Unit 1 Capitalism

OUTLINE Introduction Inequality Economic Growth Technological Progress The Capitalist Revolution Varieties of Capitalism

A. Introduction

The Context for This Unit What sort of issues does economics look at? What can we learn from historic data? ‘Hockey Stick’ diagram shows rapid, sustained growth in average living standards since 1700. How did this happen?

This Unit Economic inequality and divergence The technological revolution and growth The role of capitalism in economic growth Importance of the government in capitalist economies Economic Tools: Measuring living standards: GDP per capita Growth rates and analysing data using ratio scales Identifying cause and effect: Natural experiments

B. Inequality

How unequal is the world? World income distribution in 2014: Countries are ranked by average income from left to right. Differences between the rich and the poor are huge within every country. There are also huge differences in income between countries.

Understanding the skyscraper figure Countries lined up from poorest (left) to richest (right). For each country, average income of the poorest 10% is the frontmost bar. Average income of the richest 10% is the backmost bar for that country. The width of each bar corresponds to the population (see e.g. Singapore). Income inequality in Niger is much higher than it is in Singapore, because the gap between the richest and poorest groups is twice as large in Niger. 90/10 ratio

Inequality over time 1,000 years ago, the world was ‘flat’: Small differences between countries 1980: Poorest countries (dark red) were Lesotho and China. The richest (dark green) were Switzerland, Finland and the US. Skyscrapers have increased since: Differences between the richest 10% and the rest of a country’s population have become more pronounced.

Inequality and growth We can link growing between-country inequality to the ‘hockey stick’ diagram. When sustained growth occurred, it began at different times in different places. (Why?) The countries that took off economically a century or more ago—UK, Japan, Italy—are now rich. The countries that took off only recently, or not at all, are in the ‘flatlands’.

Closer look: Measuring income Gross Domestic Product (GDP) = the total value of all the goods and services produced in a country in a given period, such as a year. Usually expressed in per-capita terms: GDP per capita = GDP population For cross-country comparison, a technique called purchasing power parity (PPP) is used. Why is GDP an imperfect measure of well-being? Other factors such as health, education, the environment…

C. Economic Growth

Timing of growth Growth take-off occurred at different points in time for different countries: Britain was the first country to experience sustained economic growth. It began around 1650. In Japan, it occurred around 1870. The kink for China and India happened in the second half of the 20th century. In some economies, substantial improvements in people’s living standards did not occur until they gained independence from colonial rule or interference by European nations.

Growth rates The GDP growth rate is the percentage change in GDP from one year to the next. We can calculate it as: Percentage changes allow us to compare GDP growth of a country in different years: a $1 billion increase in a country’s GDP would be very large if GDP was $3 billion, but not if GDP was $300 billion. Often, growth is reported as the average rate over a period of years. The calculation of these so-called compound annual growth rates is more involved (see ‘Find out more’ in Unit 1.2).

Ratio scale Directly compare growth rates across countries over time by using a different scale on the vertical axis. The ratio scale uses ratios to represent distance. For example, the ratio between 3 and 6, and between 6 and 12, is the same. With a ratio scale: A straight line means a constant growth rate. A steeper line means a faster (accelerating) growth rate.

Ratio scale application: Hockey stick linear scale ratio scale Lines for the latecomers Japan and China are much steeper than was the case in Britain or Italy i.e. their growth rates have been much faster.

D. Technological Progress

Defining technological progress Technology = A process taking a set of materials and other inputs, like the work of people and machines, to produce an output. By reducing the amount of work-time it takes to produce the things we need, technological progress has allowed for significant increases in living standards. 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 18th century.

The Industrial Revolution Industrial Revolution = a wave of technological advances and organizational changes starting in Britain in the 18th century, which transformed an agrarian and craft-based economy into a commercial and industrial economy. For example, today the productivity of labour in producing light is half a million times greater than it was among our ancestors around their campfire.

A connected world Technological progress also greatly improved the speed at which information travels, making the world more connected.

E. The Capitalist Revolution

Capitalism, economic systems, institutions Capitalism is an economic system characterized by a particular combination of institutions that began at around the time of the Industrial Revolution. An economic system is a way of organizing the production and distribution of goods and services in an entire economy. Institutions are the different sets of laws and social customs regulating production and distribution in different ways in families, private businesses, markets and government bodies.

