Price Mechanism in a Socialist Economy (With Diagram)

The below mentioned article provides an overview on the Price Mechanism in a Socialist Economy.

The price mechanism has little relevance in a socialist economy because it is regarded as a distinguishing feature of a free market economy. In a collectivist or socialist economy the various elements of the price mechanism—costs, prices and profits—are all planned and calculated by the planning authority in accordance with the targets of the plan.

Thus, rational economic calculation is impossible in a planned economy because unlike a free market economy the price mechanism is regulated and controlled. The various assumptions under which the price system works in a free market economy do not hold well in a collectivist economy.

In a socialist economy, it is the central planning authority that performs the functions of the market. Since all the material means of production are owned, controlled and directed by the government, the decisions about what to produce are taken within the framework of a central plan.

The decisions, as to the nature of goods to be produced and their quantities, depend upon the objectives, targets and priorities laid down by the central planning authority. The prices of the various commodities are also fixed by this authority. Prices reflect the social preferences of the common man. Consumers’ choice is limited only to the commodities that the planners decide to produce and offer.

The problem of how to produce is also decided by the central planning authority. “It establishes the rules for combining factors of production and choosing the scale of output of a plant, for determining the output of an industry, for the allocation of resources, and for the parametric use of prices in accounting.”

The central planning authority lays down two rules for the guidance of plant managers. One, that each manager should combine productive goods and services in such a manner that the average cost of producing a given output is the minimum.

Two, that each manager should choose that scale of output which equalises marginal cost to price. Since all resources in the economy are owned and regulated by the government, the raw materials, machines and other inputs are also sold at prices which are equal to their marginal cost of production.

If the price of a commodity is above its average cost, the plant managers will earn profits and if it is below the average cost of production, they will incur losses. In the former case, the industry would expand and in the latter case it would cut down production, and ultimately a position of equilibrium will be reached where price equals both the average cost and the marginal cost of production.

In case where costs differ with plants, the plant managers produce up to the point where long-run marginal cost (LMC) is equal to price (P=AR=MR), in such a situation, it is only in the marginal plant that LAC=LMC=MR=AR=P at point E₁, as shown in Figure 5 (B).

All other plants would earn extra revenue (profit) equal to PA BE, as shown in Figure 5 (A) which would go to the government. The low cost units will subsidies the high cost units and in equilibrium total revenue and total cost would be the same for the industry as a whole.

But how can the central planning authority find out the equilibrium market and accounting prices? Starting from historically given prices, it can instruct the plant managers to regard them as correct prices. If they are wrong, surpluses or shortages will emerge. Prices will be readjusted. This process will continue until the equilibrium position is reached by trial and error.

The process of trial and error would, however, proceed on the basis of historically given prices which would necessitate relatively small adjustments in prices from time to time.

Thus “all decisions of the managers of production and of the productive resources in public ownership and also all decisions of individuals as consumers and as suppliers of labour are made on the basis of these prices. As a result of these decisions the quantity demanded and supplied of each commodity is determined. If the quantity demanded of a commodity is not equal to the quantity supplied, the price of that commodity has to be changed. It has to be raised if demand exceeds supply and lowered if the reverse is the case. Thus the central planning board fixes a new set of prices which serves as a basis for new decisions, and which results in a new set of quantities demanded and supplied.”

The problem for whom to produce is also solved by the state in a socialist economy. The central planning authority takes this decision at the time of deciding what and how much to produce in accordance with the overall objectives of the plan.

In making this decision, social preferences are given weightage. In other words, higher weightage is given to the production of those goods and services which are needed by the majority of the people over luxury items.

They are based on the minimum needs of the people, and are sold at fixed prices through government stores. Since goods are produced in anticipation of demand, an increase in demand brings about shortages and this leads to rationing.

Thus, the problem of income distribution is automatically solved in a socialist economy because all resources are owned and regulated by the state. All interest, rent and profit are fixed by the state and go to the state exchequer.

As regard wages, they are also fixed by the state according to the amount and quality of work done by an individual. Each individual is paid according to his ability and work. Economic surpluses are deliberately created and invested for capital formation and economic growth.

Conclusion:

Thus the price mechanism is not incompatible with a socialist economy.

Rather, it helps the socialist economy in two ways:

First, it serves as a basis for accounting—a means to evaluate and compare cost of production and output based on accounting prices and costs.

Second, it acts as an incentive to the people to do things in accordance with plan targets. Thus in a socialist state, it is the central planning authority that performs the functions of the market. Since all the material means of production are owned, controlled and directed by the government, the decisions about what to produce, how to produce, and for whom to produce are taken within the framework of a central plan.

The prices are fixed by the central planning authority. Prices reflect the social preferences. Even in producing goods, social preferences are given weightage. So the price mechanism does not operate in a collectivist economy the way it operates in a free market economy because the state owns controls and regulates the means of production and distribution within the economy.

But this does not mean that prices do not play any part in such an economy. In fact, they are used to solve the problem of how to produce.