Unit 1 Prosperity, inequality, and planetary limits

1.8 Capitalist institutions

How can we explain the change from a world in which living conditions changed little unless there was an epidemic or a war, to the world of continuous technological revolution—in which each generation was noticeably, and predictably, better off than the previous one?

An important part of our answer is what we call the capitalist revolution: the emergence in the eighteenth century and eventual global spread of a way of organizing the economy that we now call capitalism. The term ‘capitalism’ was barely heard of a century ago, but Figure 1.13 illustrates how its use has skyrocketed since then. It shows the fraction of articles in the New York Times (excluding the sports section) that include the word ‘capitalism’.

capitalism

An economic system in which the main form of economic organization is the firm, where the private owners of capital goods hire labour to produce goods and services to be sold in markets with the intent of making a profit. The main economic institutions in a capitalist economic system are private property, markets, and firms.

economic system

A way of organizing the economy that is distinctive in its basic institutions. Economic systems of the past and present include: central economic planning (e.g. the Soviet Union in the twentieth century), feudalism (e.g. much of Europe in the early Middle Ages), slave economy (e.g. the US South and the Caribbean plantation economies prior to the abolition of slavery in the nineteenth century), and capitalism (most of the world’s economies today).

institution

An institution is a set of laws and informal rules that regulate social interactions among people, and between people and the biosphere; sometimes also termed ‘the rules of the game’.

In everyday language, the word ‘capitalism’ is used in different ways, partly because people have strong feelings about it. In the language of economics, we use the term in a precise way: we define capitalism as an economic system characterized by a particular combination of institutions. An economic system is a way of organizing the production and distribution of goods and services in an entire economy. And by institutions, we mean the various sets of laws and social customs regulating production and distribution.

The institutions that characterize capitalism are private property, markets, and firms.

Since most of us live in capitalist economies, it is easy to overlook the importance of institutions that are fundamental for capitalism to work well. They are so familiar that we hardly notice them. Before seeing how these institutions combine in the capitalist economic system, we need to define them.

private property

Something is private property if the person possessing it has the right to exclude others from it, to benefit from the use of it, and to exchange it with others.

Over the course of human history, the extent of private property has varied. In some societies, such as that of our distant ancestors, the hunter-gatherers, almost nothing except personal ornaments and clothing was owned by individuals. In others, crops and animals were private property, but land was not. The right to use the land was granted to families by consensus among members of a group, or by a chief, without allowing the family to sell the plot.

In various economic systems, some human beings—as enslaved people—could be private property.

Private property may be owned by an individual, a family, a business, or some entity other than the government. Some things that we value are not private property: for example, the air we breathe and most of the knowledge we use cannot be owned or bought and sold.

market

A market enables people to exchange goods and services by means of directly reciprocated transfers (unlike gifts), voluntarily entered into for mutual benefit (unlike theft, taxation), in a way that is often impersonal (unlike transfers among friends, family).

Markets are a means of transferring goods or services from one person to another. There are other ways, such as by theft, a gift, or a government order. Markets differ from these in three respects.

gains from trade, gains from exchange

The benefits that each party gains from a transaction compared to how they would have fared without the transaction.

• Reciprocity. The transfer of a good on a market is reciprocated: unlike gifts and theft, one person’s transfer of a good or service to another is directly matched by a transfer in the other direction (either of another good or service as in barter exchange, or money, or a promise of a later transfer when buying on credit).
• Participation is voluntary. All transfers are willingly undertaken, because the things being exchanged are private property and both buyer and seller expect to benefit: there are mutual gains from exchange.
• Competition. In most cases buyers and sellers are limited in the prices they can set. A seller charging a high price, for example, will find that buyers will purchase from other competing sellers offering lower prices.

firm

An economic organization in which private owners of capital goods hire and direct labour to produce goods and services for sale on markets to make a profit.

But private property and markets alone do not define capitalism. In many places they were important institutions long before capitalism. The most recent of the three components making up the capitalist economy is the firm.

The kinds of firms that make up a capitalist economy include restaurants, banks, large farms that pay others to work there, industrial establishments, supermarkets, and internet service providers. Other productive organizations that are not firms, and which play a lesser role in a capitalist economy, include family businesses, in which most or all of the people working are family members; non-profit organizations; employee-owned cooperatives; and government-owned entities (such as railways and power or water companies). These are not firms, either because they do not make a profit, or because the owners are not private individuals who own the assets of the firm and employ others to work there.

Figure 1.14 shows that the three parts of the definition of a capitalist economic system are nested concepts. The left-hand circle describes an economy of isolated families who own their tools and the goods they produce, but have little or no exchange with others.

