In some ways, the Cold War seems to be back. East and West are fighting once again over spheres of influence. Over the past several years, we observed wars in Georgia, Ukraine and Syria. Two sides fighting each other indirectly. However, one thing is different. The new Cold War is just plain geopolitics, whereas the old one had roots in economics as well. It was a battle between Capitalism and Socialism.
In a capitalist economy, factors of production (machines, buildings, equipment etc.) are privately owned. People are free to use these factors of production how they please. However, this freedom is still limited as someone who has a more profitable use for the production factors will acquire them. As a result, people are basically forced to use the production factors in the most profitable manner. This form of economic organization arises without much government interference. Entrepreneurs determine what is to be produced and in what quality and quantity, based on what consumers demand.
For example, a bakery can invest in bread machines which leads to higher productivity.
The trade of goods and services enables specialization. Since people do what they are good at, they will produce more than someone who does not possess the specified knowledge. On top of that, they could become better and better at it, so in the end they are more efficient. Moreover, ownership allows for investment. For example, a bakery can invest in bread machines which leads to higher productivity. The accumulation of capital, hence the name capitalism, raises the production capacity of an economy.
In a socialist economy, the factors of production are not privately owned, but in hands of the state. It is a form of economic organization that is planned from above. The central planning agency determines what is to be produced and in what quality and quantity. The government decides which products and services the consumers need. An advantage is that the government can easily reduce the consumption of harmful goods, like alcohol and tobacco. Since there is not market function an equilibrium between demand and supply is not achieved. Consumers do not guide production, only the orders of the government do. This is why a socialist economy is called a planned economy. Among the production factors that the government determines is labor. People are not always able to perform the job they aspire. Profits in this economy do not exist. Whereas in a capitalist economy profits shift production to those places where it is most efficient, in the socialist economy the use of production factors is decided by the government.
Economic calculation is the process of determining what should be produced and in what quality and quantity. In a capitalist economy, this is what entrepreneurs do. In their hunt for profit, they try to spot opportunities to satisfy consumers. They produce a product at the lowest possible cost which they can sell for the highest possible price. The difference is their profit. At this point, the social benefit of private profits becomes apparent. Since resources are scarce, society has to be careful with them. We must satisfy the most urgent demands using the least costly methods. The market function ensures that goods are possessed by the people that value them the most.
The planner is not able to observe profits to know whether production factors have been put to good use.
In a socialist economy, production is planned by the central planning agency. The planner also aims to produce efficiently and create the most welfare. However, the planner faces a problem, namely that there are no market prices available to reflect the scarcity of goods. Moreover, the planner is not able to observe profits to know whether production factors have been put to good use.
In a capitalist economy the persons who reaches the highest level of productivity with certain production factors will possess them while in an socialist economy, the productivity depends on how well the planner puts them to use. As a result, the capitalist economy is likely to reach create more economic value.
The central planner also faces another difficulty. This is known as the “knowledge problem”. The local bakery knows what his clients want. He also knows how to produce it cheaply. He knows how much his clients want. He knows what and how to produce, and in what quality and quantity. This goes for all entrepreneurs. It is of course very difficult to centralize all this information in the central planner’s office so it can determine who has to produce what and in what way. If the central planner is able to centralize all this information it would be possible to consider all potential uses of production factors while entrepreneurs have a limited set of information. However, this seems to be an impossible task.
China turned its back on socialism and more or less embraced capitalism.
And the winner is…
A look at history shows that socialism failed in many countries. The Soviet Union collapsed. China turned its back on socialism and more or less embraced capitalism. Cuba also starts to open up and allow for more free trade. Not far away, Cuba’s ally Venezuela, which still uses a socialist economy, is in chaos. North Korea is not doing better economically than its Southern neighbor. In theory the socialist economy could ensure production that create the most welfare. However, in reality the socialist economy very often leads to a demise. There is a long standing confrontation between these two economic systems. Fortunately, the fight between capitalism and socialism is over. We can only hope the new Cold War will not spiral out of control.
Further reading suggestions:
Ludwig von Mises “Human Action”; “Socialism”
Friedrich Hayek “The Use of Knowledge in Society,”; "The Pretense of Knowledge” (Address delivered on reception of the Nobel Prize in economics, 1974.)
Leonard Read “I, pencil”