The free market economy has undeniably succeeded in raising the standards of living in the West. But capitalism has always generated numerous debates. Especially during economic crises, the capitalist or free market economy is frequently the target of attacks.
Members of extreme left-wing parties or organisations in Western countries, for instance, not only criticise bankers, managers and speculators but also reject our capitalist system altogether, which they suggest to replace with a socialist system. Such a suggestion is well-nigh absurd because, in economic terms, socialism is doomed to failure.
As early as 1920 the economist Ludwig von Mises gave a good explanation for the deficiencies of a socialist system in his article “Economic Calculation in the Socialist Commonwealth”. For him a socialist economy, in contrast to a capitalist system, does not provide an appropriate basis for ‘economic calculations’.
A Socialist Economy and Its Serious Problems
With regard to socialism, we have to take certain features as well as conditions for granted. In a (pure) socialist system the “commonwealth” (e.g. in the form of the state) would own all of the resources and/or means of production. It would be, so to speak, in control of all the factors (i.e. labour, natural resources, real capital etc.) for the production of goods and services. Under these conditions, socialist enterprises would face serious problems.
Generally speaking, a socialist system would not have a market for resources, which, in turn, would not become objects of exchange. Enterprises or people, in other words, could not trade money for capital goods, vehicles, plots of land and/or other items. Correspondingly, in a (pure) socialist economy there would be no price formation in connection with capital goods or resources, even though prices are vitally important in an economy.
The Vital Role of Prices
To illustrate the importance of prices, it is useful to depict their characteristics in a free market economy because of the fact that in this economic system they can float freely. A free market system represents, so to speak, ‘the collection of voluntary exchanges of buyers and sellers’. What prevails are the laws of supply and demand. As a medium of exchange for their economic transactions people, of course, use money in different forms (cash, credit cards etc.).
Within a free market system prices basically constitute signals or messages. They convey the relative scarcity of goods and services. Simply put, if a product has a high price tag, it is scarce, whereas a product with a low price tag is plentiful. Prices are, therefore, not arbitrary, random or chaotic. Nevertheless, they, needless to say, fluctuate in a market economy by responding to supply and demand in addition to adapting to changing needs and conditions of scarcity.
Another crucial function, in this context, refers to the allocation of resources. That is, through their responses to supply and demand or conditions of scarcity prices play a vital role in allocating resources to the most productive uses. They determine, for example, where a particular resource is needed, how much of each resource is used and how resulting products are supplied to millions of consumers.
The Impact of Prices on Consumers and Producers
Apart from this, it is worth looking at consumers as well as producers. In general, price-coordinated markets give consumers the opportunity to ‘communicate’ to other people what and how much they desire and, additionally, how much they are willing to pay or offer for a particular product or commodities.
Producers, at the same time, signal to consumers what they want to supply or sell in exchange for money or another form of compensation. Consequently, price-coordinated markets guide both consumers and producers, whose behaviour is also affected.
A price-coordinated system enables consumers and producers to make responsible economic decisions. Imagine you, as a consumer, intend to purchase an expensive luxury article. Before spending a lot of money on this high-priced item, you would certainly ensure that your other needs are satisfied or taken care of.
Now try to empathize with a producer. (Or, perhaps, you are one.) Again prices serve as points of orientation. Although producers cannot realistically know what numerous different consumers desire, prices indicate what needs to be produced or where resources should be employed. This brings us to other but related issues – profits and losses.
The Significance of Profits and Losses
Consider the following scenario: You are a car manufacturer, producing cars with a particular combination of features (model a). More precisely, during the production process your enterprise purchases specific parts or resources from other companies, utilizes self-made components and has the cars of model a assembled by your employed workers. Hence, production costs incur.
You, eventually, sell the cars for a price that not only covers the production costs but also allows you to turn a profit. Let’s assume they sell well. Also imagine you produce other types of cars with a different combination of features (model b) in a production process that is more complicated and expensive. You, then, offer the cars of model b for a higher price, but they sell badly.
As a result, you would have to reduce the prices for model b to whatever level was necessary to stimulate sales, even if you took a loss. If you did not sell the unsold cars, you would not cover the high production costs and would be in danger of incurring a bigger loss. In the future, you would surely continue to manufacture the profit-yielding model a, while you would stop putting your resources into the production of the unprofitable model b.
These scenarios, in sum, show the significance of the prospect of profits and the threat of losses since they create incentives. Prices together with profits and losses form the foundations for what Ludwig von Mises calls an “economic calculation”. However, such a calculation would be impossible in a (pure) socialist economic system.
‘Groping in the Dark’ vs. Reasonable Economic Management, or the Fate of Socialist “Commonwealths” vs. the Opportunities of a Free Market Economy
A “commonwealth”-controlled socialist economy, as von Mises points out, would completely lack free price formation. The absence of free market prices for capital goods or resources entails the absence of points of orientation (regarding the use of these resources) and incentives, which are provided by the hope for profits and the threat of losses. Accordingly, a socialist system would have no basis for an economic calculation. This would result in – to quote von Mises’s words – ‘groping in the dark’.
Socialist systems like the one in the former Soviet Union were, in fact, state-controlled. In these economies prices were also set by central planners. Due to the absence of price formation in response to supply and demand, neither socialist planners nor Soviet enterprises could estimate the production costs. Moreover, they could not calculate on the basis of a profit-and-loss account whether resources or a certain combination of them had been used efficiently.
By contrast, the free market economy opens up various possibilities. Here the means of productions are not owned by “a commonwealth” (e.g. in the form of the state) but are in the hands of private entrepreneurs. These people and their enterprises do not befall the fate of socialist planners because there are free market prices for resources and a market for capital goods or means of production, which become objects of exchange.
Through the existence of a market and prices for resources, an economic calculation is feasible. According to von Mises, the possibility of these calculations allows for reasonable economic management.
Alongside these economic calculations, another important feature concerning free market economies is the existence of competition. The fact that they compete against other entrepreneurs or enterprises requires private entrepreneurs to choose among different combinations of resources, to use them productively and to save costs. Profits and losses signal them whether they have employed the resources in an efficient way.
Parts of this text are only loosely based on von Mises’s article. In addition to this, I used the following introductory books.
Murphy, Robert P. Lessons for the Young Economist. Auburn, AL.: Ludwig von Mises Institute, 2010.
Sowell, Thomas. Basic Economics: A Common Sense Guide to the Economy. 4th ed. New York: Basic Books, 2011.