as labor are very much
under priced it's relatively easy for a
lot of investment decisions to pay off
including government-run industrial
policies this is a highly complex topic
with a lot of different angles but for
more information you could just start by
googling socialist calculation to be