In the planned economy of a communist state, the state decides what should be produced, estimating needs and wants and directing industries to produce what it believes is required and in the allocated amounts. Thus, consumer wants are dictated by the state.
The state also decides on how to produce managing all the factors of production and directing them in their usage and allocation. All resources are owned and managed by the state, with no private property. Finally, the distribution of goods and services is also dictated by the State, which dispenses goods according to need with the aim of promoting equality.
Such a system fails for several reasons. Firstly, the process of collecting and disseminating information about consumer preferences, production methods and material costs is very wasteful in terms of the resources used up in the planning process. Secondly, it is inaccurate as it is very difficult to get comprehensive and correct information in such large amounts, leading to resource misallocation and a reduction in allocative efficiency. Consumer wants are frequently misjudged, reducing their welfare and production techniques are inadequate, raising costs.
Another major problem is that of a lack of incentive. Since all men are treated equally and given rewards independent of their contribution, they have no incentive to work hard, reducing their productivity, and no desire to innovate and be efficient in production, reducing the productive efficiency of firms. Losses are underwritten by the state, no factories close down because of losses and employment is assured, thus removing the penalty for inefficiency.
The lack of competition in a planned economy due to the guaranteed survival of firms and the lack of profit motive also means that inefficiency is tolerated and allowed to remain. The concentration of power in the bureaucracy also encourages corruption, leading to further wastage and resulting in government policies harmful to economic growth. The bureaucracy also tends to stifle personal initiative and creativity preventing the discovery of more efficient production methods.
The long-time standoff between the Communist states and the West also severely restricted trade between them. Thus, the communist states could not benefit from the gains arising from specialization, comparative advantage, variety of products, larger export markets and technological exchange. This was further worsened by their heavy defence expenditure, leaving little for domestic consumption and investment. Without much investment, productive capacity could not increase and growth was slow, resulting in poverty.
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In the capitalist economy, resources are privately owned and managed exclusively for the benefit of their owners. There is minimal government information and resource allocation is basically done via the price mechanism, allowing demand and supply forces to act freely.
In the product market, goods that are demanded by consumers will tend to have high prices, encouraging profit-conscious producers to produce them. Thus, there is consumer sovereignty and consumer welfare is promoted. Also, the competition between producers ensures that only the efficient ones survive, forcing producers to cut costs and use factors of production in the most efficient ways possible. In this way, by lowering costs, they can maximise profits. Finally, the goods and services are distributed according to individual incomes, encouraging factors of production to go where there price, and hence need, is the greatest.
In the capitalist system, resource allocation is automatically coordinated by price signals via demand and supply. If the price is too high, at P1, there will be an excess of Q1Q1’, leading to competitive price cuts. If price is too low, at P2, a shortage will cause consumers to bid up prices. Thus, prices will tend to rise towards P0, where the market is cleared. This allocation system is cost-free and efficient.
Also, because rewards are commensurate with contributions, people have the incentive to work hard so as to increase wages or innovate to increase profits, increasing productivity and lowering production costs. The system of inheritance also encourages savings and thus allows greater investments, which eventually increase the capital stock and lead to economic growth, raising living standards in the long run.
Competition among producers ensures that only efficient firms survive. Consumers get a greater variety of goods which are also higher in quality, because producers innovate to increase profits.
The transition of Capitalism, however, is not free of problems, as evidenced by the inflation, unemployment and crime without economic growth to compensate seen in Russia.
