Capitalism

Capitalism is an economic model designed to combat the problem that we don't live in a post scarcity society. Since most people consider a free market to be a core part of capitalism this article will also cover market economics. Socialism is its biggest competitor politically speaking, although most present-day economists on the left support mixed economies (typically Social Democracy) rather than pure Socialist economies.

Homo Economicus

An important simplifying assumption taught in Econ 101 is that consumers (and indeed, all market participants) are rationally self-interested. "Rational" is defined to refer to someone who has perfect information about the market (i.e. prices, good availability, their own preferences etc.) and whom always acts in a manner which optimizes their outcome (i.e. gives them the best possible result). Needless to say this is 'extremely' unrealistic, to the point where these assumptions are often seen as talking about an entirely different species (hence the phrase "homo economicus"). Needless to say, these are just simplifying assumptions and actual economists are quite aware that these assumptions aren't strictly correct (there are entire fields of economics which challenge these assumptions, such as Behavioral Economics, Austrian Economics and even certain aspects of Keynesian and neo-Keynesian economics).

Invisible Hand

The concept behind the invisible hand is that, in a free and competitive market, businesses pursuing their own interests (i.e. making a profit) do so by advancing the interests of others (i.e. producing the best good for the fulfilment of the customer's needs at the lowest possible cost). This has always been a controversial proposition since a lot of thinkers have (explicitly or implicitly) regarded the interests of parties as a zero-sum game, thus casting the interests of one party a "trade off" against the interests of another. The argument regarding the Invisible Hand is that competitive markets create an alignment between the producer's interests and the consumer's interests whereby the producer serves their interests best by best serving those of the consumer. A classic example is that if I have a chocolate bar and you have a set of trading cards, and if we would both prefer what the other person has over what we currently have, then if we exchange the goods we both become better off (in terms of personal satisfaction). Under even a very modest version of a rationality assumption, it can be safely presumed neither of us would actually want to make said exchange unless we genuinely did prefer to make said exchange; thus we can generally accept that mutually agreed upon exchanges are mutually beneficial.

Supply and Demand

The price of something is determined by supply and demand. A higher quantity of a product means it is less likely a buyer will pay an outrageous amount of money for it because they can walk down the street and get it for a cheaper price. If the seller is the only one in possession of the product then that seller is the only way the buyer can get the product. If the buyer refuses to pay the seller's price the seller will just move onto a different customer who is willing to buy it.

If there is high demand (relative to supply) for a product sellers can get more money out of the product because if desired badly enough buyers will pay whatever price. If there isn't high demand (relative to supply) for a product sellers are forced to lower prices^[1] in order to raise demand.

All other things being held constant, higher demand for a product causes the price to go up (and less demand for a product cause the price to go down, higher supply of a product causes the price to go down, and lower supply of a product causes the price to go up).

In a purely free competitive market, for identical goods where there are a large number of sellers, individual sellers are "price takers," i.e. they have negligible influence on the market price and therefore if they cut back on production, they will not make any more additional money since other sellers will increase output in response.

Market Failures

Market failures are instances when a completely free market cannot produce a Pareto-optimal (i.e. no individual's condition can be improved without making any other individual's condition worse) outcome. The classical examples of market failures are Externalities (when a transaction between some parties creates costs or benefits for parties who are not involved in the transaction), Natural Monopolies (when increasing returns to scale make it cheaper for there to be a single supplier or single network service), and Public Goods (when someone cannot be excluded from benefitting from a good/service they do not pay for, and which no individual's consumption of reduces the ability of other individuals to consume the good).

Almost all economists agree that market failures exist, but economists often disagree as to what market failures exist and how they should be rectified. For instance, many economists with more Social Democratic views believe that Naturally Monopolistic things (for instance, telephone and electricity network/distribution infrastructure) should be provided by the State and regulated so as to ensure fair access. Many economists with Free Market views believe that Externalities can be dealt with via proper enforcement of property rights as well as the Coase Theorem (i.e. if a large corporation is polluting a river which damages the land held by different landowners, this pollution should be treated as the corporation trespassing on the landowner's property. And in addition, where open communication may happen between those who generate an Externality and those to whom an Externality accrues, negotiation between the parties can come to a mutually satisfactory solution).

