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Part I: Varieties of Capitalism
Chapter 2
Liberal Market Capitalism
(latest revision 2009)
In Part I, we will consider the liberal market economy and the social market economy. The liberal
market economy, or free market economy, is most associated with the United States and Great Britain.
But it is also found in Canada, Australia, New Zealand, and Ireland. The social market economy is found
mostly on the European continent. But there are variations within the social market economy; the social
market economies of Scandinavia are different from the social market economies of France and Italy.
This chapter will examine the theory of the liberal market economy. “Liberal” is from the Latin word
for “free”. (Do not confuse this with political liberals.) Economists have both studied and appreciated
liberal market economies since the 18th century. The “father” of the theory of the market economy is
Adam Smith, a Scottish philosopher who lived mainly in the late 18th century. His most important work
was published in 1776. The views he propounded have been enhanced by a large number of people over
more than two centuries and are held in some form by the majority of economists today. Throughout this
course, we will be considering the shift to greater use of free markets in most countries of the world. The
ideas of this chapter are a major reason for this important shift.
1. Values of a Liberal Market Economy
Let us begin by considering the values inherent in a liberal market economy. Whether you agree or
disagree with these values greatly determines your support or opposition to a liberal market economy.
The first value in the theory of a liberal market economy is the assumption about the nature of people.
This type of person has been called “Economic Man”. This was mentioned in the previous chapter.
People are assumed to act as rational, self-interested, maximizers. Consumers attempt to
maximize the satisfaction they get from their purchases, given their limited incomes. Businesses attempt
to maximize their profits. Workers attempt to maximize their wages or other benefits of a job.
A second value of a liberal market economy is individualism. The individual is seen as the center of
society. The function of government is to serve the individual. One prominent economist who supported
the liberal market economy argued that President John Kennedy’s call to “ask not what your country can
do for you; ask only what you can do for your country” is not an acceptable statement for a free people.
A third value of a liberal market economy is that life is a competitive struggle in which the fittest
people survive and prosper. People of great wealth are admired as being particularly intelligent, bold,
brave, and so forth. On the other hand, poverty is seen as a moral failing. So when President Obama
proposed in 2008 that taxes be raised on people earning more than $250,000 per year, many on the
political right charged that “this was designed to punish the successful”.
A fourth value of a liberal market economy is equality of opportunity. Everyone should have an
equal opportunity to succeed. This is sometimes called a meritocracy. Liberal market economies are
opposed to feudalism, a system in which people are born into certain stations in life. However, equality of
opportunity is not the same as equality of results. Supporters of liberal market economies often oppose
redistributions specifically designed to make people more equal.
A fifth value of a liberal market economy what sociologist Max Weber called the Protestant Ethic. In
this ethic, people are to work hard, be thrifty, and seek personal economic gain. However, accumulated
wealth is never to be used for “conspicuous consumption”. Instead, it is to be used for good works and to
be re-invested. Therefore, we see very wealthy people endowing universities (Stanford, Duke, Vanderbilt,
Rockefeller) or creating foundations to do charitable work (Gates).
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2. Basic Institutions of a Liberal Market Economy
A most important institution of a market economy is private property. A certain individual (or group
of individuals) own some property and therefore have all of the rights and responsibilities that result from
that ownership. He or she has the right to use the property in a lawful manner and also to prevent others
from using that property (that would be called stealing). He or she has the right to sell the property, the
right to use the property in a business and therefore profit from the property, and the right to change the
property. Private property is essential to provide incentives to accumulate wealth. No one would
accumulate wealth if he or she believed that this wealth could be taken away at any time. We will see
later in the course that some of the countries that are converting from communism to market economies
have had problems because they have not had properly specified and enforced property rights.
A second major institution of a liberal market economy is called Free Enterprise. This allows each
person the right to engage in any type of economic activity. In the theory of liberal market economies, the
word “freedom” means “freedom from government restriction”. As long as the government neither limits
your action nor requires you to do certain things, you are considered free. As we will see, other people
have had different definitions of “freedom”.
Finally, liberal market economies require Free Competitive Markets. As we saw in Chapter 1, in a
market economy, the three questions (what, how, and for whom) are answered through the interactions of
buyers and sellers. Competition means that no one buyer and no one seller can influence the price of
product alone. Therefore, no one buyer or seller can determine what will be produced, how it will be
produced, or who will get it. Sufficient competition is a major requirement. It encourages innovation to
lower costs of production or to improve products. It creates variety for consumers.
3. The Invisible Hand
We want an economy to work as well as possible for the benefit of society. But when we say
"society", exactly whom do we mean? In the days of Adam Smith (1776), the prevailing view was called
mercantilism. In this view, the goal of an economy was to earn gold and silver for the king. The king
would then use the gold and silver to pay for a large military for defense and conquest. To Smith, this was
wrong. The goal of an economy, he argued, was to serve consumers. "The consumer is the king." This
has been called "consumer sovereignty".
(A) A Change in Consumers’ Tastes
To illustrate Smith’s argument, assume there are two products: A and B. The consumer (the king) has
a change in tastes; consumers now prefer more of A and less of B. Let us start with A. The demand for
A increases. There is now a shortage of A, as buyers want to buy more while sellers have not changed the
amount they wish to sell. Recognizing this shortage, sellers of A will raise the price of A. The price has
two main functions in a market economy: first, it provides information telling people what to do.
Second, it provides incentives for them to act on this information. The increase in the price tells sellers
all they need to know; they do not need any fancy market research. The increase in the price tells sellers
of A to produce more of A because buyers want more of A. It also provides the incentive to do just that.
Sellers are self-interested. Their goal is the maximization of their profits. They produce more of A
because doing so increases their profits. Sellers probably do not know why the price increased. And
they do not need to know this. Sellers certainly do not care that they made buyers happy by producing A.
But by acting in their own self-interest, they have also acted in the social (consumers') interest.
Now, let us look at sellers of B. The demand for B has fallen. There is now a surplus of B because
buyers are not buying as much while sellers have not changed the amount they wish to sell. Recognizing
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this surplus, sellers will be forced to lower the price of B. (Think of what happened when airlines or
automobile companies found that they could not sell enough of their product.) The decrease in the price
of B provides all the information these sellers need; it tells them that buyers do not desire as much B. It
also provides an incentive to produce less B. Producing less B provides sellers of B with the highest
possible profit under the new condition of reduced demand for B.
What about the workers? A major goal of workers is to maximize wages. As the production of A
increases, producers of A will need to hire more workers. To attract them, the wages paid to workers
producing A rise. As the production of B decreases, the producers of B will either hire fewer workers or
will reduce the wages of their workers. Those facing lower wages or loss of jobs in B will find the higher
wages in A attractive. Workers will move to produce those goods and services that consumers desire
most. As just one example: nature was "cruel" and located a large amount of oil in Alaska. Consumers
desire oil greatly, but Alaska is not a desirable location for most workers. How did oil companies get
workers to go to Alaska to produce oil? The answer, of course, was that they raised the wages
substantially. A person working maximum overtime could earn perhaps $75,000 or more in six months in
Alaska. That attracted all the workers that the oil companies needed.
Both companies and workers are guided, as if by an invisible hand, to produce the goods and
services that are most desired by consumers. And this occurs when all of them were only pursuing
their own self-interest. To quote Adam Smith, "He...neither intends to promote the publick (sic) interest,
nor knows how much he is promoting it...he 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."
Imagine that sellers of B and their workers refuse to follow the information and incentives provided by
the falling price of B. They truly love what they are doing and do not wish to change. They would
produce a certain amount of B. Some of the B that they produce will not sell. Their profit is less than if
they had decreased production. The reduced profit will eventually force them out of business. Producers
and workers must follow the wishes of consumers, even if they hate it, or perish.
