Play Store Economics
JANUARY 01, 1964 by DEAN RUSSELL
Dr. Russell is a member of the staff of the Foundation for Economic Education and Director of the FEE School of Political Economy.
The "father of the Tennessee Valley Authority," Senator George Norris, once said: "A proposal from a great association of Tennessee says, in effect, ‘Let TVA property be subject to taxation the same as everybody else’s property.’… If we go to that extreme, Senators can see that the TVA would be out of business in three months."
Senator Norris was wrong. There is no more reason why the Tennessee Valley Authority should go broke with its annual real loss than there is that the United States Post Office must go out of business with its staggering yearly deficit. There is no necessary relationship in either instance between their production costs and their selling prices. In fact, there can’t be any such relationship; for as we shall see, government planners have no possible way of ever knowing the complete costs of their projects. Since they can’t calculate their full real costs, obviously they can’t set asking prices that are economically realistic. And since they can’t set realistic prices, the resulting allocation of scarce resources is necessarily inefficient.
I had read about this basic economic problem of "socialist calculation" in my college textbooks, but I never fully understood the arbitrary and unrealistic nature of nonmarket pricing and allocation of resources until I began "playing store" with my five-year-old son. We started our game by making a generous supply of price tags to correspond with the "play money" he already owned. Then he was given a roll of scotch tape and asked to put prices on all his merchandise, or scarce resources. And like any other manager who doesn’t have to worry about costs and prices that are set by competition in a market economy, my son’s price selections were remarkable.
In his enthusiasm for our game, the youngster had appropriated his mother’s jewelry box and priced all the items in it, along with his own toys. I quickly bought back her engagement ring for thirty cents. He was somewhat disappointed when I refused to buy a fascinating charm bracelet at $300. And he was completely heartbroken when I passed up his favorite cloth dog at $500.
Actually, the only reason you and I can understand my son’s unrealistic pricing is because we live in an economy in which prices (and the resulting allocation of resources) are still mostly determined by competition and consumer choice. If this were not so—if you and I lived in the arbitrary play world of socialist production and pricing—it is doubtful that we could do much better.
Without Market Guides, Pricing Must Be Arbitrary
Perhaps I shouldn’t have, but I decided to try to explain to that youngster about production costs and product prices and how they serve as guides for resource allocation (what to produce) in a market economy. But at age five, he didn’t understand my economic explanations—any more than do the adults who price electricity for the Tennessee Valley Authority or for similar projects in Russia.
In all three cases play store in my basement, communism in Russia, and socialism in Tennessee—the price setters always select whatever prices suit their whims at the moment. There is no automatic economic mechanism to decree otherwise. For even when the consumers are permitted a choice (and choose not to buy at all), this does not in any way necessarily affect the continued existence of the government project. If the project were privately owned, however, of course it would go bankrupt and the resources would be converted to the production of a product more in demand by the consumers.
That engagement ring in my basement play store was a real bargain, as is electricity in Tennessee. For reasons I can only guess at, TVA electricity is priced well below the prevailing rates charged by privately owned companies in adjoining areas; the real cost of producing it, however, is considerably higher. How much higher, neither I nor the TVA managers have any positive way of knowing.
For example, the planners of TVA can never know the real or market value of the various private electric companies and lands they acquired by "eminent domain" (or the threat thereof) when they moved into Tennessee with their philosophy of common ownership of the means of producing electricity. While our American courts still do the best they can in assigning prices to confiscated property, in the final analysis it is still an arbitrary decision. By its nature, the procedure of judicial pricing of capital assets is still necessarily somewhat similar to that followed by my five-year-old son in his play store, outside of the real market economy.
But in contrast to my young son, the managers of the Tennessee Valley Authority claim they do use realistic cost accounting and a double-entry system of bookkeeping. Thus, from the very beginning, they were faced with the problem of what interest rate (if any) to charge against TVA for the arbitrarily selected capital expenditures finally recorded in their books as a cost of producing electricity.
In a realistic market situation where persons are free to choose, this issue presents no pricing or allocation problem to a businessman; he records in the cost column whatever it cost him to borrow the capital. Even when the businessman uses his own capital instead of borrowing it, he knows that there is still a real "alternate opportunity" interest cost—that is, he could have loaned his capital to someone else at 5 per cent interest, with comparatively little risk of losing it. Thus, if a businessman can’t earn more than the prevailing interest rate on the capital invested in his own business, clearly he has misallocated his resources; and he should choose another profession.
