Because of the way power is organized, the core institutions in society are ____ and ____.

Shinjuku, Tokyo

History, instability, and growthGlobal economyInequalityInnovation

How capitalism revolutionized the way we live, and how economics attempts to understand this and other economic systems

• Since the 1700s, increases in average living standards became a permanent feature of economic life in many countries.
• This was associated with the emergence of a new economic system called capitalism, in which private property, markets and firms play a major role.
• Under this new way of organizing the economy, advances in technology and specialization in products and tasks raised the amount that could be produced in a day’s work.
• This process, which we call the capitalist revolution, has been accompanied by growing threats to our natural environment, and by unprecedented global economic inequalities.
• Economics is the study of how people interact with each other, and with the natural environment, in producing their livelihoods.

In the fourteenth century, the Moroccan scholar Ibn Battuta described Bengal in India as ‘A country of great extent, and one in which rice is extremely abundant. Indeed, I have seen no region of the earth in which provisions are so plentiful.’

And he had seen much of the world, having travelled to China, west Africa, the Middle East and Europe. Three centuries later, the same sentiment was expressed by the seventeenth century French diamond merchant Jean Baptiste Tavernier who wrote of the country:

Even in the smallest villages, rice, flour, butter, milk, beans and other vegetables, sugar and sweetmeats, dry and liquid, can be procured in abundance.1

At the time of Ibn Battuta’s travels, India was not richer than the other parts of the world. But India was not much poorer, either. An observer at the time would have noticed that people, on average, were better off in Italy, China and England than in Japan or India. But the vast differences between the rich and the poor, which the traveller would have noted wherever he went, were much more striking than these differences across regions. Rich and poor would often have different titles: in some places they would be feudal lords and serfs, in others royalty and their subjects, slave owners and slaves, or merchants and the sailors who transported their goods. Then—as now—your prospects depended on where your parents were on the economic ladder and whether you were male or female. The difference in the fourteenth century, compared with today, was that back then the part of the world in which you were born mattered much less.

Fast forward to today. The people of India are far better off than they were seven centuries ago if we think about their access to food, medical care, shelter and the necessities of life, but by world standards today most are poor.

Ibn Battuta (1304–1368) was a Moroccan traveller and merchant. His travels, which lasted 30 years, took him across north and west Africa, eastern Europe, the Middle East, south and central Asia and China.

Figure 1.1a tells some of the story. To compare living standards in each country, we use a measure called GDP per capita. People obtain their incomes by producing and selling goods and services. GDP (gross domestic product) is the total value of everything produced in a given period such as a year, so GDP per capita corresponds here to average annual income. GDP is also referred to as gross domestic income. In Figure 1.1a the height of each line is an estimate of average income at the date on the horizontal axis.

If you have never have seen an ice-hockey stick (or experienced ice hockey) this shape is why we call these figures ‘hockey-stick curves’.

A different way of looking at the data in Figure 1.1a is to use a scale that shows GDP per capita doubling as we move up the vertical axis (from $250 per capita per year to $500, then to $1,000, and so on). This is called a ratio scale and is shown in Figure 1.1b. The ratio scale is used for comparing growth rates.

By the growth rate of income or of any other quantity, for example population, we mean the rate of change:

If the level of GDP per capita in the year 2000 is $31,946, as it was in Britain in the data shown in Figure 1.1a, and $32,660 in 2001, then we can calculate the growth rate:

Whether we want to compare levels or growth rates depends on the question we are asking. Figure 1.1a makes it easy to compare the levels of GDP per capita across countries, and at different times in history. Figure 1.1b uses a ratio scale, which makes it possible to compare growth rates across countries and at different periods. When a ratio scale is used, a series that grows at a constant rate looks like a straight line. This is because the percentage (or proportional growth rate) is constant. A steeper line in the ratio scale chart means a faster growth rate.

To see this, think of a growth rate of 100%: that means the level doubles. In Figure 1.1b, with the ratio scale, you can check that if GDP per capita doubled over 100 years from a level of $500 to $1,000, the line would have the same slope as a doubling from $2,000 to $4,000 dollars, or from $16,000 to $32,000 over 100 years. If, instead of doubling, the level quadrupled (from say, $500 to $2,000 over 100 years), the line would be twice as steep, reflecting a growth rate that was twice as high.

He travelled throughout Europe, visiting Toulouse, France where he claimed to have ‘very little to do’ and thus began ‘to write a book in order to pass away the time.’ This was to become the most famous book in economics.

In An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776, Smith asked: how can society coordinate the independent activities of large numbers of economic actors—producers, transporters, sellers, consumers—often unknown to each other and widely scattered across the world? His radical claim was that coordination among all of these actors might spontaneously arise, without any person or institution consciously attempting to create or maintain it. This challenged previous notions of political and economic organization, in which rulers imposed order on their subjects.

Even more radical was his idea that this could take place as a result of individuals pursuing their self-interest: ‘It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest,’ he wrote.

Elsewhere in the Wealth of Nations, Smith introduced one of the most enduring metaphors in the history of economics, that of the invisible hand. The businessman, he wrote: ‘intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.’

Among Smith’s insights is the idea that a significant source of prosperity is the division of labour or specialization, and that this in turn is constrained by the ‘extent of the market.’ Smith illustrated this idea in a famous passage on the pin factory by observing that ten men, each fully specialized in one or two of 18 distinct operations, could produce close to 50,000 pins a day. But ‘if they had all wrought [pins] separately and independently … they certainly could not each of them have made twenty, perhaps not one pin in a day.’

But such an enormous number of pins could only find buyers if they were sold far from their point of production. Hence specialization was fostered by the construction of navigable canals and the expansion of foreign trade. And the resulting prosperity itself expanded the ‘extent of the market’, in a virtuous cycle of economic expansion.

Smith did not think that people were guided entirely by self-interest. Seventeen years before The Wealth of Nations, he had published a book about ethical behaviour called The Theory of Moral Sentiments.6

He also understood that the market system had some failings, especially if sellers banded together so as to avoid competing with each other. ‘People in the same trade seldom meet together,’ he wrote, ‘even for merriment and diversion, but the conversation ends in a conspiracy against the public; or in some contrivance to raise prices.’

He specifically targeted monopolies that were protected by governments, such as the British East India Company that not only controlled trade between India and Britain, but also administered much of the British colony there.

He agreed with his contemporaries that a government should protect its nation from external enemies, and ensure justice through the police and the court system. He also advocated government investment in education, and in public works such as bridges, roads, and canals.

Smith is often associated with the idea that prosperity arises from the pursuit of self-interest under free market conditions. However, his thinking on these issues was far more nuanced than he is given credit for.

Figure 1.1a used a conventional scale for the vertical axis, and Figure 1.1b used a ratio scale.

1. For Britain, identify a period of time when its growth rate was increasing and another period in which its growth rate was roughly constant. Which figure did you use, and why?
2. Identify a period during which GDP per capita was shrinking (a negative growth rate) faster in Britain than in India. Which figure did you use and why?

The GDP per capita of Greece was $22,494 in 2012 and $21,966 in 2013. Based on these figures, the growth rate of GDP between 2012 and 2013 (to two decimal places) was:

• –2.40%
• 2.35%
• –2.35%
• –0.24%

• The GDP per capita decreased by $528. To find the growth rate divide by the 2012 GDP per capita $22,494 (and not the 2013 GDP per capita $21,966).
• Greece’s GDP per capita decreased between 2012 and 2013, resulting in a negative growth rate.
• The GDP per capita changed by $21,966 − $22,494 = −$528. The growth rate of GDP per capita is given by this change as a percentage of the 2012 figure: −$528/$22,494 = −2.35%.
• The decrease in the GDP per capita of $528 is 2.35% of $22,494 and not 0.235%.

