CHAPTER

81
Economic Planning and Mechanism Price Mechanism
INTRODUCTION
The price mechanism1 is a system of economic organisation in which each individual in his capacity as a consumer, producer and resource owner is engaged in economic activity with a large measure of freedom. It is related to a free market economy, where the factors of production are privately owned. Individuals are free to choose any occupation, to buy and sell goods and services from anyone and to anyone based on mutual benefit at prices determined by market forces. Ultimately the price mechanism leads to the maximization of efficiency and output through the equilibriating forces of demand and supply for goods and services. But the analysis of the price mechanism is based on certain restrictive assumptions: the existence of perfect competition of the product and factor markets; perfect knowledge about present and future price and non-price variables; the prevalence of constant returns to scale; the absence of external economies; perfect divisibility of capital; no changes in population and in the tastes, habits and fashions of consumers; and the maximization of profits by producers. Our main task is to find out the relevance of the price mechanism in the context of economic planning.

1. For detailed study of the role of Price Mechanism refer to authors Advanced Economic Theory, Ch. 5.

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PRICE MECHANISM IN A PLANNED ECONOMY The price mechanism is a distinguishing feature of a free market economy and hence it is contended that the price mechanism has little relevance in a planned economy. Under economic planning the various elements of the price mechanismcosts, prices and profitsare all planned and calculated by the planning authority in accordance with the targets of the plan. Thus in a planned economy rational economic calculation is impossible because unlike a free market economy the price mechanism is regulated and controlled. The various assumptions under which the price system works do not hold good under planning. This matter had been hotly debated from the beginning of the twenties. Prof. Ludvig von Mises was the first to declare that economic planning was doomed to failure in the absence of a free market mechanism. He was supported by Hayek and Robbins who held that to assign rational valuations to the means of production without private property might be logically conceivable, but it was practically impossible. Prof. Robbins wrote: On paper we can conceive this problem to be solved by a series of mathematical calculations, but in practice it is quite unworkable. It would necessitate the drawing up of millions of statistical tables based on many more millions of individual computations. By the time equations were solved, the information on which they were based would have become obsolete and they would need to be calculated again. Thus the price mechanism would be a farce under economic planning. On the other hand, Taylor, Lerner, Lange and many others have shown the working of the price mechanism under economic planning. According to Oskar Lange, The actual capitalist system is not one of perfect competition, it is one where oligopoly and monopolistic competition, prevail. This adds a much more powerful argument to the economists for economic planning, 2 and the price mechanism can be changed to meet requirements of the national plan. He points out that Mises failure to recognise a rational system under economic planning stems from his confusion regarding the true nature of prices in a socialist society. Prices may be determined by independent buyers and sellers or they may be an index of terms on which alternatives are offered. Mises errors in assuming that prices can be determined only in the former sense. Lange, therefore, does not agree that in the absence of a competitive market there is no practical method of discovering the right prices. He agrees with Taylor and asserts that the method of trial and error for determining accounting prices under a planned economy would need the solution of only those equations which relate to the consumers and the managers of production. The rational allocation of resources under economic planning in the light of a competitive market requires the satisfaction of three conditions of equilibrium. First, each producer and consumer must adjust his selling and buying in such a manner that he cannot add to either his income or his satisfactions. This is the subjective condition of equilibrium. Secondly, each price must be such that the total supply and demand for each commodity are equal. This is the objective condition of equilibrium. Thirdly, the income of consumers must equal their receipts from selling productive services plus profits. These three conditions are fulfilled by the parametric function of prices whereby each individual tries to adjust himself to the actual market price through the process of trial and error. The process of trial and error goes on until the objective condition of equilibrium is satisfied and equilibrium finally reached. Actually, it is historically given prices which serve as a basis, for the process of successive trial. For the satisfaction of these subjective and objective
2. On the Economic Theory of Socialism. Italics mine.

