The reason productive inefficiency was so rampant in centrally planned economies was the highly inefficient process of “material balance”. Producers would purposely become wasteful in the usage of the factors of production when left with remaining material to prevent it from being unsupplied the following cycle and later reduced quota’s of resources. This was the reason the former USSR had the reputation of having goods that were “too heavy”.
They could not exploit economies of scale, as all goods and resources were given to them at a fixed rate.
There is no incentive for technological innovation. The free and mixed market principles mean a firm’s priority lies within maximised profits. This occurs when costs are lowest. Lowest costs occur when technology increases the efficiency of the usage of resources (this is the solution to the dynamic problem). However in the mixed economy the main objective of a firm is to ensure it uses all its resources in providing its required target. There is no need for technological progress. Thus the benefits to the economy of such advances are no longer a possibility.
The second form of inefficiency is allocative inefficiency. If an economy is allocatively inefficient it is not producing what people want. Allocative inefficiency means goods people want become scarce thus prices rise and fewer people can be provided for. The poorest are the worst sufferers. There is greater wastage as there is a surplus of unnecessary goods. This surplus is the waste that could have been put to better use elsewhere, the opportunity cost of greater output. This is shown below as the production possibility
This under production is what led to the exhaustion of natural resources in the domestically planned economies in Eastern Europe. This lead to what’s known as the static problem. It creates a misallocation of resources, providing materials where they aren’t needed and falling short in areas that do need them. This meant an over usage of resources and factor substitution in the economy, creating large inequalities and a relatively poverty stricken society, with poor/low living standards. The excessive use of inputs also raises the cost to producers and consumers alike, reducing the profits and output of the society as a whole. This reduces the government’s international buying power as well as those firms which rely on imports to build their goods, i.e. imports make up a portion of their utilized intermediate goods in the production of their final good. The intermediate goods show the derived demand that is needed for the final goods. Allocative efficiency will result in a shortage of consumer goods due to the artificially high price created by the government.
Allocative efficiency occurs when the lack of available information sends misleading signals to the government. The contribution of the signals generated by demand and supply being ignored in a planned economy nullifies the concept of consumer sovereignty. This pushes demand and supply away from the market mechanisms placing of equilibrium.
As shown below;
S
P1
Price
Equilibrium
P2
D
Q2 Q1 quantity
This equilibrium occurs when both consumers and producers are satisfied with their relative quantities of a commodity. As shown in the planned economy, neither is satisfied at the same time.
The governments own agenda such as the massive arms race against the USA by the USSR and its desire to create a large military stockpile meant that various other economic industries were uncatered for on account of the heavy subsidisation of the armed forces and their ancillary industries.
The combined affect of these two forms of inefficiency, i.e. economic efficiency is market failure. As a result of inefficiencies within the economy, there will be a cumulative effect of a reduction in disposable income within the economy. Less investment within the economy, hot money will be removed from the marked. This is because in the planned economies, when investment rose, returns fell, making investment unprofitable and undesirable. The economy will be uncompetitive internationally, as it produces goods which are of too poor quality for the global market. These goods will be too highly priced and their balance of payments will show and inclination to buy imported goods as they will be cheaper and better made.
The government had incomplete information. This meant that they did not have all the information needed to correctly analyse and decide on the production of goods and the allocation of resources.
The government proved slow to react. It didn’t produce what people want, was slow to respond to changes in demand thus was wasteful and reduced it’s economies production potential. This in turn exaggerated the problem of co-ordination failure, where the ever changing economy left the government behind and was told to produce something that was no longer needed where things that were, were left undone.
The planned economy failed to take social and private costs. These key areas left externalities unchecked. This left the economies environmental vitality seriously damaged even after an extremely high period of economic prosperity.
In summation there are several reasons why the planned economy failed. It only ever dealt with the symptoms of its economic problem; it never tried to tackle the underlying disease it bore. It leads to complacency and inefficiency on the part of producers to the detriment of the economy as a whole. It interfered with speculation and created a misallocation of resources. It lowered the living standards of the population and reduced their choice and buying power, as they had little disposable income. The USSR focused too heavily on the military and ignored other key areas of its economy. It failed to safeguard workers interests. It suffered heavy tax revenue reductions. It became internationally uncompetitive. And even since the early times of the Bolshevik revolution, the government could never react quickly enough and make the correct informed choices it needed to in order to make central planning work.
Sources;
Anderton 3rd Edition
Sloman Economics 4th Edition
Principles of economics – McGraw Hill
The Economist (Various editions)
London School Of Economics, reference material
Economic rent is the price required to keep a particular factor of production (land, labour, capital and enterprise) in their current state
Opportunity cost is the cost incurred when sacrificing one choice to make another occur. Generally explained as giving up one thing for another.
Material balance was the process where how much a producer used was utilized to calculate the amount of resources that would be allocated to them for the subsequent period.
Economies of scale are the better usage of raw materials of a firm as it grows in size.
Static problem is when the existing resources are not used in accordance with possible production to provide maximum utility for consumers.
Consumer sovereignty is a term describing the process whereby a consumer casts a “vote” when they buy a good or service, this acts as a signal to producers to make more or less of their particular commodity.
Market failure occurs when market signals lead to a misallocation of resources
When investors who speculate on the profitability of money see a higher rate of interest and return move their funds from one financial sector to another.