Assume that sellers actually cared about consumers and wanted to make consumers happy. How
would they know what to do? Imagine the time and cost to get all the information they would need to
know. More than likely, they would still not produce the right goods or services. Yet, in trying to
maximize their own profits or wages, people are guided to produce the right goods and services. They
may not even know that they are doing so. To quote Adam Smith again, "by pursuing his own selfinterest he frequently promotes that of society more effectively than when he really intends to promote it."
(Question: Explain why there are so many reality shows on television.)
(B) A Change in the Relative Scarcity of Factors of Production
Let us take a different example. In 1973, there was a mysterious disappearance of the anchovy catch
off the Peruvian coast. The supply of anchovies was significantly reduced. This hardly seems like the
most important news; in fact, very few people even knew of it. In the United States, anchovies are mainly
used in the production of animal feed. When the supply of anchovies was reduced, producers of animal
feed had to turn to other sources of protein (mainly wheat). These other sources were more expensive.
This increase in cost caused an increase in the price of animal feed. When the price of animal feed
increased, the costs of production increased for those companies producing beef and pig products. The
rising costs of production forced them to increase the prices of the beef and pig products. Consumers
were totally unaware of the disappearance of the anchovies. But when they went to market, they noticed
that the prices of hamburger, steak, ham, and bacon had all increased. Faced with these higher prices,
they ate more chicken, fish, and cheese. They were guided, as if by an invisible hand, to economize on
that which had become scarce. Again, the rising price provided all the information consumers needed
to know. They did not need to know why the beef and pig product prices had increased. And it provided
the incentive for them to buy fewer products that were produced with anchovies and more products that
were not. The market not only guides producers to produce those products consumers desire, it also
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guides consumers to buy less of those products that use resources that have become relatively scarce.
(As another example, when oil became relatively scarce, it was important that consumers use less of it.
This was accomplished once the price of gasoline rose to more than $4.50.)
To summarize: the "invisible hand" is the market. The most important variable in the market is the
price of the product. The price has two functions: it provides information to both buyers and sellers
and it provides incentives to act on that information. People act in the own self-interest. Buyers act to
maximize the satisfaction they get from the products they buy, given the limitations of their incomes.
Sellers act to maximize profits. Workers act to maximize the wages they receive. In pursuing their
own self-interest, sellers and workers ultimately do that which is best for society as a whole (that is, for
consumers), even though doing so is not their intent and even though they may not know they are
doing so. This is the magic of the market.
(C) Case on the Invisible Hand: Environmental Regulations
We know that many activities that people undertake cause harm to the environment. In this case, let us
focus on the harm to the environment from air pollution. Government needs to concern itself first with the
question of how much air pollution to allow and how much to prevent. We will not be concerned with
that question here. But once it has been decided how much air pollution to eliminate, there is an important
question that government agencies must answer: how should the air pollution be reduced? In most
cases, air pollution has been reduced through laws that make certain polluting activities illegal. This is
known as “command and control regulation”. You are familiar with one example of this type of
regulation --- the requirement that all cars licensed in California have a smog control device that works.
Command and control regulation has been criticized by many economists. First, they argue that
government regulations are not the least costly means to achieve the goals the decrease in air pollution.
There is too much paperwork involved. And the regulators are likely to make serious mistakes, especially
as they must rely on people from the industries involved for the information they need to make their
decisions. Second, they argue that the government requires all polluters to reduce their pollutants
equally. The government does not distinguish between those companies who can reduce pollutants
easily (that is., at low cost) and those who cannot. By requiring equal reduction in air pollution by all
polluters, studies show that command and control regulations are at least 4 to 6 times more expensive than
other methods. And third, they argue that government regulations create a hostile, adversarial
relationship between the industries involved and the government. Instead of trying to reduce their
pollution, companies devote their energies to trying to avoid the regulations. Because of these objections
to government regulations, these economists have recommended the use of market solutions. And indeed
market solutions have come to be used more and more.
One important example of the use of markets to reduce air pollution has occurred in the greater Los
Angeles area. This area has long been noted for excessive air pollution. The local government is required
by the Clean Air Act of 1990 to reduce air pollution emissions. The use of market solutions in greater Los
Angeles has so far focused exclusively on industrial polluters. Under a program of the South Coast Air
Quality Management District, companies in the greater Los Angeles area are given “rights to pollute”.
This means that they are allowed to dump a certain amount of emissions into the air --- and no more.
Some companies can meet, and even exceed, these limits easily. Other companies have a very difficult
time meeting these limits. Those companies who cannot meet the limits have the right to buy the
“rights to pollute" from the other companies. The price is determined by the demand for and supply of
these rights. There are companies, such as AER*X, who specialize in dealing in rights to pollute. Let us
illustrate the way such a market would work. Suppose that Company X has the right to dump 50 tons of
pollutants per year into the air. And suppose that it could install a new production process that would
reduce its emissions by 10 tons at an added cost of $20,000 per year. Under command and control
regulation, Company X would have no incentive to reduce its emissions below 50 tons. But under the
market approach, it does. Suppose that rights to pollute sell for $5,000 per ton. Company X could spend
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the $20,000 to reduce its pollutants by 10 tons, and then sell the rights to those 10 tons to Company Y for
$50,000 ($5,000 times 10 tons), pocketing the difference of $30,000. Company X now has a financial
incentive to reduce its air pollution as much as it can --- even below the level required by the
government. Company Y also has the same financial incentive. If Company Y cannot find a way to
reduce its pollutants, it is required to pay an extra $50,000. This adds to its costs of production. Since
Company Y is now a high cost producer in comparison to its competitors, it may be faced with the
prospect of financial losses. The market forces Company Y either to find a way to reduce its pollution
or, eventually, to go out of business. In a market, those who are inefficient (in this case in reducing
pollution) die out. So the market solution gives both companies the proper incentives. It also generates
the result that most of the reduction in air pollution is accomplished by the companies who can do it
most cheaply. And it gives companies the incentives to actually reduce pollutants more than required.
As companies discover ways to produce with less pollution, the government can then reduce the total
amount of “rights to pollute”. (A reduced supply of “rights to produce” would raise the price. This
would create an even greater incentive to find ways to reduce pollutants.) Studies show that this trading
program has saved billions of dollars, despite the fact that only a small number of the possible trades have
actually taken place. Nitrous oxide emissions have been reduced 35% and sulfur dioxide emissions have
been reduced 25%. The air quality in the greater Los Angeles area is better than it once was. But the
program of trading “rights to pollute” can take only a small amount of the credit because it is limited to
industrial polluters. Most of the air pollution in the Los Angeles area is generated by automobiles.
President Obama has proposed a similar “cap and trade” program to reduce carbon emitted into the
atmosphere in order to reduce climate change.
4. Laissez Faire
If markets work so well, then what is the proper function for the government in a liberal market
economy? This is a major question. To those who believe strongly in the market system, the answer is
called laissez faire. Literally translated, this means "let it be" or "hands off". "That government is best
that governs least" is a famous quotation from Thomas Jefferson. Yet, laissez faire does not mean an
absence of government. Indeed, there are certain well-specified functions for government, even in a
market system. Most economists agree on these functions; their disagreements are in the implementation.
Let us enumerate the proper functions of government under laissez faire.
(A) Provide the Rules
The first, and probably most important, function of government under laissez faire is that government
provides the rules by which markets operate. Government also acts to enforce those rules. Buyers
and sellers respond to the incentives created by those rules. As an illustration of the importance of the
rules, take football. The game in Canada has changed just a few rules from that in the United States: three
downs instead of four, a wider field and a 40 yard end zone, no backfield in motion penalty, and so forth.
