Play Store Economics

Dr. Russell is a member of the staff of the Foundation for Economic Education and Director of the FEE School of Political Economy.

The "father of the Tennessee Val­ley Authority," Senator George Norris, once said: "A proposal from a great association of Ten­nessee says, in effect, ‘Let TVA property be subject to taxation the same as everybody else’s prop­erty.’… If we go to that extreme, Senators can see that the TVA would be out of business in three months."

Senator Norris was wrong. There is no more reason why the Tennessee Valley Authority should go broke with its annual real loss than there is that the United States Post Office must go out of business with its staggering yearly deficit. There is no necessary relationship in either instance be­tween their production costs and their selling prices. In fact, there can’t be any such relationship; for as we shall see, government plan­ners have no possible way of ever knowing the complete costs of their projects. Since they can’t calculate their full real costs, obviously they can’t set asking prices that are economically realistic. And since they can’t set realistic prices, the resulting allocation of scarce re­sources is necessarily inefficient.

I had read about this basic eco­nomic problem of "socialist cal­culation" in my college textbooks, but I never fully understood the arbitrary and unrealistic nature of nonmarket pricing and allocation of resources until I began "playing store" with my five-year-old son. We started our game by making a generous supply of price tags to correspond with the "play money" he already owned. Then he was given a roll of scotch tape and asked to put prices on all his merchandise, or scarce resources. And like any other manager who doesn’t have to worry about costs and prices that are set by com­petition in a market economy, my son’s price selections were remark­able.

In his enthusiasm for our game, the youngster had appropriated his mother’s jewelry box and priced all the items in it, along with his own toys. I quickly bought back her engagement ring for thirty cents. He was somewhat disappointed when I refused to buy a fascinating charm bracelet at $300. And he was completely heartbroken when I passed up his favorite cloth dog at $500.

Actually, the only reason you and I can understand my son’s unrealistic pricing is because we live in an economy in which prices (and the resulting allocation of resources) are still mostly deter­mined by competition and consum­er choice. If this were not so—if you and I lived in the arbitrary play world of socialist production and pricing—it is doubtful that we could do much better.

Without Market Guides, Pricing Must Be Arbitrary

Perhaps I shouldn’t have, but I decided to try to explain to that youngster about production costs and product prices and how they serve as guides for resource al­location (what to produce) in a market economy. But at age five, he didn’t understand my economic explanations—any more than do the adults who price electricity for the Tennessee Valley Author­ity or for similar projects in Russia.

In all three cases play store in my basement, communism in Russia, and socialism in Tennessee—the price setters always select whatever prices suit their whims at the moment. There is no auto­matic economic mechanism to de­cree otherwise. For even when the consumers are permitted a choice (and choose not to buy at all), this does not in any way neces­sarily affect the continued exist­ence of the government project. If the project were privately owned, however, of course it would go bankrupt and the re­sources would be converted to the production of a product more in demand by the consumers.

That engagement ring in my basement play store was a real bargain, as is electricity in Ten­nessee. For reasons I can only guess at, TVA electricity is priced well below the prevailing rates charged by privately owned com­panies in adjoining areas; the real cost of producing it, however, is considerably higher. How much higher, neither I nor the TVA managers have any positive way of knowing.

For example, the planners of TVA can never know the real or market value of the various pri­vate electric companies and lands they acquired by "eminent do­main" (or the threat thereof) when they moved into Tennessee with their philosophy of common ownership of the means of pro­ducing electricity. While our American courts still do the best they can in assigning prices to confiscated property, in the final analysis it is still an arbitrary decision. By its nature, the pro­cedure of judicial pricing of cap­ital assets is still necessarily somewhat similar to that followed by my five-year-old son in his play store, outside of the real mar­ket economy.

But in contrast to my young son, the managers of the Tennes­see Valley Authority claim they do use realistic cost accounting and a double-entry system of bookkeeping. Thus, from the very beginning, they were faced with the problem of what interest rate (if any) to charge against TVA for the arbitrarily selected capital expenditures finally recorded in their books as a cost of producing electricity.

