What Exactly Is a Socialist Economy?

Nevertheless, some economists and political philosophers have contended that the capitalist model is inherently flawed. Such a system, they say, necessarily creates clear winners and losers.

Because the means of production are in private hands, those who own them not only accumulate a disproportionate share of wealth but have the power to suppress the rights of those they employ.

Socialist Theory

This idea of class conflict lies at the heart of socialism. Its most prominent voice, Karl Marx, believed low-income workers, faced with these injustices, would inevitably revolt against the wealthy bourgeoisie. In its place, he envisioned a society where the government—or the workers themselves—owned and controlled industry.

In contrast to capitalism, socialists believe shared ownership of resources and central planning offer a more equitable distribution of goods and services. In short, they hold that workers who contribute to economic output should expect a commensurate reward. This sentiment is crystallized in the socialist slogan: “From each according to their ability, to each according to their need.”1

Below are some of the key tenets of socialism:

• Public or collective ownership of the means of production
• Central planning of the economy
• Emphasis on equality and economic security
• Goal of reducing class distinctions

Marx himself thought that toppling the existing capitalist order required a revolution led by the working class or proletariat. However, many socialist leaders—including influential “social democrats” in France, Germany, and Scandinavia—advocate reforming, rather than replacing, capitalism to achieve greater economic equality.

Another source of confusion regarding the term “socialism” stems from the fact that it’s often used interchangeably with “communism.” In fact, the two words have different meanings.

According to Friedrich Engels, who worked alongside Marx, socialism is the first phase of the revolution, in which the government plays a prominent role in economic life, and class differences begin to shrink.

This interim stage ultimately gives way to communism, a classless society where the working class no longer relies on the state. In practice, however, communism is the name often given to a revolutionary form of socialism, also known as Marxism-Leninism, which took root in the Soviet Union and China during the 20th Century.

Socialism in Practice

In a capitalist economy, the market determines prices through the laws of supply and demand. For example, when demand for coffee increases, a profit-seeking business will boost prices to increase its profit. If at the same time, society’s appetite for tea diminishes, growers will face lower prices and aggregate production will decline.

In the long run, some suppliers may even exit the business. Because consumers and suppliers negotiate a new “market-clearing price” for these goods, the quantity produced more or less matches the public’s needs.

Under a true socialist system, it’s the government’s role to determine output and pricing levels. The challenge is synchronizing these decisions with the needs of consumers. Socialist economists such as Oskar Lange have argued that, by responding to inventory levels, central planners can avoid major production inefficiencies. So when stores experience a surplus of tea, it signals the need to cut prices, and vice versa.

One of the critiques of socialism is that, even if government officials can adjust prices, the lack of competition between different producers reduces the incentive to do so. Opponents also suggest that public control of production necessarily creates an unwieldy, inefficient bureaucracy. The same central planning committee could, in theory, be in charge of pricing thousands of products, making it extremely difficult to react to market cues promptly.

Furthermore, the concentration of power within the government can create an environment where political motivations override the basic needs of the people. Indeed, at the same time the Soviet Union was diverting vast resources to build up its military capability, its residents often had trouble attaining a variety of goods, including food, soap, and even television sets.

One Idea, Multiple Forms

The word “socialism” is perhaps most associated with countries such as the former Soviet Union and China under Mao Zedong, along with present-day Cuba and North Korea. These economies conjure the idea of totalitarian leaders and public ownership of virtually all productive resources.

However, other parts of the world sometimes use the same term to describe very different systems. For instance, the main Scandinavian economies—Sweden, Denmark, Norway, and Finland—are often referred to as “social democracies” or simply “socialist.” But rather than the government running the entire economy, such countries balance market competition with robust social safety nets. That means nearly universal healthcare and laws that rigorously protect worker rights.

Even in decidedly capitalist countries, such as the United States, some services are thought too important to leave to the marketplace alone. Consequently, the government provides unemployment benefits, social security, and health insurance for seniors and low-income earners. It’s also the main provider of elementary and secondary education.

A Complicated Track Record

The most ardent critics of socialism contend that its goal of raising the standard of living for those in the lower and middle classes is hard to prove historically. By the 1980s, the economic well-being of most Russians trailed that of Westerners by a wide margin, laying the groundwork for Soviet disintegration. Meanwhile, China’s growth accelerated only after it began implementing pro-market reforms in the late 1970s and 80s.

A study of income levels around the globe by the Fraser Institute, a right-leaning think tank, supports this assessment.2 Countries with the highest levels of economic freedom have historically had higher per capita averages. See the map below for an illustration of economic freedom around the world.

When one looks at European-style socialism—with democratically elected leaders and private ownership of most industries—the results are quite different. Despite their relatively high taxes, Norway, Finland, and Switzerland are three of the top five most prosperous nations according to the 2019 Legatum Prosperity Index.

While in certain respects, these countries have moved farther to the right in recent years, some argue that Scandinavia is proof that a large welfare state and economic success are not mutually exclusive.

The Bottom Line

The disintegration of the Soviet Union marked a major setback for the Marxist brand of socialism. However, more moderate versions of the ideology continue to have a strong influence throughout the world. Even in most Western democracies, the debate is not about whether the government should provide a social safety net, but rather how big it should be.