Those who are familiar with football will know that the game is very different in the two countries. The
types of players attracted are also very different; many of the better American players would not be good
players under Canadian rules. Similarly, many companies that are presently successful might not be
successful with a different set of rules and many that are not successful might become successful with
different rules. Rules provide the incentives that determine rewards and penalties. The goal here is to
have a set of rules that will guide people to behave in ways most desired by society. As we will see later,
creating rules and enforcing them has become the most difficult stumbling block in the transition of
former communist countries into market economies.
Perhaps the most important government rule involves property rights. This was mentioned earlier in
this chapter. "I own my car." What does this mean? It certainly does not mean that I can do anything I
want with my car. I cannot, obviously, drive it in the space you happen to be standing. But, of course, I
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can do certain things with my car. As noted earlier, I have the right to use my car, the right to transform it,
the right to earn an income from using it, and the right to sell it. To bring-about socially desirable results,
first, the property rights need to be clearly specified. This means that the owner and other individuals
potentially interested in the property have full knowledge of the rights involved with its ownership. For
example, if I buy a car, I have a right to know how many miles it has been driven previously. The point is
that, if ownership rights are to be transferred, both buyer and seller know exactly what it is that is being
transferred. Second, property rights need to be exclusive. This means that all of the benefits and all of
the costs from owning an asset must accrue to the owner, and to no one else. The key here is that private
property rights make one accountable for the results of one's actions. If I manage my property poorly, I
am the one who will suffer. Third, property rights need to be transferable. Transferability forces the
owners to consider the full opportunity cost of the property. If my car is worth more to someone else than
it is to me, that person will buy it from me. In this way, property is transferred to the person who has the
most highly valued use. And, fourth, property rights need to be enforceable. If these four conditions
noted above are met, the owner of the property will have a strong incentive to use it efficiently because
any decline in value of the property would represent a personal loss.
(B) Promote or Maintain Competition
A second function of government under laissez faire is to promote or maintain competition.
Competitive markets were mentioned earlier in this chapter as a main institution of liberal market
capitalism. If we are going to "let it be" (laissez faire), what prevents the gasoline station from charging
you $10 per gallon. The answer, of course, is that they have competition. A station charging $10 per
gallon would have few, if any, customers, as people would buy elsewhere. But, of course, competition is
not good for the competitor. Who wants to compete if one doesn't have to? As Adam Smith put it more
than 200 years ago, "People of the same trade seldom meet together, even for merriment and diversion,
but the conversation ends in a conspiracy against the public, or in some diversion to raise prices." The
laws to promote or maintain competition are called the antitrust laws. In the United States, they date to
the passage of the Sherman Act of 1890. They are enforced by the Anti-trust Division of the United
States Department of Justice and by the Federal Trade Commission. Most economists support the
goal of promoting or maintaining sufficient competition. But as mentioned earlier, they differ in the
interpretation. Some will look at a given situation and believe that competition is sufficient; others will
look at the same situation and see competition lacking.
(C) Provide Information
A third function of government under laissez faire results from the fact that market participants need
information to be able to make proper market decisions. If a gasoline station charges $10 per gallon, you
will leave to buy gasoline somewhere else. You can do this because you know that there are other
stations selling for less. If you did not have this knowledge, you might pay much too much for gasoline.
In many cases, buyers do not know much about the product. Gaining information is costly. In some
cases, gaining sufficient information may not even be possible. In these cases, the government informs
market participants (or perhaps pressures sellers to provide this information). For example, I would not
know high quality meat from poor quality meat. I have no idea what chemicals were injected into the
animal and what food coloring has been used. Therefore, a government agency (the Department of
Agriculture) provides information on the quality and safety of the meat. Recently, the government has
forced manufacturers of food products to put nutritional information on their packages as well as tell
people where the products were produced. As another example, government pressure caused the film and
television producers to "volunteer" to put ratings on their films. If I go to a film and it says "NC - 17", I
have a good idea what I am going to see. If I find that kind of film objectionable, I can choose not to see
that film. "Warning! The Surgeon General has determined that cigarette smoking causes cancer" is also
an example of government providing information. Notice that no one is told not to smoke cigarettes; they
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are informed, however, what cigarette smoking can do. As a final example, one goes to a restaurant and
notices a sign in the window that says "A". This means that a trained government inspector has
determined that the restaurant is sanitary and that one can eat there without risking one's health. Most of
us would not know how to conduct these inspections, and would not have access if we did know.
An interesting example of the importance of information involves Proposition 65 in California. You
have probably seen signs regarding Proposition 65 frequently. Under the proposition, the state
government must make a list of all chemicals known to cause cancer or birth defects (presently around
660 chemicals). If companies expose people to those substances, they must provide a warning. The
chemicals are not banned. Only the warning must be provided. The idea was that companies would fear
losing buyers if their products had warning labels and their competitors’ products did not. Also,
companies would fear losing customers if they got bad publicity for using dangerous chemicals. In the
first decade after the proposition was passed, air emissions of 147 of these chemicals declined twice as
much in California as in the United States as a whole (while emissions of the other chemicals declined at
about the same rate). These emissions declined simply because companies did not want to have to provide
the warning.
In 2008, we saw the results of poor information. Many investors had bought very complex financial
assets (such as derivatives) with no way to evaluate just how safe these assets were. Rating companies
had regarded these assets as safer than they actually were. But the investors found out that these assets
were indeed very risky. Many investors lost their entire investments. The result of this precipitated the
steep decline of the global economy in 2008 and 2009. One of the calls for reform is to find ways for the
government to find better ways of providing investors information about the safety of various financial
assets. Most economists agree that good information is essential for markets to work well. But they
disagree about just what information government should provide and how it should provide it.
(D) Public Goods
For the fourth function of government under laissez faire, consider national defense. Imagine there is
no government. Imagine also there is a real enemy (Canada). The Canadians are massed at the border
ready to swoop down and conquer us all. An entrepreneur sees an opportunity for profit. People want to
be defended. So the entrepreneur decides to start a business. It will be called the United States Military,
Inc. There will be four divisions. Workers will be hired, machinery will be bought, and so on. Assume
that the entrepreneur then tries to sell you defense (remember that you do indeed want to be defended).
The charge is the same as today's actual charge of about $2,000 per person. Will you pay? Even though
you want the defense, the answer for many people is "no". Why? You will not pay because, if others
do pay for the defense and you do not, you will get it anyway. There is simply no way for me to be
defended in America and for you not to be defended. Put another way, it is possible for one to be a free
rider.
Defense is an example of what is called a public good. Public goods have several inherent
characteristics. First, they are non-rival. If I have an automobile, you may not have it. But I can have as
much defense as I desire without taking any away from you. Second, they are non-excludable. It is not
possible for one who pays for the good to exclude those who do not pay (the free riders) from the benefits
of that good. Third, they are collective. They are either provided for everyone or for no one. Other
examples of public goods include fire protection, police protection, flood prevention, and public health
(disease prevention).
Why are public goods provided by the government? The answer is that, in the case of public goods,
the market fails to provide what consumers desire. People want to be defended; however, no defense
will be provided in a private market because each person is waiting for the others to pay. Only the
government has the legal power to force people to pay. Anyone refusing to pay for defense will find the
government going into their bank account and simply taking the money plus a penalty. No private
company can possibly do this.