Capital Costs

In a realistic market situation where persons are free to choose, this issue presents no pricing or allocation problem to a business­man; he records in the cost col­umn whatever it cost him to bor­row the capital. Even when the businessman uses his own capital instead of borrowing it, he knows that there is still a real "alternate opportunity" interest cost—that is, he could have loaned his capital to someone else at 5 per cent in­terest, with comparatively little risk of losing it. Thus, if a busi­nessman can’t earn more than the prevailing interest rate on the capital invested in his own busi­ness, clearly he has misallocated his resources; and he should choose another profession.

The managers of the Tennessee Valley Authority are not bound by this realistic market proce­dure. Even so, for some unknown reason, they did (and still do) re­cord a low interest charge against a small segment of the hundreds­-of-millions-of-dollars that were spent on the electrical part of that project. Why only a part, and why only at a rate that is well below the interest cost that even our largest private utilities must pay when they borrow money? Well, the decision was made on much the same basis that my five-year-old son decided to charge $500 for his toy dog; he could do as he pleased without fear of competi­tion or bankruptcy in his play store, and that happened to be what pleased him at the moment. He doubtless had his reasons, just as the managers of the Tennessee Valley Authority had their rea­sons for their actions, including their recent and confusing pro­cedure of selling revenue bonds that are necessarily guaranteed by the taxing powers of the fed­eral government of which TVA is a department. That "solution" proves nothing about the economic merit of TVA; it merely measures the purchaser’s appraisal of the government’s ability to collect taxes.

Also, it never entered my son’s mind to charge a price that would cover the rent on the house in which he was playing store—just as our government officials gave no consideration whatever to the cost of the unknown millions of man-hours of labor that were ex­pended by various other govern­ment departments and agencies on the Tennessee Valley Authority. Yet, someone paid—and is still paying—that unknown and unre­corded cost.

In their efforts to convince the American people that government ownership is cheaper and more productive than private ownership, the planners of the Tennessee Valley Authority decided that TVA should not pay taxes to the federal government, or even record the existence of such a social cost. Why? 1 don’t know.

The Taxpayer Is Liable

In a socialist economic system—and in a basement play store—it doesn’t really make much dif­ference one way or the other. What­ever the taxes and interest cost of the capital are or should be—and regardless of whether or not those costs are recorded—the price of the product is still always whatever the planners want it to be. There is absolutely nothing in a socialist economy, either in the­ory or practice, to decree other­wise.

If you write to the Tennessee Valley Authority and ask them if their rates for electricity can be used as a valid measurement for the rates charged by private com­panies, the reply will be, in effect, "Certainly." Ordinarily, that reply will be sent to you in a franked envelope! No government enter­prise ever has to worry about in­creases in the cost of postage or taxes. Nor must they fret about securing additional capital; they have a seemingly inexhaustible source (you, the taxpayer) at ab­solutely no cost or risk to any manager of a socialized project.

Actually, this is not the fault of the managers of government proj­ects, either in Tennessee or Russia. For even if they did want to re­cord the full cost, there just isn’t any realistic way to determine it for a project that is backed by the taxing and police powers of gov­ernment. The very best that the manager of such a command op­eration can do is to observe what the costs are for similar products and services in a competitive mar­ket of investor and consumer choice, and then record similar costs against the government project. To some extent, TVA has followed that procedure. But in a totally socialized world, the econ­omy would degenerate into utter chaos in the relatively few years it would take the managers to for­get the realistic relationships be­tween costs and prices that had served to allocate resources in the once free market.

No Basis for Comparison

If you doubt this, imagine that the entire world has finally been organized on the Russian, Chinese, Tennessee Valley Authority idea of government ownership and op­eration of the means of production—all production. And imagine that, as has been the case in Rus­sia for many years, no person can own or sell or rent land, machin­ery, or any other capital equip­ment. Literally, there is not (and cannot be) a market price for any of them under their economic sys­tem. Now imagine that you are suddenly in charge of allocating the vacant land in a large city to its most productive use—that is, to the use that will satisfy the most urgently felt wants of con­sumers in general.

