history of capitalism three page essay

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There’s no doubt we live in a capitalist world. The rewards that stem from private

property, profit and loss, and entrepreneurial creative destruction have made the

capitalist system an inevitable outcome for any modern economy that hopes to

succeed. But capitalism is not without fault. Monopolies, externalities, inequity, and

countless other issues mar capitalism’s record. In a challenge to capitalism’s dominant

place in our society, Oskar Lange argues that a socialist system that simulated market

processes could retain the benefits of a capitalist economy while avoiding its biggest

flaws. In particular, he posits a system that replicates the conditions of perfect

competition through central planning rather than decentralized decision-making.

However, though Lange’s trial error solution would work elegantly on the blackboards

of university economics classes, it fails in the ever-changing economies of reality. By

ignoring the discovery role of the entrepreneur in a dynamic economy, Lange engineers

a system that prioritizes short term efficiency at the expense of innovation and

adaptability. Without the profit and loss signals that drive entrepreneurial activity in a

market economy, Lange’s price system will never provide the incentives for consumers

and firms to make efficient economic decisions.

Before delving into the details of Lange’s proposal, it’s worth taking a step back

to review the basic results of a perfectly competitive market in economic theory. When

firms in an industry produce a homogeneous, when there is perfect information, no

transactions costs, and free entry and exit, competition will always drive profits to zero

and maximize consumer welfare. To see why, imagine it costs a pizza shop $8 to

produce a pizza that they can sell for $10 (producing a profit of $2). Restaurant owners

that sell other foods making less profit would switch over to selling pizzas to grab a

piece of the profits. As more firms enter the pizza market, the supply of pizzas

increases, which drives the price down, and the process continues until the price of

pizza hits $8 and there are no excess profits remaining. Any consumer that values the

pizza at more than $8 can buy one and therefore every transaction where the benefit of

producing a pizza exceeds the cost takes place. Price equals marginal cost, and the

market achieves the most efficient outcome.

Lange does not deny the benefits markets can potentially provide, but he notes

that the results of a market could just as easily be implemented by a central planner. In

a 1936 article, Lange sets out a system with free markets in both consumer goods and

labor. In other words, workers are free to work in whichever field they desire and buy

whichever products they want. However, unlike a capitalist economy where the means

of production are privately owned and the ultimate goal of a firm is to maximize profits,

in Lange’s world a “Central Planning Board” would make production decisions and set

prices. Producers would be required to follow two rules. First, they would be required

to use resources in such a way that minimizes the average cost of production, and

second, to set the price of their output equal to the average cost. In this way, the

socialist economy replicates the results of a capitalist one, imposing the price equals

marginal cost condition that arises naturally under perfect competition.

A challenge for Lange’s system is that many of the prices that guide decision-

making will not exist in this socialist economy. As supply chains have become more

complex, a seemingly simple consumer good can actually be the result of dozens or

even hundreds of intermediate transactions. In a free market, prices help an economy

direct resources to their most useful ends. But, Lange claims, there is no reason that

there can’t be prices in a socialist economy. All the central planning board has to do is

set up an arbitrary set of prices and adjust based on supply and demand. If they find

that demand for steel is greater than supply while demand for coal is lacking, they can

raise the price of steel and lower the price of coal. In fact, the system could even work

“much better” than its capitalist alternative since “the central planning board has a

much wider knowledge of what is going on in the whole economic system” (Lange,

1936). It could avoid the situations of market failure - externalities, market power,

business cycles - all while preserving the efficiency of capitalist production.

Although Lange’s logic is sound, his plan mistakes the sterile competition of

economic theory for the dynamic market process that makes up real capitalism. In

simple economic models, the entrepreneur is relegated to the role of an arbitrager.

They seek profits by entering existing successful markets and leaving failing ones. In

reality, entrepreneurs compete on a much grander scale. The best entrepreneurs earn

profits not by imitating what other successful people have done, but by developing

previously unknown methods to produce more efficiently. Competition affords “the

opportunity for anybody who knows a cheaper method to come in at his own

risk” (Hayek, 1948). In our pizza example above, an entrepreneur earned profits by

copying firms who produced a pizza for $8 and sold for $10. A more successful

entrepreneur would find a way to produce it for $4. Lange’s central planning board

might be able to efficiently run the structure of production that has existed in the past,

but who in Lange’s socialist system has any incentive to try anything new? Managers in

Lange’s economy, bound as they are by his rules, would have no grounds to step

outside of accepted practice.

Lange’s primary mistake in his argument comes in failing to appreciate the that

profit and loss is necessary to incentivize entrepreneurs to invent new products and

business practices. Consumers have unpredictable preferences. There are infinitely

many combinations of resources, countless ways to organize the structure of

production. It is undeniably true that entrepreneurs rely on trial and error. No single

entrepreneur (or planner) can possibly predict consumer behavior and design a perfect

production process. But if one thousand try, some of them might come up with some

good ideas. A market economy clearly separates the great ideas from the bad ones as

“profit tells the entrepreneur that consumers approve of his ventures; loss, that they

disapprove” (Mises, 1949). With the allure of profits creating incentives to experiment

and innovate, the economy becomes a hive of creative activity. Lange’s solution can

only hope to be a hollow shell.

The market socialism debate highlights the broader dangers of taking economic

models too seriously. If we believe that our economic models can accurately capture

the most important features of reality, then there is no problem applying their results to

a planned economy. If, however, we believe that what the model leaves out is just as

important as what it explains, we should be much more cautious in our dreams of

steering markets towards better results.