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(E) Externalities
Companies have a strong incentive to provide the products that buyers desire. They also have a strong
incentive to produce efficiently, using the least possible amount of the resources for which they have to
pay. Therein lies the problem. The full cost generated in the production of a product is commonly
much greater than the cost paid for by the producers of that product. For example, a paper mill pays
for its pulp, its workers, and its machinery. But in the process of producing paper, it releases its waste
into the river, damaging the river for fishing, swimming, aesthetic enjoyment, and so forth. This damage
imposes costs on others --- the loss of fish hurts businesses that catered to people fishing and hurts those
who like to fish for recreation while the loss of beauty hurts people who enjoyed viewing the river and
perhaps also lowers property values. In addition, the production of paper uses electricity. The electricity
is likely produced from coal. Burning coal releases pollutants into the air. These damages are called
external costs (or negative externalities). They are major costs resulting from the production of paper;
but no part of that cost is paid by the paper mill or by the paper consumer. The result is that, from the
point of view of what is best for the people in the society, too much paper is produced. In the language
of the economist, the market has failed to internalize all of the costs of making paper. Put another way,
companies make profits by dumping part of their cost on others. The buyers and the sellers are receiving
improper signals from the market.
There are also external benefits (or positive externalities). In this case, a person's actions provide
benefits to society beyond the benefits that the individual person receives. One good example is
Research and Development (R&D). Consider the enormous benefits to society from the creation of the
personal computer. Most businesses and large numbers of households have benefited. While some of the
creators of the personal computer became very rich, the amount they received is very small in relation to
the total benefit to the world. A similar example would come from the development of the vaccine that
eliminated polio. While Dr. Salk became very wealthy as a result, the benefits to the world as a whole far
exceeded any amount he received. If the benefits that the person received were not sufficient, the product
might not be produced even though it was desirable for society as a whole.
Education is yet a second example of an external benefit. Your decision to attend college will benefit
you greatly. You will likely gain a better job with higher pay. But others will benefit as well. You may
learn things that you can teach to co-workers. Your children will be better educated if you are better
educated. The democracy works better because educated people make better citizens.
In the case of external benefits, the market again fails to send the proper signals to people. In this
case, too little is being produced from the point of view of society as a whole. Indeed, there are probably
many activities that would be very worthwhile for the society but are not presently being done at all
because the benefits to the one who would do them is too small.
Externalities present a role for the government. The market fails to send the proper signals to
individuals; only the government has the ability to remedy this. In the case of external costs, the
government could tax the activity or it could regulate it. Paying an automobile registration fee based
on the amount of pollutants your car gives off would be an example of a tax. Having to have a smog
control device on your car or not being allowed to smoke in a public place are examples of regulations.
In the case of external benefits, the government could subsidize the activity. There is presently a
considerable tax benefit for research and development activities. And, of course, you do not pay the full
cost of attending this college. Most economists agree that externalities represent a market failure and an
area for government intervention. But they disagree on two important points. First, which externalities
are important enough to warrant government intervention? For example, government does not allow
me to build a factory on my residence (as that might harm my neighbors). But some areas go further and
require that your homes be a certain color and even that you cut the grass once a week. Or government
does not allow you to smoke in a public elevator but it does allow you to be on this elevator if you have
not taken a bath for weeks. Second, if the government should intervene, how should it do so? The
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debate here is between those who favor regulation (known as command and control) and those who favor
market-type incentives.
(F) Merit Goods
There are some goods that are provided by government that fit none of the above categories.
However, through a political process, we have determined that these ought to be available to people.
These are called merit goods or political goods. One example is the beach. Another is a city park.
Neither is a public good, since it is possible to require one to pay to be able to enter (just as Disneyland
does). Yet, we have decided that restricting these goods to those willing and able to pay is not
acceptable. Therefore, they are made available to all without charge. In recent years, we have had an
important political debate about health care. Surely, health care is not a public good (one must pay for it
to have access to it). But is it a right that should be provided to all citizens? Many people believe so.
Others disagree. (Keep in mind that a public good is inherent in the nature of the good. If it is possible
physically for one to have to pay for the good to be able to receive the benefits of the good, then that good
is not a public good.)
(G) Redistribution of Income
In a free market economy, what determines the income people receive? People receive wages
according to their contribution to the revenue of their employer. Alex Rodriguez earns over $25 million
per year playing baseball because it was expected that he would increase attendance and television
viewers; each of these viewers would bring in revenue for his employer, the New York Yankees.
Similarly, Tiger Woods earns about $100 million in the same year from advertising endorsements because
it was believed that he would increase the sales of the products by at least that much.
If one is paid according to the revenues one brings in for one's employer, there is a question of what to
do with people who cannot bring in revenue. These are the elderly, the disabled, and so forth. Shall we
just let them die? Most of us would say "of course not". So, income is taken from those who earn it
(that is, they produce goods and services) and redistributed to those who cannot earn it. The
phenomenon is an old one. However, until the 1930s, it was done mainly within families, by churches,
and by private charities. It is still done by these groups today. However, it is more likely to be done
through government today than was true in the past.
Most people accept that some redistribution must be done in a civilized society. But there are two
main disagreements. First, who should be able to receive income that has been earned by others?
Most accept that the elderly and the disabled should be entitled to receive income (although there is a
debate today about who exactly is elderly or disabled). But what about single mothers with small
children? There is great controversy here. Second, how much of the redistribution should be done
through government and how much through other private agencies? Many political conservatives
want the redistribution function taken over by churches and private community groups, such as the
YMCA and YWCA, while many liberals are more inclined to have the redistribution take place through
the government.
To summarize, free markets work well in the interest of society (that is, consumers). But these
markets only work within a system of rules. These rules are the responsibility of government.
Markets also may fail to do what is right for society as a whole. This is called “market failure”. When
markets fail, there is a role for government to correct the failures. Markets fail to do what is right for
society if there is not sufficient competition. Government needs to promote or maintain sufficient
competition. Markets fail to do what is right for society if buyers and sellers do not have appropriate
information. Government can act to provide this information. Markets fail to do what is right for
society when there are public goods. Government can provide these public goods. Markets fail to do
what is right for society when there are negative or positive externalities. Government can correct for
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negative externalities (for example, pollution) by taxing the activities or by regulating the activities.
Government can correct for positive externalities (for example, research) by subsidizing the activities.
Certain goods that are considered important (called merit goods) may not be provided in markets.
Government can provide these goods. Finally, government can intervene to provide funds to people
that otherwise could not earn income (especially the elderly and disabled).
5. Criticisms of Government Involvement in the Economy
We have just discussed the functions of government in a market economy with laissez faire. It was
argued there that government has a role to play when the market fails to perform properly. Here, we will
consider the arguments of what is called Public Choice Theory. In this theory, the government in a
democracy may also fail to perform its functions properly. While Public Choice has generated a vast
literature, there are four aspects we will focus on here.
(A) Voting Behavior
One phenomenon commented on frequently these days is the small percent of people who choose to
vote. Of the voting age population, not much more than half vote in presidential elections and not much
more than one third vote in congressional off-year elections. To the public choice economist, this is not
surprising. First of all, these economists assume that people act in their own self-interest.
Therefore, you vote based on what you believe will be best for you (this, of course, does not preclude
the possibility that your self-interest is to have the best for the country). As a rational person, you
compare the benefits of voting and the opportunity costs of voting. The opportunity cost is the time
that must be spent going to the polls, standing in line, casting the vote, and then returning home. More
important is the time that must be spent to gain the information necessary so that you can vote for what is
best for you. You must read the ballot, study the issues carefully, listen to the various candidates, and
discuss with others. The problem is that the perceived benefit is likely to be low. The reason is that a
single vote has little chance of affecting the outcome. Unless you know that there is a race like a 2004
governor’s race in Washington (the winner won by only 400 votes out of 5 million) or the 2008 Senate
election in Minnesota (the winner won by a bit more than 200 votes), the results of the election will be the
same whether you vote or not. Knowing this, a rational person may choose not to vote. Public Choice
economists call this "rational abstention" and argue that it should not be confused with "apathy" (to
abstain means to refuse to participate). Voters do care very much about the election outcome; they simply
realize that the results of the election will be the same whether they vote or not. Rational abstention is
very damaging to the argument on behalf of democratic government, since elections may not determine
the true will of the people in the society.
