Business & Economy

What is Capitalism?

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Nathan McLellan

This article is the first in a series by Nathan McLellan on a Christian vision for economics. Nathan is completing a Ph.D. in Christian ethics at Southern Methodist University. He holds a master’s degree in economics from Massey University and master’s degree in theology from Regent College. He was formerly the Head of Research at the Marketplace Institute Regent College and an economist at the New Zealand Treasury. He is the author of research on economic growth, productivity, and business cycles. He is also a Research Fellow at the New Zealand Maxim Institute.

What is capitalism? This is not an easy question to answer, not least because the very term "capitalism" generates such different responses. For some, capitalism represents everything that is wrong with the world; for others it ensures that human societies continue to flourish. The first part of this article considers capitalism as an economic system. It does so by providing an account of how capitalism is believed to operate from the perspective of someone who is a supporter of capitalism. The second part of this article then considers the relationship between mainstream economics and capitalism. The final part of the article considers the ideology—or "mindset"—underpinning capitalism, with its particular understanding of the human person and society.

Capitalism is rooted in the presupposition of scarcity. Humans are assumed to have unlimited wants for goods and services, but because resources are limited, humans face the reality of scarcity. This generates the so-called economic problem: unlimited wants and limited resources require choices as to how these resources should be allocated to meet particular human wants. This requires capitalism—like all other economic systems—to answer three basic economic questions: i) what goods should be produced? ii) how should these goods be produced? and iii) for whom should these goods be produced? As a starting point, capitalism answers these questions as follows: i) it should produce the goods that "consumers" want; ii) it should produce these goods in the most efficient way possible (i.e., at the lowest cost for a target level of output) by private firms; and iii) it should produce goods for whoever is able to pay for them. Each of these initial answers requires further elaboration.

Capitalism works on the basis that consumers know what they want. They are able to communicate these subjective wants to producers. For example, if a greater number of consumers want oranges this will cause the demand and, consequently, the price of oranges to increase relative to other goods. This increase in the price of oranges acts as a 'signal' to producers to supply more oranges for purchase and consumption. Thus, under capitalism, prices provide producers with critical information on how to allocate resources (land, labor, capital, and materials) in order to meet consumer wants. In this way, the market becomes the means of coordinating economic activity.

What motivates producers to supply the goods that consumers want is the prospect of generating a profit. It is this profit motive that "is the fundamental force that drives the system [i.e., capitalism] throughout history."[1] The profit motive is what spurs firms to "innovate," by finding ways to produce goods and services in the most efficient way possible, or to develop new products that consumers are likely to purchase.

Under capitalism, consumers purchase goods and services using their market income. Consumers earn this income by working for businesses or other organizations—exchanging their "labor" for salaries or wages—or from dividends and other distributions that have been earned from investing in businesses that are producing goods and services for consumers.

Supporters of capitalism will acknowledge that its success as an economic system depends on the institution of private property. In contrast with socialism—where the means of production (capital, land, etc.) are "socially" owned—under capitalism persons privately own the means of production. Thus, for capitalism to function, it is essential that private property rights be enforced. Individuals are seen to have the "right" to acquire and hold property, and the rule of law is necessary to ensure the protection of this property right.

Mainstream economics provides the chief theoretical justification as to why capitalism should succeed in addressing the economic problem. In much contemporary discussion, capitalism and mainstream economics are often conflated. Strictly speaking, however, economics is an academic discipline that attempts to understand and model how markets and economies work. Mainstream economics—or neoclassical economics as it is called by economists—is an "overarching theory" or "metatheory" that emerged as a distinct approach to economic theorizing from the late 19th century at the time of the so-called "marginal revolution" in economics.[2] Over the ensuing century, this became the mainstream approach to economics—that is, the one that is currently taught in the large majority of economics and business schools.