Since your decision as "chief land allocator" must necessarily be made arbitrarily and without consulting the consumers, will you choose to allocate the land to office buildings or to the growing of beets? Office buildings, you say? Well, why? In the absence of a market for land and capital, how can you know that the consumers (the people in general) would rath­er have the land used for office buildings than beets? The land is not for sale or rent in a socialized economy where private ownership and use are automatically forbid­den. Thus no one can bid on it for those or any other uses. And thus there is no rational or effective economic mechanism that consum­ers can use to inform the planners of their preferences.

In a market economy of private ownership, however, the most de­sirable use for the land (and oth­er means of production) can be, and is, quickly decided by the highest bidder. If the beet grower outbids the office builder, the land is used for beets. If he has mis­calculated and can’t at least cover his total costs by the sale of his product to willing buyers who have freedom of choice, he goes broke—and some other person who is searching for profit-mak­ing opportunities replaces him and produces whatever product he thinks the consumers will buy. Thus the consumers, by their buy­ing or abstention from buying, will make sure that the land is used for a purpose that pleases them.

But under total socialism, there is no price and no market for any capital good, including land. No person is free to produce what he thinks the consumers would pre­fer. Thus all land, all natural re­sources, all building materials, and all capital of any description must be arbitrarily assigned to whatever purpose happens to please the planner. Literally, there is no other alternative in a com­mand economy.

Even when prices are assigned to the final products that consum­ers are permitted to buy (as is now generally the practice in Rus­sia), this does not determine the amount or type of production. While the Russian planners some­times double consumer prices overnight, or even cut them in half, those political maneuvers and whims have no bearing at all on what will be included in the next five-year plan. Those deci­sions are made on other grounds.

Anyone’s Guess

In a market economy, however, a price rise is a signal to consum­ers to consume less of that prod­uct, and to producers to produce more of it. But under government ownership, prices are always arbi­trary and usually capricious. Un­der socialism, prices serve merely as a distribution device that the planners have found easier to ad­minister than a system of ration coupons. In the final analysis, they have no choice but to assign the prices somewhat as my five-year-old youngster set them in his play store.

Again, this is not the fault of any particular socialist. By its nature, government ownership and production cannot possibly operate in any way except arbitrarily. That’s why the Russian govern­ment assigns, or knowingly per­mits, a considerable amount of vegetable farming to be done with­in the city limits of Moscow, by persons who still live in log cabins.

My guess (based on the real ac­tions of producers and consumers in a market economy) is that farm­ing would not be done in Moscow, if the land were privately owned and if producers and consumers had a real choice in the matter. I will also guess that those log cab­ins without plumbing would have disappeared long ago in a free market. But I’ll admit it’s only a guess; for no one can possibly know how the land and building resources in Moscow would have been allocated by a free people, freely choosing.

Nor can we positively know that the once-privately-owned steam generating plants in Tennessee would have continued forever to be the cheapest and most efficient way to produce electricity. The evidence is clear, however, that steam was generally cheaper than hydro when our American plan­ners forced the change from one to the other. The incontestable proof of it is that private inves­tors who were searching for the lowest production costs—and thus the highest profits—almost al­ways chose steam generation in Tennessee.

Change by Decree

The only possible way to find rational answers to economic ques­tions such as these is to put the resources up for sale and see how the buyers use them. The reason that "apartment and office" type land in Moscow is still used for vegetable production is because the government officials just hap­pen to want it used for that pur­pose. The fact that, economically speaking, such arbitrary allocation of resources is probably irrational should surprise no one. It can’t very well be otherwise. But even the communist planners are finally reaching the conclusion that the construction of most of those mammoth hydroelectric projects all across Russia was a serious misallocation of scarce resources that could have been better used for other purposes.