(B) The Special Interest Effect
There are only two ways for a person to gain income. One is to contribute to the revenue of
one's employer. That is, one earns income by producing new wealth. The other is to find a way to
have income redistributed from someone else to oneself. In this case, there is no new wealth; one
person's gain is the other person's loss (known to economists as a "zero sum game"). Some of this
redistribution involves transfers that have little justification. There are many ways for these transfers to
be accomplished. We define a special interest as a group of people that use the political process to gain
an increase in income at the expense of others.
Special interests will likely be successful at using the government for their own gain if the benefits
of the government activity are concentrated in a small number of people, each of whom receives a
large individual benefit, while the costs are spread over many people, each of whom pays a small cost.
As an example, take the case of price supports for agriculture. Prices of some 13 agricultural products are
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set by the government; if the farmers cannot sell all they produce at this price, the government buys the
surplus. These price supports raise the price of food. Buying and storing the surplus costs taxpayer money
that could be used for other purposes (a tax cut or another government program). The price supports cause
farmers to grow food that nobody wants to eat. This is inefficient, to say the least. Economists almost
universally oppose such programs. So why has this program existed for seventy years? The answer
involves the special interest effect. Farmers represent a special interest. The programs have brought
each farmer in America an average gain of between $10,000 and $15,000 each year. (Since many farmers
received nothing at all from the program, other farmers must have received many tens of thousands of
dollars of payments.) These farmers are willing to lobby Congress for this program as long as the cost per
farmer is less than the amount of the payments. (To lobby is to promote a program directly with a
Representative, Senator, or other government official.) On the other hand, these programs cost each
American an average of perhaps $100 to $150 per year in higher taxes and higher food prices. And most
people are unaware of this. As long as lobbying Congress costs more than this amount, people will not
get involved to stop the programs. Farmers lobby Congress heavily on their behalf while few are there
to lobby against them. The programs continue to grow despite the fact that many more people are hurt
than are helped by them.
(C) The Shortsightedness Effect
The same reasoning applies when the benefits come in the present while the costs are paid in the
distant future (or when the costs come in the present while the benefits come in the distant future).
This is called the shortsightedness effect. To some people, it is a result of the need for re-election. Thus,
politicians look ahead no more than two years (for Representatives), six years (for Senators), and four
years (for the President). Politicians tend to favor programs that have benefits that appear in the present
and costs that will be paid in the distant future (well after the next election). And they tend to oppose
programs that have costs that are paid in the present while the benefits will not arrive until the distant
future. So, good programs may not be undertaken while bad ones are.
(D) Bureaucracy
Most government agencies are bureaucracies. While legislatures pass the laws, it is the bureaucracies
that administer these laws. We define a bureaucracy as an organization that produces a product that is
not sold through a market and which obtains at least part of its revenue from sources other than the
sale of its product (usually from taxes). The traditional view of a bureaucracy in a democracy derives
from the famous sociologist Max Weber. He saw bureaucrats as knowledgeable, talented people who
objectively administer the laws. More recently, "bureaucrat" has come to be a dirty word. Bureaucrats
are seen as bungling, inefficient, and uncaring. Public Choice economists reject both of these views.
They see bureaucrats as self-interested, rational, maximizers. In this view, bureaucrats act to maximize
their own welfare. Their welfare depends on salary, perquisites, status in the agency and number of
subordinates (power), size of the budget over which one has control, and non-monetary benefits
(the quiet life). All of these are enhanced when the agency is growing. Thus, in this view, the main
incentive is to maximize the size of the agency (known often as "empire building").
Because the agency's production is not sold in a market and because it receives revenue from sources
other than sale of the product, the agency does not have to meet the same conditions of efficiency that a
profit-maximizing company would have to meet. In the view of Public Choice economists, both the size
of the agency and its budget are commonly expanded well beyond the size that would be economically
optimal. For one example, hospitals are notorious for over-investing in equipment that is then
underutilized. And many university athletic departments have income of more than $100 million per year.
Yet they constantly claim they are losing money. Where does this money go? The answer commonly is a
Hall of Champions or new office for the coaches or "recruiting trips" to find the best players in Hawaii
and the Caribbean. (Indeed, if a bureaucracy has not spent all of its allotted funds by the end of the year,
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there is great pressure to see that it all is spent. It does not matter that the spending is for things that are
relatively unimportant. Funds not spent this year will mean a reduced budget for next year.) This
phenomenon of bureaucracy will be especially important when we analyze communist economies.
In general, the public choice theory has remained controversial in Economics. Yet, there is a lesson
here. Government may fail to provide socially optimal results, just as markets may fail. Whether we
should rely on markets or on the government may depend on the circumstance. When we do ask
government to do something, we need to carefully analyze the incentives facing those with decisionmaking power inside government.
6. Full Employment
The argument that liberal market economies generate full-employment began with Say’s Law (1795).
Say’s Law is commonly stated in the following cliché form: “supply creates its own demand”. This
means that everything that can be produced if we have full employment (called Potential Real
Gross Domestic Product) will be bought. There will always be full employment. To paraphrase the
movie Field of Dreams, if they (the companies) build it, they (the buyers) will come! Recessions will not
last long and will be eliminated automatically.
Assume there is a period where buyers are not buying enough goods and services (such as 2008 and
2009). Since they are not selling the goods or services, companies do not hire the workers to produce
them. These workers become unemployed. This is a recession. According to this view, such a recession
would last only a short time. Automatically, three changes would occur that should end the recession.
First, the sellers have a surplus of the goods or services. What do sellers do when they can’t sell their
product? The answer is that they lower prices. As prices fall, buyers will buy more goods and services.
When the price falls enough, the buyers will buy all the goods and services that can be produced
(the Potential Real Gross Domestic Product).
Second, the companies cannot receive less money from consumers and continue to pay their workers
all they were paying before. So, the companies will desire to reduce the number of workers hired. This
reduction is another surplus. What will workers do when there is a surplus (that is, when there are
unemployed workers)? Like all sellers, they will lower the price (now called the wage). As wages fall,
companies will be more willing to hire workers. When the wages have fallen enough, all of those
workers willing and able to work will be hired. This is full employment. Notice that, even though
wages have fallen, the workers are not worse off. That is true because the prices of the goods and services
have also fallen. The real wage (what can be bought with the income earned in an hour of work) has not
changed.
But we are not done. There is a third adjustment mechanism. The money that people chose not to
spend is instead saved in financial institutions. These financial institutions try to lend this money out, but
no one is borrowing. They too also have a surplus – this time, a surplus of money to lend. As with any
other seller, what do the financial institutions do when they have a surplus? The answer is that they lower
the price (now called the interest rate). As interest rates fall, households will desire to save less
because savings is less rewarding. And both consumers and businesses will desire to buy more
goods and services because borrowing to pay for them is cheaper. Eventually, interest rates will fall
enough that buyers will buy everything that can be produced.
Let us summarize this view. If there is a recession, three adjustments will take place to eliminate it.
First, the price level will fall, encouraging people to buy more goods and services. Second, wages will
fall, encouraging companies to hire more workers. And third, interest rates will fall, encouraging
people to save less and to borrow more for consumer or business investment spending. In a relatively
short time, the recession will be gone. Except for this short transition time, there will be full
employment. Everything that can be produced will be bought.
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This view might be analogous to a person getting a common cold. If you do get a cold and you do
nothing about it, the cold will go away by itself. There are changes that will happen in your body that will
get rid of the cold. You are not aware of these changes and do nothing to bring them about. You will not
feel well for a short time --- perhaps up to two weeks. After that, you will feel fine and will forget that
you were ever sick.
