as / THE WINDS OF CHA.

\GE: THE TRIUMPH OF THE MARKET 391

One approach to reforms, then, would retain the kev elements of the command economy, but improve the precision of its commands.
At the other pole are those who press for greater decentralization of decision making. This group
stresses that a modem economy is too complex to be directed by a bureaucracy out of touch with
production and consumers. They warn that the use of quantitative targets, such as output, leads
to distortions and that distortions are worsened when con- sumers and producers face prices on
goods that are unrelated to the social scarcity of these goods. A clear statement of the new view
of the market came in the "Abalkin Report" of the Soviet deputy prime minister in late 1989: [T]he
main features of the model of a new economic svstem are ... the use of the market as the main
form of coordinating the activities of the participants in production. We have become convinced
on the basis of our own experience that there is no worthy alternative to the market mechanism
as the method of coordinating the activities and interests of the economic sub- jects.
But stating the goal was not enough. To make the difficult transition from Marx to market would
require both political will and the economic wisdom to take the necessary steps.
Strategies for Transition
A cruel joke heard in Eastern Europe is "Question: What is socialism? Answer: The longest road
from capitalism to capitalism." Having decided to take the road back to a market economy, a
command economy must remove barriers that hinder the growth of the market. Among the major
obstacles on the road to reform are the following:
Price reform and free-market pricing. Prices of both inputs and outputs are often far from what they
would be were they market-determined. Food and housing are heavily subsidized, while
automobiles and consumer durables sell for more than twice world price levels. Sooner or later,
prices must be freely determined by supply and demand.
J Hard budget constraints. Soviet-style enterprises operate with "soft budget constraints," a term
signifying that operating losses are covered by subsidies and do not lead to bankruptcy. In a
market economy, firms must be fiscally responsible. Enterprises must know that unprofitability
ultimately means economic bankruptcy for the fiim and economic ruin for the managers.
Privatization. In market economies, output is primarily produced in private firms; in the United
States, for example, only 3 percent of GNP is produced by the federal government. In socialist
countries, by contrast, between 80 and 90 percent of output is produced by the state. Moving to
the market will require that the actual decisions about buying, selling, pricing, producing,
borrowing, and lending must be made by private agents.
Other important tasks of the transition will be to set up the legal framework for a market, to
establish a modern banking system, to break up the pervasive monopolies, to tighten monetary and
fiscal policy in order to prevent a runaway inflation, to open up the economy to international
competition, and to allow the domestic currency to be convertible into foreign currencies. Clearly,
reformers in the Soviet-style economies have a big job to do.
One other critical question concerns the sequencing of the transition. Where should reformers begin?
The reform debate is currently divided into two camps: the radical (or "big-bang" approach) and the
gradual or step-by-step approach. The big- bang approach was tried in Poland in January 1990, when
the Polish government removed controls on most prices and opened the economy to foreign trade.
While it is too early to judge the success of the Polish experiment, many observers believe that it
has reinvigorated the economy and introduced market forces. At the same time, rising unemploy ment, declining real wages, and a disruption of economic life have led to increasing disillusionment
with a market economy in Poland.
A more cautious approach is step-by-step reform, which separates the transition into different
phases. Advocates of this approach would begin by creating the legal framework for the market (law
on property, law on bankruptcy, etc.). The next phase would include such steps as reducing the
budget deficit, reforming prices, and closing unprofitable enterprises. The final step would be to free
prices and introduce foreign competition and currency convertibility.
The step-by-step approach has been adopted by the Soviet Union and most other Eastern European
countries. In the early years of perestroika (restructuring) under President Gorbachev, from 1985
392 EFFICIENCY, EQUITY, AND GOVERNMENT

1990, Soviet reforms were piecemeal and achieved very little. Under pressure from a deteriorating economy and
from his political opposition, particularly Russian President Yeltsin, a group of radical economists, led by Stanislav
Shatalin, proposed a "500-day plan." Under the 500-day plan, the Soviet Union would turn much of the power of
the central government over to the republics and would introduce a market in a whirlwind 500 days.