Imagine that the GDP per capita of a country had doubled every 100 years. You are asked to draw both linear and ratio scale graphs that plot GDP on the vertical axis, and the year on the horizontal axis. What will be the shapes of the curves?

• An upward-sloping curve with increasing slope (called convex shape)

  An upward-sloping straight line

• An upward-sloping straight line

  A straight horizontal line

• An upward-sloping straight line

  An upward-sloping curve with decreasing slope (called concave shape)

• An upward-sloping convex curve

  An upward-sloping convex curve

Note: Linear scale graphs are ‘normal’ graphs in which the difference in height between 1 and 2, and the difference between 2 and 3, would be the same on the vertical axis.

• An upward-sloping straight line on a ratio scale graph means that the growth rate of the GDP per capita is constant. An upward-sloping convex curve on a linear scale graph means that the GDP per capita increases by a greater and greater amount in absolute terms over time, consistent with a positive constant growth rate.
• An upward-sloping straight line on a linear scale graph means that the GDP per capita increases by the same amount every year. A straight horizontal line on a ratio scale graph means that the GDP per capita is constant over the years.
• An upward-sloping straight line on a linear scale graph means that the GDP per capita increases by the same amount every year. An upward-sloping concave curve on a ratio scale graph means that the growth rate decreases each year. Here the growth rate is constant.
• An upward-sloping convex curve on a ratio scale graph means that the growth rate increases each year. Here the growth rate is constant.

History, instability, and growthInnovation

1.4 The permanent technological revolution

The science fiction show Star Trek is set in the year 2264, when humans travel the galaxy with friendly aliens aided by intelligent computers, faster-than-light propulsion, and replicators that create food and medicine on demand. Whether we find the stories silly or inspiring, most of us, in optimistic moods, can entertain the idea that the future will be transformed morally, socially, and materially by technological progress.

No Star Trek future awaited the peasant’s grandchildren of 1250. The next 500 years would pass without any measurable change in the standard of living of an ordinary working person. While science fiction began to appear in the seventeenth century (Francis Bacon’s New Atlantis being one of the first, in 1627), it was not until the eighteenth century that each new generation could look forward to a different life that was shaped by new technology.

Remarkable scientific and technological advances occurred more or less at the same time as the upward kink in the hockey stick in Britain in the middle of the eighteenth century.

Important new technologies were introduced in textiles, energy and transportation. Its cumulative character led to it being called the Industrial Revolution. As late as 1800, traditional craft-based techniques, using skills that had been handed down from one generation to the next, were still used in most production processes. The new era brought new ideas, new discoveries, new methods and new machines, making old ideas and old tools obsolete. These new ways were, in turn, made obsolete by even newer ones.

In everyday usage, ‘technology’ refers to machinery, equipment and devices developed using scientific knowledge. In economics, technology is a process that takes a set of materials and other inputs—including the work of people and machines—and creates an output. For example, a technology for making a cake can be described by the recipe that specifies the combination of inputs (ingredients such as flour, and labour activities such as stirring) needed to create the output (the cake). Another technology for making cakes uses large-scale machinery, ingredients and labour (machine operators).

Until the Industrial Revolution, the economy’s technology, like the skills needed to follow its recipes, was updated only slowly and passed from generation to generation. As technological progress revolutionized production, the time required to make a pair of shoes fell by half in only a few decades; the same was true of spinning and weaving, and of making cakes in a factory. This marked the beginning of a permanent technological revolution because the amount of time required for producing most products fell generation after generation.

Technological change in lighting

To get some idea of the unprecedented pace of change, consider the way we produce light. For most of human history technological progress in lighting was slow. Our distant ancestors typically had nothing brighter than a campfire at night. The recipe for producing light (had it existed) would have said: gather lots of firewood, borrow a lighting stick from some other place where a fire is maintained, and start and maintain a fire.

The first great technological breakthrough in lighting came 40,000 years ago, with the use of lamps that burned animal or vegetable oils. We measure technological progress in lighting by how many units of brightness called lumens could be generated by an hour of work. One lumen is approximately the amount of brightness in a square metre of moonlight. One lumen-hour (lm-hr) is this amount of brightness lasting an hour. For example, creating light by a campfire took about 1 hour of labour to produce 17 lm-hr, but animal fat lamps produced 20 lm-hr for the same amount of work. In Babylonian times (1750 BC) the invention of an improved lamp using sesame oil meant that an hour of labour produced 24 lm-hr. Technological progress was slow: this modest improvement took 7,000 years.

Three thousand years later, in the early 1800s, the most efficient forms of lighting (using tallow candles) provided about nine times as much light for an hour of labour as had the animal fat lamps of the past. Since then lighting has become more and more efficient with the development of town gas lamps, kerosene lamps, filament bulbs, fluorescent bulbs and other forms of lighting. Compact fluorescent bulbs introduced in 1992 are about 45,000 times more efficient, in terms of labour time expended, than lights were 200 years ago. Today the productivity of labour in producing light is half a million times greater than it was among our ancestors around their campfire.

Figure 1.3 charts this remarkable hockey-stick growth in efficiency in lighting using the ratio scale we introduced in Figure 1.1b.

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Figure 1.3 The productivity of labour in producing light.

William Nordhaus. 1998. ‘Do Real Output and Real Wage Measures Capture Reality? The History of Lighting Suggests Not’. Cowles Foundation For Research in Economics Paper 1078.

Transformational technological change is still occurring. Hans Rosling claims that we should say ‘thank you industrialization’ for creating the washing machine, a device that transformed the wellbeing of millions of women.

The process of innovation did not end with the Industrial Revolution, as the case of labour productivity in lighting shows. It has continued with the application of new technologies in many industries, such as the steam engine, electricity, transportation (canals, railroads, automobiles), and most recently, the revolution in information processing and communication. These broadly applicable technological innovations give a particularly strong impetus to growth in living standards because they change the way that large parts of the economy work.

By reducing the amount of work-time it takes to produce the things we need, technological changes allowed significant increases in living standards. David Landes, an economic historian, wrote that the Industrial Revolution was ‘an interrelated succession of technological changes’ that transformed the societies in which these changes took place.7

A connected world

In July 2012, the Korean hit ‘Gangnam Style’ was released. By the end of 2012 it had become the best-selling song in 33 countries, including Australia, Russia, Canada, France, Spain and the UK. With 2 billion views by the middle of 2014, ‘Gangnam Style’ also became the most watched video on YouTube. The permanent technological revolution has produced a connected world.

Everyone is part of it. The materials making up this introduction to economics were written by teams of economists, designers, programmers and editors, working together—often simultaneously—at computers in the UK, India, the US, Russia, Colombia, South Africa, Chile, Turkey, France and many other countries. If you are online, some of the transmission of information occurs at close to the speed of light. While most of the commodities traded around the globe still move at the pace of an ocean freighter, about 21 miles (33 km) per hour, international financial transactions are implemented in less time than it took you to read this sentence.

