A command economy is an economic system in which the government, or the central planner, determines what goods and services should be produced, the supply that should be produced, and the price of goods and services. Some examples of countries that have command economies are Cuba, North Korea and the former Soviet Union.
Government Controls Production in Command Economy
In a command economy, the government controls major aspects of economic production. The government decides the means of production and owns the industries that produce goods and services for the public. The government prices and produces goods and services that it thinks benefits the people.
A country that has a command economy focuses on macroeconomic objectives and political considerations to determine what goods and services the country produces and how much it will produce. It generally has macroeconomic goals that the government wants to meet, and it will produce goods and services to do so. The government allocates its resources based on these objectives and considerations.
For example, suppose a communist country with a command economic system has macroeconomic objectives of producing military items to protect its citizens. The country is in fear that it will go to war with another country within a year. The government decides it must produce more guns, tanks and missiles and train its military. In this case, the government will produce more military items and allocate much of its resources to do this. It will decrease the production and supply of goods and services that it feels the general public does not need. However, the population will continue to have access to basic necessities. In this country, the government feels military goods and services are socially efficient.
How Do Command Economies Control Surplus Production and Unemployment Rates?
Historically, command economies don't have the luxury of surplus production; chronic shortages are the norm. Since the days of Adam Smith, economists and public figures have debated the problem of overproduction (and underconsumption, its corollary). These issues were largely resolved by 19th century economist Jean-Baptiste Say, who demonstrated that general overproduction is impossible when a price mechanism exists.
To see the principle of Say's law clearly, imagine an economy with the following goods: coconuts, jumpsuits and fish. Suddenly, the supply of fish triples. This does not mean that the economy will be overwhelmed with goods, workers will become desperately poor or that production will cease to be profitable. Instead, the purchasing power of fish (relative to jumpsuits and coconuts) will drop. The price of fish falls; some labor resources may be freed up and shift to jumpsuit and coconut production. The overall standard of living will rise, even if the allocation of labor resources looks different.
Command economies also have not had to deal with unemployment, because labor participation is compelled by the state; workers do not have the option of not working. It's possible to eradicate unemployment by handing everyone a shovel and instructing them (under threat of imprisonment) to dig holes. It's clear that unemployment (per se) is not the problem; labor needs to be productive, which necessitates that it can freely move to where it is most useful.
What Makes Command Economies Fail?
Command economies took most of the blame for the economic collapse of the Soviet Union and current conditions in North Korea. The lesson taken from the second half of the 20th century was that capitalism and free markets were indisputably more productive than socialism and command economies.
Three broad explanations for such failure were given: socialism failed to transform the nature of human incentives and competition; political government processes corrupted and ruined command decisions; and economic calculation was proven to be impossible in a socialist state.
Explanation One: Human Incentives
Soviet revolutionary thinker Vladimir Lenin first tried to implement an economic structure that lacked competition and profits in 1917. By 1921, Lenin was forced to adopt the New Economic Plan to incorporate some form of motivation for positive production. Political economists in the Western economies often argued that such motivations were still directed incorrectly. Rather than satisfying customers, the concern of the socialist producer was to satisfy his higher-ranking political officer. This discouraged risk and innovation.
Explanation Two: Political Self-Interest
In response to concerns about high executive salaries and profits, economist Milton Friedman countered regulatory thinking by inquiring, "Is it really true that political self-interest is nobler somehow than economic self-interest?" This argument states that concentrated power in the political realm tends to flow into the wrong hands. Leninists and Trotskyites complain that Stalinist command economies fail based on political corruption, not inherent flaws in the economic system.
Explanation Three: Socialist Calculation Problem
In 1920, Austrian economist Ludwig von Mises, in an article entitled "Economic Calculation in the Socialist Commonwealth," argued that without free markets, no correct price mechanism could form; without a price mechanism, accurate economic calculations were impossible.
Famed socialist economist Oskar Lange later admitted it was Mises's "powerful challenge" that forced socialists to try to build a system of economic accounting. After decades of trying to replicate the price mechanism in free markets, however, the Soviet Union still collapsed. Mises responded, arguing that such attempts were doomed to failure because no monopolistic government could reasonably be "in perfect competition with itself," which is how prices arise.
(For related reading, see: What's the Difference Between a Market Economy and a Command Economy?)