There is one point to stress about this argument. First, notice that all of these adjustments are
automatic. No government action has caused any adjustment to happen. Companies lower prices
because they cannot sell their products. Workers accept lower wages in order to become employed.
Financial institutions lower interest rates in order to lend the money they have. The end result is to
eliminate the recession. If this is true, then what is the proper role for government? The answer, of
course, is to do nothing. The system works well with no government involvement. The economy has the
ability to self-correct. Contrast this view with that of President Obama and his advisers as to the way to
approach the recession of 2008/2009.
7. Distribution of Income
We discussed the distribution of income earlier as one of the functions of government. As noted there,
to determine if a company will hire each worker, we must answer two questions: what is the benefit of
hiring that worker and what is the opportunity cost of hiring that worker? The opportunity cost is just
equal to the wage. This means that, if the wage $100 per hour, the employer can hire as many
construction workers as desired at that wage. Each additional worker will cost the employer an additional
$100 per hour. What is the benefit from hiring an additional worker? First, each additional worker adds
to production. However, the employer is not interested in just production. The employer is interested in
revenues. So we must multiply the additional production by the price received. Assume that I am the
worker. If the company hires me, I add ten units to production per hour. If each of those ten units sells for
$10 each, I am responsible for adding $100 (10 times $10) of new revenue for the company. If my wage
is $50 per hour, the company profits from hiring me. If my wage is $150 per hour, the company would
lose if it hired me. As long as the addition to revenue is greater than the addition to cost (which equals the
wage), the company is better off hiring that worker. So in a liberal market economy, one is paid
according to the amount that one adds to production.
Employers do think in these terms. This is easiest to see in the case on entertainers and athletes. For
example, it has been said that Ray Romano was paid $1.8 million for each episode of his television show
Everyone Loves Raymond. Why would anyone pay that much money to one person for one episode of a
half-hour show? The answer, of course, is that they expect him to bring in a large number of viewers.
The large number of viewers allows the television network to charge higher prices to advertisers.
Consider the large number of viewers and the high prices charged to advertisers, the television network
expected Ray Romano to contribute at least $1.8 million in additional revenue each episode.
Notice that there is an implied value judgment in this line of reasoning. A person is paid according to
his or her addition to revenue. If you earn more than I earn, it must be because you add more to
revenue than I do. This could only occur for two reasons: (1) you are physically more productive than
I am or (2) you produce a product of greater value to society than I do, as evidenced by the higher price
it commands. If this is so, then you deserve to be paid more than I do. People who earn high incomes
deserve them!
If wages reflect the value one contributes to revenues, then what about profits? In a competitive
market economy, profits will be just the minimum amount necessary to keep the company in business.
That is, the profits earned by a company will equal just the amount that could be earned doing
something else. The company will have no incentive to go out of this business and do something else, as
the profits will not be different. And no other company will have an incentive to enter the industry and
compete with this company as the profits will not be different.
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Let us illustrate this by assuming you run a business. You spent $1,000,000 to become owner of the
business. The profits of the business are $200,000 per year. This is a 20% return. Assume also that the
best alternative for the $1,000,000 is to put it in the bank in an account paying $50,000 interest per year
(5%). What will happen? New companies will see that your business is very profitable. They will take
their money out of the bank and start businesses to compete with you. These new businesses will increase
the amount of the product produced. The greater amount of production on the market will cause the price
of the product to fall. As the price falls, your profits will fall as well. When your profits have fallen to
$50,000 (5%), there will be no more incentive for someone to come in and compete with you. Now
suppose your profits had only been $10,000 (1%). What will happen? Companies in your industry will
go out of this business because they are not earning as much as they could earn in the bank. As they
leave, the amount of the product produced will decrease. Less of the product on the market will cause the
price to rise. The higher price will raise the profits of those who remain. When your profits have risen
back to $50,000 (5%), there will be no more incentive for someone to leave this industry. So in the end,
all companies will end up earning just the 5% that could have been earned in the bank ($50,000).
This is an important point. Imagine a company invents a new process that lowers the cost of
producing the product. The company’s profits will rise. But these profits will cause new competitors to
come in to the industry and do the same thing. The new companies will increase the amount produced of
the product. This greater production will cause the price to decrease. The lower price will cause the
profits to decrease until they are back equal to the amount that could have been earned in the bank. Notice
that all of the benefits from lowering the costs of production ultimately go to the consumer as lower
prices. If all of the benefits ultimately go to the consumers, why would companies bother to develop
ways to produce cheaper? The answer is that they make profits for a short while. It takes time for the
new companies to be able to compete with them. The profits they can make for a short time are enough to
motivate the companies to try to find ways to become more efficient. (Becoming more efficient over time
is called “dynamic efficiency”.) The same argument applies if the company finds a way to improve the
product.
Let us summarize. In a market economy, one’s wage reflects the value one contributes. One earns
more either by becoming more productive or by producing goods and services of higher value. And the
profits of companies will equal just the minimum necessary to keep them in that business – the amount
they could have earned in the next best alternative (assuming there is sufficient competition).
Companies will have a strong incentive to find ways to lower the costs of producing the product (and
also to find ways to improve the product). But the benefits of lowering the costs of production
ultimately all go to the consumers.
8. Free International Trade
In the economic thinking of mercantilism (prior to Adam Smith), the goal was to earn more money for
the king. To accomplish this, imports were often restricted and exports were often promoted. Countries
developed colonies. Adam Smith (1776) was the first to argue against that free trade was more desirable
because it brought about a higher standard of living. His basic argument was that exchange increases
overall production by increasing specialization and division of labor (division of labor refers to the
way the tasks are divided and who does which task).
Why do you not do everything for yourself? Why do you not grow your own food, build your own
home, make and fix your own clothes, and so on? The answer is obvious; you are better at some things
than others. You are better off if you specialize in those things you do best. Assume you are very good at
fixing cars. You are best off if you devote all of your work time to fixing cars. You will fix more than
just your own car. The additional cars you fix will be your surplus production. You will then exchange
this surplus production with someone who specializes in producing food or with someone who specializes
in producing clothing. As a result of specializing, you learn your job well. You may even learn it so well
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that you are capable of developing new machines or new techniques to improve your ability to fix cars.
And you will not have to waste time going from one task to another. The result is that there are more
goods and services to go around --- more fixed cars, more food, and more clothing. Specialization, of
course, is a very common phenomenon. Doctors specialize in just one part of the body or in one disease.
Baseball players specialize in one position. Radio stations specialize in just one type of music. Teachers
specialize in just one academic subject.
In the early nineteenth century, British economist David Ricardo extended this analysis. What would
be the best result, he asked, if someone were better at everything than the other person? Suppose you are
better than I am at each of two tasks. On task 1, you are much better than I am. On task 2, you are just a
little better than I am. Since your advantage over me is greatest for task 1, we say that you have a
comparative advantage in task 1. Since your advantage is least for task 2, we say that you have a
comparative disadvantage in task 2. Alternatively, I have a comparative advantage in task 2; even though
you can do task 2 better than I can, my disadvantage is least for this task. The comparison is not between
you and me. The comparison is between task 1 and task 2. Since I am relatively better at task 2, I have
the comparative advantage in task 2. Ricardo showed that the people would still be better off specializing
in those tasks for which they have a comparative advantage and trading with others. This principle is
commonly referred to as the law of comparative advantage.
To illustrate the law of comparative advantage, assume that a lawyer can type faster than her secretary.