Neoclassical economics is based on several assumptions about how people behave. Weintraub suggests that these can be reduced to three, namely that: "1. People have rational preferences among outcomes. 2. Individuals maximize utility and firms maximize profits. 3. People act independently on the basis of full and relevant information."[3] Neoclassical economists can take these behavioral assumptions and show that in a world of perfect competition—that is, a world in which there are numerous buyers and sellers of the same product, and no one buyer or seller has the power to influence the market price—a market system will deliver a Pareto optimal outcome.[4] Named after the economist Vilfredo Pareto, Pareto optimality is a situation in which no one can be made better off without making someone else worse off. In this situation, resources are allocated to the right production activities to produce the goods that consumers want.

Proponents of capitalism appropriate the neoclassical account outlined above to provide a theoretical justification for capitalism on the basis that the neoclassical account of how markets function is most closely approximated by capitalism as an economic system.[5] Although a number of neoclassical economists will acknowledge that there are several factors that may prevent an economy reaching a Pareto optimal outcome (e.g., market power, imperfect information, spillover costs and benefits, etc.), these economists will continue to support the capitalist system, arguing these problems can be addressed through policy interventions (e.g., taxes and subsidies). Moreover, even when policy interventions are ineffective, mainstream economists will oftentimes argue that the capitalist system still continues to approximate most closely the theoretical market system of neoclassical economics compared to other economic systems. In this way, mainstream economics as an academic discipline underwrites the current form of capitalism by supplying a theoretical account of how the problem of scarcity is overcome through the use of markets, whereby an economy satisfies wants because markets have facilitated the efficient production of goods and services by firms through competition and the efficient allocation of resources through "price signals". Williams, therefore, rightly notes, "Mainstream economic theory (sometimes referred to as the 'neoclassical synthesis') has become the primary defender of capitalism in the twentieth century, arguing that it alone provides the conditions that meet economic theoretical requirements for maximum economic efficiency and therefore achieve maximum social utility or welfare."[6]

Although the foregoing discussion necessarily passes over a lot of detail, it is hoped that supporters of capitalism, who have a working knowledge of neoclassical economics, will not object to the presentation: indeed, that they will find it to be a fair description of how capitalism is seen to work. The goal now is to discuss how this account of capitalism as an economic system also has a particular way of understanding the human person and society, which fosters a way of viewing and living in the world. To illustrate this point we will consider Milton Friedman's famous article The Social Responsibility of Business is to Increase its Profits. In this article, Friedman—whose work stands squarely in the neoclassical tradition—contends:

In a free-enterprise, private property system, a corporate executive is an employee of the owners of the business. He [sic passim] has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom [emphasis added].[7]

To do otherwise, even to obtain some other societal "good," would be to act irresponsibly, "spending someone else's money for a general social interest."[8]

Why does Freidman contend that business has a responsibility "to make as much money as possible"? In other words, why does Friedman make profit maximization a prescription for how businesses should behave? Because, in a nutshell it makes sense for business to maximize profit given capitalism's particular understanding of the human person and society.

In the same article, Friedman also writes:

The political principle that underlies the market mechanism is unanimity. In an ideal free market resting on private property, no individual can coerce any other, all cooperation is voluntary, all parties to such cooperation benefit or they need not participate. There are no values, no 'social' responsibilities in any sense other than the shared values and responsibilities of individuals. Society is a collection of individuals and of the various groups they voluntarily form.[9]

This quote highlights that the ideology of capitalism upholds the notion of the autonomous individual and the importance of his or her freedom. The individual should be at complete liberty to choose whether or not to enter into exchange with others: to choose what goods and services to buy, to decide which business to 'sell' his or her labor to, and to join whatever "groupings" he or she thinks will be beneficial.

This understanding of the human person as an autonomous individual is drawn primarily from mainstream economic theory. As briefly noted above, neoclassical economics sees the human person as making independent and rational consumption decisions. As an independent decision maker, an individual does not take others' wellbeing into consideration when making decisions, and others' actions are taken into account only in so far as they affect market prices. As a rational decision maker, an individual is assumed to hold "well ordered preferences" and to allocate resources in an efficient manner. In other words, rationality is defined as means-end (procedural) rationality. When autonomous, rational individuals pursue their own interests in this way, society as a whole is seen to be better off.

