By Alex Houtz
We live in an America increasingly open to the idea of upending our economic system to create a utopian vision of fairness and equality. Senator Bernie Sanders, first in 2016 and again this election cycle, energized a coalition of voters on the premise of “democratic socialism”, promising Medicare-for-all, college-for-all, housing-for-all, and more for the American populace. Of course, in one way or another, the government would be setting prices for goods and services, whether that price is “free” or otherwise.
But this price-setting is the key reason why, even if the government is otherwise efficient, benevolent, and free of corruption, that government-mandated prices will always fail. In the economy, prices are set through the interaction of supply and demand. Consumer preferences, substitutes, complements, and other factors all determine the demand curve. Operating and opportunity costs make-up the supply curve. In its simplest form these two concepts determine the price of every good available. This theory is called price theory.
A major component of price theory is the information that price carries with it. The clearest illustration of this information is the price of goods around Houston, Texas surrounding the landfall of Hurricane Harvey. Reports of cases of water selling for $99 and a gallon of gas costing $20 entered the news. To most people, this looks like immoral price gouging.
In price theory, though, these spikes in prices demonstrate a sudden surge in demand for these goods. Because demand increased, firms have a strong incentive to manufacture and ship a certain number of goods, carefully balancing costs to manufacture and the price of sale, to the area of high demand. Eventually, price will fall to a new equilibrium to reflect the increase in supply and the increase in demand.
This balancing of costs and expected sale price by firms eliminates wasteful production and drives the entire economy to economic efficiency. Without the increase in price, firms would not know how much more to produce and ship. In this situation, waste occurs, leading to inefficiency and welfare loss.
Under government planning, such a balance does not occur. When prices are set, they fail to send information throughout the economy. For example, housing prices tend to rise in metropolitan areas. Well-meaning politicians, seeking to protect low-income individuals from losing housing, enact rent controls to prevent any more rent increases.
This policy, though, prevents prices from playing their role in the economy. With prices artificially low, entrepreneurs do not create more housing. Shops and office spaces are not converted into apartments and empty land is not developed into housing. As a result, a shortage of housing develops.
In some scenarios, due to price controls, wasteful production is encouraged. During the Great Depression, the Roosevelt Administration paid farmers to destroy crops to keep agriculture produce prices high. Instead of finding different employment, farmers that could not compete at market prices either left their land empty or continued to grow crops that would be destroyed.
This inability of the government to run the economy through economic planning due to the disappearance of price information is called the economic calculation problem. Economist Ludwig von Mises discovered this problem, using it as one of his primary attacks on arguments of the wave of economic planners that emerged in the mid-20th century. Both during and since that time, a number of common defenses for state planning of the economy have been developed.
First, supporters of socialism argue that markets have inefficiencies as well. This statement is true but neglects the fact that markets must still react to prices set by costs and consumer desires. Even in the most inefficient market condition, monopoly, firms are constrained by costs and demand. In addition, this argument ignores the entrepreneurial opportunities that inefficiencies in the market provide, leading, in the long run, to shrinking inefficiencies.
The second common argument is the belief that, at its root, the economy is a set of equations. Given enough computing power and surveys, governments can use technology to compute the optimum outcome for each market. This response, though, ignores the basic building block of all of economics: consumer preferences. These preferences are not only unique to each individual, but also change over time. The amount of information needed at any given time, even supposing such equations could be built, is insurmountable.
Beyond this, to build equations, central planners need to balance preferences. Assigning values to consumer preferences becomes arbitrary, leading to any equation developed failing to reflect true market preferences.
While many arguments against socialism exist, the foundations of price theory, resulting in the economic calculation problem, cause the collapse of socialist ideology. Simply, central planners cannot possibly obtain enough information to efficiently operate the economy. So while the promises of government politicians advocating central planning sound appealing, the wise course of action is to steer widely around the economic bombs these policies plant.
Alex Houtz is entering his first year of PhD studies in Economics at the University of Notre Dame this fall.
This article is republished with permission from Fundation for Economic Education.