The Soviet government came to the brink of this radical reform in the fall of 1990 and then retreated. The
power of the entrenched management, party, and other vested interests was too strong to allow a revolution
from above. The transition to the market slowed and the Soviet economy continued to deteriorate through
1991.10 In August of 1991, an abortive coup d'6tat by the supporters of the old system led to an overthrow of the
Communist Party and a rejection of centralized planning. Democratic and republican forces took over both the
governments and the program for economic reform. By the end of 1991, the prospect for a center-designed
reform appeared slight, and the several republics were charting their own course. In a sense, the 500-Day plan
was precipitated by an inept coup.
Outlook for Reform. Reforms in socialist countries are in their infancy, and it will be many years before we can
evaluate the results. A sober assessment of the chances for success finds many pitfalls along the road to the
market. To begin with, things may get worse before they get better. A command economy is a delicately
balanced web of interests and classes. A thoroughgoing reform will disrupt the normal channels of commerce and
may actually slow economic growth for a time. There will be strong resistance from the entrenched bureaucracy
striving to maintain its economic power. Past reform efforts have always been laid low by central planners.
Moreover, the journey from Marx to market is heading into uncharted waters. The transition from a centrally
planned economy to a market economy is without precedent in economic history. We do not know whether the
transition will trigger instabilities, high unemployment, rapid inflation, or political revolt.
The stakes are enormous for the Soviet Union, as is noted by one study of the Gorbachev reforms:
Gorbachev confronts an unpleasant dilemma. Without a radical economic and political upheaval, the Soviet
Union will probably be unable to sustain its economic power. . . . Essential to such an upheaval, however, is a
decision to slash Soviet military expenditures and divert more resources to decentralized consumption and
innovation, but this in turn will force, at the very least, a temporary reduction of military might and prestige... .
Moreover, there is always the chance that, in the process of doing all this, Gorbachev will fail in bringing about
economic reform but succeed in relegating the Soviet Union to a lesser military and political position."
With this analysis of the economic reform movement, we conclude our discussion of alternative economic
systems. And, indeed, the circle is closed, for we see that reform stems from the need to confront economic
scarcity and to face the age- old dilemma of guns versus butter. No lesson could better illustrate the central
tenet of economics that scarcity and the limitation of economic goods is pervasive no matter what the form of
economi organization.
A. Evolution of Economic Thought
1. Growing from roots in nationalist and protectionist mercantilism, political economy as a discipline
began with the classical economists: Adam Smith, whose invisible-hand doctrine proclaimed a beneficial
natural order in the price system and who severely criticized government interference in the

marketplace; and Malthus and Ricardo, the gloomy prophets of diminishing returns and of
the struggle over distribution of limited social income among the wage workers, landowners,
and profit-seeking capitalists.
2.Flagging classicism gave way a century ago to neoclassical economics, which provided a
synthesis of utility and costs, marginalism extended beyond Ricardian rent analysis to all
factors of production, and modern welfare economics studying government policies for
changing the income distribution or for correcting microeconomic inefficiencies.
3.
The Keynesian revolution added to the microeconomics of neoclassical economics an
overdue macroeconomics that eventually synthesized fiscal and monetary analysis.
4.Important counterweights to modern mainstream economics have come from both left and
right. Conservative libertarian critics stress that planning and government intervention
imperil personal freedoms along with economic efficiency, while rational-expectations
macroeconomists argue that systematic policies cannot cure business cycles. Galbraithian
iconoclasm holds that consumer tastes are shaped by advertising, while others fret over
corpocracy that weakens innovativeness in large businesses. Radical economists denounce
inequality, pollution, and imperialism.
B. .Alternative Economic Systems
5.In reaction to the periodic crises and depressions of capitalism, critics have spawned "isms"
of the Marxist, socialist, and communist varieties.
6.The Marxian offshoot from Ricardian classicism has played a pivotal role in intellectual and
political histoiy. Scientific socialism purports to predict the laws of motion of capitalism:

exploitation and pauperization, class struggle and class-conditioned ideology, imperialism,