Although the neoclassical framework is capable of analyzing non-market/material consumption and even, in principle, investigating benevolent motivations for action, in reality "it has focused on [material] consumption and wealth accumulation, a satisfaction based on having [emphasis original]."[10] Hence, Alvey writes concerning the evolution of neoclassical economics over the past fifty years:

There was a slippage from the assumption of utility maximization to wealth maximization, and ultimately to the explicit adoption of "greed" as the operational microeconomic assumption. In addition, the radical Chicago economists [e.g., Gary Becker] tried to extend the economic model into the study of non-traditional areas… such as the economics of crime, marriage, suicide, adoption, and so on.[11]

The result of this shift is to see human fulfillment simply in terms of material consumption.

Capitalism's view of the autonomous individual flows through to its understanding of society, where, as Friedman contends, "society is a collection of individuals and of the various groups they voluntarily form."[12] This view of society is in accord with neoclassical economic theory, which also sees society as a collection of individuals and the common good as the summation of individual happiness. When coupled with the fact that the neoclassical framework tends to reduce consumption to the material, at the aggregate level of society, gross domestic product (GDP) becomes the measure of societal wellbeing and promoting economic growth becomes a primary national policy objective. In this world, it makes sense for businesses to pursue profit as a primary objective because it maximizes income and the amount of goods and services available for consumption.

With this understanding of capitalism in hand, a subsequent article considers a Christian vision for economic life and a critique of capitalism that arises from this.

Footnotes:

  1. Robert L. Heilbroner, The Nature and Logic of Capitalism (New York, N.Y: W. W. Norton & Company, 1985), 142.
  2. E. Roy Weintraub, "Neoclassical Economics," The Concise Encyclopedia of Economics (Liberty Fund Inc., 2008).
  3. Weintraub, "Neoclassical Economics."
  4. N. Gregory Mankiw, Principles of Economics, 5th ed. (South-Western College Pub, 2008), 66–7. This textbook is very widely used in introductory economics courses. There are other assumptions required for perfect competition not listed by Mankiw, including costless entry and exit from the market, and non-increasing returns to scale.
  5. Other theoretical schools also provide theoretical support for capitalism (e.g., Austrian economics), however, because these schools are considered to be heterodox by the majority of the economics profession, they are not discussed at length in this article.
  6. Paul S. Williams, "Capitalism," ed. Joel B. Green, Dictionary of Scripture and Ethics (Baker Academic, 2011).
  7. Milton Friedman, "The Social Responsibility of Business Is to Increase Its Profits," The New York Times Magazine, September 13, 1970. Friedman is making this point in relation to public corporations. He allows that "the case of the individual proprietor is somewhat different." He or she "is spending his own money, not someone else's." Ibid.
  8. Friedman, "The Social Responsibility of Business Is to Increase Its Profits."
  9. Ibid.
  10. Albino Barrera, Modern Catholic Social Documents and Political Economy (Georgetown University Press, 2001), 136.
  11. James Alvey, "A Short History of Economics as a Moral Science," Journal of Markets and Morality 2, no. 1 (Spring 1999): 66.
  12. Friedman, "The Social Responsibility of Business Is to Increase Its Profits."

Works Cited:

  • Alvey, James. "A Short History of Economics as a Moral Science." Journal of Markets and Morality 2, no. 1 (Spring 1999): 53–73.
  • Barrera, Albino. Modern Catholic Social Documents and Political Economy. Georgetown University Press, 2001.
  • Friedman, Milton. "The Social Responsibility of Business Is to Increase Its Profits." The New York Times Magazine, September 13, 1970.
  • Heilbroner, Robert L. The Nature and Logic of Capitalism. New York, N.Y: W. W. Norton & Company, 1985.
  • Mankiw, N. Gregory. Principles of Economics. 5th ed. South-Western College Pub, 2008.
  • Weintraub, E. Roy. "Neoclassical Economics." The Concise Encyclopedia of Economics. Liberty Fund Inc., 2008.
  • Williams, Paul S. "Capitalism." Edited by Joel B. Green. Dictionary of Scripture and Ethics. Baker Academic, 2011.

Source: Marketplace Institute



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