The speed at which information travels provides more evidence of the novelty of the permanent technological revolution. By comparing the known date of a historical event with the date at which the event was first noted in other locations (in diaries, journals or newspapers) we can determine the speed at which news travelled. When Abraham Lincoln was elected US president in 1860, for example, the word was spread by telegraph from Washington to Fort Kearny, which was at the western end of the telegraph line. From there the news was carried by a relay of riders on horseback called the Pony Express, covering 1,260 miles (2,030 km) to Fort Churchill in Nevada, from where it was transmitted to California by telegraph. The process took seven days and 17 hours. Over the Pony Express segment of the route, the news travelled at 7 miles (11 km) per hour. A half-ounce (14 gram) letter carried over this route cost $5, or the equivalent of five days’ wages.

From similar calculations we know that news travelled between ancient Rome and Egypt at about 1 mile (1.6 km) per hour, and 1,500 years later between Venice and other cities around the Mediterranean it was, if anything, slightly slower. But, a few centuries later, as Figure 1.4 shows, the pace began to quicken. It took ‘only’ 46 days for the news of a mutiny of Indian troops against British rule in 1857 to reach London, and readers of the Times of London knew of Lincoln’s assassination only 13 days after the event. One year after Lincoln’s death a transatlantic cable cut the time for news to travel between New York and London to a matter of minutes.

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Figure 1.4 The speed at which information travelled (1000–1865).

Tables 15.2 and 15.3 from Gregory Clark. 2007. A Farewell to Alms: A Brief Economic History of the World. Princeton, NJ: Princeton University Press.

1.5 The economy and the environment

Humans have always relied on their environment for the resources they need to live and produce their livelihoods: the physical environment and the biosphere, which is the collection of all forms of life on earth, provide essentials for life such as air, water and food. The environment also provides the raw materials that we use in the production of other goods—such as wood, metals, and oil.

Figure 1.5 shows one way of thinking about the economy: it is part of a larger social system, which is itself part of the biosphere. People interact with each other, and also with nature, in producing their livelihood.

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Figure 1.5 The economy is part of society, which is part of the biosphere.

Through most of their history, humans have regarded natural resources as freely available in unlimited quantities (except for the costs of extracting them). But as production has soared (see Figures 1.1a and 1.1b), so too have the use of our natural resources and degradation of our natural environment. Elements of the ecological system such as air, water, soil, and weather have been altered by humans more radically than ever before.

The most striking effect is climate change. Figures 1.6a and 1.6b present evidence that our use of fossil fuels—coal, oil, and natural gas—has profoundly affected the natural environment. After having remained relatively unchanged for many centuries, increasing emissions of carbon dioxide (CO2) into the air during the twentieth century have resulted in measurably larger amounts of CO2 in the earth’s atmosphere (Figure 1.6a) and brought about perceptible increases in the northern hemisphere’s average temperatures (Figure 1.6b). Figure 1.6a also shows that CO2 emissions from fossil fuel consumption have risen dramatically since 1800.

Between 1300 and 1850 there were a number of exceptionally cold periods as you can see from Figure 1.6b. Research this so-called ‘little ice age’ in Europe and answer the following.

1. Describe the effects of these exceptionally cold periods on the economies of these countries.
2. Within a country or region, some groups of people were exceptionally hard hit by the climate change while others were less affected. Provide examples.
3. How ‘extreme’ were these cold periods compared to the temperature increases since the mid-twentieth century and those projected for the future?

Figure 1.6b shows that the average temperature of the earth fluctuates from decade to decade. Many factors cause these fluctuations, including volcanic events such as the 1815 Mount Tambora eruption in Indonesia. Mount Tambora spewed so much ash that the earth’s temperature was reduced by the cooling effect of these fine particles in the atmosphere, and 1816 became known as the ‘year without a summer’.

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Figure 1.6a Carbon dioxide in the atmosphere (1010–2020) and global carbon emissions from burning fossil fuels (1750–2018).

Years 1010–1975: David M. Etheridge, L. Paul Steele, Roger J. Francey, and Ray L. Langenfelds. 2012. ‘Historical Record from the Law Dome DE08, DE08-2, and DSS Ice Cores’. Division of Atmospheric Research, CSIRO, Aspendale, Victoria, Australia. Years 1976–2020: Dr. Pieter Tans, NOAA/GML and Dr. Ralph Keeling, Scripps Institution of Oceanography. Carbon Dioxide Information Analysis Center (CDIAC) Datasets.

Since 1900, average temperatures have risen in response to increasingly high levels of greenhouse gas concentrations. These have mostly resulted from the CO2 emissions associated with the burning of fossil fuels.

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Figure 1.6b Northern hemisphere temperatures over the long run (1000–2019).

Michael E. Mann, Zhihua Zhang, Malcolm K. Hughes, Raymond S. Bradley, Sonya K. Miller, Scott Rutherford, and Fenbiao Ni. 2008. ‘Proxy-based reconstructions of hemispheric and global surface temperature variations over the past two millennia’. Proceedings of the National Academy of Sciences 105 (36): pp. 13252–13257; Morice, C. P., J. J. Kennedy, N. A. Rayner, and P. D. Jones (2012). ‘Quantifying uncertainties in global and regional temperature change using an ensemble of observational estimates: The HadCRUT4 dataset’. Journal of Geophysical Research. Updated 15 September 2016.

The human causes and the reality of climate change are no longer widely disputed in the scientific community. The likely consequences of global warming are far-reaching: melting of the polar ice caps, rising sea levels that may put large coastal areas under water, and potential changes in climate and rain patterns that may destroy the world’s food-growing areas. The long-term physical and economic consequences of these changes, and the appropriate policies that governments could adopt as a result, are discussed in detail in Unit 20 (Economics of the environment).

The authoritative source for research and data about climate change is the Intergovernmental Panel on Climate Change.

Climate change is a global change. But many of the environmental impacts of burning fossil fuels are local, as residents of cities suffer respiratory and other illnesses as a result of high levels of harmful emissions from power plants, vehicles, and other sources. Rural communities, too, are impacted by deforestation (another cause of climate change) and the depletion of the supply of clean water and fishing stocks.

From global climate change to local resource exhaustion, these effects are results of both the expansion of the economy (illustrated by the growth in total output) and the way the economy is organized (what kinds of things are valued and conserved, for example). The relationship between the economy and the environment shown in Figure 1.5 is two-way: we use natural resources in production, which may in turn affect the environment we live in and its capacity to support future production.

But the permanent technological revolution—which brought about dependence on fossil fuels—may also be part of the solution to today’s environmental problems.

Look back at Figure 1.3, which showed the productivity of labour in producing light. The vast increases shown over the course of history and especially since the mid-nineteenth century occurred largely because the amount of light produced per unit of heat (for example from a campfire, candle, or light bulb) increased dramatically.

In lighting, the permanent technological revolution brought us more light for less heat, which conserved natural resources—from firewood to fossil fuels—used in generating the heat. Advances in technology today may allow greater reliance on wind, solar and other renewable sources of energy.

Which of the following variables have followed the so-called ‘hockey-stick’ trajectory—that is, little to no growth for most of history followed by a sudden and sharp change to a positive growth rate?

• GDP per capita
• labour productivity
• inequality
• atmospheric CO2

• GDP per capita grows slowly or not at all in economies prior to industrialization, whereupon it begins to grow at an ever-increasing rate.
• Labour productivity grows slowly or not at all in economies prior to industrialization, whereupon it begins to grow at an ever-increasing rate.
• There is no unidirectional trend in inequality over time. While early hunter-gatherer tribes were undoubtedly almost perfectly equal, economies in the modern era have varied from highly equal to highly unequal.
• See Figure 1.6a. The growth in atmospheric CO2 began from the mid-nineteenth century as a consequence of the burning of fossil fuels as the technologies introduced in the Industrial Revolution spread.

