A centrally planned economy or a command economy is one where the price and allocation of resources, goods and services is determined by the government rather than autonomous agents as it is in a free market economy. The government of a centrally planned economy decides where and when production and investment will be directed.
Most countries have rejected this model however there is a small number that still use it, The People's Republic of China had developed overtime from a centrally planned economy to a more mixed economy although the government and state owned enterprises (SOEs) still play a large role in the Chinese economy. The Republic of Cuba is another example of a centrally planned economy. The Democratic Peoples Republic of Korea is perhaps the most accurate example of a centrally planned economy, in the DPRK, the government is controlled by one person who appoints others to run the economy and they have total control.
There is no effort to differentiate goods from one another. In free and mixed economies, firms compete for consumers, when two firms sell a similar product, they try to make theirs standout from the other to capture the attention of the consumer. This practice is known as product differentiation and is essential to the competition of a market economy.
There is no concept of supply and demand, through the use of production targets, a centrally planned economy determines how much of each good will be produced and what the price will be. In contrast, a market economy the level of demand determines the level of supply and the price reflects this interaction of market forces. For example, under the Gosplan central planning agency in the Soviet Union, food prices were extremely low which pleased Russians initially because food was so cheap but, eventually the prices were set too low and eventually a shortage of food emerged.
There are very few benefits that stem from a centrally planned economy although there are some examples where central planning is an effective economic organization.
When the government is able to control the allocation of resources, it can easily direct the economic efforts of the state towards specific goals. For example, in Russia in the early 20th century, Russia was able to rapidly industrialize from a simple agrarian state into an industrial powerhouse.
In Cuba, the communist government places great emphasis on the healthcare system and as a result the Cuban healthcare system is one of the best in the world.
An advantage of a centrally planned economy is that the planners or, those who direct the economy, can direct the economic activities to mitigate harm caused by certain activities or encourage activities that have positive effects. There are implications to limiting or promoting certain economic activities but depending on what planners think is best for an economy or country, the strict planning can produce a positive outcome.
Suppose a central planning committee wanted to minimize or eliminate the negative externality created by the combustion of fossil fuels and the emissions they release. A centrally planned economy would be able to direct firms to only construct energy projects that have zero emissions and to stop using electrical generation methods that produce emissions and pollution. While this would have very large repercussions for the economy it would be done in order to eliminate the effects of fossil fuel combustion and to switch to renewable methods. Additionally this can be used to limit the inefficient use of energy in homes, factories and other areas of an economy.
An example of this is in The Peoples Republic of China where, in 2010, the central government announced that they would close over 2000 factories that are very energy inefficient. The factories had been open since the 1950s/60s and as a result their equipment is very energy intensive and strains the energy resources of China.
The disadvantages far outweigh the advantages of a centrally planned economy. The main disadvantage of centrally planned economies is the vast inefficiency that comes from ignoring natural market forces. Under a planned system the government cannot detect or track the preferences of consumers in time to shift production, this leads to an inefficient allocation of goods, also known as the local knowledge problem. This inability to understand what consumers want in time leads to a less than optimal distribution in the economy.
In a market economy, consumer preferences drive production and production shifts when preferences do, this leads to an efficient allocation. For example, if a firm makes sugary soda drinks and the consumers decide they want a healthier option the firm will make an effort to make a healthier drink in order to keep the business of the consumers.
In market economies, the local knowledge problem is much less of a problem because the production is autonomous and decentralized. Firms make an effort to understand consumer preferences in the markets they operate in. Due to the rigid control of a planned economy and the slow flow of information the market is not allowed to change output levels according to consumption and as a result changes in output are usually too large or too small leading to unsteady output levels over time.
Planned economies suppress the incentive for people and firms to maximize their benefit from the economy and thus suppresses innovation as firms do not need to compete for market share. In a free market, firms seek to compete as much as possible to capture as much of the market as they can. Because they can earn more money by competing, firms in a free market have the incentive to innovate to make a better product for consumers.
Central planning is not synonymous with communism or socialism because central planning is specifically an economic model. Both socialism and communism use central planning as a way of achieving other social and political goals, but usually operate as part of a mixed economy.