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conditions in a planned economy, the planning authority should lay down two rules for the guidance of plant managers: (i) each manager should combine productive goods and services in such a manner that the average cost of producing a given output is the minimum; and (ii) each manager should choose that scale of output which equalises marginal cost to prices. In a planned economy raw materials, machines and other inputs are sold by public enterprises at prices which are equal to their marginal cost of production. So pricing in a planned economy is based on marginal-cost pricing like that in a capitalist economy. If the price or marginal cost of commodity is above the average cost of production, 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 the industry would cut down production, and ultimately a position of equilibrium would be reached where price equals both average and marginal cost of production. Thus as pointed out by Lange, The rules of consistency of decision and of efficiency in carrying them out are in socialist economy exactly the same as those that govern the actual behaviour of entrepreneurs in a purely competitive market. But how can the 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 accordingly. This process will continue till the equilibrium position is reached. This leads to the rational allocation of resources and this is how price mechanism operates under economic planning. According to Lange, This trial and error procedure would or at least could, work much better in a socialist economy than in a competitive market. For the Central Planning Board has a much wider knowledge of what is going on in the whole economic system than any private entrepreneur can ever have, and consequently, may be able to reach the right equilibrium prices by a much shorter series by successive trials than a competitive market actually does. Thus, it is wrong to say that the price mechanism has no relevance in a planned economy. Rather, it works better in a planned economy than in a capitalist economy. The former is able to minimize the malallocation and wastage of resources associated with the working of the price mechanism under the latter. The planning authority being better equipped in locating mistakes, price-output fluctuations and in rectifying them, the economy is able to secure optimum utilisation and production of resources. Moreover, a planned economy brings about an optimum income distribution in the society. The price mechanism helps in achieving all this under economic planning in two ways. First, it serves as a basis of accountinga means to evaluate and compare cost of production and output based on accounting prices and costs. Secondly, it acts as an incentive to the people to do things in accordance with plan targets. Thus the role of the price mechanism in economic planning lies in assuring the maximum productive efficiency of the economy through proper cost accounting and in providing sufficient incentives to the people. PRICE MECHANISM IN AN UNDERDEVELOPED ECONOMY The price mechanism being closely associated with free market developed economies does not work properly in underdeveloped economies. There is little dispute over this. But economists differ over the role of the price mechanism under development planning. There is the view that the price mechanism should be allowed to operate in the interests of efficient resources allocation

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and for providing incentives to the people. The majority view holds that the price system is ineffective, unreliable and irrelevant for the solution of the complex problems faced by underdeveloped countries. The state should, therefore, assume control over the market system and change it in accordance with the targets of the national plan. It should use development planning to improve and strengthen the market mechanism rather than supplant it with overall controls. According to the first view, a properly functioning market system tends to stimulate both economic efficiency and economic growth in various ways. The availability of a variety of goods through the market stimulates the consumer to work harder in order to increase his income. The market system provides an incentive to entrepreneurs to innovate and invent to bring about technological improvements. Thus it leads to the accumulation of both human and physical capital. People acquire the critical skills in order to earn a higher reward and accumulate physical capital to earn higher profits. Besides, the price mechanism does all this automatically without requiring much of administrative interference. As an administrative instrument it is relatively cheap to operate in comparison with the costs and difficulties of controls under planning. Economists are, however, sceptical about reliance on the price mechanism to stimulate rapid economic development in under developed countries. The price mechanism is in a rudimentary form in such economies. It is too weak to bring about necessary changes required for rapid development. If such economies are left free to market forces they may lead to wide fluctuations and keep them stagnant. Investment decisions cannot, therefore, be left to the free working of the market forces. There are various reasons why the price mechanism does not function properly in underdeveloped countries. First, is the inelastic supply of products. When the demand for a product increases, its supply is unresponsive. The reasons are the small size of markets, lack of the means of transport and communication, lack of capital, intermediate goods and personnel with entrepreneurial, managerial and labour skills. Moreover, a decrease in price does not induce increases in demand for a given product because of the low level of income. Under the circumstances, producers in under developed countries know that even if they try to produce more at a price which seems attractive, they will saturate the market, the price will fall and they will lose. Thus the price mechanism performs poorly in such economies due to lack of social and economic overhead capital, intermediate goods and the small size of markets. Second, the price mechanism works imperfectly because of the ignorance and unfamiliarity with market mechanism in such economies. A large part of the economy comprises the nonmonetised sector where people are engaged in barter trade. They are not aware of the working of the market system. As a result, the price mechanism is not able to bring about an efficient resources allocation. Further, certain institutional factors are responsible for bringing about price distortions and retard the smooth operation of the price mechanism. The product, factor, money and capital market are not organised properly. Mostly peasants produce for subsistence and even when the marketable surplus is available it cannot be sold at remunerative prices due to lack of market organisation and intelligence. Trade in agricultural products is concentrated into the hands of a few intermediaries which is more akin to monopoly rather than perfect competition. In the factor market, wages are much lower in the non-organised agricultural sector while they are even higher than the opportunity cost of labour in the industrial sector where labour is organised in strong unions. Labour in these two categories assumes the nature of non-competing groups because the former is unskilled and the latter is skilled. In the money