Historically, economies like the left-hand circle have existed, but have been much less important than a system in which markets and private property are combined (the middle circle). Private property is an essential condition for the operation of markets: buyers will not want to pay for goods unless they can have the right to own them. In the middle circle, most production is done either by individuals (shoemakers or blacksmiths, for example) or in families (for example, on a farm) rather than by firms with owners and employees. Prior to 1600, most of the economies of the world worked like this. Where firms, meaning employment for wages, existed, they played only a minor role.

In a capitalist system, which in Britain expanded during the seventeenth and later centuries, most production takes place in firms. Firms combine inputs—including equipment, raw materials, and labour—to produce outputs. Markets and private property are essential for firms to function for two reasons.

capital goods, capital

Capital goods (sometimes shortened to ‘capital’) are the durable and costly non-labour inputs used in production (e.g. machinery, equipment, buildings). They do not include some essential inputs (e.g. air, water, knowledge) that are used in production at zero cost to the user.

labour market

The market in which employers offer wages to individuals who may agree to work under their direction. Economists say that employers are on the demand side of this market, while employees are on the supply side.

• Outputs and capital goods are private property: The firm’s buildings, equipment, and other durable inputs, which are called capital goods, belong to the owners; so do the resulting outputs.
• Firms use markets to buy inputs and sell outputs: The owners’ profits depend on markets in which customers may willingly purchase the products at a price that will more than cover production costs.¹ And they buy their inputs in other markets, including the labour market, where they hire workers and pay them wages to operate their capital goods.

In other societies, private firms and markets have been relatively unimportant. The government has been the institution that owns capital goods, thereby controlling production, and deciding how goods should be distributed, and to whom. This is called a centrally planned economic system. It existed, for example, in the Soviet Union, East Germany, and many other eastern European countries prior to the end of Communist Party rule in the early 1990s.

Another contrast is with a slave economy: an economic system where most of the work is done by people who are not hired for wages but, instead, like the land on which they work, are the property of another person.

Though governments and families are essential parts of the workings of every economy, most economies today are capitalist according to our definition: they share the three characteristics of private property, markets, and firms. How these institutions of capitalism combine with each other and with families, governments, and other institutions differs greatly across countries—so it would be more precise to describe capitalism not as a specific economic system, but as a class of systems.

Capitalism, power, and competition

Capitalism is an economic system that combines centralization with decentralization. It concentrates power in the hands of owners and managers of firms who are then able to secure the cooperation of large numbers of employees in the production process. But it limits the powers of owners and of other individuals, because they face competition to buy and sell in markets.

So when the owner of a firm interacts with an employee, the owner is ‘the boss’. But when the same owner interacts with a potential customer they are simply another person trying to make a sale, in competition with other firms. It is this combination of competition among firms, and concentration of power and cooperation within them, that accounts for capitalism’s success as an economic system.

A striking characteristic of firms, distinguishing them from families and governments, is how quickly they can be born, expand, contract, and die. A successful firm can grow from just a few employees to a global company with hundreds of thousands of customers, that employs thousands of people, in a few years. Firms can do this because they are able to hire additional employees on the labour market, and attract funds to finance the purchase of the capital goods they need to expand production.

Firms can die in a few years too. A firm that does not make profits will not have enough money (and will not be able to borrow money) to continue employing and producing. The firm shrinks, and some of the employees lose their jobs.

Contrast this with a successful family farm. The family will be better off than its neighbours; but unless it turns the family farm into a firm, and employs other people to work on it, expansion will be limited. If, instead, the family is not very good at farming, then it will simply be less well off than its neighbours. The family head cannot dismiss the children as a firm might get rid of unproductive workers. As long as the family can feed itself, there is no equivalent mechanism to a firm’s failure that will automatically put it out of business.

Government bodies also tend to be more limited in their capacity to expand if successful, and are usually protected from failure if they perform poorly.

How could capitalism lead to growth in living standards?

The emergence of capitalism brought two major changes, both of which enhanced the productivity of individual workers.

Technology

As we have seen, the continuous technological revolution coincided with the transition to firms as the predominant means of organizing production. This does not mean that firms necessarily caused technological change. But firms competing with each other in markets had strong incentives to adopt and develop new and more productive technologies, and to invest in capital goods that would have been beyond the reach of small-scale family enterprises.

Specialization

The growth of firms employing large numbers of workers—and the expansion of markets linking the entire world in a process of exchange—allowed historically unprecedented specialization in the tasks and products on which people worked. As Adam Smith explained, organizing production so that workers specialize in different tasks enables firms to increase output with the same number of employees.