The key to a country’s prosperity lies in the degree of its economic freedom. A country that has total economic freedom will be prosperous. A country with little to no economic freedom, such as a command-control economy, will face severe poverty. In this essay I will cover some empirical evidence and theoretical reasons as to why.
A 2010 paper by Peter T. Leeson, “Two Cheers for Capitalism?” demonstrates economic freedom directly corresponds to GDP per capita. His economic freedom data comes from the Fraser Institute Economic Freedom of the World Report, where countries are given a score of economic freedom from 1 to 10. Leeson demonstrates that the relationship between economic freedom and GDP per capita is not only positive, but exponential. Also, for countries with high economic freedom, GDP per capita has grown from 1985 to 2005. By contrast, countries that have scaled back their economic freedom by more than one Fraser-point have faced stagnating GDP per capita from 1985 to 2005.
Centrally planned economies attempt to create prosperity by moving economic choice from individuals to a central planning committee. Centrally planned economies have the state ration goods and services instead of having it done through a free market. This economic strategy has been tried many times and always ends in a stagnating, poor economy. Consider the economic disparity between communist North Korea and capitalist South Korea. They speak the same language, have the same cultures, same geography, etc. The one difference is their economic system. South Korea embraces capitalism, hence they have individual liberties such as private ownership and freedom to trade. North Korea’s economy is fully state controlled, where free enterprise is not respected. Simply by relinquishing control—allowing people to be economically free—creates a staggering change in the lifestyles between these two countries.
Why do capitalist economies provide such a stark increase in GDP per capita over socialist economies? Why don’t the command-control systems ever seem to function well? It is because the economic planning committee do not have the information required to efficiently use resources. The issue is detailed by Friedrich Hayek in his seminal paper, “The Use of Knowledge in Society.” Hayek argues that an economic planning committee cannot determine the scarcity of products as efficiently as a price system can, and therefore it is infeasible for them to efficiently make planning decisions.
To determine the demand for a product, the committee first needs to know the preferences for every consumer in the market. Consumer preferences are best known by the consumer. Given the infinite possible variations of infinite products, it is difficult to tell what a person’s preferences will be beforehand, until he is faced with a selection and makes his purchases. The reason that a free market can satisfy these unknowable preferences is because of competition. Many firms compete in the market, and consumers pick the products that they want to buy. For a firm to survive, they have to produce products that people want. Competition among many independent firms gives consumers the opportunity to act on their preferences. This trial and error process is what allows the market to maximize utility for as many consumers as possible.
The details of production for every single good in the economy will also probably not be known to the planning committee. Will the planning committee know if a particular machine in the economy is not being properly used? If a person’s skillset is not being fully utilized? If it is the high or low season for a particular good? There are so many goods with intricate production processes, and manufacturing each one requires many small pieces of local knowledge. It is unlikely that the planning committee will be able to keep an eye on it all. In a free market, firms are generally specialized to a particular set of tasks, i.e., Pfizer researches and manufactures drugs, Walmart buys and resells goods, and Apple designs and retails consumer electronics. A central planning committee would be taking on a level of responsibility far higher than the management of even the largest firms. Therefore, it is unlikely that the committee will be able to focus its efforts in the same way as the management of many independent, specialized firms.
When widening our view to general equilibrium, the committee runs into the issue of managing resources between industries. Suppose the market for steel is in equilibrium. When a new factory opens which uses steel, the demand for steel will go up and so will its price. This in turn will affect the supply of all goods that use steel, such as cars, boats, and planes. Prices convey levels of scarcity, so anytime steel faces a shortage, the price rises and all other users of steel will lower their consumption. If cars switch to a steel substitute, then the price of the substitute will rise, and then the price of the substitute’s substitutes will rise, creating a chain reaction until every product remotely tied to steel is now produced at a new quantity. Without prices, it becomes impossible to process changes in production for a surplus or shortage of steel. The information for these chain reactions is known not by one single person, but in many dispersed pieces among every individual. The price is what allows individuals to react correctly to changes in quantity, without ever needing to know the reason why.
In an effort to create a more prosperous society, the central planning committee will have to use coercion to force the population to comply with the central plan. However, both empirically and theoretically, it is clear that coercive systems are actually inferior to economically free ones, which do a superior job of efficient production and maximizing welfare for consumers. Forgoing economic freedom means you lose the competition to satisfy consumers, specialized efficient management for each good, and prices to manage the flow of resources. Economic freedom allows countries to become prosperous; without which they will remain stagnant and poor.