The managers of the Tennessee Valley Authority are not bound by this realistic market procedure. Even so, for some unknown reason, they did (and still do) record a low interest charge against a small segment of the hundreds-of-millions-of-dollars that were spent on the electrical part of that project. Why only a part, and why only at a rate that is well below the interest cost that even our largest private utilities must pay when they borrow money? Well, the decision was made on much the same basis that my five-year-old son decided to charge $500 for his toy dog; he could do as he pleased without fear of competition or bankruptcy in his play store, and that happened to be what pleased him at the moment. He doubtless had his reasons, just as the managers of the Tennessee Valley Authority had their reasons for their actions, including their recent and confusing procedure of selling revenue bonds that are necessarily guaranteed by the taxing powers of the federal government of which TVA is a department. That "solution" proves nothing about the economic merit of TVA; it merely measures the purchaser’s appraisal of the government’s ability to collect taxes.
Also, it never entered my son’s mind to charge a price that would cover the rent on the house in which he was playing store—just as our government officials gave no consideration whatever to the cost of the unknown millions of man-hours of labor that were expended by various other government departments and agencies on the Tennessee Valley Authority. Yet, someone paid—and is still paying—that unknown and unrecorded cost.
In their efforts to convince the American people that government ownership is cheaper and more productive than private ownership, the planners of the Tennessee Valley Authority decided that TVA should not pay taxes to the federal government, or even record the existence of such a social cost. Why? 1 don’t know.
The Taxpayer Is Liable
In a socialist economic system—and in a basement play store—it doesn’t really make much difference one way or the other. Whatever the taxes and interest cost of the capital are or should be—and regardless of whether or not those costs are recorded—the price of the product is still always whatever the planners want it to be. There is absolutely nothing in a socialist economy, either in theory or practice, to decree otherwise.
If you write to the Tennessee Valley Authority and ask them if their rates for electricity can be used as a valid measurement for the rates charged by private companies, the reply will be, in effect, "Certainly." Ordinarily, that reply will be sent to you in a franked envelope! No government enterprise ever has to worry about increases in the cost of postage or taxes. Nor must they fret about securing additional capital; they have a seemingly inexhaustible source (you, the taxpayer) at absolutely no cost or risk to any manager of a socialized project.
Actually, this is not the fault of the managers of government projects, either in Tennessee or Russia. For even if they did want to record the full cost, there just isn’t any realistic way to determine it for a project that is backed by the taxing and police powers of government. The very best that the manager of such a command operation can do is to observe what the costs are for similar products and services in a competitive market of investor and consumer choice, and then record similar costs against the government project. To some extent, TVA has followed that procedure. But in a totally socialized world, the economy would degenerate into utter chaos in the relatively few years it would take the managers to forget the realistic relationships between costs and prices that had served to allocate resources in the once free market.
No Basis for Comparison
If you doubt this, imagine that the entire world has finally been organized on the Russian, Chinese, Tennessee Valley Authority idea of government ownership and operation of the means of production—all production. And imagine that, as has been the case in Russia for many years, no person can own or sell or rent land, machinery, or any other capital equipment. Literally, there is not (and cannot be) a market price for any of them under their economic system. Now imagine that you are suddenly in charge of allocating the vacant land in a large city to its most productive use—that is, to the use that will satisfy the most urgently felt wants of consumers in general.
Since your decision as "chief land allocator" must necessarily be made arbitrarily and without consulting the consumers, will you choose to allocate the land to office buildings or to the growing of beets? Office buildings, you say? Well, why? In the absence of a market for land and capital, how can you know that the consumers (the people in general) would rather have the land used for office buildings than beets? The land is not for sale or rent in a socialized economy where private ownership and use are automatically forbidden. Thus no one can bid on it for those or any other uses. And thus there is no rational or effective economic mechanism that consumers can use to inform the planners of their preferences.
In a market economy of private ownership, however, the most desirable use for the land (and other means of production) can be, and is, quickly decided by the highest bidder. If the beet grower outbids the office builder, the land is used for beets. If he has miscalculated and can’t at least cover his total costs by the sale of his product to willing buyers who have freedom of choice, he goes broke—and some other person who is searching for profit-making opportunities replaces him and produces whatever product he thinks the consumers will buy. Thus the consumers, by their buying or abstention from buying, will make sure that the land is used for a purpose that pleases them.
But under total socialism, there is no price and no market for any capital good, including land. No person is free to produce what he thinks the consumers would prefer. Thus all land, all natural resources, all building materials, and all capital of any description must be arbitrarily assigned to whatever purpose happens to please the planner. Literally, there is no other alternative in a command economy.
