Let’s face it; there is not a proposed economic system that we may deem perfect. Within these economic systems are exerted negative externalities, required losses of freedoms for individuals, and Pareto optimality’s that makes one economic actor better off at the expense of another. The debate of which economic system mitigates these factors most effectively has raged on for centuries and remains in discourse among rivaling ideologies to this day. Among these ideologies and proposed economic systems, the two top contenders have surmounted to capitalism and socialism.
Due to both of these terms being constantly conflated with other similar economic systems, we will refer to capitalism and socialism in more definitive terms. Capitalism will reflect a laissez-faire free market system and socialism will signify a centrally planned economy. We will do this to ensure gray areas will be minimized, as a free market differs from the modern US economic system which practices state capitalism, and cronyism, which in itself is constructed by governmentally planned elements.
So what is the fundamental divergence between these two systems? It is the ownership of the means of production and capital. In a capitalist economy, the means of production are privately owned and maintained by individual entrepreneurs. Individuals mix their land with labor and create what is called capital to be employed in the production process. Capitalists utilize price mechanisms such as profits and losses to determine the distribution of scarce resources to satisfy consumer demand. If profits ensue through a consensual transaction, this represents the capitalist efficiently satisfying consumer demand by making the consumer better off, or else the transaction would not have occurred, and is then rewarded for his actions with payment. If the capitalist sustains losses, he will refrain from continuing his process and is punished for his inefficient ventures by losing his investment. On the other hand, in a socialist economy, the means of production are owned by the public or the community, i.e. the government. In this system, instead of individuals seeking profits, a group of administrators overseeing the production process determines how scarce resources will be rationed out to ensure everyone in the community receives an equal amount of goods and services.
The above-mentioned explanation also offers insight into why a socialist economy is inefficient and produces poor results in regards to satisfying consumer demand. The consistent failures of planned economies are not necessarily owed to the lack of incentives and the public unrest due to the removed economic autonomy amongst individuals. Of course, these factors can and do play their important roles. After all, who is going to take out the trash? And why should that community trash man receive equal income to the community surgeon? Disregarding these inquiries, let’s theoretically assume that members of the community do not care which job they are assigned or the compensation they would receive for their labor services. John does not mind the hazardous conditions of being the community trash man, and Bob does not care that his job requires more knowledge and skill and yet receives the same wages as John. In other words, incentives play no role; rather they receive physic income for serving their community. Instead of incentives, it is the absence of an effective price mechanism that offers poor distribution of scarce resources which fails to satisfy the millions of subjective demands and tastes of the community.
In a free market system, a price conveys information regarding the current market supply and demand of a particular good, service, or resource. Think of a price as a ledger composed of the current market conditions for a particular good. It is knowledge shared amongst all economic actors built into a single number. It is a representation of the millions involved in the current production of the good or service, and the millions of consumers who demand that good or service. It is through the price mechanism that economic actors can efficiently allocate scarce resources to ensure an effective distribution to the populace. For example, all other things held equal, if the price of milk increased from $2.00/gallon to $2.50/gallon, this price signifies that either the production of milk has decreased, or the demand for milk has exceeded the current supply. The increased price regulates consumers to withhold the amount of milk they purchase to ensure a shortage does not manifest.
On the contrary, in a socialist economy, prices are not set by the supply of producers and the demands of consumers. Instead, administrators must attempt to organize thousands of factories and laborers to produce the goods deemed necessary for the community, essentially overlooking the subjective preferences of consumers. In essence, they must arbitrarily determine what to produce, when to produce it, how to produce it, and what capital goods to employ to produce it. Borrowing the milk example, let’s assume there is a population of 100,000 people in the socialist community of Marxville. The administrators then decide to produce and ration out 1 gallon of milk every three days to the populace. What happens if 10,000 individuals in the community do not like milk or are lactose intolerant? There will then be a 10,000-gallon surplus, which embodies a waste of scarce resources, such as the milk itself, the labor to obtain the milk, or the employment of capital in this process when it could have been utilized elsewhere.
