The Soviet Union Economic Failure

What Explains the Economic Failure of the Soviet Union?

The economic growth model Opens in new window can help explain one of the most striking events of the twentieth century: the economic collapse of the Soviet Union.

The Soviet Union was formed from the old Russian Empire following the communist revolution of 1917.

Under Communism the Soviet Union was a centrally planned economy Opens in new window where the government owned nearly every business and made all production and pricing decisions.

In 1960 Nikita Khrushchev, the leader of the Soviet Union, addressed the United Nations in New York City. He declared to the United States and the other democracies, ‘We will bury you. Your grandchildren will live under Communism.’

Many people at the time took Khrushchev’s boast seriously. Capital per hour worked grew rapidly in the Soviet Union from 1950 to the 1980s. At first, these increases in capital per hour worked also produced rapid increases in real GDP per hour worked.

Rapid increases in real GDP per hour worked during the 1950s caused some economists in the United States to predict incorrectly that the Soviet Union would someday surpass the United States economically.

In fact, diminishing returns to capital meant that the additional factories the Soviet Union was building resulted in smaller and smaller increases in real GDP per hour worked.

The Soviet Union did experience some technological change Opens in new window, but at a rate much slower than in the United States and other high-income countries.

Why did the Soviet Union fail the crucial requirement for growth: implementing new technologies?

The key reason is that in a centrally planned economy the people in charge of running most businesses are government employees and not entrepreneurs Opens in new window or independent business people, as is the case in market economies.

Soviet managers had little incentive to adopt new ways of doing things. Their pay depended on producing the quantity of output specified in the government’s economic plan, not on discovering new, better and lower-cost ways to produce goods. In addition, these managers did not have to worry about competition from either domestic or foreign firms.

In contrast, entrepreneurs and managers of firms in market economies such as Australia, Hong Kong and the United States are under intense competitive pressure from other firms. They must constantly search for better ways of producing the goods and services they sell.

Developing and using new technologies is an important way to gain a competitive edge and higher profits. The drive for profit provides an incentive for technological change that centrally planned economies are unable to duplicate.

In market economies decisions about which investments to make and which technologies to adopt are made by entrepreneurs and managers with their own money on the line.

In the Soviet system these decisions were usually made by salaried bureaucrats trying to fulfill a plan formulated in Moscow.

Nothing concentrates the mind like having your own funds at risk.

In hindsight, it is clear that a centrally planned economy, such as the Soviet Union’s, could not, over the long run, grow faster than a market economy.

The Soviet Union collapsed in 1991, and contemporary Russia now has a more market-oriented system, although the government continues to play a much larger role in the economy than governments in many other market economies.