Command Economy Explained: Definition, Characteristics, and Functionality

What Is a Command Economy?

A command economy, or planned economy, is a system where a central governmental authority controls the production levels and pricing for goods and services, resulting in most industries being publicly owned. This approach contrasts with a free-market system, where supply and demand determine production and prices.

The main alternative to a command economy is a free-market system, in which supply and demand dictate production and prices.

The command economy is a component of a communist political system, while a free-market system exists in capitalist societies.

Key Takeaways

• A command economy is characterized by central governmental control over production levels and prices, with little to no private ownership of industries.
• In these economies, government plans set national economic priorities, often through multi-year strategies, and limit competition.
• Critics argue that command economies suffer from incentive problems and a lack of necessary information to efficiently allocate resources, leading to inefficiencies and resource waste.
• Supporters claim that command economies can better allocate resources for social welfare and respond more effectively in crises.
• Command economies differ from free-market systems, where production decisions are made by market forces like supply and demand instead of government mandates.

How Command Economies Function

Cuba, North Korea, and the former Soviet Union all have command economies. China maintained a command economy until 1978 when it began its transition to a mixed economy that blends communist and capitalist elements. Its current system has been described as a socialist market economy.

The command economy, also known as a planned economy, requires that a nation’s central government own and control the means of production.

Private ownership of land and capital is nonexistent or severely limited. Central planners set prices, control production levels, and limit or prohibit competition within the private sector. In a pure command economy, there is no private sector, as the central government owns or controls all business.

In a command economy, government officials decide on economic growth, resource allocation, and output distribution, often through multi-year plans.

Criticisms of Command Economies

Capitalists may argue that command economies face at least two major problems: first is the incentive problem and second is an information vacuum among the central planners making all the decisions.

The Incentive Problem

The incentive problem originates at the top. In a command economy, political interest groups often dominate policymaking more than in capitalist economies because they lack market-based constraints like credit ratings or capital flight.

Wages are set centrally for workers, and profits are eliminated as an incentive for management. There is no apparent reason to produce excellence, improve efficiency, control costs, or contribute effort beyond the minimum required to avoid official sanction.

Advancing in a command economy involves pleasing party bosses and having connections, not maximizing shareholder value or meeting consumer demand. Corruption tends to be pervasive.

The incentive problem includes the issue known as the tragedy of the commons on a larger scale than is seen in capitalist societies. Resources that are commonly owned are effectively unowned. All of their users (or workers) lack any incentive to preserve them. Things such as housing developments, factories, and machinery wear out, break down, and fall apart rapidly in a command economy.

The Information Vacuum

The problem of economic calculation in a command economy was first described by Austrian economists Ludwig von Mises and F. A. Hayek. Central planners must somehow calculate how much of every product and service should be produced and delivered.

In a free-market system, this is determined in a decentralized manner through the interaction of supply and demand. Consumers shape demand by the products and services they buy or don’t buy. Producers respond by creating more of the products and services that consumers demand.

Moreover, all of these factors are quantifiable. At every step of the supply chain, someone is keeping count of the number of avocados, pairs of blue jeans, and lug wrenches that are in demand out there.

In a command economy, central planners should, at least initially, have a grasp on the basic life-or-death needs of the population in terms of food, clothing, and shelter. But without the forces of supply and demand to guide them, they have no rational method to align the production and distribution of goods with consumer wants and preferences.

Over time, the incentive and economic calculation problems of a command economy mean that resources and capital goods are wasted, and the society is impoverished.

Benefits of Command Economies

Supporters of command economies argue they prioritize social welfare in resource allocation, unlike free-market economies that focus on private profit.

Command economies may have better control of employment levels than free-market economies. They can create jobs to put people to work when necessary, even in the absence of a legitimate need.

Lastly, command economies are believed to better handle national emergencies, like wars or natural disasters. Even market-based societies may temporarily enhance government powers during such events.

What Are the Characteristics of a Command Economy?

Government planners control command economies from the top. Monopolies are common, viewed as necessary to meet national economic goals.

In general, this includes:

• Public ownership of major industries
• Government control of production levels and distribution quotas
• Government control of prices and salaries

How Does a Command Economy Differ From a Free-Market Economy?

In a free-market economy, private enterprises determine their levels of production in response to the law of supply and demand. In a command economy, the decision is dictated by government.

Few free-market economies today operate entirely on the principle of laissez-faire. A government may use public policies and regulations to encourage the production of a product, such as fuel-efficient cars. Some command economies have loosened their control. China’s economic boom did not begin until it created its own blend of socialist ideology and capitalist enterprise.

How Do Central Plans Work in a Command Economy?

Communist nations with command economies are prone to introducing multi-year plans that are expected to result in improved conditions for all its people. China has had no fewer than 14 five-year plans, with the current one ending in 2025.

Central plans set industry goals and sector strategies, requiring participation in objectives like reducing carbon emissions or revitalizing rural areas.

The Bottom Line

A command economy is a system in which a central governmental authority sets permitted levels of production, as well as the terms of distribution and pricing. It’s a component of communist political systems. Command economies are a contrast to free markets, in which prices are determined largely by supply and demand.