History, instability, and growth

1.6 Capitalism defined: Private property, markets, and firms

Looking back over the data in Figures 1.1a, 1.1b, 1.3, 1.4 and 1.6 we see an upward turn, like the kink in our hockey stick, repeated for:

• gross domestic product per capita
• productivity of labour (light per hour of work)
• connectivity of the various parts of the world (the speed at which news travels)
• impact of the economy on the global environment (carbon emissions and climate change)

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

An important part of our answer will be 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’—which we will define shortly—was barely heard of a century ago, but as you can see from Figure 1.7, its use has skyrocketed since then. The figure shows the fraction of all articles in the New York Times (excluding the sports section) that include the term ‘capitalism.’

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Figure 1.7 Mention of the word ‘capitalism’ in New York Times articles (1851–2015).

Calculations by Simon DeDeo, Santa Fe Institute, from New York Times. 2016. ‘NYT article archive’.

Capitalism is 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 different sets of laws and social customs regulating production and distribution in different ways in families, private businesses, and government bodies.

This means that you can:

• enjoy your possessions in a way that you choose
• exclude others from their use if you wish
• dispose of them by gift or sale to someone else …
• … who becomes their owner

In some economies in the past, the key economic institutions were private property (people owning things), markets (where goods could be bought and sold) and families. Goods were usually produced by families working together, rather than by firms with owners and employees.

In other societies, the government has been the institution 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.

Though governments and families are essential parts of the workings of every economy, most economies today are capitalist. 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, we hardly ever notice them. Before seeing how private property, markets and firms combine in the capitalist economic system, we need to define them.

Over the course of human history, the extent of private property has varied. In some societies, such as the hunters and gatherers who are our distant ancestors, 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 other economic systems some human beings—slaves—were private property.

In a capitalist economy, an important type of private property is the equipment, buildings, and other durable inputs used in producing goods and services. These are called capital goods.

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.

Which of the following are examples of private property?

• computers belonging to your college
• a farmer’s land in Soviet Russia
• shares in a company
• a worker’s skills

• Although computers owned by the college may be used by many students, they are still property of the college, which requires payment (tuition) for access and can exclude their use by non-students.
• In the Soviet era Russia your land could be transferred to others by the state and hence was not private property.
• Shares in a company represent a claim to that company’s future profits; this claim can be sold, gifted, or realized as the owner wishes and represents income to which non-shareholders are not entitled.
• While intellectual property is private property (of your company, your university or yourself), your skills in general are not disposable to others for them to become the owners.

Markets are:

• a way of connecting people who may mutually benefit
• by exchanging goods and services
• through a process of buying and selling

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:

• They are reciprocated: unlike gifts and theft, one person’s transfer of a good or service to another is directly reciprocated 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 one buys on credit).
• They are voluntary: Both transfers—by the buyer and the seller—are voluntary because the things being exchanged are private property. So the exchange must be beneficial in the opinion of both parties. In this, markets differ from theft, and also from the transfers of goods and services in a centrally planned economy.
• In most markets there is competition. A seller charging a high price, for example, will find that buyers prefer to buy from other competing sellers.

‘The poorest man may in his cottage bid defiance to all the forces of the Crown. It may be frail, its roof may shake; the wind may blow through it; the storms may enter, the rain may enter—but the King of England cannot enter; all his forces dare not cross the threshold of the ruined tenement.’ – William Pitt, 1st Earl of Chatham, speech in the British Parliament (1763).

1. What does this tell us about the meaning of private property?
2. Does it apply to people’s homes in your country?

Think about a social networking site that you use, for example Facebook. Now look at our definition of a market.

What are the similarities and differences between that social networking site and a market?

Which of the following are examples of markets?

• wartime food rationing
• auction websites such as eBay
• touts selling tickets outside concert halls
• sale of illegal arms

• The transfer of goods and services that occur in a centrally planned economy as a result of government orders is not a market.
• An auction-based market is still a market, just one in which the pricing mechanism works through bidding as opposed to a negotiated or listed price.
• A resale market is still a market, even though the goods in question have already been sold once before.
• An illegal market is still a market in the economic sense.

A firm is a way of organizing production with the following characteristics:

• One or more individuals own a set of capital goods that are used in production.
• They pay wages and salaries to employees.
• They direct the employees (through the managers they also employ) in the production of goods and services.
• The goods and services are the property of the owners.
• The owners sell the goods and services on markets with the intention of making 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. Note: a firm pays wages or salaries to employees but, if it takes on unpaid student interns, it is still a firm.

Firms existed, playing a minor role, in many economies long before they became the predominant organizations for the production of goods and services, as in a capitalist economy. The expanded role of firms created a boom in another kind of market that had played a limited role in earlier economic systems: the labour market. Firm owners (or their managers) offer jobs at wages or salaries that are high enough to attract people who are looking for work.

In economic language, the employers are the demand side of the labour market (they ‘demand’ employees), while the workers are the supply side, offering to work under the direction of the owners and managers who hire them.

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, employing 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. This is because 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 people who work there 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.

Defining capitalism precisely

In everyday language, the word ‘capitalism’ is used in different ways, in part because people have strong feelings about it. In the language of economics, we use the term in a precise way because that helps us to communicate: we define capitalism as an economic system combining three institutions, each of which we need in turn to define.

‘Capitalism’ refers not to a specific economic system, but to a class of systems sharing these characteristics. How the institutions of capitalism—private property, markets, and firms—combine with each other and with families, governments, and other institutions differs greatly across countries. Just as ice and steam are both ‘water’ (defined chemically as a compound of two hydrogen atoms bonded with one oxygen atom), China and the US are both capitalist economies. But they differ in the extent to which the government influences economic affairs, and in many other ways. As this demonstrates, definitions in the social sciences often cannot be as precise as they are in the natural sciences.

Some people might say that ‘ice is not really water’, and object that the definition is not the ‘true meaning’ of the word. But debates about the ‘true’ meaning (especially when referring to complex abstract ideas like capitalism, or democracy) forget why definitions are valuable. Think of the definition of water, or of capitalism, not as capturing some true meaning—but rather as a device that is valuable because it makes it easier to communicate.

Definitions in the social sciences often cannot be as precise as they are in the natural sciences. Unlike water, we cannot identify a capitalist economic system using easy-to-measure physical characteristics.

History, instability, and growth

1.7 Capitalism as an economic system

Figure 1.8 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 capital goods and the goods they produce, but have little or no exchange with others.

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Figure 1.8 Capitalism: Private property, markets and firms.

In a capitalist system, production takes place in firms. Markets and private property are essential parts of how firms function for two reasons:

• Inputs and outputs are private property: The firm’s buildings, equipment, patents, and other inputs into production, as well as the resulting outputs, belong to the owners.
• Firms use markets to 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.8

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). Prior to 1600 a great many of the economies of the world were like this.

A distinctive aspect of the definition of capitalism as an economic system is that under it most production takes place using privately owned capital goods that are operated by workers who are paid wages. This contrasts with government ownership of capital goods in a centrally planned economy, where private firms and markets are relatively unimportant.

Another contrast is with an economic system defined as a slave economy, 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. Going beyond these definitions, capitalist economic systems also include work done by government officials and unpaid work in the home, and, historically, by slaves.

