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I have a basic question: my understanding is that in a market economy, economic decisions are governed by prices, i.e prices signal what should be produced & how much. This is opposed to central planning, where a committee decided what should be produced & how much.

Now, in companies or households, such economic decisions are made by "central planning": i.e. - the CEO/board, or parents. Why shouldn't prices be used at these levels too? For example, why don't companies create a "currency" and tell employees to work on things that people with more "money" (senior management) will buy? Or, in a family, for parents to create a "currency" and tell family members to work on things that others will pay for? (done in small ways in some families, but not with everyone participating).

Bottom line of the question: When is it better to use a "market economy" (with prices) as compared to central planning? Is it a function of size? I don't think so...

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  • $\begingroup$ And why can it not be a function of size? Responding to the wants, desires and needs of a population is infinitely complex. Understanding what needs to be done in a company, when and why is decidedly less so. So, you would argue that system complexity, represented here by size, should not be a factor? Perhaps it has something to do with a "threshold" effect? If managers overvalue some piece of the puzzle and undervalue another, maybe only one piece of the puzzle is fitted. Managers are left with an incomplete puzzle until market forces adjust. What an interesting question! $\endgroup$ – 123 Oct 14 '16 at 14:57
  • $\begingroup$ The reason I don't think it's a function of size is even in a family of 4 - there is imperfect decision making. Basically, I (personally) don't believe that it's possible to make good decisions for more than yourself (even that can be hard!), so it's quite hard to account for the needs, tastes, ideas etc. of others even in a simple family set up in a complete way... $\endgroup$ – appa Oct 14 '16 at 17:38
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There is a school of thought that says that people unconsciously use cost-benefit analyses in their relationships with other people. In this idea, people show kindness only because they anticipate getting rewarded for those acts, so it is in their own self-interest to do so.

Monetizing small tasks takes time, and then collecting money for tasks done takes more time. So people do this mentally instead, moreso by feelings than rational calculation. At the level of an interpersonal relationship, words and feelings matter whereas in a business relationship, only tasks and services or goods rendered matter. Thus, monetizing the countless miniscule interactions that take place in a personal relationship would be impossible and there needs to be some degree of trust to replace that.

At the level of a firm, an employment contract stipulates generally what somebody is being paid for. It is more efficient for the company to let individuals decide what to do in a day, or to instruct them to undertake certain tasks (depending on the organizational structure of the firm) than to spend time haggling for a price at which they should be paid in order to carry out various parts of their jobs. As other users have commented, when a firm gets too large, there are diseconomies of scale as it becomes too difficult to control a large number of workers. Then work tends to be contracted out to other firms and the use of money comes in.

However, token economies work well in situations such as mental asylums, to encourage those people to undertake tasks and follow rules.

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  • $\begingroup$ Thanks for your thoughts, especially liked your point about asylums, didn't know that currency systems were used there. I understand how words & feelings matter (above, have added an example of the question of 'What should we get for dinner tonight?', which can be a challenging negotiation with a lot of history & sense of sacrifice!), and still wonder whether from a world-view of purely maximizing efficiency wouldn't a token currency be the best choice in such situations as well... $\endgroup$ – appa Oct 15 '16 at 5:02
  • $\begingroup$ Which is that school of thought you are referring to? $\endgroup$ – luchonacho Aug 19 '17 at 10:47
  • $\begingroup$ @luchonacho the idea that people are rational $\endgroup$ – ahorn Aug 20 '17 at 4:11
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    $\begingroup$ Rationality and altruism are not exclusive. My goal function may include other people's welfare. $\endgroup$ – Giskard Aug 21 '17 at 18:56
  • $\begingroup$ Which is the name of that school? Are you referring to Rational Choice Theory? $\endgroup$ – luchonacho Aug 23 '17 at 12:14
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A market economy is useful when we have different players with different goals. i.e the firms objective is profit maximisation and the the consumer's goal is utility maximisation.