Even when prices are assigned to the final products that consumers are permitted to buy (as is now generally the practice in Russia), this does not determine the amount or type of production. While the Russian planners sometimes double consumer prices overnight, or even cut them in half, those political maneuvers and whims have no bearing at all on what will be included in the next five-year plan. Those decisions are made on other grounds.
In a market economy, however, a price rise is a signal to consumers to consume less of that product, and to producers to produce more of it. But under government ownership, prices are always arbitrary and usually capricious. Under socialism, prices serve merely as a distribution device that the planners have found easier to administer than a system of ration coupons. In the final analysis, they have no choice but to assign the prices somewhat as my five-year-old youngster set them in his play store.
Again, this is not the fault of any particular socialist. By its nature, government ownership and production cannot possibly operate in any way except arbitrarily. That’s why the Russian government assigns, or knowingly permits, a considerable amount of vegetable farming to be done within the city limits of Moscow, by persons who still live in log cabins.
My guess (based on the real actions of producers and consumers in a market economy) is that farming would not be done in Moscow, if the land were privately owned and if producers and consumers had a real choice in the matter. I will also guess that those log cabins without plumbing would have disappeared long ago in a free market. But I’ll admit it’s only a guess; for no one can possibly know how the land and building resources in Moscow would have been allocated by a free people, freely choosing.
Nor can we positively know that the once-privately-owned steam generating plants in Tennessee would have continued forever to be the cheapest and most efficient way to produce electricity. The evidence is clear, however, that steam was generally cheaper than hydro when our American planners forced the change from one to the other. The incontestable proof of it is that private investors who were searching for the lowest production costs—and thus the highest profits—almost always chose steam generation in Tennessee.
Change by Decree
The only possible way to find rational answers to economic questions such as these is to put the resources up for sale and see how the buyers use them. The reason that "apartment and office" type land in Moscow is still used for vegetable production is because the government officials just happen to want it used for that purpose. The fact that, economically speaking, such arbitrary allocation of resources is probably irrational should surprise no one. It can’t very well be otherwise. But even the communist planners are finally reaching the conclusion that the construction of most of those mammoth hydroelectric projects all across Russia was a serious misallocation of scarce resources that could have been better used for other purposes.
Nikita Khrushchev and his Minister of Power for Plant Construction, I. T. Novikov, recently decreed that future emphasis in socialist planning will be on steam generators rather than hydroelectric construction. Perhaps they were influenced somewhat by Professor Z. F. Chukhanov (Corresponding Member of the USSR Academy of Sciences) and various other Russian economists who are increasingly inching toward the market economy processes. In a publication approved by the Russian government,’ Mr. Chukhanov recently claimed that the communist hydroelectric program has been a waste of billions of rubles’ worth of resources because of the planners’ failure to charge against those projects the total "social costs" involved. Marxian dogma forced him to use the euphemism "social costs" for the economic realities that, in a market economy, are determined by interest, profits, and other allocation guideposts that have been repudiated in communist theory.
Does Professor Chukhanov really know that those hydroelectric projects have been a waste of resources? No, he is only guessing. All he really said is that if he were running that arbitrary play store economy, he would do it differently. And he then advanced still another arbitrary "mathematical solution" to the economic problem of how to allocate scarce resources to their most efficient uses in a nonmarket economy.
The only thing that can be said in favor of his particular addition to the "simultaneous equations" and similar mathematical approaches is that his is at least understandable. In effect, he claims that the industry that is allocated the most capital for expansion should be charged the highest "social cost"—that is, alternate opportunity cost, or interest in the broadest sense. For example, he points out that hydroelectric capacity has been increasing at an annual rate of 13 per cent in Russia. He then arbitrarily recommends that 13 per cent of the total new investment in hydroelectric construction should be recorded as an additional charge against that industry as a proper cost of capital, or "social cost." That’s a pretty steep rate of interest! Is 13 per cent a rational guess as to the real cost of capital in Russia? No one knows, including Professor Chukhanov.
Anyway, even if his scheme is adopted by the Russian central planning board, that unusually high rate of return cannot attract new capital into electricity production; investment decisions in Russia are made arbitrarily by the planners, and for reasons that are seldom concerned with return on capital. Thus, their capital or resource allocations cannot possibly be any more rational than are the decisions by our own United States planners to build more dams to water more deserts to grow more food to be bought by more government agents to be stored in more subsidized and surplus ships. Prices and costs and economic reality are no more related in those schemes than they were in that basement play store that was so happily presided over by my five-year-old son.