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

How could capitalism lead to growth in living standards?

Two major changes accompanied the emergence of capitalism, both of which enhanced the productivity of individual workers:

Technology

As we have seen, the permanent 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. In the next section, we will see how this specialization can raise labour productivity and living standards.

Using our definition, explain whether each of the following entities is a firm by investigating if it satisfies the characteristics that define a firm. Research the entity online if you are stuck.

1. John Lewis Partnership (UK)
2. a family farm in Vietnam
3. your current family doctor’s office or practice
4. Walmart (US)
5. an eighteenth-century pirate ship (see our description of The Royal Rover in Unit 5)
6. Google (US)
7. Manchester United plc (UK)
8. Wikipedia

History, instability, and growthGlobal economy

1.8 The gains from specialization

Capitalism and specialization

Look around at the objects in your workspace. Do you know the person who made them? What about your clothing? Or anything else in sight from where you are sitting?

Now imagine that it is 1776, the year that Adam Smith wrote The Wealth of Nations. The same questions, asked anywhere in the world, would have had a different answer.

At that time many families produced a wide array of goods for their own use, including crops, meat, clothing, even tools. Many of the things that you might have spotted in Adam Smith’s day would have been made by a member of the family, or of the village. You would have made some objects yourself; others would have been made locally and purchased from the village market.

One of the changes that was underway during Adam Smith’s life, but has greatly accelerated since, is specialization in the production of goods and services. As Smith explained, we become better at producing things when we each focus on a limited range of activities. This is true for three reasons:

• Learning by doing: We acquire skills as we produce things.
• Difference in ability: For reasons of skill, or natural surroundings such as the quality of the soil, some people are better at producing some things than others.
• economies of scale: Producing a large number of units of some good is often more cost-effective than producing a smaller number. We investigate this in more detail in Unit 7.

These are the advantages of working on a limited number of tasks or products. People do not typically produce the full range of goods and services that they use or consume in their daily life. Instead we specialize, some producing one good, others producing other goods, some working as welders, others as teachers or farmers.

But people will not specialize unless they have a way to acquire the other goods they need.

For this reason, specialization—called the division of labour—poses a problem for society: how are the goods and services to be distributed from the producer to the final user? In the course of history, this has happened in a number of distinct ways, from direct government requisitioning and distribution as was done in the US and many economies during the Second World War, to gifts and voluntary sharing as we do in families today and as practiced among even unrelated members of a community by our hunting and gathering ancestors. Capitalism enhanced our opportunities for specialization by expanding the economic importance of both markets and firms.

Specialization exists within governments and also in families, where who does which household chore is often associated with age and gender. Here we look at the division of labour in firms and in markets.

The division of labour in firms

Adam Smith begins The Wealth of Nations with the following sentence:

The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgement with which it is anywhere directed, or applied, seem to have been the effects of the division of labour.

He went on to describe a pin factory in which the specialization of tasks among the working men allowed a level of productivity—pins produced per day—that seemed to him extraordinary. Firms may employ thousands or even hundreds of thousands of individuals, most of them working at specialized tasks under the direction of the owners or manager of the firm.

This description of the firm stresses its hierarchical nature from top to bottom. But you can also think of the firm as a means by which large numbers of people, each with distinct skills and capacities, contribute to a common outcome, the product. The firm thus facilitates a kind of cooperation among specialized producers that increases productivity.

We return to the question of who does what within the firm and why in Unit 6.

Markets, specialization, and comparative advantage

Chapter 3 in The Wealth of Nations is titled: ‘That the Division of Labour is Limited by the Extent of the Market’, in which Smith explains:

When the market is very small, no person can have any encouragement to dedicate himself entirely to one employment, for want of the power to exchange all that surplus part of the produce of his own labour, which is over and above his own consumption, for such parts of the produce of other men’s labour as he has occasion for.

When you hear the word ‘market’ what word do you think of? ‘Competition’ probably is what came to mind. And you would be right to associate the two words.

But you might have also come up with ‘cooperation’. Why? Because markets allow each of us pursuing our private objectives to work together, producing and distributing goods and services in a way that, while far from perfect, is in many cases better than the alternatives.

Markets accomplish an extraordinary result: unintended cooperation on a global scale. The people who produced the phone on your desk did not know or care about you; they produced it rather than you because they are better at producing phones than you are, and you ended up with it because you paid them, allowing them to buy goods that they need, also produced by total strangers to them.

A simple example illustrates how, when people differ in their ability to produce different goods, markets allow them to specialize. It shows something surprising: all producers can benefit by specializing and trading goods, even when this means that one producer specializes in a good that another could produce at lower cost.

Imagine a world of just two individuals (Greta and Carlos) who each need both of two goods, apples and wheat, to survive. They differ in how productive they are in growing apples and wheat. If Greta spent all her time, say, 2,000 hours in a year, producing apples, she would produce 1,250. If she only produced wheat, she would produce 50 tonnes per annum. Carlos has less fertile land than Greta for producing both crops: if he devoted all his time (the same amount as Greta) to apple growing, he would produce 1,000 per year, and if he produced only wheat he would produce 20 tonnes. See Figure 1.9a for a summary.

Figure 1.9a Absolute and comparative advantage in the production of apples and wheat.

Although Carlos’ land is worse for producing both crops, his disadvantage is less, relative to Greta, in apples than in wheat. Greta can produce two and a half times more wheat as he can but only 25% more apples.

Economists distinguish who is better at producing what in two ways: absolute advantage and comparative advantage.

Greta has an absolute advantage in both crops. Carlos has an absolute disadvantage. She can produce more of either crop than he can.

Greta has a comparative advantage in wheat; Carlos has a comparative advantage in apples. Although she is better, Carlos is least disadvantaged in producing apples. Greta has a comparative advantage in producing wheat.

Initially, Carlos and Greta are not able to trade with each other. Both must be self-sufficient, consuming exactly what they produce, so they will each produce both goods in order to survive. Greta chooses to use 40% of her time in apple production, and the rest producing wheat. Column 1 of Figure 1.9b shows that she produces and consumes 500 apples and 30 tonnes of wheat. Carlos’ consumption is also shown: he spends 30% of his time producing apples, and 70% producing wheat.

Now suppose that there are markets where apples and wheat may be bought and sold, and that 40 apples can be bought for the price of 1 tonne of wheat. If Greta specializes in growing wheat only, producing 50 tonnes of wheat and no apples, while Carlos specializes in apples, total production of both crops will be higher than it was under self-sufficiency (column 2). Then they can each sell some of their own crop in the market, and buy some of the good that the other produced.

For example, if Greta sells 15 tonnes of wheat (column 3) in order to buy 600 apples, she can now consume more apples and more wheat than before (column 4). And the table shows that buying the 15 tonnes of wheat produced by Greta, in return for 600 apples, similarly enables Carlos to consume more of both goods than was possible in the absence of specialization and trade.

Figure 1.9b Comparing self-sufficiency and specialization. Under self-sufficiency, both consume exactly what they produce. Under complete specialization, Greta produces only wheat; Carlos produces only apples; and they trade the surplus of their production above what they consume.

In constructing this example we assumed market prices are such that a tonne of wheat could be exchanged for 40 apples. We will return to how markets work in Units 7 to 12, but Exercise 1.10 shows that this assumption was not critical. There are other prices at which both Greta and Carlos would benefit from trading with each other.