Should the lawyer both practice law and also do all of her own typing? Of course, the lawyer should not
do her own typing. Every hour spent typing would have a very high opportunity cost --- an hour not spent
in court nor preparing for court. Hours spent in court commonly are worth $400 or $500 each. The high
opportunity cost would be much greater than the time that could be saved by typing faster. The lawyer
should specialize in going to court and let the secretary specialize in typing, even though the lawyer
types faster. Baseball fans know that one of the greatest pitchers of all time was Babe Ruth. He pitched
for Boston early in his career and has pitching records that still have not been broken. Nonetheless, he
was converted into a right fielder and home run hitter. First, why did he not do both --- pitch and hit
home runs? The answer is that each task requires many hours of practice every week. There are only so
many hours available to practice. One who tries to do both tasks is likely to have insufficient practice
time for each task and therefore is likely to be mediocre at each task. Like most other people, baseball
players are better if they specialize. Why did Babe Ruth not choose pitching over right field? The answer
is that he had a comparative advantage in batting. He was a better pitcher than others of his day. But
there were other pitchers who were very good. He was a much better batter than others of his day. His
record for home runs in a season lasted for 34 years. His record for home runs in a career lasted until
1974. His advantage over others as a home run hitter was much greater than his advantage over others as
a pitcher. Therefore, it was best for him to specialize in hitting home runs and let others do the pitching.
Smith and Ricardo focused their analysis on nations. The same principle holds: nations are better off
if they specialize in those products for which they have a comparative (not absolute) advantage and
trade with other countries. But what determines the comparative advantage that a country will have?
The most important theory to answer this question came from two Swedish economists, Eli Heckscher
(1919) and his student, Bertil Ohlin (1933). Their theory has two aspects. First, certain countries have
abundant amounts of certain factors of production and lesser amounts of other factors of production.
So, the United States has abundant agricultural land while, in Sweden, agricultural land is very scarce.
The United States has abundant capital and skilled labor while, in China, both are relatively scarce. But
China has abundant unskilled labor while, in the United States, such labor is relatively scarce. The second
aspect of the theory is that certain goods require certain factors of production. Thus, automobile
production is capital-intensive, wheat production is land-intensive, textile production is labor-intensive,
computer software production is technology-intensive, and so forth. The Heckscher-Ohlin theory says, in
Ohlin’s words,
“Commodities requiring for their production much of the abundant factors of production and little of
the scarce factors of production are exported in exchange for goods that call for factors in the opposite
proportions.”
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Do the actual patterns of trade fit the predictions of the Heckscher-Ohlin theory? The answer seems to
be “basically yes”. Most (but not all) of American trade, as well as that of other countries, seems to be
consistent with this theory. America exports goods that use high technology and imports goods that
require much unskilled labor.
The conclusion that trade is beneficial to each country is widely accepted by most economists. But
this does not mean that trade is good for every person. Within each country, trade generates “winners”
and “losers”. The “losers” have often been strong opponents of policies that open trade between
countries. In many cases, they have been able to prevent such opening. (Review the special interest effect
from Page 10 above.) Who are these “winners” and who are these “losers” from international trade?
As we have just seen, if trade is free, a country exports those goods that require the factors of
production that are in relative abundance and imports those that require the factors of production that
are relatively scarce. For the United States, this means exporting goods that use large amounts of arable
land, capital, and highly skilled labor. It also means importing goods that require large amounts of
unskilled labor. Suppose, as is likely to be the case, that the United States has a comparative advantage in
production of computer software. The ability to trade, and therefore to sell in foreign countries, increases
the demand for American computer software. This increase in demand both increases the quantity of
computer software products sold and also increases their prices. Both the increased quantity sold and the
increased prices will increase the profits of owners of computer software companies. They will also
increase the number of people employed in the computer software industry as well as their wages.
Therefore, the owners of computer software companies and their workers are both “winners”. On
the other hand, assume, as is likely to be the case, that the United States has a comparative disadvantage
in textiles. With free trade, the United States will import textile products. These imports increase the
supply of textile products in the United States, decreasing their prices. The decrease in prices will reduce
the profits of the owners of American textile companies. The decrease in textile prices will also decrease
the number of jobs for American textile workers and their wages. Therefore, the owners of American
textile companies and their workers are “losers” from international trade. In general, for the United
States, free trade benefits owners of arable farmland and highly skilled workers. Free trade hurts
unskilled and semi-skilled workers. In a country such as China, the opposite should occur. In China,
free trade should benefit unskilled and semi-skilled workers as well as the owners of the companies
that employ them. In China, free trade should hurt highly skilled workers. In summary, owners of
factors of production specific to export industries tend to gain from international trade while owners of
factors of production specific to import-competing industries tend to lose.
The analysis of the benefits of free trade shows clearly that the gain to the “winners” from free trade
exceed the harm to the “losers”. We know this because we showed that the United States as a whole is
better off with free trade. Yet, in political decision-making, the “losers” are often able to prevent policies
that promote free trade. You can explain this from the Special Interest Effect argument explained above.
Often policies that are good for the country as a whole are not enacted.
There are other benefits from free trade besides the argument analyzed above. First, there are gains
from what are called “economies of scale”. This means that if companies can sell their products around
the world, they can become bigger companies. And bigger companies have advantages that allow them to
produce at a lower cost. Producing at lower cost means that prices charged can be lower. Second, there
are gains due to increased competition. More competition forces prices to be lower for consumers.
And competition from other companies forces domestic companies to become more efficient and to make
better products just to be able to compete. The American automobile industry provides the best example.
When there were only three American companies, the automobiles were over-priced and of laughable
quality. But now, there is competition from all over the world. The American automobiles are of much
better quality and the profits of the companies are lower.
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The increase in the standard of living is the key to the benefits from international trade.
According to a recent study of three economists at the Institute for International Economics, the opening
of international trade since 1945 has raised the American national income by $1 trillion per year.
This means that the average person in the United States has an income about $5,000 higher, and the
average American household has an income almost $13,000 higher today as a result of the opening
of the policies that opened trade since 1945. As we will see, the countries in the developed world (such
as the United States) have trade that is not as free as it could be, especially trade with poor countries
involving their agricultural products. If we were to open ourselves to such trade, according to these
economists, our national income would rise by another $500 billion per year, or another $2,000 per
person. Many other similar studies have been done, reaching the same basic conclusion.
In this course, we will consider several different cases involving trade. We will consider the European
Union, the American trade relations with Japan and China, and the North American Free Trade Area
(NAFTA) with Canada and Mexico. We will also consider the globalization of international financial
markets. From the above argument, as well as from other arguments you will see in the course, you might
surmise that market economists support global integration. And you would be right! But in this section,
let me just mention one final argument that we will be considering. Reporter Thomas Friedman describes
the Golden Arches Theory of International Relations: no two countries have ever gone to war when
both countries had a McDonalds. The point is not that we love our Big Macs. The point is that countries
that are integrated economically have compelling reasons not to go to war. Globalization raises the cost of
using war as a means of advancing one’s interests.
9. Economic Growth
Liberal market economies are considered to promote economic growth. By economic growth, we
mean increases in overall production and therefore an increase in the standard of living. The process of
economic growth begins with the savings of the population. This savings is then channeled through a
series of financial institutions. These financial institutions lend this money to the businesses for
business investment spending. Business investment spending is the buying by private businesses of
capital goods, such as machinery, tools, equipment, buildings, and so forth. These capital goods increase
the ability to produce and therefore increase incomes.
According to the Protestant Ethic (see above), people in market economies have incentives to
accumulate wealth. This incentive is enhanced by the existence of private property rights, guaranteeing
that any amount you accumulate cannot be taken away from you. One way to accumulate wealth is to
save. And the Protestant Ethic stresses that income should be saved and not spent on conspicuous
consumption. Therefore, people in a market economy will accumulate savings.