Law of Diminishing Returns and how it affects supply

The Law of Diminishing Returns states that the higher quantity of a product you make within a certain period of time the higher the cost of making an individual piece of that quantity. As an example if it costs two dollars to produce a single bottle in one day, and it will cost more than four dollars to make two bottles in one day. For the sake of this example lets say it costs five dollars to make two bottles and each additional bottle costs an extra dollar to produce in one day.

As mentioned above individual sellers have no control over prices and have to accept whatever the market price is. Going with the above example if the market price for bottles is seven dollars then sellers will make a profit off the first five bottles they produce, make even on the sixth one, and lose money on any consecutive bottles made within one day. If an individual seller wants to make a profit from any bottles after the fifth one either the price has to go up or production costs have to be lowered. Additionally, the producer can slow down the rate of production to produce only a profitable amount of bottles per day.

As for why each additional product costs more to produce than the last, imagine you are starving so you go to a fast food restaurant and order burgers. The first few burgers you buy taste delicious and are quenching your hunger. After a while it becomes less rational to spend money on burgers because if you eat enough you'll puke. (This is a related concept called marginal utility. Think of it this way: the utility, or satisfaction, that you gain from each burger decreases with each one you eat, until there is only a marginal amount to be gained from eating another one. At that point, you stop.)

Another analogy would be someone who owns an apple orchard. In a few hours her workers could go through and easily pick all the apples off of the bottom branches. The ones on the top branches however require more effort to get to. If a profit is to be made from those prices have to be increased. In a factory setting adding a few workers will increase productivity because they can specialize on specific tasks, but if you add enough workers, people will be bumping into each other. Some workers will also be standing around doing nothing because there aren't any tasks to do. Paying these workers their wages is a waste of the employer's money because no profit is coming from it. Whether all situations operate in this manner is debatable but it's a well-observed effect.

Economies of Scale

Economies of Scale refers to a situation where it is cheaper for a business to produce more of an item than less. Think of it as like buying in bulk, but for producers.

It costs a great deal to make one hand-built automobile, as it takes a few skilled workers a fairly long period of time to make it using hand tools and whatnot. Since this manufacture of only one unit of product takes a long period of time and uses skilled laborers (who earn more money than unskilled), the end product (a hand-built car) ends up costing a lot of money.

It costs far less to make one machine-manufactured automobile because of the economy of scale. This states that an efficient production process that makes the product faster with unskilled laborers can in turn make more product in a far shorter period of time and therefore cost less to make and sells for a lower price. The entire industrial revolution is built upon this concept.

For a good real-life example: look at a Ford Model T or a Volkswagen Beetle. Making either car by hand would result in a far slower turnout and a more expensive product, but the entire point of both vehicles was a cheaper product for the masses. They were cheaper because the more of them were made, the cheaper they became to manufacture: the beginning capital (factory construction, machinery purchase, etc.) was far greater than making a hand-built car, but the volume of the sales made up for it.

Role of government

Both economists and people in general are divided on the exact role the government should play in the economy. Some people - anarchists - believe that existence of government can't be justified at all, while others believe there are quite a few important roles governments can and should fill. Each political ideology generally differs as to which role/s it believes the government should fill; some of these various roles include:

