Socialism and Incentives
NOVEMBER 01, 1986 by DAVID OSTERFELD
One of the major issues of socialism is that of incentives. Critics often argue that because it “abolishes” profits and losses, socialism eliminates incentives. Defenders maintain that since it eliminates the role of capitalists and entrepreneurs, workers under socialism “produce for themselves.” Therefore, it is held, socialism actually maintains or even stimulates incentives.
The issue of incentives is vitally important. But the traditional way of presenting this issue is misleading. The real issue is not the presence or absence of incentives, per se. Incentives cannot be eliminated. They are omnipresent. Every politico-economic system generates a set of incentives. The real issue is whether a particular set of incentives is “right” or “wrong,” i.e., whether it is appropriate to attain the goals sought or claimed for it by those implementing the political and economic policies.
The goals of both socialism and capitalism are identical: prosperity and freedom. This identity of goals makes a comparison of their performances relatively easy. The differences are indeed striking. Socialist systems have compiled an uninterrupted record of economic failure and political oppression.
The Soviet Union contains some of the most fertile agricultural land in the world. Prior to the communist revolution of 1917 Russia was the world’s largest exporter of grain. Collectivization of agriculture during the 1920s and 1930s was quickly followed by dramatic declines in agricultural output. Between five and ten million Russians died of starvation during these years with twelve to thirteen million more saved by food donated from the Western capitalist countries. Today, the Soviet Union employs nearly 25 per cent of its labor force and invests in excess of 25 per cent of its capital in agriculture, both of which are far higher than any other industrialized country. Despite its tremendous agricultural potential, the Soviet Union is now the world’s largest food importer. It now imports nearly one-third of its food, and this is despite having grudgingly permitted the establishment of private mini-farms one-half to one acre in size. These private plots comprise only three per cent of the total cropland yet produce 27 per cent of the nation’s food. It is unlikely that the Soviet Union could exist without these plots.
This pattern is repeated with monotonous regularity throughout socialist countries. Most of the Eastern European nations are blessed with fertile agricultural land. The adoption of socialist policies in most of these countries has been quickly followed by declining production, food shortages, and bread lines.
Agricultural output in China was virtually stagnant during the 25-year reign of Mao Tse-tung. The Chinese government now acknowledges that during just one three-year period, the so-called “Three Difficult Years” from 195962, between 20 and 30 million Chinese died of starvation. By the time of Mao’s death in the mid-1970s the average Chinese was less well fed than he was during the 1920s or even during the Japanese occupation of the 1930s. Beginning in 1977 Mao’s successors abandoned his “socialist experiment.” As a result, says The Economist, “food grain output has increased by 12 per cent a year since then, despite bad weather in 1980.”
Out of a population of only eight million, two million Cambodians died of starvation in the late 1970s after socialist measures were applied to agriculture by the Khmer Rouge.
In 1957 Ghana became the first African country to receive its independence, quickly followed by a number of others. At the time of independence famine had become a thing of the past in Africa. Yet within a few years the continent was being ravaged by perennial famines. Millions were dying from starvation or diseases associated with malnutrition. Once again, the • correlation is striking.
Ghana, as Sven Rydenfelt notes, “is one of the world’s best endowed countries: fertile soil, ample rainfall, and a favorable climate . . . .” At the time of independence it was the world’s leading producer of cocoa. But after President Kwame Nkrumah adopted what he termed “African socialism” Ghana’s cocoa production declined by 50 per cent. Similar production declines occurred in other crops such as cassava.
Like Ghana, much of Ethiopia is ideally suited for agriculture. “Ethiopia is one of those countries so richly endowed by nature,” agronomist Doreen Warriner wrote in 1973, “that the agrarian structure, feudal in every sense of the term, does appear to be the only constraint on development.” In March 1975 the feudal period ended; “Ethiopian socialism” began. But instead of development, agricultural performance, poor to begin with, deteriorated rapidly. It is now well established that over one million Ethiopians have died of starvation in the most recent famine.
