A business firm is limited, not only in its over-all size, but also in the range of functions it can perform efficiently. General Motors makes millions of automobiles, but not a single tire. It buys them from Goodyear, Michelin, Firestone, and other tire manufacturers. Nor do automobile manufacturers own their own automobile dealerships across the country. Typically, automobile producers sell cars to local people who in turn sell to the public. In short, the automobile manufacturer specializes in manufacturing automobiles, leaving other functions to people who develop different knowledge and different skills needed to specialize in those particular functions.
The perennial desire to "eliminate the middleman" is perennially thwarted by economic reality. The range of human knowledge and expertise is limited for any given person or for any manageably-sized collection of people, so that only a certain number of links in the great chain of production and distribution can be mastered and operated efficiently by the same set of managers. Beyond some point, there are other people who can perform the next step in the sequence more cheaply or more effectively—and, at that point, it pays a firm to sell its output to some other businesses that can carry on the next part of the operation more efficiently. Newspapers seldom, if ever, own and operate their own news stands, nor do furniture manufacturers typically own or operate furniture stores. Most authors do not do their own publishing, much less own their own bookstores.
Prices play a crucial role in all of this, as in other aspects of a market economy. Any economy must not only allocate scarce resources which have alternative uses, it must determine how long the resulting products remain in whose hands before being passed along to others who can handle the next stage more efficiently. Profit-seeking businesses are guided by their own bottom line, but this bottom line is itself determined by what others can do and at what cost. When an oil company discovers that it can make more money by selling gasoline to local filling stations than by owning and operating its own filling stations, then the gasoline passes out of its hands and is then dispensed to the public by others. In other words, the economy as a whole operates more efficiently when the oil company turns the gasoline over to others at this point, though the oil company itself does so only out of self-interest. What connects the self-interest of a company with the efficiency of the economy as a whole are prices. When a product becomes more valuable in the hands of somebody else, that somebody else will bid more for the product than it is worth to its current owner. The owner then sells, not for the sake of the economy, but for his own sake. However, the end result is a more efficient economy, where goods move to those who value them most.
Despite superficially appealing phrases about "eliminating the middleman," middlemen continue to exist because they can do their phase of the operation more efficiently than others. It should hardly be surprising that people who specialize in one phase can do that phase better than others.
As in other cases, one of the best ways of understanding the role of prices and profits is to see what happens in their absence.
Socialist economies not only lack the kinds of incentives which force individual enterprises toward efficiency and innovation, they also lack the kinds of financial incentives that lead each given producer in a capitalist economy to limit its work to those stages of production at which it has lower production costs than alternative producers. Capitalist enterprises buy components from others who have lower costs in producing those particular components, and sell their own output to whatever middlemen can most efficiently carry out its distribution. But a socialist economy may forego these advantages of specialization.
In the Soviet Union, for example, many enterprises produced their own components, even though specialized producers of such components could manufacture them at lower cost. Two Soviet economists estimated that the costs of components needed for a machine-building enterprise in the U.S.S.R. were two to three times as great as the costs of producing those same components in specialized enterprises. But what does cost matter in a system where profits and losses are not decisive?
This was not peculiar to machine-building enterprises. According to these same Soviet economists, "the idea of self-sufficiency in supply penetrates all the tiers of the economic and administrative pyramid, from top to bottom." Just over half the bricks in the U.S.S.R. were produced by enterprises that were not set up for that purpose, but which made their own bricks in order to build whatever needed building to house their main economic activity. That was because these Soviet enterprises could not rely on deliveries from the Ministry of Construction Materials, which had no financial incentives to be reliable in delivering bricks on time or of the quality required.
For similar reasons, far more Soviet enterprises were producing machine tools than were specifically set up to do so. Meanwhile, specialized plants set up for this purpose worked below their capacity—which is to say, at higher costs than if their overhead had been spread out over more output—because so many other enterprises were producing these things for themselves. Capitalist producers of bricks or machine tools have no choice but to produce what is wanted by the customer, and to be reliable in delivering it, if they intend to keep those customers in competition with other producers of bricks or machine tools. A socialist monopoly has no such pressures.
By contrast, General Motors can produce millions of automobiles without producing a single tire to go on them, because they can rely on Goodyear, Michelin, or whoever else supplies their tires to have those tires waiting to go on the cars when they come off the production lines. To leave General Motors high and dry, with no tires to go on their cars, would be financially suicidal to a tire company, since it would lose a customer for millions of tires each year.
Reliability is an inherent accompaniment of the physical product when keeping customers is a matter of economic life and death under capitalism, whether at the manufacturing level or the retail level. Back in the early 1930s, when refrigerators were just beginning to become widely used, there were many technological and production problems with the first mass-produced refrigerators sold by Sears. The company had no choice but to honor its money-back guarantee by taking back 30,000 refrigerators, at a time when they could ill afford to do so. This provided enormous pressure on Sears to either stop selling refrigerators (which is what some of its executives and many of its store managers wanted) or else greatly improve their reliability, which is what they eventually did, becoming one of the leading sellers of refrigerators in the country.
None of this was painless. Nor is it likely that a socialist monopoly would have been forced to undergo such economic trauma to please its customers. There was a reason why Soviet enterprises could not rely on their suppliers and chose instead to make many things for themselves, even though they were not specialists in making those things. The suppliers did not have to please their customers. All they had to do was follow orders from the central planning commission in Moscow.
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