Monday, February 20, 2006

How a Free Market Works

In both the ECN 201 Microeconomics class and the ECN 200 Basic Economic Principles courses I assigned the same article by Murray Rothbard entitled What is the Free Market? and one of the questions asked in both courses was:

Explain why the socialist planners in the former Soviet Union were unable to take a bumper (i.e., very large) harvest of wheat and convert it to bread and other baked goods for consumption by consumers in cities throughout the former Soviet Union.

To date the few assignments I have received have all paraphrased Rothbard to the effect that the Soviet planners lacked a free market and prices to guide them. Some have also added that the absence of prices and profits also resulted in a lack of incentives to produce. While I have accepted these answers so far, it is clear that those answering the question didn’t really grasp why the free market and price system is important and how they work.

A real life story from my wife’s experience may help clarify the problem. My new wife is from Ryazan, a city in western Russia with about the same size population as Tucson. Ryazan is located about three hours by train or car south of Moscow. According to my wife, there were no stores with food for sale in the city in the period prior to the fall of communism in the early 1990s. Despite the fact that among the city’s industries was a large meat processing plant (the total output of which was sent to Moscow for sale) people had to travel by car (if they had one) or by train to Moscow to do their grocery shopping. My wife and her former husband had to travel by car with his parents (who owned the car) once a month to do their grocery shopping. The trip took three hours each way to get to Moscow and back and the rest of the day was spent in lines in stores trying to get food. Back in Ryazan they had a small apartment (for themselves and their two children) with a small kitchen and a refrigerator about half the size of contemporary American refrigerators.

I had previously visited Moscow and St. Petersburg (then known as Leningrad) in my senior year of college 1969 as a part of a Russian history course that included a 2 week field trip to the Soviet Union. I observed that life was drab but the people I saw and met had sufficient food, clothing and shelter. There was not much variety in the food – mostly fresh potatoes and vegetables. Meat was very scarce and people’s main source of animal fat for energy was the lard that food was frequently used for cooking. Obtaining food required going from store to store and standing in long lines hoping they still had food in stock when you reached the counter. The clothing was dull and ill fitting. The colors were mostly dark blues, grays, browns and blacks and even these dark colors were dull compared to the same colors in clothes manufactured in the west. The quality of western clothing was so superior that a westerner could not walk down a street without having a dozen or more people approach them with offers to purchase the extra clothes they had back at the hotel. The ruble prices offered for the used clothing were usually in excess of the original price paid in the west. This despite the fact that the buying or selling of items outside regular stores was illegal. The housing was mostly small apartments.
This was the situation in Russia for most of its citizens under communist rule. Practically everyone was poor by western standards but it was not the absolute poverty of the third world. Things were bad but not desperate.

In a market economy prices for food in a city, like Ryazan, would be high. This would signal producers that there was an opportunity for profit and they would begin moving food to Ryazan to sell. But, without a market driven price system, this signal did not exist so the city’s plight did not come to the attention of the planners in Moscow. The other, non-market, signal that would have alerted the planners would have been large numbers of people dieing of starvation or masses of hungry people taking to the streets and rioting. But, there was no shortage of food in the sense that people were going hungry. Food was not plentiful and it was inconvenient to obtain it but, with effort, sufficient food could be obtained. Like a person with a long illness who has learned to live with his or her pain, the people of the former Soviet Union endured. Thus, in the absence of signals, the planners, occupied with trying to make all the economic decisions for a nation that stretched from the Baltic to the Pacific, easily overlooked Ryazan.

As my first described it to me when I first visited her in Ryazan in 2002, “…there was a fellow named Gorbachev in charge and things got really bad. Then one day things suddenly changed. Gorbachev was gone and food appeared in the stores in Ryazan”. The change was literally overnight as Russia went from communist central planning to a free market. The first thing that changed was money became important. Under the communists prices were set by the planners with some attempt to ration scarce goods. But, both the lack of good information and political meddling made most prices meaningless and rationing was done by having people wait in long lines or use political influence to obtain needed goods. Further, incomes did not vary much so everyone tended to suffer equally. Acquiring money through saving was not allowed. The government owned all the businesses so there was no place to invest one’s money. Starting one’s own business was illegal. Finally, it was illegal to take money abroad, but that didn’t matter because, the currency was basically worthless outside of the Soviet Union.

With the communists no longer in control entrepreneurs were free to begin making money by providing products to consumers. Farmers dug into their limited supplies of food that they had hidden for emergencies and began selling it in the cities. Making a profit, they returned home and began growing and scrounging anything edible to take to the cites to sell. Others, not in farming began noticing arbitrage opportunities where food in large cities, like Moscow, was more plentiful and therefore less expensive while in places like Ryazan it was scarce and expensive. They went to the places with less expensive food, purchased it and returned home to sell it at a profit. (The fall of communism meant that people were no longer paid when they took off from work, it also meant that gasoline prices were allowed to rise and trains, which were still run by the state but needed money to keep operating, were now making everyone pay the regular fare. In the past paying was more of an honor system which most people chose not to honor.) It was thus profitable for people out of work to specialize in traveling long distances to obtain food and other goods for re-sale in their home cities but costly for people with jobs. In a market system goods that are in great demand and short supply command high prices while those which are in large supply and/or not in great demand have lower prices. While planners had to try to figure everything out in order to make the economy run (and when they did not know everything, which was all the time, goods became scarce), entrepreneurs in a market economy don’t have to know everything. They just have to be able to identify which goods command a high price and can be produced or obtained at a lower price somewhere else.

The Russia I visited in 2002 was vastly different from the Soviet Union of 1969. Food was plentiful and in greater variety. Clothing was also plentiful and of comparable quality to western clothing. In 1969 you could literally spot a foreign tourist a mile away by their clothing. In 2002 the only way to identify a western tourist was if they spoke in a language other than Russian or, in the case of Americans, if they wore a wedding band on their left hand (Europeans generally wear wedding bands on their right hands). I even took a three day bus tour with my then fiancée using a Russian name and not speaking (I don’t speak Russian) and easily passed myself off as one of the locals.

Prior to the fall of communism people, including economists, were wondering if it was possible to convert from the communist economic model to a market economy peacefully given the huge distortions created by the communist central planning. In the 1999 book The Commanding Heights. The Battle Between Government and the Marketplace that is Remaking the Modern World. authors Daniel Yergin and. Joseph Stanislaw describe the situation in Poland when the communist economy collapsed. The communist generals who had staged a coup earlier and replaced the civilian communist rulers in a last ditch attempt to save the system gave up and turned the government over to Solidarity. American economists, trained in free market economics under the tutelage of Milton Friedman and the University of Chicago, and fresh from their success in turning the Chilean economy around after its short bout of communism under Salvador Allende were called in to perform the same miracle in Poland. But Poland was a complete disaster. With food supplies expected to run out in the cities in a matter of days and mass starvation imminent, the American advisors advised going cold turkey by instantly abolishing all forms of government control over the economy and letting it move to a free market instantly rather than the gradual transition the many were urging. The government declared that effective at midnight a couple of days later the transition would occur. The American economists crossed their fingers and made reservations to leave on the first plan out after midnight just in case the experiment didn’t work and chaos ensued. The transition to a market economy took place at midnight as planned and by 5 a.m. there were lines of farmers making their way to the cities with food. Within days the food shortage had ended.

Seeing Ryazan in 2002 I could easily believe my then fiancée when she described the change as no food one day and food suddenly appearing within days of the unreported (in Russia) coup that moved the country from communist central planning to a market economy literally over night.

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