• Enforcing Property Rights: Stealing is wrong. Not only is theft generally agreed upon to morally damaging to the individual who steals, and causes suffering to those who are stolen from, but widespread theft (such as the looting that occurs in riots) creates massive market inefficiencies. In addition, the enforcement of property rights is a vital aspect of determining the size, scope and affected parties of various Externalities. If someone desires a product they should pay the agreed-upon price. Fraud is considered a form of stealing (as theft by trick) so it would fall under this.
• Providing Public Services: Some things, such as lighthouses, the rule of law, fireworks shows, and clean air are considered impossible for an individual person or organization to make a profit from because property rights are near impossible to enforce on these things. The government however can pay for these things with tax money, which they can force everyone to pay. Whether they should do this is the subject of debate among the many different schools of economic thought. See below.
• Helping Out In Recessions: Some schools of economics see "stimulating" an economy in recession as a duty of the government. This is generally done through either fiscal policy (i.e. government spending) or, these days, monetary policy or "quantitative easing" (often referred to as "printing money"). See John Maynard Keynes and the Keynesian school below for more information on how this concept works in practice. On the other side of the coin, the Austrian School of Economics sees the root of the business cycle in over-expansion of the money supply and credit by governments, so they argue refraining from that is the cure instead.
• Regulating Monopolies and Oligopolies: The problem with monopolies is that due to the law of diminishing returns, it's impossible for them to make a profit making huge quantities of a product, so prices naturally stay high. The government can intervene in these situations and either force the company to break up, put a minimum limit on how much they have to produce, put a maximum limit on how much they can charge, and/or use tax money to reimburse the company for any lost profits if they increase supply. The problem with oligopolies is it reduces the likelihood that individual suppliers will renege on a deal to keep total supply in the economy as low as possible. The government can regulate these in a similar manner. Again, whether the government should regulate mono/oligopolies is debated. Though a moderate consensus is that governments should break up mono/oligopolies as well prevent them from forming, what constitutes a mono/oligopoly is not agreed upon. Further to the left, economists believe that the state should assume control of a mono/oligopoly if it is naturally occurring, such as in the generally agreed-upon case of water or energy suppliers (it is extremely hard to foster competition when actual land control is involved). More free market oriented economists, on the other hand, argue either that busting up monopolies/oligopolies in unnecessary (at least if there are sufficiently low barriers to market entry), or that monopolies/oligopolies can only survive in the long run due to government protections, that technological advancements can undermine monopolies/oligopolies thus rendering said regulation unnecessary (a classic example is how the Eastman-Kodak duopoly was rendered obsolete by digital cameras), and that the side effects of the government trying to combat the mono/oligopoly will lead to far worse results than if just left alone.
• Regulating The Money Supply: Money is the lifeblood of a capitalist/market economy. The issue of managing inflation is frequently cited, particularly given the inflations and 'stagflations' of previous eras. In addition, many economists, including some market-oriented economists, accept the use of monetary policy as a way to combat recessions. On the other hand, some strongly market-oriented economists believe that inflation can often work as a subtle form of taxation (i.e. the government prints money, spends it, and only *after* the government has spent the money do consumer prices rise to adjust for the increase in the overall money supply) and/or that activist monetary policy perpetuates rather than counteracts the business cycle, which implies that money should either be commodity-backed or even fully denationalized (i.e. issued by competing private banks).
• Banning Products: Markets will produce whatever people are willing to pay for even if the product imposes substantial negative externalities (a good example is cigarettes). In these cases, government intervention is the only way to stop production and consumption of them. This creates the black market problem however, such as in the case of illegal drugs. Thus, whether banning the creation of certain products should happen is, again, hotly debated. The classic argument economists make is that goods which impose negative externalities should be permitted, but taxed in order to "internalize the externality" (i.e. to make the full costs of the product fall upon the individual consuming said product).
• Bailing Out Companies: Some companies are considered "too big to fail" . If they go under, their suppliers may have to lay people off or go under as well because of the lost business. The unemployed workers now have less money coming in and this could affect demand in other markets. In situations like this the government can preventively step in but this is very controversial. Opponents saying doing this prevents companies from learning from their mistakes and enforces the behavior that required the bailout in the first place, however, the people most often proposing a bailout are also the people most likely to support regulations that would (at least in theory) prevent furhter occurences of that "bad behavior".

Key Capitalist Thinkers and Their Ideas (In Chronological Order of Appearance)

