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POLSIS, School of Government & Society (College of Social Sciences) Student ID No. (srn): Programme of study: Year of study: Module title: Module banner code: Module leader: Seminar teacher: Submission date: Assignment title: Extension: Extension approved by: 1185243 Bsc Economics 3 The Russian Economy From Plan to Market A Richard Connolly 17/12/2013 Essay 1 Describe and assess the role of prices in the functioning of the Soviet economy yes / no date approved: new date:

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Describe and assess the role of prices in the functioning of the Soviet economy

1185243 Bsc Economics Module: The Russian Economy: From Plan to Market Tutor: Richard Connolly Word Count: 2061

The Soviet Union followed the doctrine of Karl Marx. The inevitable eventuality of conflict between the different tranches of class within society in a capitalist state was believed to establish, in the long run, a communist stage of social development. Within this communist economy, the role of prices greatly differed between that of Adam Smiths traditional free markets. The free market used price as a medium in order to coordinate the relative scarcities of resources and products from the interplay of supply and demand, whereas the command economy simply did not. Price in the communist command economy in its simplest form was merely a unit of accounting; price was not the by-product from the interaction between supply and demand, but arose from the minds of planners situated in the upper echelons of the Soviet hierarchy. The nature of this insinuated that relative prices in fact did not reflect relative scarcities, but were arbitrarily set, with no real sound economic rationale behind it. The differentiated role of price had implications that were multi-faceted; this essay will introduce four main points of the nature of prices within the Soviet Union. The first will provide an overview of the decisions of the firm and their allocation choices in the face of, what Kornai called, the soft budget constraint. Section two will look at, not the producer, but the consumer, and prices relating to them. The third will dissect the manifestations of inflation, and the fourth and final section will look at the role of the second economy. The soft budget-constraint syndrome, a concept formulated by Kornai (1979), pertains wherever a funding source such as the State, finds it impossible to keep an enterprise to a fixed budget (Maskin 1996). The softening of the budget constraint appears when the strict relationship between expenditure over earnings has been relaxed, because excess expenditure over earnings will be paid by some other institution, typically by the state; the centralised economies of the Soviet Union were prevalent with soft budget constraints, as Kornai compellingly established. Although the maximization of profits were on the agenda of state owned enterprises, the Marxist ideologies of full employment meant that the collapse of the even the chronic loss makers was not permitted. (Kornai et al 2003) Moreover the general principle of producing at the margin was not present in Soviet production techniques, alternatively the preferred method of Soviet production was to take average costs, therefore inefficient and below average firms were prevalent in the market, meaning there existed a great number of subsidies, not only from the state but as transfer payments from more successful, above average cost producing firms also. The nature of these transfer payments from both the state, and fellow firms meant that prices did not measure enterprise efficiency, nor did the presence or absence of profits have much operational significance for enterprise. Consequently, the significance of Kornais soft budget constraint is that the firms survival does not depend on the market (and subsequently prices), but in the frames of bureaucratic coordination and financial bargaining with authorities; the priorities of planners reign supreme in determining the allocation of resources. (Kornai 1992).