The opportunity to trade—that is, the existence of an apple market and a wheat market—has benefited both Greta and Carlos. This was possible because specializing in the production of a single good increased the total amount of each good produced, from 800 to 1,000 apples and from 44 to 50 tonnes of wheat. The surprising thing mentioned above is that Greta ended up buying 600 apples from Carlos even though she could have produced those apples at a lower cost herself (in terms of labour time). This was a better way to spend their time because while Greta had an absolute advantage in producing both goods, Carlos had a comparative advantage in producing apples.

Markets contribute to increasing the productivity of labour—and can therefore help to explain the hockey stick of history—by allowing people to specialize in the production of goods for which they have a comparative advantage, that is the things at which they are—relatively speaking—least bad!

Suppose that market prices were such that 35 apples could be bought for 1 tonne of wheat.

1. If Greta sold 16 tonnes of wheat, would both she and Carlos still be better off?
2. What would happen if only 20 apples could be bought for the price of a tonne of wheat?

History, instability, and growthGlobal economyInnovation

1.9 Capitalism, causation and history’s hockey stick

We have seen that the institutions associated with capitalism have the potential to make people better off, through opportunities for both specialization and the introduction of new technologies, and that the permanent technological revolution coincided with the emergence of capitalism. But can we conclude that capitalism caused the upward kink in the hockey stick?

We should be sceptical when anyone claims that something complex (capitalism) ‘causes’ something else (increased living standards, technological improvement, a networked world, or environmental challenges).

In science, we support the statement that X causes Y by understanding the relationship between cause (X) and effect (Y) and performing experiments to gather evidence by measuring X and Y.

We want to make causal statements in economics—to understand why things happen, or to devise ways of changing something so that the economy works better. This means making a causal statement that policy X is likely to cause change Y. For example, an economist might claim that: ‘If the central bank lowers the interest rate, more people will buy homes and cars.’

But an economy is made up of the interactions of millions of people. We cannot measure and understand them all, and it is rarely possible to gather evidence by conducting experiments (though in Unit 4 we will give examples of the use of conventional experiments in one area of economics). So how can economists do science? This example shows how the things we observe in the world can help us investigate causes and effects.

natural experimentAn empirical study exploiting naturally occurring statistical controls in which researchers do not have the ability to assign participants to treatment and control groups, as is the case in conventional experiments. Instead, differences in law, policy, weather, or other events can offer the opportunity to analyse populations as if they had been part of an experiment. The validity of such studies depends on the premise that the assignment of subjects to the naturally occurring treatment and control groups can be plausibly argued to be random.

We can observe that capitalism emerged at the same time as, or just before, both the Industrial Revolution and the upward turn in our hockey sticks. This would be consistent with the hypothesis that capitalist institutions were among the causes of the era of continuous productivity growth. But the emergence of a free-thinking cultural environment known as ‘The Enlightenment’ also predated or coincided with the upturn in the hockey sticks. So was it institutions, or culture, both, or some other set of causes? Economists and historians disagree, as you will see in Unit 2, when we ask ‘What were the causes of the Industrial Revolution?’

Scholars in all fields try to narrow the range of things on which they disagree by using facts. For complicated economic questions, like ‘Do institutions matter economically?’, facts may provide enough information to reach a conclusion.

A method for doing this is called a natural experiment. It is a situation in which there are differences in something of interest—a change in institutions for example—that are not associated with differences in other possible causes.

The division of Germany at the end of the Second World War into two separate economic systems—centrally planned in the east, capitalist in the west—provided a natural experiment. During this time a political ‘Iron Curtain’, as the British Prime Minister Winston Churchill described it, divided the country. It separated two populations that until then had shared the same language, culture, and capitalist economy.9

Because we cannot change the past, even if it were practical to conduct experiments on entire populations, we rely on natural experiments. In this interview, Jared Diamond, a biologist, and James Robinson, a professor of government, explain.

In 1936, before the Second World War, living standards in what later became East and West Germany were the same. This is a suitable setting for using the natural experiment method. Before the war, firms in Saxony and Thuringia were world leaders in automobile and aircraft production, chemicals, optical equipment and precision engineering.

With the introduction of centralized planning in East Germany, private property, markets and firms virtually disappeared. Decisions about what to produce, how much and in which plants, offices, mines and farms were taken not by private individuals, but by government officials. The officials managing these economic organizations did not need to follow the principle of capitalism and produce goods and services that customers would buy at a price above their cost of manufacture.

A functioning capitalist economy was restored in West Germany following the Currency Reform of 1948.

The East German Communist Party forecast in 1958 that material wellbeing would exceed the level of West Germany by 1961. The failure of this prediction was one of the reasons the Berlin Wall separating East from West Germany was built in 1961. By the time the Berlin Wall fell in 1989, and East Germany abandoned central planning, its GDP per capita was less than half of that of capitalist West Germany. Figure 1.10 shows the different paths taken by these and two other economies from 1950. It uses the ratio scale.

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Figure 1.10 The two Germanies: Planning and capitalism (1950–89).

Conference Board, The. 2015. Total Economy Database. Angus Maddison. 2001. ‘The World Economy: A Millennial Perspective’. Development Centre Studies. Paris: OECD.

Notice from Figure 1.10 that West Germany started from a more favourable position in 1950 than East Germany. Yet in 1936, before the war began, the two parts of Germany had virtually identical living standards. Both regions had achieved successful industrialization. East Germany’s relative weakness in 1950 was not mainly because of differences in the amount of capital equipment or skills available per head of the population, but because the structure of industries in East Germany was more disrupted by splitting the country than was the case in West Germany.10

Unlike some capitalist economies that had even lower per capita incomes in 1950, East Germany’s planned economy did not catch up to the world leaders, which included West Germany. By 1989, the Japanese economy (which had also suffered war damage) had, with its own particular combination of private property, markets, and firms, along with a strong government coordinating role, caught up to West Germany, and Spain had closed part of the gap.

We cannot conclude from the German natural experiment that capitalism always promotes rapid economic growth while central planning is a recipe for relative stagnation. Instead what we can infer is more limited: during the second half of the twentieth century, the divergence of economic institutions mattered for the livelihoods of the German people.

History, instability, and growthGlobal economyPolitics and policy

1.10 Varieties of capitalism: Institutions, government, and the economy

Not every capitalist country is the kind of economic success story exemplified in Figure 1.1a by Britain, later Japan, and the other countries that caught up. Figure 1.11 tracks the fortunes of a selection of countries across the world during the twentieth century. It shows for example that in Africa the success of Botswana in achieving sustained growth contrasts sharply with Nigeria’s relative failure. Both are rich in natural resources (diamonds in Botswana, oil in Nigeria), but differences in the quality of their institutions—the extent of corruption and misdirection of government funds, for example—may help explain their contrasting trajectories.

The star performer in Figure 1.11 is South Korea. In 1950 its GDP per capita was the same as Nigeria’s. By 2020 it was more than seven times richer by this measure.

South Korea’s take-off occurred under institutions and policies sharply different from those prevailing in Britain in the eighteenth and nineteenth centuries. The most important difference is that the government of South Korea (along with a few very large corporations) played a leading role in directing the process of development, explicitly promoting some industries, requiring firms to compete in foreign markets and also providing high quality education for its workforce. The term developmental state has been applied to the leading role of the South Korean government in its economic take-off and now refers to any government playing this part in the economy. Japan and China are other examples of developmental states.11

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Figure 1.11 Divergence of GDP per capita among latecomers to the capitalist revolution (1928–2018). Note: Former Soviet Union series excludes Russian Federation post 1992.