Refer to the Market
In several of his speeches over the past four years, Mr. Khrushchev has casually identified the only possible way by which his planners can rationally allocate resources in a socialist economy—that is, by observing what happens in the nonsocialist economies and then following along behind. For example, he recently pointed out that private investors in the United States have been investing less capital in steel production and more capital in the production of plastics. So, announced Mr. Khrushchev, the Russian planners will do likewise.2
A Most Tricky Problem
But suppose there were no market economy for him to observe? How could he then possibly know which should have priority? To that question, an economist friend of mine once replied: "All this nonsense about the socialist planners being unable to make rational economic calculations is just that—nonsense. Why, all they need do to determine real prices, and thus to have a rational guide for allocating resources, is to add up their costs and then price the products accordingly."
Astoundingly enough, that economist seems unaware that a cost is always a price, and that it is impossible to add up prices that don’t exist in order to determine what an asking price should be.
Another person once said to me:
"The Russian planners can always assign prices to their consumer products and then work backwards in order to establish relative costs, and thus to properly allocate their basic resources." But since those arbitrarily assigned consumer prices could not possibly be related to land and capital costs in the first place, it is astounding to imagine that they can be related in the second place.
A graduate student of mine once wrote: "But the socialist managers could act like competition existed. In that way, free market-type prices could be determined, and thus resources could be allocated in much the same way as in a market economy." As a young idealist, perhaps that student shouldn’t be expected to understand that persons never "act like" in real life; they always choose among the realities that face them. It is hardly surprising that socialist managers choose to do what they are told to do.
In short, the mental processes of the intelligentsia in the United States have been so conditioned by realistic free market procedures that most of us are incapable of even thinking about the idea of an economic system without an automatic pricing mechanism to allocate scarce resources and to determine what will and will not be produced.
As another of many examples of unrealistic socialist play store economics, the Russian planners have generally neglected to record a difference in land value (rent) between a factory in the middle of Moscow and a similar factory in distant Siberia. Under government ownership and socialist production, there can be no such thing as a realistic rental price to serve as a guide for the best use of land. But the only way you and I can know that such socialist practices are economically irrational is because we can compare the results against those of the market economy of choice. Otherwise, we too might well imagine that the area around Broadway and Wall Street should be allocated to the growing of wheat. Why not? After all, it is closer to the New York market than is Kansas. And as the socialist planners are quick to point out, everyone already knows that food is more important than office buildings. So there is no particular need to consult the consumers about it.
Signs of Recognition
Since, under a socialist system, I couldn’t do any better than the communist planners, I can only marvel that the Russian level of living is perhaps as much as one-third of our own. The only way I can account for any economic progress there at all is to assume that the Russian planners generally base their "play store" cost accounting and production practices on the realistic costs and prices set in the comparatively free markets that still exist in most nations.
In fact, a direct and unusual admission of this procedure has recently been published by two leading professors of the Central Planning School in Poland.³ They first explain that the customary allocation of resources in socialist nations is done by what they call "direct economic calculation"—that is, by the "technical coordination" of specific machines, raw materials, and labor to produce whatever it is the Central Planning Board wants produced. While prices are usually arbitrarily assigned to these resources after they have been allocated, they play no part whatever in determining what will be produced. Then the two planning professors said: "The best methods of producing a given output cannot be chosen [by this socialist direct economic calculation] but are taken from outside the system…. i.e., methods of production used in the past, or so-called ‘advanced’ methods of production, usually taken from the practice of more advanced countries and used as data for plan-building by the [socialist] country under consideration."
Well, there you have it, directly from the communist planners themselves—they base their calculations on the data supplied by free market nations. (Since they refer to "so-called advanced methods" in a derogatory sense, obviously the reference is not to Russia.) True enough, by "trial and error" procedures, the planners can learn from their own mistakes that one way of producing something is technically more efficient than another way. But since consumers have no choice in the matter, the planners can never really know if the particular project itself represents the best or most efficient use of the resources in the first place. Only a market economy can supply that type of information.
If the socialists ever take over the entire world, let us hope they will be intelligent enough to leave one country with a market economy of private ownership wherein consumers can direct production and allocation of resources by their buying and abstention from buying. Otherwise, the planners soon will be faced with the baffling problem in a socialist world of whether or not to allocate platinum to the production of nose rings for pigs. But, of course, if socialists were intelligent enough to understand the vital need for some rational, uncoerced, and automatic way to allocate resources according to consumer preferences, they wouldn’t be planners in the first place.
Why Not Make It Free?