Nikita Khrushchev and his Min­ister of Power for Plant Construc­tion, I. T. Novikov, recently de­creed that future emphasis in so­cialist planning will be on steam generators rather than hydro­electric construction. Perhaps they were influenced somewhat by Pro­fessor Z. F. Chukhanov (Corre­sponding Member of the USSR Academy of Sciences) and various other Russian economists who are increasingly inching toward the market economy processes. In a publication approved by the Rus­sian government,’ Mr. Chukhanov recently claimed that the com­munist hydroelectric program has been a waste of billions of rubles’ worth of resources because of the planners’ failure to charge against those projects the total "social costs" involved. Marxian dogma forced him to use the euphemism "social costs" for the economic realities that, in a market econ­omy, are determined by interest, profits, and other allocation guide­posts that have been repudiated in communist theory.

Does Professor Chukhanov real­ly know that those hydroelectric projects have been a waste of re­sources? No, he is only guessing. All he really said is that if he were running that arbitrary play store economy, he would do it dif­ferently. And he then advanced still another arbitrary "mathe­matical solution" to the economic problem of how to allocate scarce resources to their most efficient uses in a nonmarket economy.

The only thing that can be said in favor of his particular addition to the "simultaneous equations" and similar mathematical ap­proaches is that his is at least understandable. In effect, he claims that the industry that is allocated the most capital for expansion should be charged the highest "social cost"—that is, alternate opportunity cost, or interest in the broadest sense. For example, he points out that hydroelectric ca­pacity has been increasing at an annual rate of 13 per cent in Rus­sia. He then arbitrarily recom­mends that 13 per cent of the total new investment in hydroelectric construction should be recorded as an additional charge against that industry as a proper cost of capi­tal, or "social cost." That’s a pret­ty steep rate of interest! Is 13 per cent a rational guess as to the real cost of capital in Russia? No one knows, including Professor Chuk­hanov.

Anyway, even if his scheme is adopted by the Russian central planning board, that unusually high rate of return cannot attract new capital into electricity pro­duction; investment decisions in Russia are made arbitrarily by the planners, and for reasons that are seldom concerned with return on capital. Thus, their capital or re­source allocations cannot possibly be any more rational than are the decisions by our own United States planners to build more dams to water more deserts to grow more food to be bought by more govern­ment agents to be stored in more subsidized and surplus ships. Prices and costs and economic reality are no more related in those schemes than they were in that basement play store that was so happily presided over by my five-year-old son.

Refer to the Market

In several of his speeches over the past four years, Mr. Khrush­chev has casually identified the only possible way by which his planners can rationally allocate re­sources in a socialist economy—that is, by observing what hap­pens in the nonsocialist economies and then following along behind. For example, he recently pointed out that private investors in the United States have been investing less capital in steel production and more capital in the production of plastics. So, announced Mr. Khrushchev, the Russian planners will do likewise.2

A Most Tricky Problem

But suppose there were no mar­ket economy for him to observe? How could he then possibly know which should have priority? To that question, an economist friend of mine once replied: "All this nonsense about the socialist plan­ners being unable to make ra­tional economic calculations is just that—nonsense. Why, all they need do to determine real prices, and thus to have a rational guide for allocating resources, is to add up their costs and then price the products accordingly."

Astoundingly enough, that econ­omist seems unaware that a cost is always a price, and that it is impossible to add up prices that don’t exist in order to determine what an asking price should be.

Another person once said to me:

"The Russian planners can always assign prices to their consumer products and then work back­wards in order to establish rela­tive costs, and thus to properly allocate their basic resources." But since those arbitrarily assigned consumer prices could not possibly be related to land and capital costs in the first place, it is astounding to imagine that they can be re­lated in the second place.

A graduate student of mine once wrote: "But the socialist managers could act like competi­tion existed. In that way, free market-type prices could be de­termined, and thus resources could be allocated in much the same way as in a market economy." As a young idealist, perhaps that student shouldn’t be expected to understand that persons never "act like" in real life; they always choose among the realities that face them. It is hardly surprising that socialist managers choose to do what they are told to do.