• Adam Smith: Wrote The Wealth of Nations, laying the philosophical foundations of the capitalist system. Low taxes, next-to-zero regulation, and the invisible hand are part of all his ideas.
• David Ricardo: Came shortly after and formulated the basis of trade theory by noticing the difference between comparative and absolute advantage. Absolute means a nation can simply produce more in a given time period, but comparative means that a nation can produce at less of a cost. Very few nations have an absolute advantage in trade, but having a comparative advantage in something is very useful (imagine that Brazil grows pineapples, Iceland catches cod and they trade with each other. Both parties benefit because of their specializations).
• Alfred Marshal: Discovered the concept of Supply and Demand and lent more credos to the invisible hand. His methods of quantifying the benefits of production and consumption are the basis of welfare economics. His most important work, Principles of Economics (mercifully, that's the full title) was the leading economic textbook for a very long time.
• Henry George: Could be seen as among the first left-leaning capitalists. He believed in general that people had property rights, but that nature was sacred and belonged to all people equally, and thus advocated public ownership of land. Without getting too technical, he also saw common ownership of land as a way to decrease poverty. His philosophy, which came to be known as Georgeism, is popular among environmentalists and green-politics activists. His most important work is Progress and Poverty: An Inquiry into the Cause of Industrial Depressions and of Increase of Want with Increase of Wealth: The Remedy (shortened: Progress and Poverty).
• Thorsten Veblen: Veblen's work focuses mostly on studying the relationship between individuals and social institutions in terms of economics. His most famous work is The Theory of the Leisure Class: An Economic Study of Institutions (shortened as The Theory of the Leisure Class).
• Joseph Schumpeter: The most influential economist on the study of entrepreneurship and innovation; Schumpeter argued that economics booms and busts were primarily caused by technological shifts rather than any other factor. A Classical Liberal but one who believed free market economics was doomed, due to either State Socialism or Corporatist stagnation choking off the innovation and entrepreneurship which free markets (in his view) depended on; as he once said, "Capitalism without the entrepreneur is Socialism." His focus on technological changes led him to coin the phrase "creative destruction," i.e. how the invention of new technology can totally destroy the market for old technology (for example, the automobile wiping out the horse-and-carriage industry, or the digital camera wiping out the Eastman-Kodak duopoly). Considered the founder of Evolutionary Economics.
• John Maynard Keynes: The first capitalist thinker to seriously propose extensive government intervention in the economy, or at least, the first with a serious following (see the Keynesian schools below). Despite his reputation in some circles as a leftist, he was definitely not a socialist (he was a Social Democrat). Whereas economists before Keynes were more focused on keeping inflation low, Keynes was obviously more focused on economic downturns. He proposed that deficit spending by government could be used as direct economic stimulus to help get economies out of recessions, and believed that regulation should be used to surgically remove the economic behaviors that caused the last recession. What Smith is to the basic free-market model, and microeconomics, Keynes is to the basic mixed-market model, and macroeconomics. His most important work is The General Theory of Employment, Interest, and Money (shortened: The General Theory) in 1936.
• Friedrich Hayek: An intellectual opponent of John Maynard Keynes who developed a sophisticated critique of the idea that economists could "scientifically" manage the economy through mathematical models or fiscal policy (an idea shared by both the State Socialists as well as the Socially Democratic Keynesians). His most famous argument was posed in his article The Use Of Knowledge In Society (1945), where he argued that there was no possible replacement for market prices since market prices are ultimately the product of subjective agglomerated individual preferences, which are necessarily dispersed throughout the minds of the entire population and thus no central planning bureaucracy could possibly access them all. Hayek's conceptualization of the economy as a distributed information processing network has had influences on fields like computer science. His criticisms of Keynes' ideas about economic stabilization ultimately won him the 1974 Nobel Prize in Economics (shared with economist Gunnar Myrdal), and he is considered one of the most influential economists of the 20th century; Hayek is the second most frequently cited economist in the Nobel lectures (second only to Kenneth Arrow) and was greatly influential on Austrian Economics, Evolutionary Economics and Information Economics. His ideological rival, John Maynard Keynes, nominated him for membership in the British Academy. Hayek was a critic of State Socialism not only on economic grounds but also on civil liberties grounds; his work The Road To Serfdom argued that State Socialism would inevitably destroy civil/cultural/personal liberties, and Keynes himself was in "deeply moved agreement" with Hayek's thesis.
• Milton Friedman: A central figure of the Chicago School or Monetarist School of Economics. Friedman was the 1976 Nobel laureate for his work on monetary policy; he advocated that the best monetary policy would be a constant fixed growth rate in the money supply. Like Hayek, Friedman was a classical liberal and deeply concerned with civil liberties as well as economic ones; he was involved in ending conscription in the United States and advocated the legalization of illicit drugs. Friedman is known for several particular policy proposals, from the Constant Money Growth Rule to the Negative Income Tax to School Vouchers (a policy which Sweden adopted). The Economist described him as "the most influential economist of the second half of the 20th century".
• Robert Solow: Found that economic growth comes not from adding more input (labor and capital) but through advances in technology. Another notable contribution is the introduction of the Neo-Classical growth model, also known as the Solan-Swan growth model. He is a Neo-Keynesian (see below).
• Paul Krugman: The face of modern Keynesian economics. Predicted the 2007-8 financial collapse in his most popular work The Return of Depression Economics. That said, his most important contributions have been in trade theory. (He is among the few leftists who are in full support of free trade.) His work fathered both new trade theory, and new economic geography, both of which are way to complex to begin to explain here. Depression Economics may be his most popular work, but his most important works are the papers in Journal of International Economics and Journal of Political Economy which introduced those two theories, which won him his Nobel prize. For the life of us, we can't find the names of those papers but rest assured they're overly long and filled with overly complex vocabulary. He is identified as a Neo-Keynesian, but says he's leaning Post-Keynesian these days.