Consumer goods are not the only economic factors conveyed by prices. Prices reflect all factors of production. Land varies in value and utility, and this is reflected by prices. Land that is fertile and located in a climate well suited for growing crops will be more favorable for farming compared to a dry, unfertile area. In order to proficiently utilize the fertile farmland, a price that reflects the value of the land must be instituted so that farmers do not flock to these lands and excessively consume it resulting in a shortage. Regarding labor and capital, the prices of these factors of production ensure they are utilized appropriately in the production process. For example, let’s say the market rate for factory labor is currently at $5.00/hour, while a factory engineer is $20.00/hour. This low wage rate signifies that the particular demand for the factory worker’s skill set is lower than the factory engineers. This same concept applies to capital goods. If the price of a metal lathe machine is $5,000, but the price of a woodworking lathe machine is $3,000, this may signify not only is there a greater demand for the metal lathe machine, but there is a higher demand amongst consumers for metal products rather than those made of wood.
There are various stages in the production process ranging from mining, refining, manufacturing, distributing, retailing and so forth. Prices allow producers to direct scarce resources to the particular step in the production process that is more profitable. If an entrepreneur can make $5000/month in mining while only $3,000/month in retailing, if he is business savvy, he will direct his labor and capital resources to mine in order to garner higher profits. As soon as other entrepreneurs realize the profitable mining process, they will follow suit and begin investing their resources into this production step as well. Initially, entrepreneurs will face increased prices of both labor and capital due to the competitive atmosphere, but in due time when enough entrepreneurs enter this particular market, the prices will be driven down due to the increased supply of resources and entrepreneurs will start designating their resources to other stages in the production process. As mentioned earlier, this price signal is acting as a bundle of knowledge to inform entrepreneurs on the current state of the particular market to ensure they are using their resources competently.
On the contrary, in a socialist system, there are no prices that reflect consumer demand for the administrators to direct resources in a logistically efficient manner. They would have to place laborers in random assignments and utilize capital in arbitrary stages of the production process. How would the organizers determine that more laborers are needed in mining rather than manufacturing? How would these organizers determine which production stage a non-specific capital good would be most efficiently utilized in? This issue drives into even greater depths when the production of capital goods is introduced. The organizers must address the manufacturing of the components that make up the capital. Imagine the waste of resources and headache it would be to sort out all the nuts, screws, bolts, and panels that would be needed to build a dozen machines, ultimately producing capital goods that are unneeded for the production process and conclusively do not reflect genuine demand? Perhaps they could give out a survey to the millions of people that make up and economy and ask them what they would like them to produce, but what if their preferences change the very next day due to a number of factors? It should be noted, a socialist economy can produce particular goods and services, but in a wasteful manner. Both a capitalist and socialist economy can produce pencils. However, capitalists utilize price mechanisms can ensure they are efficiently using the correct methods and materials to produce them, or they face losses. On the other hand, a socialist economy will not know if it is inefficiently producing goods until a shortage or surplus manifests, as there is no loss signal to notify them of their incorrect process. The key word is efficiency.
Even Leon Trotsky, a founding Soviet revolutionary and dedicated Marxist, stated that “centralized economic planning would insoluble without the daily experience of millions, without their critical review of their own collective experience, without their expression of their needs and demands and could not be carried out within the confines of the official sanctums and even if the Politburo consisted of seven universal geniuses, of seven Marxes, or seven Lenins, it will still be unable, all on its own, with all its creative imagination, to assert command over the economy of 170 million people”
The debate between capitalism and socialism remains steadfast. Both sides introduce particular concerns they have with the other and the staunch supporters of each have yet to relinquish any concessions. But look at the results. Even in the absence of a genuine free market in capitalist nations, there have been unprecedented amounts of wealth within economies who maintain a degree of private ownership of capital, while centrally planned economies hardly last more than a few decades before their system collapses. The results are not owed only to the incentives and economic freedom private ownership of capital provides, but the price systems that guide these economies to prevent severe economic downturns. Even planners from Soviet Russia admitted to employing prices they observed internationally in order to attempt some stabilization in their production processes, which clearly demonstrates the necessity of price mechanisms. It is nothing short of baffling to observe the ego of man, who believes he and a group of his comrades can efficiently plan the millions of lives that constitute a society and the materials that ensure the quality of these lives. To quote Nobel Prize-winning economist Friedrich Hayek, “the curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”