Each player must make a decision optimising against the others decision. In this sense each player faces the constraint placed by the other player.

When there is freedom to choose a market economy yields the most optimal distribution of goods. (As both firms and consumers have different goals)

In a planned economy there is no freedom to choose, rather it is can be viewed as just an endowment of goods given to each individuals. for a planned economy to be optimal (theoretically) it requires:

  1. Knowledge of everyone preferences
  2. Knowing the all sets of efficient allocation of goods

This is elaborated in upon in basic welfare economics with the use of edgeworth box analysis.

However, as you said in the case of the household: size matters as in the case a large economy it is impossible to know everyone's needs.

Hope this helps.

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  • $\begingroup$ Thanks @EconJohn, I felt it was impossible to know everyone's needs even in a household of 4, which is why I felt size didn't matter! (rather, any size of > 1). So why not market economics in a household (or a company)? $\endgroup$ – appa Oct 14 '16 at 17:41
  • $\begingroup$ For a household i'd argue simply its not practical from a social perspective people don't have a market in their home because its assumed there is a degree of interdependence (a person is assumed to love their kids/spouse and are willing to forgo their consumption for the sake of a relationship). A company is a firm and is only focused on profit maximisation for all our intents and purposes, and it seems to be less efficient by having a "real goods" payment system in place than just giving the employee a cheque for $x. in short its inefficient for a company have a market based pay system $\endgroup$ – EconJohn Oct 14 '16 at 19:27
  • $\begingroup$ Nicely articulated, "interdependence" v/s "profit maximization". Still wonder though - take an example of "What should we get for dinner tonight?", something that has history, negotiations and sometimes a feeling of sacrifice (!), which can all be removed through some currency... :) Thanks for your thoughts! $\endgroup$ – appa Oct 15 '16 at 4:59
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    $\begingroup$ "a market economy yields the most optimal distribution of goods" you might be forgetting all the conditions that the First Welfare Theorem requires. $\endgroup$ – luchonacho Aug 19 '17 at 10:49
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In his 1974's Nobel Prize speech titled "The Pretense of Knowledge", Hayek presented a fierce attack on Keynesianism (which argued for an active government), whilst defending free markets. His view is centered on the idea that there is too much "local knowledge" which is available to individuals but not to governments. Markets can use that information efficiently, whereas a central planner cannot. His view is also guided by a different ontological view of the economic system from his opponents, one centered in complexity. Some quotes from the speech:

Unlike the position that exists in the physical sciences, in economics and other disciplines that deal with essentially complex phenomena, the aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones. [...] We know: of course, with regard to the market and similar social structures, a great many facts which we cannot measure and on which indeed we have only some very imprecise and general information. And because the effects of these facts in any particular instance cannot be confirmed by quantitative evidence, they are simply disregarded by those sworn to admit only what they regard as scientific evidence: they thereupon happily proceed on the fiction that the factors which they can measure are the only ones that are relevant. [...]

Into the determination of these prices and wages there will enter the effects of particular information possessed by every one of the participants in the market process - a sum of facts which in their totality cannot be known to the scientific observer, or to any other single brain. It is indeed the source of the superiority of the market order, and the reason why, when it is not suppressed by the powers of government, it regularly displaces other types of order, that in the resulting allocation of resources more of the knowledge of particular facts will be utilized which exists only dispersed among uncounted persons, than any one person can possess. [...]

To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm. [...]

If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants.

(He had a relatively similar critique on central planning and the USSR in his book "The Road to Serfdom")

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  • $\begingroup$ Strange that you criticize the other answer for forgetting all conditions of the first welfate theorem but your answer does not mention monopoly or externalities either. $\endgroup$ – Giskard Aug 21 '17 at 18:57
  • $\begingroup$ @denesp I did not attempt to respond or correct EconJohn's answer. The two provide different point of views on the issue. $\endgroup$ – luchonacho Aug 21 '17 at 19:05

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