Furthermore with the relevant authorities readily available to step in to close the gap between revenues and costs in inefficient firms, firms have little to no incentive to innovate and improve their production techniques; the motivation to continually drive down costs and increase efficiency does not have its root deeply planted in the psyche of Soviet firms thus leading to poor levels of betterment and advancements. Also, without knowing relative prices, enterprise managers may find it difficult when choosing inputs and thus make less than adequate capital investment decisions, again another factor that ultimately results in low growth prospects for firms. Taking GNP per employed worker as a rough gauge of relative levels of technological development, we find that in 1987 the level of the USSR and Eastern Europe combined was about half that of the major OECD countries as a group; it was about 56 percent in 1960. (Schroeder 1989) The literature of Qian and Xu (1991) also touch upon this subject and remark that the relatively poor performance of the Soviet Union in developing new technology is another implication of this kind of soft budget constraint. (Maskin 1996) Following the revolution, the Soviet government strove to distribute resources equally by eliminating the bourgeois capitalist lifestyle and values. The prices of goods deemed particularly desirable from the viewpoint were kept artificially low to benefit the common citizen. Retail prices were very rarely altered. The Soviet Union used a so called dual price system in order to insulate the price of consumer goods from the influence of production costs by a turnover tax; consumers face a hard budget constraint unlike the soft alternative for producers, therefore are more responsive to relative prices and consumer price policy strongly influences households. The turnover tax mentioned previously was set in place to redistribute income. Accordingly there was a tax to raise the price of luxury goods in order to fund subsidies placed on staple goods. Consequently consumer prices artificially lowered via the use of subsidies produced an excessive growth in demand; chronic shortages are the result as supply cannot keep pace (Kornai 1992). In essence price distortions are set in place to try and adhere to official ideology of the classical system, however the result is the opposite, instead of satisfying the basic needs of the population, the nation was somewhat deprived of their basic needs through the lack of supply. The nature of inflation was somewhat different in the Soviet economy compared to any other economy. The tedious and possibly impossible task of monitoring the millions of different consumer and producer prices, meant that prices were arbitrarily fixed and very rarely did planners change or adjust these prices. Furthermore changes in prices indicated plan systems were not functioning well, therefore adding an extra incentive for planners to keep prices stable; the official stance virtually no inflation. Even during times of severe inflation around the rest of the world, the Soviet Union saw very little change in prices, between 1970 1975, prices only changed a miniscule 0.3%; also retail prices of goods in great and increasing demand, like meat and housing, have been unchanged since 1962 and 1928 respectively, because of government policy. We must however take into account the reliability of the data, because of the shortage of data, the rates of increase can only be estimated (Birman and Clarke 1985).

As a result any imbalances between supply and demand were reflected in shortages; shortages were one of the key manifestations of inflation. Furthermore, major diversion of time was still a problem; queues were a common occurrence in Soviet stores and being forced to exercise the theory of second best (thus lowering the utility of the consumer) was a very likely result; the low price tag attached to staple goods did less than good to attribute toward the shortages. Demand outstripped supply and consumers had to find other means of finding the goods that they needed. Inflation also manifested from the high marginal propensity to save (MPS) in the Soviet economy. Although Pickersgill disputes the relevance of the high MPS, and in fact goes on to say that it is not abnormally high by international standards, Birman and Clarke recognise the importance of the large amounts of cash and liquid assets held in the Soviet economy; Birman and Clarke remark that the general order of magnitude is such that total money supply is roughly ten times what is needed for regular turnover. The significance of this excess supply of money is that it leads to excess demand because the nations purchasing power greatly exceeds the supply of goods (Birman and Clarke 1985). Whilst the underlying reasons as to why the supply of money is so great is not particularly relevant to this essay, the fact that the nations purchasing power was particularly high, coupled with the inability of price adjustments, and low retail prices, added to the already prevalent shortages of the Soviet economy. The second economy was the venue the typical citizen turned to in the face of shortages. The role of the second economy was pivotal. It worked as a pressure valve, a release xing command, maintaining microbalance and covering holes in economic life left by the mistakes or oversight of the planners and central managers. (Ericson 2008) The lack of a clear and concise market makes it difficult in attaining the correct resources needed for both production and consumption. The fulfilment of targets and quotas is absolute, and it is imperative that enterprise managers meet these targets. The absence of price and signals of scarcity put planners at a disadvantage when efficiently allocating resources. The lengthy bureaucratic formalities that managers must go through before receiving resources, leaves them no choice but to resort to other forces to fulfil their needs, and more importantly, the needs of the plan; these other forces being the participating population of the second economy. Digressing back to the previous point, the second economy flourished in both the consumer and producer markets. The activity in the second economy was highly apparent in the consumer sector due to the biases against providing consumer goods and services, nevertheless second economy activity also thrived in the producer sector. The diversion of resources in production toward second economy channels in order to raise funds or partake in barter trades was a very common occurrence; furthermore it was not peculiar for production organisations, for example in construction, to perform activities for private gain on the side, outside of the plan; it is said that around 10% of total income was derived privately and roughly 18% of all consumption expenditure was done on private terms (Gregory and Stuart et al., 1998). So you can see, the price distortions of the Soviet Union, accrue almost one fifth of consumer expenditure to be taken in an illegal fashion; with an empire as vast as the Soviet, one fifth is a very large figure indeed.

