I ended the previous bit of this essay with these questions: First, why is it that central planning appears to work in familial situations and in firms but not in economies? Second, does planning really work for firms and corporations? Finally, if it is indeed true that centralized planning does not work at the economy level, why do petty despots (like Nehru) go for it despite the ruin it causes?
I will address the first two questions here and the third question in the next part.
Let’s see why planning works in families. The parents are emotionally motivated to do what’s best for the family and are best placed to plan for the family simply because they care. They know the preferences of family members, know the means available, the tradeoffs involved, and so on. The information and computing power required to get to an approximate solution to meet the objectives are well within their cognitive capacity. Though not trivial, planning for a family is a manageable task.
Planning at the firm level is non-trivial and therefore there are significant failures. We should remember that most firms fail. We get to know only of those that survive in the competition. Their plans worked. Furthermore, like all things, firms are not immortal. They are born, live for a while and then die. Most die in infancy and only a few grow up to be mega-successes. The relentless force of market competition weeds out those that are unable to plan successfully.
The corporate plans that work are due to a combination of perseverance, diligence and a great deal of luck. It is hard to pick winners. It has to be so because if you could pick winners, you would be fabulously rich by investing in those firms that win and make it big. This is lesson number one: that you never know with any certainty which plans would work and which won’t. Fortunately for us, even though most firms fail, we can be certain that some will work and that’s what is important for the economy. The corollary to that is when anyone is deluded enough to think that they can pick winners, you can safely bet they can’t. Economy-wide central planners engage in trying to pick winners, and end up picking losers. The numbers are against them.
It is a numbers game, start to finish. Assuming that a startup’s survival into the next year is, say, 10%, then out of a 1000 firms that started on a particular year, you would expect only one to be around after year three. Further assume that after three years, the infant stage is over and with maturity, the survival rate climbs. Of these surviving firms, some go on to become large firms and some become humongous.
In the Silicon Valley, an area of about 25-mile radius in the San Francisco bay area, there are many fabulously successful firms (Apple, Google, Facebook) and hundreds more big, important firms. These helped push the economy of California to be the 6th largest economy in the world. How successful is California’s economy? California’s population is around 3% of India’s but California’s GDP is 125% of India’s.
Part of the reason for the Silicon Valley’s successful corporations is that it is relatively easy to start a company here. There are tens of thousands of startups every year, which guarantees that a handful will win the numbers game. No central planning board of wise men from some government agency is needed to choose winners. The market picks winner.
Let’s dig a bit into what “the market picks winners” means. There are two major market forces involved: the investors and the consumers. The investors are motivated to pick winners because it’s their money on the line. If they choose wisely, they win — meaning that the company they invested in is profitable. Being profitable means that the company’s products are bought — chosen — by the consumers, and that the cost of making those products is less than the benefits. It’s profits all around: the investors, the firm, and the consumers.
Note that all this is decentralized decision making. Investors choose which firms to back, firms choose what to make, and consumers choose what to buy. There is no compulsion involved. That’s what is meant by the “free market” — people freely choose what they do in the marketplace. They are all motivated by the single-minded pursuit of profits. But wait, that’s not all. The carrot of profits in the market is balanced with the stick of losses in that same market. The free market is a “profit and loss” system. The discipline of losses keeps all marketplace participants from making rash decisions. Those who err systematically are weeded out by the impersonal judgement of the market.
I am the average consumer, not an entrepreneur or an investor. All I care about are my own needs and whether I have choices in the marketplace. I don’t care what goes on in the insides of corporations, how they make their decisions, etc. When I think of buying a tablet, for example, I choose among the various producers. I cannot make or break a tablet company but if enough consumers feel one way or the other, the company can go belly up. The consumer is the king in a free market, and the company merely a serf trying its best to please the king.
This is what I mean when I say that planning appears to work in firms. Firms that are incompetent in their planning, fail. Eventually, every firm fails but there are others to take the space so vacated. A modern, advanced, industrialized society depends on firms successfully competing to produce goods and services that consumers value enough to buy them.
In the next bit, we’ll see why centralized planning cannot work in any modern economy. Let’s close with another quote from Walter E. Williams:
“What we call the market is really a democratic process involving millions, and in some markets billions, of people making personal decisions that express their preferences. When you hear someone say that he doesn’t trust the market, and wants to replace it with government edicts, he’s really calling for a switch from a democratic process to a totalitarian one.”