The capitalist economy: Definitions A capitalist economy is one that combines three particular institutions: Private Property: the right and expectation that one can enjoy one’s possessions in ways of one’s own choosing, exclude others from their use, and dispose of them by gift or sale. Markets: A way of connecting people who may mutually benefit by exchanging goods or services through a process of buying and selling. Firms: A business organization which pays wages and salaries to employ people, and purchases inputs, to produce and market goods and services with the intention of making a profit.

The capitalist economy: Characteristics A striking characteristic of firms, distinguishing them from families and governments, is how quickly they can be born, expand, contract and die. A striking characteristic of firms, distinguishing them from families and governments, is how quickly they can be born, expand, contract and die.  Ideally, a capitalist economy is dynamic (Schumpeter‘s creative destruction)

The capitalist revolution Institutions associated with capitalism have the potential to make people better off through: Impact on technology: Firms competing in markets have strong incentives to adopt and develop new technologies. Specialization: The growth of firms and the expansion of markets linking the entire world allows for historically unprecedented specialization in tasks and production. Together with the Technological Revolution, this increased worker productivity. A striking characteristic of firms, distinguishing them from families and governments, is how quickly they can be born, expand, contract and die.

Did capitalism cause the hockey-stick growth? In an economy made up of interactions of millions of people, we cannot measure and understand all interactions. Sometimes, natural experiments can help us investigate causal relationships. Example: The division of Germany at the end of World War II into two separate economic systems, capitalist in the west and centrally planned in the east.

F. Varieties of Capitalism

Institutions and growth Not all capitalist economies are equally successful Economic conditions: Firms, private property, or markets may fail. Political conditions: Capitalist institutions are regulated by the government. The government also provides essential services (infrastructure, education). Example: In 1950, GDP per capita in South Korea was the same as in Nigeria. Both were capitalist countries. By 2013, South Korea was ten times richer by this measure.

Conditions for capitalist dynamism 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. Further ingredients include: Political conditions Government providing infrastructure, education, healthcare, national defense Laws and regulation (e.g. competition law, patents) Taxation and other interventions Economic conditions Secure private property Competitive markets Meritocratic environment

Summary: When is capitalism dynamic? 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: These firms can produce goods at low cost. Public policy supporting these conditions: Governments enforce laws and provide regulation. Public policy that supplies essential goods and services: These may not be provided in sufficient quantities by private firms, and include education and basic research.

Capitalism, inequality, democracy Democracy is a political system, that ideally: Gives equal political power to all citizens: This power is defined by individual rights such as freedom of speech, assembly and the press. Selects political leaders by means of elections: In these elections, virtually all adults are eligible to vote, and the governing party leaves office if it loses. Capitalism emerged in Britain, the Netherlands, and in most of today’s high-income countries long before democracy.

Capitalism, inequality, democracy The advent of democracy—and especially the extension of the vote to those without property and to women— saw a reduction in economic inequality because it gave more political power to the less well off.

Environmental consequences Increased production and population growth affects the environment: Global impacts – climate change Local impacts – pollution in cities, deforestation

Capitalism and environmental sustainability These effects are the results of both a) The expansion of the economy (growth in total output) b) The way the economy is organized (what kinds of things are valued and conserved) Technological progress may also be part of the solution, by making it possible to use less resources to produce more output.

Democracy and environmental sustainability Nature of relationship is complex due to: National costs and global benefits: While the citizens of a nation may adopt policies to protect the environment of that particular nation, they may have little incentive to protect the global environment, particularly if they will bear the costs and a great many others share in the benefits. Effect on future generations: Democratic citizens today are making decisions affecting people who may not be born for hundreds of years. These are examples of external effects, which arise when actions taken by a person have consequences—benefits or costs—that are felt by others.

Summary Looking at the data: Economic inequality between and within countries (skyscraper) Economic growth and technological progress (hockey stick) 2. Capitalism as an economic system: Key institutions: private property, markets, and firms 3. Varieties of capitalism: Economic and political conditions for capitalist dynamism Capitalism, democracy, and inequality Environmental consequences

In the next unit Social interactions among people: mutual gains and conflicts A closer look at external effects and social dilemmas: How do these arise? What is the role of institutions and policy? Using games to analyse and predict equilibrium outcomes of strategic interactions