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market, the market rate of interest is much higher than the bank rate. Rather, it varies over a wide range. It is very high in the rural sector where sufficient credit facilities are not available and the farmers have to depend upon the moneylender who enjoys a sort of monopoly. Where credit facilities are provided by the government in certain cases to agriculturists and small businesses for specific purposes, the rate of interest is modest. The capital market is unorganised and scattered which makes the transference of funds to productive channels difficult. Thus, due to distortions of the product, factor, money and capital markets the price mechanism does not operate properly in under-developed countries. Again underdeveloped countries are not free market economies. Here the government intervention is inevitable to push them off the dead centre of economic activity which obstructs the working of the price mechanism. The prices of products are controlled and regulated to adjust supplies to demand in order to avoid inflationary pressure. The government also fixes minimum wages in the case of sweated labour. Infant industries are provided protection through subsidies and import restrictions. So less efficient firms operate at higher costs and losses. Even consumers are required to pay higher price due to import restrictions on commodities. Certain enterprises are run as public undertakings whose commodity prices are fixed by the state. So the state plays a major role in making the price-mechanism inoperative in underdeveloped countries. Besides the market system leads to inequalities of income and wealth and the concentration of economic power in the hands of a few people. There also arise divergencies between social and private returns. Since the governments of underdeveloped countries aim at the reduction of inequalities of income and wealth, they put impediments on the working of the price mechanism. The above factors lead to the obvious conclusion that the price mechanism itself cannot bring about an equilibrium between aggregate demand and aggregate supply. It is unable to overcome structural rigidities and break the vicious circles operating in the underdeveloped countries. And finally, individual investment decisions cannot be relied to mobilise and utilise efficiently the available resources for accelerated development of the economy. As aptly put by Prof. Galbraith, The market cannot reach forward to take great strides when these are called for. As it cannot put a man in space so it cannot bring quickly into existence a steel industry where there was little or no steel making capacity before. Nor can it quickly create an integrated industrial plant. Above all, no one can be certain that it will do so in countries where development has lagged and where there is not only a need for development but an urgent demand that it occur promptly. To trust to the market is to take an unacceptable risk that nothing or too little, will happen. It is, therefore, contended that the market system should be controlled by deliberate state action in the form of economic planning to increase the rate of economic growth and to have an equitable distribution of income and wealth. There is, however, no need to dispense with the market system altogether as it is done in a centrally planned economy. Rather, development planning should improve and strengthen it in order to achieve the twin objects of the price mechanism under economic planningto serve as a basis of accounting and to provide an incentive to the people. This can be achieved in a mixed economy where the government formulates the development plan and creates the necessary conditions for development. It provides political and monetary stability, and economic and social overheads. Data about the available resources and development potentialities of the economy are made known. The targets to be achieved during the plan period are laid down. The financial resources for the plan are estimated. The state carries out investment itself, directly manages resources for production and even controls

prices of products and services. Last but not least, it facilitates, guides, controls and encourages private enterprises. A proper price mechanism is essential to calculate costs and prices of products and services and to provide incentives to both the public and private sectors of the economy. It is easy to invest in the required channels in the public sector in keeping with the plan targets and also to provide sufficient incentives. But to induce the private sector to invest and produce in accordance with the requirements of the plan, necessitates an appropriate price mechanism. Besides providing the necessary infrastructure in the form of social and economic overheads, the private sector may be given cheap credit facilities, rebates, subsidies, tax concessions. Moreover, divergencies, if any, between social and private returns can be offset by appropriate tax resources and subsidies. But the perfection of the market system through such measures cannot lead to economic equality and rapid development simultaneously. A just income distribution must follow rapid growth because too much emphasis on the reduction of income inequalities will retard development.3 Lastly, it is difficult nay impossible to forecast price changes when the elasticities are low in underdeveloped countries. It is, therefore, necessary to decide how much to rely on prices and how far to assume that the price system is ineffective so that planning authority must ensure that the economy will produce what is demanded at whatever prices. If the price system works to an extent, investment can concentrate on the most profitable enterprises and except the trimming and balancing to be undertaken by the planning authority.4 Such a decision, however, depends on the stage of economic development through which an underdeveloped country is passing. If it is in the early phase of development, the price mechanism is of little importance. The main problem is to increase the productive capacity of the economy and to evolve an exchange economy by state action. This will mean deliberately distorting the price and cost differentials and holding on to these distortions (as in the case of an effective protectionist policy or a farm support programme to increase the food supply) instead of letting the prices and costs be distorted by random imperfections of the market and short run and speculative factors associated with inflation and balance of payments difficulties. It implies strengthening the price mechanism where it is the weakest in the economy through economic planning. Ultimately, it is only when the economy has reached a higher stage of development that the price mechanism plays its dual role of providing highest efficiency through proper cost accounting and appropriate incentives under development planning. Thus rational economic planning must aim at enlarging markets and utilising for its purposes the price formation that takes place in the markets which are thus expanded.5

3. H.G. Johnson, Money, Trade and Economic Growth, 1962. 4. C.P. Kindleberger, Italics mine. 5. G. Myrdal, Economic Theory and Underdeveloped Regions, 1957.

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