cyclical crises, and ultimate proletarian victory.
7.Socialism is a middle ground between capitalism and communism, stressing government
ownership of the means of production, planning by the state, income redistribution, and
peaceful transition to a new world.
8.Historically, Marxism took its deepest roots in semifeudal Russia. A study of the what, how,
and for whom of the Soviet-style command economy shows a much greater central planning
of broad elements of resource allocation (particularly the emphasis on defense, a high rate
of investment, and rapid industrialization). The Soviet economy grew rapidly in its early
decades, but recent stagnation leaves a large gap between the standards of living of the
U.S.S.R. and those of advanced capitalist countries.
9.Faced with slowing economic growth and the desire for economic reform, the Soviet Union
and other Eastern European countries pondered the decision about whether to adopt the
market mechanism. The transition faces many obstacles, such as soft budget constraints,
frozen and distorted prices, and an inadequate legal framework. Two major transition
strategies are the big-bang approach of multiple simultaneous measures and the more cautious step-by-step approach in which reforms would be sequenced to prevent disruption.
Political opposition and worsening shortages may not allow the luxury of prudent planning of
the transition.
CONCEPTS FOR REVIEW
Economic thought

mercantilism Adam Smith:

attack on government
espousal of the invisible hand
Kicardian diminishing returns, class conflicts
neoclassical economics
Chicago School libertarianism
radical economics today
Marxist laws of economic evolution
Alternative economic systems

socialism, communism, Marxism

Soviet-style command economy what, how, for whom "in the
command economy two poles of socialist reform obstacles to the market step-by-step vs. bigbang reforms
QUESTIONS FOR DISCUSSION

10.
Make a list of the key alternative economic systems, describing each and its history.
11.
Analyze the way that what, how, and for whom are solved in a Soviet-style command
economy, and compare your analysis with the solution of the three central questions in a market
economy.
12.
Which parts of a modern American economics textbook would be wellor badlyreceived
by socialist thinkers?
13.
Libertarian economists argue that the government should not regulate the quality of drugs,
require seat belts, or have speed limits on highways. Devise the kind of argument a libertarian
might use to support such views. Construct some opposing arguments.
14.
Review the list of reservations that libertarians lodge against government interferences in
the modern mixed economy (page 379). In your view, which of these interferences expand and
which reduce economic freedoms? On which would you agree with Friedman's opposition?
15.
Consider the Soviet-style command and the American economic models. What are the
strong or weak points of each in the following tasks?
2. Setting a high ratio of investment to GNP
3. Matching shoe sizes or colors with consumer tastes
4. Controlling inflation and unemployment
5. Inventing new products or processes
16.
Prices and profits play a central role in the allocation of resources in a market economy;
explain briefly. Then contrast their role in a Soviet-style command economy.
17.
Make a list of differences between a market economy and a Soviet-style command
economy. For each of the differences, consider how an economic reformer might modify the
command economy to introduce supply, and-demand determination of prices, incomes, and
outputs.

18.
Advanced problem: The basic technique of Soviet- style central planning is material
balances. Under this technique, the total demand of each commodity is lin principle) adjusted to
equal the total supply. More precisely, demands are set so that the sum of all demands for
intermediate goods (e.g., corn for seed) plus final demands (e.g., corn for muffins) is equal to the
supplies (e.g., production, imports, and decline in inventories of corn).
Recalling the principles of efficient allocation of resources (particularly those in Chapters 9 and
17), evaluate whether a material-balances plan ensures the achievement of allocative efficiency.
[Hints: Draw a marginal cost-based supply curve and a marginal utility-based demand diagram.
Choose an arbitrary level of output, and assume this is sold at the price where output is equal to
quantity demanded (i.e., the price is determined by the intersection of the planner's quantity
with the demand cuive). Does MC = MU .Can you see anything in the material-balancing
tech:nique that satisfies the fundamental conditions for allocative efficiency?) Does your analysis
suggest why Soviet economists have criticized central planning and propose to introduce
markets as a way of improving resource allocation?