And in Tanzania President Julius Nyerere began to collectivize agriculture in 1967. A food exporter in the late 1960s, Tanzania imported $18 million worth of food in 1980 despite the fact that nearly 70 per cent of its population was engaged in agriculture.
In marked contrast to the socialist countries of the world which almost invariably find themselves on the verge of starvation despite employing between 25 and 90 per cent of their workforce in agriculture, the more capitalist countries of Western Europe and North America are able to produce huge food surpluses while employing only three to four per cent of their work force in agriculture.
A brief overview of the data reveals a clear correlation between economic systems and economic performances: socialist economies have performed goody; capitalist economies have performed quite well. The correlation is much too strong to be attributed to mere chance. To understand this correlation we need to examine the very different incentives generated by the two economic systems, and then look at how individuals would be expected to respond to these different sets of incentives.
Assume that an individual, Clem, is a member of a socialist commune. Assume that there are 1,000 members of the commune and that the output is divided equally among the members. (For the sake of simplicity we will ignore matters such as capital investment.) Let’s say that the production of the commune totals 100,000 bushels of wheat a year, or an average of 100 bushels per member. At a price of, say, $5.00 per bushel total receipts for the commune are $500,000, or $500 per member. The question is: How is Clem likely to behave? Will he work hard? Will he shirk?
Let’s assume that Clem is both naturally industrious and socially conscientious. He is concerned about the overall good of the commune. As a result, Clem works very hard and increases his production from 100 to 150 bushels of wheat a year. This increases the annual output of the commune from 100,000 to 100,050 bushels. At $5.00 per bushel the income of the commune increases from $500,000 to $500,250. Since total income is divided equally among the members, the income of each member rises from $500 to $500.25 a year. Thus, because of his extra work Clem’s production increased 50 per cent. But his income increased by a mere 25C or by 0.05 per cent. Moreover, the income of the other 999 members also increased by 25c even though they did not work any harder and their productivity did not increase.
Clearly, Clem’s activities benefited everyone in the commune except himself Everyone else had his income increase without increasing his work. But Clem’s income increased only 25c despite increasing his work load by 50 per cent. While the benefits of the extra production were diffused throughout the commune, the costs were concentrated on Clem. Given the distributional policies of the socialist commune it is clear that Clem’s decision to increase his work was “irrational,” and it is highly unlikely that he would continue his Stakhanovite exertions, thereby subjecting himself to continued exploitation by the other members of the commune. In short, the distributional policies of socialism penalize industrious behavior.
Deeper insight into socialist incentives can be obtained by looking at the situation from a different angle. Assume that the conditions of the commune are the same as described above. But now assume that instead of increasing his production Clem begins to slough off, to shirk. Assume that he cuts his production from the aver age of 100 bushels a year to only 50. What are the effects? The total output of the commune drops from 100,000 bushels to 99,950 bushels. Its total receipts therefore fall from $500,000 to $499,750. As a result each member’s income declines by 25c, from $500 to $499.75. Yet, they have not, we are assuming, reduced their work loads. Clem’s income is also reduced 25C. But he has cut his work load in half. This is a great deal for Clem! He has obtained a 50 per cent increase in leisure at a cost to himself of only 25c, or a 0.05 per cent reduction in income. In short, since the cost of Clem’s shirking is diffused among all the members of the commune while the benefits are channeled to Clem, socialism crates a strong incentive to shirk. The problem, of course, is that there is no mason why this is limited to Clem. It applies with equal force to all members of the commune. But if all members shirk, little or nothing will be produced and the commune will quickly find itself in dire straits.
The basic problem of socialism is the imbalance or asymmetry it creates between costs and benefits. At times the costs are diffused throughout the entire community while the benefits are concentrated on one or a few members. At other times it is the costs that are concentrated while the benefits are diffused. The result is that socialism, by its very nature, rewards sloth and indolence and penalizes diligence and hard work. It therefoR establishes incentives that are incompatible with its self-proclaimed goal of material prosperity. The inherent di lemma of socialism is that individuals who respond “rationally” to the incentives confronting them will produce results that are “irrational” for the community as a whole.