Figure 1.11 also shows that in 1928, when the Soviet Union’s first five-year economic plan was introduced, GDP per capita was one-half of the level in Argentina, and roughly double that of Brazil and South Korea. Central planning in the Soviet Union produced steady but unspectacular growth for nearly 50 years. GDP per capita in the Soviet Union outstripped South Korea’s by a wide margin and even overtook Argentina from the 1960s until just after Communist Party rule there ended in 1990.

Some researchers question the validity of historical GDP estimates such as this outside of Europe, because the economies of these countries were so different in structure.

The contrast between West and East Germany demonstrates that one reason central planning was abandoned as an economic system was its failure, in the last quarter of the twentieth century, to deliver the improvements in living standards achieved by some capitalist economies. Yet the varieties of capitalism that replaced central planning in the countries that had once made up the Soviet Union did not work so well either. This is evident from the pronounced dip in GDP per capita for the former Soviet Union after 1990. Economist Lisa Cook of Michigan State University asks why the transition to capitalism in Russia in the 1990s did not spark a wave of innovation. She documents the late 19th century inventions contributed by African American inventors, including gas masks, traffic lights, and light bulb technology and how this burst of innovations was cut short by a wave of attacks and anti-black mob violence. Her insights on the political and economic conditions under which innovation will flourish are relevant to understanding the vast differences across the world today in the extent of innovation.

When is capitalism dynamic?

The lagging performances of some of the economies in Figure 1.11 demonstrate that the existence of capitalist institutions is not enough, in itself, to create a dynamic economy—that is, an economy bringing sustained growth in living standards. Two sets of conditions contribute to the dynamism of the capitalist economic system. One set is economic; the other is political, and it concerns the government and the way it functions.

Economic conditions

Where capitalism is less dynamic, the explanation might be that:12 13

• Private property is not secure: There is weak enforcement of the rule of law and of contracts, or expropriation either by criminal elements or by government bodies.
• Markets are not competitive: They fail to offer the carrots and wield the sticks that make a capitalist economy dynamic.
• Firms are owned and managed by people who survive because of their connections to government or their privileged birth: They did not become owners or managers because they were good at delivering high-quality goods and services at a competitive price. The other two failures would make this more likely to occur.

Combinations of failures of the three basic institutions of capitalism mean that individuals and groups often have more to gain by spending time and resources in lobbying, criminal activity, and other ways of shifting the distribution of income in their favour. They have less to gain from the direct creation of economic value.14

Capitalism is the first economic system in human history in which membership of the elite often depends on a high level of economic performance. As a firm owner, if you fail, you are no longer part of the club. Nobody kicks you out, because that is not necessary: you simply go bankrupt. An important feature of the discipline of the market—produce good products profitably or fail—is that where it works well it is automatic, because having a friend in power is no guarantee that you could remain in business. The same discipline applies to firms and to individuals in firms: losers lose. Market competition provides a mechanism for weeding out those who underperform.

Think of how different this is from other economic systems. A feudal lord who managed his estate poorly was just a shabby lord. But the owner of a firm that could not produce goods that people would buy, at prices that more than covered the cost, is bankrupt—and a bankrupt owner is an ex-owner.

Of course, if they are initially very wealthy or very well connected politically, owners and managers of capitalist firms survive, and firms may stay in business despite their failures, sometimes for long periods or even over generations. Losers sometimes survive. But there are no guarantees: staying ahead of the competition means constantly innovating.

Political conditions

Government is also important. We have seen that in some economies—South Korea, for example—governments have played a leading role in the capitalist revolution. And in virtually every modern capitalist economy, governments are a large part of the economy, accounting in some for more than half of GDP. But even where government’s role is more limited, as in Britain at the time of its take-off, governments still establish, enforce and change the laws and regulations that influence how the economy works. Markets, private property and firms are all regulated by laws and policies.

For innovators to take the risk of introducing a new product or production process, their ownership of the resulting profits must be protected from theft by a well-functioning legal system. Governments also adjudicate disputes over ownership and enforce the property rights necessary for markets to work.

As Adam Smith warned, by creating or allowing monopolies such as the East India Company, governments may also take the teeth out of competition. If a large firm is able to establish a monopoly by excluding all competitors, or a group of firms is able to collude to keep the price high, the incentives for innovation and the discipline of prospective failure will be dulled. The same is true in modern economies when some banks or other firms are considered to be too big to fail and instead are bailed out by governments when they might otherwise have failed.

In addition to supporting the institutions of the capitalist economic system, the government provides essential goods and services such as physical infrastructure, education and national defence. In subsequent units we investigate why government policies in such areas as sustaining competition, taxing and subsidizing to protect the environment, influencing the distribution of income, the creation of wealth, and the level of employment and inflation may also make good economic sense.

In a nutshell, capitalism can be a dynamic economic system when it combines:

• Private incentives for cost-reducing innovation: These are derived from market competition and secure private property.
• Firms led by those with proven ability to produce goods at low cost.
• Public policy supporting these conditions: Public policy also supplies essential goods and services that would not be provided by private firms.
• A stable society, biophysical environment and resource base: As in Figures 1.5 and 1.12.

These are the conditions that together make up what we term the capitalist revolution that, first in Britain and then in some other economies, transformed the way that people interact with each other and with nature in producing their livelihoods.

Political systems

One of the reasons why capitalism comes in so many forms is that over the course of history and today, capitalist economies have coexisted with many political systems. A political system, such as democracy or dictatorship, determines how governments will be selected, and how those governments will make and implement decisions that affect the population.

Capitalism emerged in Britain, the Netherlands, and in most of today’s high-income countries long before democracy. In no country were most adults eligible to vote prior to the end of the nineteenth century (New Zealand was the first). Even in the recent past, capitalism has coexisted with undemocratic forms of rule, as in Chile from 1973 to 1990, in Brazil from 1964 to 1985, and in Japan until 1945. Contemporary China has a variant of the capitalist economic system, but its system of government is not a democracy by our definition. In most countries today, however, capitalism and democracy coexist, each system influencing how the other works.

Like capitalism, democracy comes in many forms. In some, the head of state is elected directly by the voters; in others it is an elected body, such as a parliament, that elects the head of state. In some democracies there are strict limits on the ways in which individuals can influence elections or public policy through their financial contributions; in others private money has great influence through contributions to electoral campaigns, lobbying, and even illicit contributions such as bribery.

These differences even among democracies are part of the explanation of why the government’s importance in the capitalist economy differs so much among nations. In Japan and South Korea, for example, governments play an important role in setting the direction of their economies. But the total amount of taxes collected by government (both local and national) is low compared with some rich countries in northern Europe, where it is almost half of GDP. We shall see in Unit 19 that in Sweden and Denmark, inequality in disposable income (by one of the most commonly used measures) is just half of the level of income inequality before the payment of taxes and receipt of transfers. In Japan and South Korea, government taxes and transfers also reduce inequality in disposable income, but to a far lesser degree.

Look again at Figure 1.10, which shows a graph of GDP per capita for West and East Germany, Japan and Spain between 1950 and 1990. Which of the following statements is correct?

• Having a much lower starting point in 1950 was the main reason for East Germany’s poor performance compared to West Germany.
• The fact that Japan and West Germany have the highest GDP per capita in 1990 implies that they found the optimal economic system.
• Spain was able to grow at a higher growth rate than Germany between 1950 and 1990.
• The difference in East and West Germany’s performance proves that capitalism always promotes rapid economic growth while central planning is a recipe for stagnation.

