Economic Cycles

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Thoughts on the Price System

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When Vladimir Lenin came to power in 1917, he mistakenly believed that running the Soviet economy would be easy. I remember reading a quote from him where he more or less said, “I know a lot of businessmen and they are not nearly as smart as I am. If they can run a business successfully, I can run an economy. After all, an economy is just one giant business.” Under War Communism, Lenin and his team nationalized everything and set all the prices in the economy. The result of these actions is not surprising to anyone who understands markets: millions of people died of starvation and Lenin suffered several major uprisings. After 3 years of this, Lenin woke up to the reality of the starving masses and implemented the New Economic Policy (NEP). The NEP was Lenin’s attempt at introducing markets – albeit on a small scale – to his centrally planned Soviet economy. With the introduction of some small markets and market prices (signals), agricultural production soared and many people who would have died under War Communism were fed and survived. The NEP was incredibly successful at pulling the Soviet economy out of its death march.

Where did Lenin go wrong? Lenin suffered from what Hayek called the “fatal conceit.” He believed he could design a functioning economy with the help of some smart friends. What he did not recognize was that markets work because of the decentralization of knowledge and of people acting on that knowledge. Knowledge is tacit, incomplete, local, and diffuse. There is no possible way one man, no matter how smart, can know what millions upon millions of people know individually. Moreover, there is no way one person, or group of people, can accurately replicate the signals that arise from the spreading of knowledge.

Prices are signals traversing from location to location. As people interact with each other in the marketplace using their local, tacit, and incomplete knowledge, prices emerge from the transactions. They contain important information that would be impossible to uncover otherwise. Like whether there is a drought in southern Florida or hoards of gluten-free fans in Boulder. Yes, it would be easy to observe a drought in Florida or gluten-free fanatics in Boulder, but prices reflect what those particular situations mean for the real people interacting there. They quantify the subjective values and desires of the people in Florida and Boulder.  All while simultaneously indicating where scarce resources ought to flow. Additionally, with repeated interactions, prices are never “out of date.” Again, you can observe a drought in Florida, but only prices can dictate how hard the orange community was hit, the depth of the devastation, and how long it will take for them to recover. A person cannot replicate these vital processes.

Prices allow for a profit and loss system. The importance of profit and loss cannot be overstated. Mises proved, long before 1989, that socialism was impossible because a socialist economy “cannot calculate.” What he meant was, when the means of production are owned by the government, there are no markets for these capital goods. Without prices in the capital goods market, there are no prices in the consumer goods market. So what’s the big deal? As the Soviets learned, with no prices to determine what should be made and how much, there is no rational way to determine the allocation of scarce resources. Massive inefficiencies would be putting it lightly.

For example, Lenin knows that his people like bread and vodka. Okay, well how much bread should be made? How much vodka? How much bread should go to St. Petersberg? How many kinds of vodka should be produced? What ratio of bread to vodka makes sense? Do the people want more wheat bread or more oat bread? How the hell do we get bananas over here??? These questions are impossible to answer. Lenin could only guess. Worse, innovation is completely stifled. What incentive is there to come up with new and better products? And how would Lenin know what new and better products people want? (Can you imagine trying to figure out how many soccer balls, nails, and vacuums to make?)

Profit and loss are the measuring stick to determine whether a business is using its resources efficiently. When a business earns a profit, this signal is absolutely crucial. It tells the owner that not only are they using resources efficiently, they are providing a good or service to consumers that they want and in a way that pleases them. On the contrary, when a business loses money, it is a signal that they need to shape up or go under. The loss part of the profit and loss scenario is just as critical, if not more so, than the profit part. Losses are what weed out bad businesses and transfer their previously owned labor and resources elsewhere, where they can be put to better use. (Side note: this is yet another reason why bailouts are so devastating to an economy. You destroy wealth by insulating bad companies from going under).

Mises’ a priori critique of socialism was devastating in that it conceded all the assumptions that socialists wanted (a “new socialist man,” observing world prices and using them, altruistic responses to incentives, etc) and still defeated them. Without prices, an economy cannot rationally allocate scarce resources. Without prices, there is no profit and loss mechanism to alert the planners of what is working and what is not. It is literally impossible to not starve a population on a massive scale if a country rejects markets and attempts to centrally plan their economy.

Lenin was no doubt a very smart man. Definitely smarter than anyone I’ve ever met. But he could not know, nor replicate, the knowledge embedded in the price signals that emerge from a functioning marketplace. If you’ve ever seen a long line for a good or service, then odds are someone messed with the prices. Take for example the food lines in Soviet Russia or the Weimar Republic. Or take the long lines for gas during the Nixon administration’s price controls. Lines are an indication that prices are not accurately reflecting current conditions. And it doesn’t necessarily have to be government intervention. If a venue does not price concert tickets high enough, there will be a line. If a road owner does not increase the price to drive on his road during peak hours, then there will be traffic (sound familiar…?) But at least when a private entity misses the correct price, they can adapt to the situation and correct it either in the short term or in the future. Government on the other hand, does not face the same incentives.

The foremost authority on prices and the importance of knowledge is Nobel Prize winner F.A. Hayek. Hayek has received some much deserved popularity of late due to a certain rap video or two, but perhaps his greatest contribution (in my opinion) is his essay, “The Use of Knowledge in Society.”

Hayek demanded his readers respect the power of the price system. I took heed many years ago. I hope you will too.

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Written by jlongo12

July 13, 2011 at 9:54 am

Posted in economics

2 Responses

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  1. Justin,

    Good piece! I would expand the “knowledge” aspect of your market description to include “information.” Knowledge without information is of limited use.

    Dick Murphy

    Dick Murphy

    July 13, 2011 at 11:26 am

    • Good point Dick. I guess I was sort of taking the view that “knowledge” and “information” are interchangeable words in this context. But indeed, prices convey vital information.

      jlongo12

      July 13, 2011 at 11:31 am


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