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 two economists from
Austria the first named Ludwig Mises 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 twenty 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 $400,000 the marketers at sixty K
a gear 180 K total and for engineers at
a hundred thousand times four 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 two
hundred thousand 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 $200,000
in revenue and they send 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 in
Esther 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 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 to 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 too 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 they're 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 in trying to get
investment decisions right but the
argument is not that government's 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
Korea 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