In short, the mental processes of the intelligentsia in the United States have been so conditioned by realistic free market procedures that most of us are incapable of even thinking about the idea of an economic system without an automatic pricing mechanism to allocate scarce resources and to determine what will and will not be produced.

As another of many examples of unrealistic socialist play store economics, the Russian planners have generally neglected to record a difference in land value (rent) between a factory in the middle of Moscow and a similar factory in distant Siberia. Under govern­ment ownership and socialist pro­duction, there can be no such thing as a realistic rental price to serve as a guide for the best use of land. But the only way you and I can know that such socialist practices are economically irrational is be­cause we can compare the results against those of the market econ­omy of choice. Otherwise, we too might well imagine that the area around Broadway and Wall Street should be allocated to the growing of wheat. Why not? After all, it is closer to the New York market than is Kansas. And as the so­cialist planners are quick to point out, everyone already knows that food is more important than office buildings. So there is no particu­lar need to consult the consumers about it.

Signs of Recognition

Since, under a socialist system, I couldn’t do any better than the communist planners, I can only marvel that the Russian level of living is perhaps as much as one-third of our own. The only way I can account for any economic progress there at all is to assume that the Russian planners gener­ally base their "play store" cost accounting and production prac­tices on the realistic costs and prices set in the comparatively free markets that still exist in most nations.

In fact, a direct and unusual admission of this procedure has recently been published by two leading professors of the Central Planning School in Poland.^³ They first explain that the customary allocation of resources in socialist nations is done by what they call "direct economic calculation"—that is, by the "technical coordina­tion" of specific machines, raw materials, and labor to produce whatever it is the Central Plan­ning Board wants produced. While prices are usually arbitrarily as­signed to these resources after they have been allocated, they play no part whatever in determining what will be produced. Then the two planning professors said: "The best methods of producing a given output cannot be chosen [by this socialist direct economic cal­culation] but are taken from out­side the system…. i.e., methods of production used in the past, or so-called ‘advanced’ methods of production, usually taken from the practice of more advanced coun­tries and used as data for plan-building by the [socialist] country under consideration."

Well, there you have it, directly from the communist planners themselves—they base their cal­culations on the data supplied by free market nations. (Since they refer to "so-called advanced meth­ods" in a derogatory sense, obvi­ously the reference is not to Rus­sia.) True enough, by "trial and error" procedures, the planners can learn from their own mistakes that one way of producing some­thing is technically more efficient than another way. But since con­sumers have no choice in the mat­ter, the planners can never really know if the particular project it­self represents the best or most efficient use of the resources in the first place. Only a market econ­omy can supply that type of in­formation.

If the socialists ever take over the entire world, let us hope they will be intelligent enough to leave one country with a market econ­omy of private ownership where­in consumers can direct production and allocation of resources by their buying and abstention from buying. Otherwise, the planners soon will be faced with the baf­fling problem in a socialist world of whether or not to allocate plat­inum to the production of nose rings for pigs. But, of course, if socialists were intelligent enough to understand the vital need for some rational, uncoerced, and auto­matic way to allocate resources according to consumer prefer­ences, they wouldn’t be planners in the first place.

Why Not Make It Free?

And so it is with our own Ten­nessee Valley Authority. That project has unquestionably been a fearful waste of scarce re­sources, and probably still is. But some considerable semblance of reality exists in its bookkeeping and production procedures because the managers can still be guided in their decisions by the prices for the products and services they buy in the market economy around them. They know what privately owned electric companies pay for labor and equipment, as well as what they charge for electricity. Thus, the TVA managers have a realistic guide for setting their own rates. The fact that they choose to set their rates consider­ably lower than the rates of pri­vate companies is hardly surpris­ing; after all, that was the pur­pose for building the project in the first place. They could just as well have set them at five times the prevailing rate, or at one-half the prevailing rate, or made it free.

It wouldn’t make any real difference because there is no necessary relationship between their costs and prices anyway.

