Lecture 2. Economic systems; How the Soviet economy was supposed to work

Today’s class Structure of the course Hayek’s paper How the Soviet-type economies were supposed to work - outline of the central planning process; - difficulties with idealized central planning and their consequences

Structure of the course Overview of the workings of a Soviet-type system Difficulties of partial reforms Systemic reforms: –Price liberalization & financial stabilization –Privatization (major topic) –Reform of government (major topic) –Assessment and current performance

Hayek’s paper misconception about the economic problem of society ( If we have all relevant info and if we start from a given system of preferences the problem of the best use of resources is the one of pure logic ) Main economic problem: how to make use of knowledge that is not given to any one mind

Hayek’s paper (cont.) It’s not whether planning is necessary, but whether planning should be done centrally by one authority or if it should be divided among many individuals Hayek’s claim: The relative efficiency of the economy depends on which system would make better use of existing knowledge dispersed among individuals

Hayek’s paper (cont.) Scientific knowledge vs. tacit knowledge and knowledge of local circumstances The importance of change The miracle of the price system Problems with Hayek’s arguments?

Soviet-type central planning in theory Leaders: Set main targets Planners: Produce initial roughly balanced and highly aggregated feasible plan Planners: Allocate aggregated targets and inputs to economic branch ministries Ministries: Allocate less aggregated targets and inputs to enterprises Enterprises: Disaggregate targets and inputs Enterprises: Send adjustments back to ministries

Soviet-type central planning in theory (cont.) Ministries aggregate adjustments made by enterprises and send back to planners adjusted aggregated targets Planners try to adjust the plan to eliminate imbalances and send the new targets and inputs back to ministries Iterations continue till a balanced plan is produced

Problems with idealized planning process Incentives? (disregard for now) Problem: How are the initial targets developed? Consequence: “Wrong” and perhaps infeasible targets are set

Problems with idealized planning process (cont.) Problem: How do planners, ministries, enterprises decide how to produce things? Consequence: “Wrong” production processes are used Also: How to structure the incentives correctly?