The Economics of Planning

Introduction to Planning

It is common for economists to conclude (too

quickly) that the experience of the old USSR

has shown that planning generated poor

economic results.

But at the same time we point to some large

corporations as efficient institutions.

But large corporations are run by plans.

“Islands in a Sea of Markets

Think of the

boundaries of a

corporation as the

external markets

where it buys its

labor, materials,

and sells its

output. The

corporation is a

plan that allocates

this labor &

materials to

produce an output

for sale to the

outside market.

The Sea ofCapital Markets

LaborMarket Sea

The BayOf Materials

CEO

Finance Dept

ProductionPersonel

OutputMarket Ocean

Marketing

Dept.Purchasing

“Islands in a Sea of Markets”

Dr. H. thinks of Singapore as a large corporation (one with strong penalties for bad behavior).

What are the differences between a planned economy and a large corporation?

Performance Measures

Mechanisms for replacing management

Ownership

Incentives

Bankruptcy

Planning in the Old USSR and PRC

According to Marxist/Leninist Thought:

No market prices

No financial markets

No trade with capitalist countries

No private property

How is it decided what will be produced without the

guidance of prices?

What production methods will be used?

How is it decided which consumers get the output?

The Plan ~ Input Output Tables

TECHNICAL COEFFICIENTS: For every sector of

the economy it is determined how much of each

input is needed to produce one unit of output. In the

example below, it takes .7 units of labor to produce

one unit of Agric., and it takes .1 units of Services to

produce one unit of Heavy Ind.

Agric Heavy Ind. Light Ind. Services

Agric .1 0 .3 0

Heavy Ind. .1 .3 .1 0

Light Ind 0 0 .2 0

Services .1 .1 .2 .1

Labor .7 .6 .2 .9

Output Targets

Planners set target output levels for each sector.

Unlike the example below, it was common for

planners to emphasize high output targets for the

“Heavy Industry” sector. According to the goals of

the planners, the development of heavy industry in

the urban sector was viewed as a first step toward

rapid economic growth. Very large steel factories

were often observed in planned economies.

Agri Heavy Ind. Light Ind. Service

Target Output 250 150 400 200

“Material Balance”

With these data, the planner can then allocate

inputs to each sector of the economy.

The target for the “Agri” sector is 250 units of

output, it takes .1 units of “Heavy Ind” inputs to

produce one unit of “Agri”, and so .1x250=25

units of Heavy Ind. Is sent to the Agri sector.

Agri Heavy

Ind.

Light Ind. Service Cons. Total Use

Agri. 25 0 120 0 105 250

Heavy Ind. 25 45 40 0 40 150

Light Ind. 0 0 80 0 320 400

Services 25 15 80 20 60 200

Labor 90 180 525

Total Output 250 150 400 200

“Material Balance”

How much labor will be sent to the “Agri.” sector?

Agri Heavy

Ind.

Light Ind. Service Cons. Total Use

Agri. 25 0 120 0 105 250

Heavy Ind. 25 45 40 0 40 150

Light Ind. 0 0 80 0 320 400

Services 25 15 80 20 60 200

Labor 90 180 525

Total Output 250 150 400 200

How much labor will be sent to the “Light Industry”

sector?

Note that while this is a simple calculation, the result

was often the mass, forced relocation of people.

“Material Balance”

To get the amount available for consumers from

each sector, we take the output target and subtract

the amount that has been used up as inputs in the

other sectors.

250 units of “Agri” were produced, but 145 (25 +

120) were used as inputs in other sectors, so 105

units of “Agri” were left over for consumers.Agri Heavy

Ind.

Light Ind. Service Cons. Total Use

Agri. 25 0 120 0 105 250

Heavy Ind. 25 45 40 0 40 150

Light Ind. 0 0 80 0 320 400

Services 25 15 80 20 60 200

Labor 175 90 80 180 525

Total Output 250 150 400 200

GDP Accounting

Agri Heavy Ind. Light Ind. Service Cons. Total Use

Agri. 25 0 120 0 105 250

Heavy Ind. 25 45 40 0 40 150

Light Ind. 0 0 80 0 320 400

Services 25 15 80 20 60 200

Labor 175 90 80 180 525 1000

Total

Output

250 150 400 200

The “size” of the economy was measured differently

in the planned economies than in the West. Using this

example, GDP according to the Western concept

would be 525, the amount of final goods available for

consumers. Under the Soviet system, GDP was

recorded as 1000 which includes output used up in the

process of production.