True enough, their prices are doubtless more realistic than my son’s price of thirty cents for his mother’s engagement ring. But we can’t know how much more real­istic since consumers and inves­tors have no real choice concern­ing TVA policies in practice. At least my son couldn’t force me to pay $500 for his favorite toy. But I have no choice at all about pay­ing whatever the government says I must pay as my share of the cost of the Tennessee Valley Authority that we all own in com­mon.

But, it might be said, the na­tives in Tennessee are quite hap­py with their low rates and lovely lakes. I have no reason to doubt that claim. And when my son’s playmates heard about his store, they were happy indeed to give him their business—especially when he most generously sup­plied many of them with the "money" with which to buy the stuff. When I put a sudden stop to that popular practice, various childish voices accused me of be­ing mean. Fortunately, however, their parents understood my ac­tions when I closed down that bar­gain basement. But when I tried to explain to the parents them­selves that perhaps the same eco­nomic and moral principles apply to various similar government projects, most of them immediately joined their children in call­ing me mean.

In fact, one parent decided to set me straight with this obser­vation: "You claim that the so­cialist planners are necessarily less efficient than private owners in a market economy. Then how do you explain the fact that the Russian planners put the first man into space?"

Shoot the Moon!

There are several possible an­swers, including the obvious one that this man-in-space program is also a socialized project here in the United States. So perhaps it could be said that the Russians are still better socialists than we Americans, although we are catch­ing up fast.

I have already explained as best I can how the Russians take full advantage of all the production and allocating processes of the market economies that still exist in most of the world. In addition, in many respects the Russians now appear to be increasingly inching toward the competitive market processes within their own economy. For example, the pro­posal by Professor Y. G. Liber­man of Kharkov Engineering and Economics Institute that "profits" should be the primary yardstick for judging factory efficiency is now being openly discussed among Russian officials. I don’t quite see how they can install and man­age a realistic profit system in a socialist economy. But if they can do it even partially, that market guidepost will naturally insure more and better production in Russia.

Even so, our comparatively free market economy is, on the whole, still vastly more efficient than the Russian planned economy. Based on their obvious and easily ob­servable inferiority in housing, food, clothing, transportation, and such, perhaps our economy is as much as 50 per cent more efficient, although the figure might be 30 or 70 per cent. Thus, if the Rus­sians wish to excel us in any given area, they simply allocate two or three times as much labor and capital as we do to the selected project. In the area of rockets and the training of scientists, it seems reasonably certain that they have followed that procedure. Thus, they are seemingly ahead of us in the space race—at the alternate opportunity or social cost of a lev­el of living for the Russian people that is only about one-third of our own.

Finally, in no sense is my dis­cussion of this issue to be taken as an "attack" against the persons in charge of these various social­ized projects—either in Russia or Tennessee. To the best of my knowledge, the management of the Tennessee Valley Authority is comparatively good. Actually, I don’t know who the managers of any of these projects are, in Ten­nessee or elsewhere. Nor do I care. I am here discussing an idea. Fur­ther, I assume that in case of war with Russia, the managers of the Tennessee Valley Authority will be as willing to fight and die for our country as you and I are. Unfor­tunately, however, the vital issue of the controlled economy versus the market economy will probably be decided long before that battle is ever joined—and then it will be too late; for in the long run, it is ideas (not battles) that de­cide the fate of mankind.

If the Tennessee Valley Author­ity represents the best system for the production of electricity, we have no real quarrel with the Rus­sian socialists, and a war would be rather pointless. But if private ownership of the means of produc­tion is preferable, then we do have a real issue—not so much with the Russians as with the millions of sincere and patriotic Ameri­cans who are happily choosing the controlled economy of democratic socialism instead of the market economy of private ownership.

—FOOTNOTES—

1 Teploenergetika, No. 12, pp. 7-12, 1961.

2 The Wall Street Journal, article by Edmund Faltermayer, March 4, 1963.

³ Aleksy Wakar and Janusz Zielinski, "Socialist Operational Price Systems," The Journal of the American Economic Association, March, 1963, p. 109.