The Social Function of Profits–The Importance of Prices in an Economy

(Start video at 26 min 46 sec)

With the collapse of the Soviet Union, supporters of the free market who were foretelling the demise of the communist system were, for at least a brief time, vindicated in the eyes of the public. However, while it was obvious that the Soviet’s economic structure failed, it was much less obvious why it failed. The typical response given by conservatives is that there was an incentive problem that is inherent within a communist system: in an economy in which everyone receives equal pay, who is going to engage in the menial yet necessary jobs in society? And while this is a very valid point (economics is, after all, a discipline that studies the actions humans engage in when faced with different incentives and different opportunity costs), the intellectual debate would end with the claim that this new system would create a new “socialist man” that would respond differently to incentives. No matter what historical evidence that was offered concerning the failure of communism wherever it has been implemented, the response was the same: the capitalistic blood was still contaminating new “socialistic man”. The debate had reached a gridlock.

Lacking from the arsenal of the defender of the free market, however, are the contributions of Ludwig von Mises who had systematically dismantled the feasibility of a socialist economy decades before. While the incentive problem will certainly always plague a socialist economy (notwithstanding the creation of the mythical “socialist man”), there exists an even more fundamental flaw in the socialist framework: it ignores the central role that the price system plays in allocating resources in an economy. Regardless of how whimsical some may feel about the fluctuation of prices, they are not mere arbitrary numbers that business owners pick out of a hat on any given day. They represent in a very liquid manner the supply of resources and the demand that consumers have of the goods when arranged in a specific way. That is, they are a valuation of the resources required to bring about the satisfaction of consumers’ preferences.

Without prices that are determined by the supply and demand of a freely functioning economy, there is no way meaningful way to engage in economic calculation (ie. figuring out who wants how much of what). It was using this application of basic economic theory that Mises was able to fully combat the supports of communism in his day and foretell of the collapse of the system in an economically sound argument years before it occurred.

In this video, economist Robert Murphy explains the central role that prices play in allocating resources in an economy. True, market prices require the possibility of both profits and loses, and so whether it is the elimination of prices in a full-blown communist system or the mere distortion of prices (via price controls or subsidies) in an interventionist economy, the result is a misallocation of resources away from consumer-satisfied preferences. This disregard of the role of prices will inevitably lead to a collapse of a communist system or to economic busts within an interventionist system.

The important role that prices play is central to understanding how resources are allocated. Communism did not collapse simply because no one wanted to “take out the garbage”. There was a much more fundamental flaw within the system; this same fundamental flaw is still present within the interventionist economies around the world and is still distorting markets and contributing to the painful economic busts we continually feel.

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