Schools Of Thought

• Austrian School: Key thinkers include Ludwig von Mises, and Friedrich Hayek, but they trace their roots back to Carl Menger (one of the three founders of neoclassical economics, alongside Walras and Jevons). Originated a strong critique of State Socialism which argued that without market prices for capital, there was no way to know what the most efficient use of any particular item of capital could be. Also known for their dislike of central banking (ie. the Federal Reserve) and fiat currency (printing money, essentially) and backing of the gold standard (ie. the rate of inflation should be tied to the market value of gold or other commodities), although some Austrians (like Hayek) argue that the money supply should be privately issued rather than publically.
• Chicago School: Central thinker is Milton Friedman. The Chicago school has been noted for being very supportive of free-market fundamentals, but Friedman's more important contributions were to monetary theory, where he advocated a central bank that only grew the money supply at a low and fixed rate (except during recessions), and should otherwise be rather laissez-faire.
• Georgeists: Based on the thinking of Henry George. As noted, those mostly likely to be Georgeists in the modern age are environmentalists and green-politicians. Milton Friedman held the opinion that their land value tax proposal would be the least damaging method of taxation to the economy.
• Institutional Economics: Developed out of Thorsten Veblen's work. Studies the interactions between institutions and how that produces an economy. The earlier strain of this is considered Heterodox.
  • New Institutional Economics: Much like Neo-Keynesians (see below), institutionalists were able to regain a lot of respect within the greater establishment by incorporating neoclassical analysis (to make that simple, "incorporating neoclassical analysis" generally just means taking a macroeconomic school and rooting it in the microeconomic basics).
• Keynesians or New Keynesians (sometimes called Old-Keynesians): First emerged as followers of Keynes during The Great Depression and post-war period. The influence of the Keynesian school and the success of Keynesian policies in practice led the post-war period until the early-70's to be referred to as, alternately, the "Golden Age of Capitalism" and "The Golden Age of Keynesianism". The original school lost support after Keynesian ideas played a key role in the "stagflation" of the 70's as predicted by Milton Friedman (see Chicago School) and after the "Lucas Critique" emerged noting that Keynesianism, as among the first macroeconomic schools of thought, had never bothered to root itself in microeconomic basics. Sub-schools emerged afterwards, including...
  • Post-Keynesians: According to Keynes biographer Lord Skidlesky, this school is the closest to Keynes' thinking.
  • Neo-Keynesians: Not to be confused with New Keynesians. Emerged in the 90's as a response to the Lucas critique by finding basis for Keynesian macroeconomics in microeconomics, though unlike other microeconomic-centric thinkers, they assume a number of market failures. The Global Financial Crisis led several economists to publically advocate for Neo-Keynesian ideas. Some economists made the argument that the recession was caused by a lack of government oversight and deregulation (their opponents vehemently deny this and claim government intervention was the root of the problem, pointing to the "Greenspan Put" (a huge period of quantitative easing/"printing money") that occurred in response to the NASDAQ crash of 2000, as well as Bush-administration policies that stimulated the housing bubble, alongside various other factors) and have supported strong regulation and deficit spending as a response. Ben Bernanke, head of the US Federal Reserve, was a prominent supporter of this view, as is Paul Krugman today.
• Social Democrats advocate use of the free market where it seems to work and use of government intervention where it doesn't (see role of government above). Whether Social Democrats are considered capitalists, socialists, or neither varies from person to person, even among Social Democrats themselves. Capitalism does allow for government intervention but social democrats are among the people mentioned above who see many market failures to correct. John Maynard Keynes was a Social Democrat, although not all contemporary Social Democrats are Keynesians

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