• Japan had even lower starting point than East Germany and yet was able to catch up with West Germany by 1990.
• Different economic systems can be successful. The Japanese economy had its own particular combination of private property, markets and firms along with a strong government coordinating role, which was different to the West Germany system.
• The growth rate of an economy’s GDP per capita can be inferred from the steepness of its curve when plotted on a ratio scale graph, as done here. The fact that the slope of Spain’s curve is greater than that of either West or East Germany from 1950 to 1990 indicates that it grew at a faster rate.
• In economics one cannot use only one piece of evidence to ‘prove’ a theory. What we can infer here is that during the second half of the twentieth century, the divergence of economic institutions mattered for the livelihoods of the German people.

Look again at Figure 1.11. Which of these conclusions is suggested by the graph?

• The Communist Party rule in the former Soviet Union before 1990 was a complete failure.
• The contrasting performances of Botswana and Nigeria illustrate that rich natural resources alone do not guarantee higher economic growth, but that higher quality institutions (government, markets and firms) may also be necessary.
• The impressive performance of South Korea’s economy implies that other countries should copy their economic system.
• The evidence from the Russian Federation and the former Soviet Union after 1990 shows that the replacement of central planning by capitalism led to immediate economic growth.

• The former Soviet Union actually had much higher growth rates than Brazil, and its GDP per capita even briefly overtook Argentina’s just before the Communist Party rule ended in 1990.
• Both Nigeria and Botswana are rich in natural resources; however, Nigeria’s growth is hindered by pervasive corruption and illegal business practices, whereas Botswana is often described as the least corrupt country in Africa and boasts one of the world’s highest average GDP growth rates.
• South Korea was a developmental state where the government and a few very large corporations played a leading role in directing the process of development. This does not necessarily mean that this system is optimal for all countries.
• GDP per capita of both countries fell after 1990. This is due to their private property not being secure, the markets not being competitive and their firms not operating competitively in their newly capitalist economy. This abrupt transition from a distinctly non-capitalist economy to a capitalist system is often referred to as ‘shock therapy’.

1.11 Economics and the economy

Economics is the study of how people interact with each other and with their natural surroundings in producing their livelihoods, and how this changes over time. Therefore it is about:

• How we come to acquire the things that make up our livelihood: Things like food, clothing, shelter, or free time.
• How we interact with each other: Either as buyers and sellers, employees or employers, citizens and public officials, parents, children and other family members.
• How we interact with our natural environment: From breathing, to extracting raw materials from the earth.
• How each of these changes over time.

In Figure 1.5 we showed that the economy is part of society, which in turn is part of the biosphere. Figure 1.12 shows the position of firms and families in the economy, and the flows that occur within the economy and between the economy and the biosphere. Firms combine labour with structures and equipment, and produce goods and services that are used by households and other firms.

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Figure 1.12 A model of the economy: Households and firms.

Production of goods and services also takes place within households, although unlike firms, households may not sell their outputs in the market.

In addition to producing goods and services, households are also producing people—the next generation of the labour force. The labour of parents, caregivers and others is combined with structures (for example, your home) and equipment (for example, the oven in that home) to reproduce and raise the future labour force working in firms, and the people who will work and reproduce in the households of the future.

All of this takes place as part of a biological and physical system in which firms and households make use of our natural surroundings and resources, ranging from fossil-fuel or renewable energy to the air we breathe. In the process, households and firms transform nature by using its resources, but also by producing inputs to nature. Currently, some of the most important of these inputs are the greenhouse gases, which contribute to the climate change problems that we saw in Section 1.5.

Suppose you can choose to be born in any time period in any of the countries in Figure 1.1a, 1.10 or 1.11, but you know that you would be among the poorest 10% in the population.

1. In which country would you choose to be born?
2. Now suppose, instead, you know you would initially be among the poorest 10% in the population, but you would have a fifty-fifty chance of moving to the top 10% of the population if you work hard. In which country would you now choose to be born?
3. Now suppose that you can only decide on the country and time period of your birth. You cannot be sure if you would be born in the city or the countryside, would be male or female, rich or poor. In which time and country would you choose to be born?
4. For the scenario in (3), in which time and country would you least want to be born?

Use what you have learned from this unit to explain your choices.

1.12 Conclusion

Throughout most of history, living standards were similar around the world and changed little from century to century. Since 1700 they have risen rapidly in some countries. This upturn coincided with rapid technological progress, and with the advent of a new economic system, capitalism, in which private property, markets and firms play a major role. The capitalist economy provided incentives and opportunities for technological innovation, and gains from specialization.

Countries differ in the effectiveness of their institutions and government policy: not all capitalist economies have experienced sustained growth. Today, there are huge income inequalities between countries, and between the richest and poorest within countries. And the rise in production has been accompanied by depletion of natural resources and environmental damage, including climate change.

Before you move on, review these definitions:

1.13 References

• Acemoglu, Daron, and James A. Robinson. 2012. Why Nations Fail: The Origins of Power, Prosperity and Poverty, 1st ed. New York, NY: Crown Publishers.
• Augustine, Dolores. 2013. ‘Innovation and Ideology: Werner Hartmann and the Failure of the East German Electronics Industry’. In The East German Economy, 1945–2010: Falling behind or Catching Up? by German Historical Institute, eds. Hartmut Berghoff and Uta Andrea Balbier. Cambridge: Cambridge University Press.
• Berghoff, Hartmut, and Uta Andrea Balbier. 2013. ‘From Centrally Planned Economy to Capitalist Avant-Garde? The Creation, Collapse, and Transformation of a Socialist Economy’. In The East German Economy, 1945–2010 Falling behind or Catching Up? by German Historical Institute, eds. Hartmut Berghoff and Uta Andrea Balbier. Cambridge: Cambridge University Press.
• Coyle, Diane. 2014. GDP: A Brief but Affectionate History. Princeton, NJ: Princeton University Press.
• Diamond, Jared, and James Robinson. 2014. Natural Experiments of History. Cambridge, MA: Belknap Press of Harvard University Press.
• Eurostat. 2015. ‘Quality of Life Indicators — Measuring Quality of Life’. Updated 5 November 2015.
• Kornai, János. 2013. Dynamism, Rivalry, and the Surplus Economy: Two Essays on the Nature of Capitalism. Oxford: Oxford University Press.
• Landes, David S. 2003. The Unbound Prometheus: Technological Change and Industrial Development in Western Europe from 1750 to the Present. Cambridge, UK: Cambridge University Press.
• Robison, Jennifer. 2011. ‘Happiness Is Love – and $75,000’. Gallup Business Journal. Updated 17 November 2011.
• Seabright, Paul. 2010. The Company of Strangers: A Natural History of Economic Life (Revised Edition). Princeton, NJ: Princeton University Press.
• Smith, Adam. 1759. The Theory of Moral Sentiments. London: Printed for A. Millar, and A. Kincaid and J. Bell.
• Smith, Adam. (1776) 2003. An Inquiry into the Nature and Causes of the Wealth of Nations. New York, NY: Random House Publishing Group.
• Sutcliffe, Robert B. 2001. 100 Ways of Seeing an Unequal World. London: Zed Books.
• World Bank, The. 1993. The East Asian miracle: Economic growth and public policy. New York, NY: Oxford University Press.