The second economy, being outside of the official economy, did not conform to the same rules and regulations. The second economy was more orientated towards a free market; scarcity, supply and demand where the engine of trade, not the imagination of the bureaucracies. The mantra of an egalitarian state did not permeate, and the gains accrued were for private means, however the nature of it did ameliorate the ubiquitous shortages/scarcities and in doing so saved the system from collapsing under its own weight and rigidity. (Powell, 1977) The existance of it was known, however the State realised the gains to the system on the whole and tolerated its activities. The state even in some cases encouraged the work of the second economy if the relationship between the official and unofficial economies was of a cooperative symbiotic nature. (Feldbrugge and JM, 1984) In essence the inability for prices to adjust to accommodate equilibrium, market clearing levels create a two tier economy. On one hand there is the low priced, scarcity ridden, quasi markets of the command economy, where the unenterprising, slow and unscrupulous can survive. The second tier consisting of the market orientated second economy, generally high priced and risky, but well endowed, where the entrapenurial and enterprising criminals can survive. (Ericson 2008) Ultimately, the second economy existed to correct the imperfections of the first; if prices were not passive, resource allocation would suit the preferences of the individuals willing to purchase the said resources, prices would adjust to equal supply and demand, and the second economy would cease to exist. From the argument proposed in this essay, it is clear to say that the passive role of prices had a negative effect on the Soviet economy. Although the intentions behind some of the ideologies were amicable, the end result was not so good. Simply put, the invisible hands of the free market are the only entities with enough knowledge to efficiently allocate price and resources. The vast amount of information and asymmetries are too great for the human mind to calculate, it is as Hayek argued, prices are an instrument of communication and guidance which embody more information than we directly have", and therefore "the whole idea that you can bring about the same order based on the division of labour by simple direction falls to the ground".

References
Books Kornai, J (1992). The Socialist System: The Political Economy of Communism. Clarendon Press. 142-152. Gregory, P., Stuart, R. and Gregory, P. 1998. Russian and Soviet economic performance and structure. Reading, Mass.: Addison-Wesley. Journals Birman I and Clarke, R. (1985). Inflation and the Money Supply in the Soviet Economy. Soviet Studies, 37 (4), p 494-504 Ericson, R. (2008). Command Economy. The New Palgrave Dictionary of Economics. 2, p 1-16. Feldbrugge, F. and JM. 1984. Government and shadow economy in the Soviet Union. Europe-Asia Studies, 36 (4), p. 528-543. Kornai J, Maskin E and Roland G. (2003). Understand The Soft Budget Constraint. Journal of Economic Literature. 41 (4), p 1-84. Maskin, E. (1996). Theories of the soft budget-constraint. Japan and the World Economy. 8 (2), p 125-133. Powell, R.P. 1977. Plan execution and workability of soviet planning. Journal of Comparative Economics 1 (1), September, p 57-56 Schroeder, G. (1989). The Implementation And Integration Of Innovations In Soviet-type Economies. Cato Journal. 9 (1), p 35-55.

Bibliography

Books Kornai, J (1992). The Socialist System: The Political Economy of Communism. Clarendon Press. 142-152. Gregory, P. and Stuart, R. 1998. Russian and Soviet economic performance and structure. Reading, Mass.: Addison-Wesley. Journals Alexeev, M., Gaddy, C. and Leitzel, J. 1992. Economics in the former Soviet Union. The Journal of Economic Perspectives, 6 (2), pp. 137--148. Birman I and Clarke, R. (1985). Inflation and the Money Supply in the Soviet Economy. Soviet Studies, 37 (4), p 494-504 Bornstein, M. 1962. The Soviet price system. The American economic review, 52 (1), pp. 64--103. Ericson, R. (2008). Command Economy. The New Palgrave Dictionary of Economics. 2 , p 1-16. Feldbrugge, F. and JM. 1984. Government and shadow economy in the Soviet Union. Europe-Asia Studies, 36 (4), pp. 528--543. Kornai J, Maskin E and Roland G. (2003). Understand The Soft Budget Constraint. Journal of Economic Literature. 41 (4), p 1-84. Maskin, E. (1996). Theories of the soft budget-constraint . Japan and the World Economy. 8 (2), p 125-133. Powell, R.P. 1977. Plan execution and workability of soviet planning. Journal of Comparative Economics 1 (1), September, p 57-56 Sampson, S. 1987. The second economy of the Soviet Union and Eastern Europe. The Annals of the American Academy of Political and Social Science, 493 (1), pp. 120--136. Schroeder, G. (1989). The Implementation And Integration Of Innovations In Soviet-type Economies. Cato Journal. 9 (1), p 35-55.