Planning and the Labor Theory of Value

Agri Heavy Ind. Light Ind. Service Cons. Total Use

Agri. 25 0 120 0 105 250

Heavy Ind. 25 45 40 0 40 150

Light Ind. 0 0 80 0 320 400

Services 25 15 80 20 60 200

Labor 175 90 80 180 525 1000

Total

Output

250 150 400 200

First note the total quantity of labor we have in this

economy; 525 units of labor.

Second, notice the total amount of goods available

for consumption: 525.

Finally, smile since the planning document is

consistent with Marxist thought!

Planning “Successes”

Compared to market processes, planning has the

potential to move resources more quickly to attain

social goals. (The planners chose the goals.)

Provision of public goods like clean water and mosquito

abatement.

Building a steel industry and other large scale projects.

“Giganticism” was a noted feature of planned

economies.

Provision of certain kinds of scientific research which

private market firms could not profitably supply.

Military action

Planning “Failures”

Asymmetric Information

Suppose the central planner has honest

intentions to serve society.

She needs information from factory

managers to help her set the “technical

coefficients”, “output targets”, and input

allocations for next year’s plan.

But she cannot tell which of the factory

managers are telling her the truth.

Planning “Failures”

Asymmetric Information

Factory managers have an incentive to provide

inaccurate information to the planners.

They provide higher estimates for the technical

coefficients in an effort to get more inputs.

They produce less than their quota noting that their

quota needs to be lowered for next years’ plan.

They produce their quota of 100 kilos of bricks, but the

bricks are of a quality that is difficult to observe by the

planners (The bricks are too large.)

Planning Failures ~ Game Problems

The factory managers thinks about the planners’ response to the failure of his factory to meet their output quota.

The planners’ could close the factory or the planner could give the factory more inputs (or lower the output quota).

The “Nash Equilibrium” was often that the manager would not reach the quota and the planner would give them more resources.

This result has been called the “Soft Budget Constraint” (Kornai).

Children overspend their weekly allowance knowing that Mom will give them movie money to get them out of the house on Saturday afternoon.

Contractors have “cost overruns” knowing that once started, the payer will have high switching costs to terminate this contract and start with another.

Governments sometimes provide bailouts for failing firms.

Games concerning “soft budget constraints”

are not just a feature of planned economies.

Planning Failures ~ Shortages

Planned economies are often noted for

shortages, especially for consumer goods.

As noted, the factory managers’ had the

incentive to produce as little as possible

with as many resources as possible.

Due to the “soft budget constraint”

demand for resources was high, but the

supply of goods was low.

Planning Failures ~ Shortages

Planners set prices

for accounting

reasons.

They had an

incentive to set

prices below the

market equilibrium

price.

Planner were then in

a position to profit

personally from the

black market 1 2 3 4 5 6

100

200

300

400

500

600

Price

Quantity

Supply (from plan)

Demand

Black Market Price

Planners' Price

Shortage

Planning Failures ~ Technological

Change

Factory managers were often in a position to note changes in technique which would increase efficiency.

If the technological change was one that would require less labor, the factory manager would lose workers in next year’s plan.

If the technological change required more capital, the manager may be “rewarded” with new machines in next year’s plan.

The incentive structure biased the direction of technological change.

Planning Failures ~ The Allocation

of New Investment

The rate of savings in the former USSR was very high (>40%).

Planners were in the position to allocate these substantial savings to new investment.

How did planners decide on which new investment to undertake? (Note: in markets this is done by private investors searching for new profit opportunities.)

Planning Failures Restricted Rights

to Exit from Chinese Collectives

Before 1956 farmers could chose to join a collective. If dissatisfied with the outcome, the farmer could exit the collective and farm independently

Starting around 1957 collective participation was mandatory and exit was not allowed.

How would this change the incentives for the cooperative managers?