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Sunday, September 7, 2008

The Communist Economic Calculation Problem

In a communist dictatorship, a handful of people make decisions for the entire economy. This is incredibly inefficient. Ignoring price signals, they can't efficiently decide whether to manufacture shoes or televisions. Further, in a communist dictatorship, there's no incentive for creativity or working hard.

A large corporation has the *EXACT SAME ECONOMIC CALCULATION PROBLEM* as a communist dictatorship. In the current economic system, large corporations are shielded from competition. They have a State-granted monopoly/oligopoly.

Suppose the corporation is manufacturing widgets, and they have a monopoly. Suppose that a widget is made of two pieces A and B. Components A and B are only useful when making widgets, so nobody besides the widget corporation manufactures them. The corporation manufacturers components A and B and then assembles them to make widgets. Suppose that the corporation manufactures A at a cost of $5 each and B at a cost of $10 each.

The problem is that the widget monopoly cannot tell if it is manufacturing A and B efficiently. Suppose the free market cost were $2 for component A and $3 for component B. There's no way that the monopoly would ever know, since it isn't subject to market competition.

The problem can't be solved by "outsourcing" A and B. The outsourcing vendor would have no choice but to sell to the widget monopoly. The management of the widget monopoly would bid out the contract to their friends, rather than seeking a truly competitive bid.

A large corporation with a State-granted monopoly/oligopoly has the *EXACT SAME* resource allocation problem as a communist dictatorship. With a monopoly, it's impossible to tell if each of its internal processes are efficient or not. In a free market with lots of small businesses, inefficiencies are obvious.

You may ask "If large corporations are so inefficient, then why are they the dominant mode of production?" The problem is State distortion of the market.

The Federal Reserve, income tax, and government regulations are an enormous disincentive to productive activity.

The Federal Reserve makes it hard for individuals to accumulate capital; their savings are eroded by inflation. It's very easy for management of large corporations to raise capital; they can borrow at a negative real interest rate.

The income tax means that approximately 50% of the economy is directly stolen by the State. With 50% of the economy at their disposal, it's very easy for politically connected insiders to lobby the State for favors. If I work twice as hard and double my income, the bad guys get $1 more for every extra $1 I get!

Government regulations are effectively subsidies of large corporations. A large corporation can effectively amortize the cost of regulation compliance. For example, compliance with Sarbanes-Oxley costs a lot more for small corporations than large corporations, as a % of assets. Sarbanes-Oxley is effectively a tax on small corporations. As another example, consider State mandates for milk pasteurization. A large industrial milk farm can afford to buy its own milk pasteurization plant, and charge extortionate fees if small farmers want to use their plant. A small milk farm cannot afford its own milk pasteurization plant, and it pays monopolistic rent to use the large farm's plant.

Large corporations don't dominate because they're actually more efficient. Large corporations dominate because their management can most effectively lobby the State for favors. If I control a $5M business, then it doesn't pay for me to spend $1M bribing Congress for favors. If I control a $100B business, then I can easily afford to spend $10M bribing Congress for favors.

1 comment:

Anonymous said...

FSK, the "Economic Calculation Problem" is the basis of a famous prediction by Mises, that the socialism must fail. It did came true for USSR and some others.

Scary part is that it equally predicts the fall of USA, in as much as USA centralizes it's decision making that concerns economy.

Where it predicts that a large corporation is "weaker" than the smaller one, is simply an explanation of why capitalism can never reach the feared state where "everything is owned by few rich".

It is then the ignorance of the crowds, still, to this day not knowing about "Economic Calculation Problem" truth, that makes them the easy target for pro-corruption propaganda.

Then it is the democracy, that allows millions of ignoramuses to make enforceable decisions, that finalizes the tragedy of stupid democracy.

Is it really that hard to see it on a simpler level? Democracy is when the herd decides which way to stampede.

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