The solution to the dilemma of socialist incentives lies in what economists call “internalizing the externalities,” i.e., making sure that both the costs and benefits of individual actions are borne by the individual and do not spill onto “society” as a whole. There are two distinct methods by which this can be accomplished: private property or coercion.
Assume that instead of living in a commune Clem lives in a market society and owns his own farm. If Clem would increase his production, just as he did in the commune, from 100 to 150 bushels, he would receive the full benefit of the additional output. The result, again assuming $5 per bushel, is that Clem’s income would increase not by a mere 25C but by $250, going from $500 to $750 per year. Conversely, by reducing his production from 100 to only 50 bushels, Clem’s income would fall not by 25C but by $250, dropping from $500 per year to only $250. Thus, private property automatically “internalizes the externalities,” i.e., it channels both the costs and the benefits of each individual’s actions onto that particular individual. In doing so it creates incentives that automatically penalize indolence and reward hard work and productivity. These are the exact opposite of the incentives generated by socialism.
To permit private property would be to acknowledge the failure of socialism. As a result, socialist systems have allowed private property only grudgingly and on a very restricted basis. Rather than admit failure socialists have usually opted for the other means to internalize externalities: coercion. To counteract the incentive to shirk, the socialist rulers can establish production quotas for Clem and the other members of the commune and then threaten them with penalties for failure to meet the quotas. Since coercion will stimulate production only if the penalties are severe enough to counteract the incentive to shirk, socialism must reduce the population to virtual slavery. But even if coercion does stimulate production the increase will be far less than under private property. Since it insures that each producer will receive the total value of his production, private property pro vides the incentive to maximize production. Coercion, on the other hand, is only able to establish the incentive to produce the minimum required to avoid punishment. It is no accident that socialism ends up enslaving its workers. Nor is it an accident that free men have always been more productive than slaves.
Socialism promises prosperity and freedom. But the incentives created by socialism place it in a dilemma. If the workers are allowed to remain “free,” they will not produce. To stimulate production they must be denied their freedom. Thus, socialism cannot achieve both prosperity and freedom. Usually it results in neither. 
1. See Sven Rydenfelt, A Pattern for Failure (New York: Harcourt. 1983), pp. 27-45; Hedrick Smith. The Russians (New York: Ballantine, 1984), pp. 264-84; and Marshall Goldman. USSR in Crisis (New York: Norton. 1983), pp. 63-87.
3. “In Praise of Peasants.” The Economist (February 2. 1985), pp. 86-87. Also see Stephen Mosher, Broken Earth (New York; Free Press. 1983), pp. 28-52. Especially see pages 37-45. Mosher quotes a Chinese peasant as saying that “People aren’t lazy all the time, just when they do collective labor. When they work on their private plots, they work hard. There is a saying, ‘Energetic as dragons on private plots, sluggish as worms on the public fields.’”
8. Two points are worthy of note. First, the reliance on devices such as “workpoints” has been ignored, To the extent that they work they constitute a clear violation of the principle of egalitarianism that permeates socialist literature, MoreOver, since “workpoints” are a reflection not of the preferences of the consumers but of the socialist ruler(s)’ opinion of the value of one’s contribution. “workpoints” are not only economically arbitrary but alsO reinforce the concentration of political power in the hands of the rulers, Second. the problem of incentives is not the sole reason for the poor performance of socialist economies. The related problem of economic calculation is also vitally important. On this issue see Ludwig von Mises’ classic Socialism (London: Jonathan Cape, 1969): Don Lavoie, National Economic Planning: What Is Left? (Cambridge: Ballinger. 1985); and David Osterfeld. Freedom, Society and the State (San Francisco: Cobden Press, 1986), pp, 221-30,