And so it is with our own Tennessee Valley Authority. That project has unquestionably been a fearful waste of scarce resources, and probably still is. But some considerable semblance of reality exists in its bookkeeping and production procedures because the managers can still be guided in their decisions by the prices for the products and services they buy in the market economy around them. They know what privately owned electric companies pay for labor and equipment, as well as what they charge for electricity. Thus, the TVA managers have a realistic guide for setting their own rates. The fact that they choose to set their rates considerably lower than the rates of private companies is hardly surprising; after all, that was the purpose for building the project in the first place. They could just as well have set them at five times the prevailing rate, or at one-half the prevailing rate, or made it free.
It wouldn’t make any real difference because there is no necessary relationship between their costs and prices anyway.
True enough, their prices are doubtless more realistic than my son’s price of thirty cents for his mother’s engagement ring. But we can’t know how much more realistic since consumers and investors have no real choice concerning TVA policies in practice. At least my son couldn’t force me to pay $500 for his favorite toy. But I have no choice at all about paying whatever the government says I must pay as my share of the cost of the Tennessee Valley Authority that we all own in common.
But, it might be said, the natives in Tennessee are quite happy with their low rates and lovely lakes. I have no reason to doubt that claim. And when my son’s playmates heard about his store, they were happy indeed to give him their business—especially when he most generously supplied many of them with the "money" with which to buy the stuff. When I put a sudden stop to that popular practice, various childish voices accused me of being mean. Fortunately, however, their parents understood my actions when I closed down that bargain basement. But when I tried to explain to the parents themselves that perhaps the same economic and moral principles apply to various similar government projects, most of them immediately joined their children in calling me mean.
In fact, one parent decided to set me straight with this observation: "You claim that the socialist planners are necessarily less efficient than private owners in a market economy. Then how do you explain the fact that the Russian planners put the first man into space?"
Shoot the Moon!
There are several possible answers, including the obvious one that this man-in-space program is also a socialized project here in the United States. So perhaps it could be said that the Russians are still better socialists than we Americans, although we are catching up fast.
I have already explained as best I can how the Russians take full advantage of all the production and allocating processes of the market economies that still exist in most of the world. In addition, in many respects the Russians now appear to be increasingly inching toward the competitive market processes within their own economy. For example, the proposal by Professor Y. G. Liberman of Kharkov Engineering and Economics Institute that "profits" should be the primary yardstick for judging factory efficiency is now being openly discussed among Russian officials. I don’t quite see how they can install and manage a realistic profit system in a socialist economy. But if they can do it even partially, that market guidepost will naturally insure more and better production in Russia.
Even so, our comparatively free market economy is, on the whole, still vastly more efficient than the Russian planned economy. Based on their obvious and easily observable inferiority in housing, food, clothing, transportation, and such, perhaps our economy is as much as 50 per cent more efficient, although the figure might be 30 or 70 per cent. Thus, if the Russians wish to excel us in any given area, they simply allocate two or three times as much labor and capital as we do to the selected project. In the area of rockets and the training of scientists, it seems reasonably certain that they have followed that procedure. Thus, they are seemingly ahead of us in the space race—at the alternate opportunity or social cost of a level of living for the Russian people that is only about one-third of our own.
Finally, in no sense is my discussion of this issue to be taken as an "attack" against the persons in charge of these various socialized projects—either in Russia or Tennessee. To the best of my knowledge, the management of the Tennessee Valley Authority is comparatively good. Actually, I don’t know who the managers of any of these projects are, in Tennessee or elsewhere. Nor do I care. I am here discussing an idea. Further, I assume that in case of war with Russia, the managers of the Tennessee Valley Authority will be as willing to fight and die for our country as you and I are. Unfortunately, however, the vital issue of the controlled economy versus the market economy will probably be decided long before that battle is ever joined—and then it will be too late; for in the long run, it is ideas (not battles) that decide the fate of mankind.
If the Tennessee Valley Authority represents the best system for the production of electricity, we have no real quarrel with the Russian socialists, and a war would be rather pointless. But if private ownership of the means of production is preferable, then we do have a real issue—not so much with the Russians as with the millions of sincere and patriotic Americans who are happily choosing the controlled economy of democratic socialism instead of the market economy of private ownership.
1 Teploenergetika, No. 12, pp. 7-12, 1961.
2 The Wall Street Journal, article by Edmund Faltermayer, March 4, 1963.
3 Aleksy Wakar and Janusz Zielinski, "Socialist Operational Price Systems," The Journal of the American Economic Association, March, 1963, p. 109.