No type of economy has been as successful at creating efficient financial institutions as the market
economy has been. Particularly in Britain and later in the United States, the list of financial institutions is
very long --- commercial banks, savings and loans, credit unions, insurance companies, investment trusts,
stock markets, bond markets, central banks, and so forth. These financial institutions are created because
they are profitable. And they are profitable because the amount of savings is large. Because these
institutions are very competitive, they have had to become very efficient at channeling the savings
deposited with them into the most profitable investments. (When they channeled their investments into
very risky loans in the period up to 2008, most of them became virtually bankrupt.) So, for example,
assume you have a $1,000 CD at a bank, paying 3% interest. The bank will want to lend that $1,000 to a
business for business investment spending. It would like to charge the borrower a very high interest rate.
But if it does, the borrower will just go to another bank. So competition will drive the interest rate down
to low levels --- perhaps 4%. Given the low profit margins, the banks will have to be sure that they lend
to one who will be able to repay. Over the centuries, these banks and other financial institutions have
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developed great expertise at evaluating borrowers and therefore being able to channel the money to those
borrowers who will have the best use for it.
Finally, the businesses have a desire for business investment spending. Buying capital goods makes
a business bigger and more profitable. The famous pitcher Satchel Page supposedly once said “don’t look
back – someone might be gaining on you”. In a competitive market economy, companies are always
looking to become bigger and better. If you do not so this as well, a competitor is likely to become able
to out-compete you. Therefore, your company must continually upgrade its capital goods just to stay up
with or ahead of the competition. Therefore, they will borrow from the financial institutions. Or perhaps
they will use their own profits. In either case, they will have both the drive to accumulate and the means
to accumulate. This accumulation is what spurs economic growth.
In a competitive market economy, companies also have incentives to find ways to lower their costs of
production, as we saw earlier. They will organize their production in order to find ways to increase
overall productivity. Companies in a competitive market economy will tend to be as efficient as is
possible with the present state of knowledge. This drive to become more efficient in competitive market
economies is also a source of growth.
In a competitive market economy, people also have incentives to improve their human capital.
“Human capital” involves the skills and abilities that are embodied in a person. So you are improving
your skills by attending college. One incentive for you to do this is that greater skills will enhance your
lifetime income. Your pursuit of your self-interest (your lifetime income) leads you to act in ways that
will raise your productivity and therefore will also increase your overall income. This increase in human
capital is also a source of economic growth.
10. Summary and Criticisms of the Liberal Market Economy
This chapter has presented a compelling theoretical case on behalf of the liberal market economy.
Liberal market economies guide companies, in the pursuit of their own self-interest, to produce those
goods and services that consumers most desire. Liberal market economies guide consumers, in the
pursuit of their own self-interest, to conserve on resources that have become scarce and to use the
resources that are the most plentiful. Liberal market economies provide incentives to produce as
efficiently as possible (productive efficiency) and to find ways to produce even more efficiently in the
future (dynamic efficiency). Liberal market economies provide incentives to continually develop new and
better products. Liberal market economies tend to generate full employment. Liberal market economies
tend to provide the greatest rewards to those who contribute most to an increase in production. And
liberal market economies provide both the incentives and the means to stimulate economic growth and
therefore increase the overall standard of living. The richest economies in the world are all market
economies of one variety or another. No wonder that countries all over the world are adopting markets.
However, there are many criticisms that can be made of market economies. Some of these will be
presented in the next chapter on Marxism. Some of these will be presented when we discuss the social
market economy as well as when we discuss the various countries. But let us close Chapter 2 by briefly
listing some of the criticisms.
First, the theory of the liberal market economy presumes that there is sufficient competition.
Competition is often the driving force that gives us the benefits of a liberal market economy. Many
industries do have sufficient competition. But there are some that do not. Electricity, airlines, and high
technology are three of the industries for which competition may not be sufficient. There are others. We
will consider this point in some detail in the next chapter on Marxism.
Second, critics of the liberal market economy see a large number of negative externalities.
Earlier, we defined a negative externality as a cost that the company does not have to pay itself. This is a
cost borne by other people. Critics of the liberal market economy believe that these economies cause
pollution and other kinds of environmental problems. They believe that companies, if left alone, will not
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pay attention to worker safety. And they believe that companies will produce unsafe or unhealthy
products. Caveat emptor (let the buyer beware) was a famous slogan in market economies until
governments started regulating product safety.
Third, critics of liberal market economies see them as subject to frequent recessions. These
critics do not believe that these recessions will go away automatically in a short time (as supporters
believe). In this belief, they focus heavily on the Great Depression of the 1930s. We will consider this
point in some detail in the next chapter on Marxism.
Fourth, critics of liberal market economies see market economies as leading to great economic
insecurity. In market economies, there may be no protections against the problems that result from old
age and disease. And in market economies, there may be no protections against the problems that result
from unemployment during the frequent recessions.
Fifth, critics of liberal market economies see them as generating great inequality. Some people
will be very rich. A significant number of people will be poor. Society becomes segregated as the rich
retreat into gated communities and the poor live in isolated “ghettos”. It becomes more and more difficult
to have “equality of opportunity”. The rich get into the best schools while the poor are forced to go to
inferior schools. Crime becomes more significant. The richer people have great power within the political
system while the poor have no power at all. This breaks down the whole idea of democracy. We will see
later in the course that, as countries came to adopt markets more and more, the inequality did increase –
sometimes significantly.
Finally, some critics of liberal market economies criticize them for their excessive emphasis on
pecuniary values. For both businesses and individuals, it is all about “making money” and “getting
ahead”. The focus is on self --- so much so that one group was labeled the “Me Generation”! One study
has shown that those who study modern Economies tend to exhibit more selfish behaviors. The critics
believe that there is a lack of humanity within market economies.
We will encounter other criticisms of liberal market economies throughout the course. The benefits of
liberal market economies and the criticisms of liberal market economies will come into stark contrast as
we discuss the various countries of the course. All of the countries we will discuss have seen the great
benefits of liberal market economies. We know this because they have all chosen to move in the direction
of greater use of free markets. However, some of them have seen the criticisms as well. As a result, there
are varieties of economies now; northern European social market economies are different from the
American liberal market economy. And both of these are different from the Japanese market economy.
The Russian and Chinese market economies (both formerly communist) are different from each other.
How a country gains the great benefits of markets without running into the problems highlighted by the
critics is a major issue of our age.
Assignment: A Marxist makes the following points about capitalism:
1. In capitalism, goods that are truly needed, like health care, are under-provided.
Production is wasted on unnecessary goods like yachts for the rich.
2. In capitalism, innovation leads to ways to reduce wages and to “deskill” workers.
As a result, wages are low and many alienating jobs are created.
3. In capitalism, the rich continually get richer and the poor get poorer.
4. In capitalism, there is a reserve army of workers. These workers escape their
miserable condition by abusing drugs and alcohol.
5. Capitalism is subject to recurring periods of recession or depression, during which
unemployment is high.
6. Freedom in capitalism is not real freedom since all but the rich are powerless.
7. In capitalism, the government is run by the rich capitalists, not the people.
8. Capitalism leads to monopoly control over industries.
9. Capitalism leads to imperialism and domination over poorer countries.
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Assume you are a supporter of liberal market capitalism as it was explained in this chapter. Draft a
reply to the points raised by the Marxist above. Your reply should both refute the points made by the
Marxist and should make the case for liberal market capitalism.
Appendix to Chapter 2: Technology and American Political Economy
(Written May 2008 and Based on a Talk I Gave for Political Economy Days, April 9, 2008)
The term “Political Economy” explains how political institutions and the economic system interact
with each other. My thesis in this Appendix is that, in each period of time, there is a dominant
technological system. The dominant technological system influences the way production takes place
(see also Marx in Chapter 3). This economic system survives because it brings great benefits to the
population. But it also brings great problems. When the problems become severe enough, they are
brought into the political system. How well the political system deals with these problems helps
determine the economic performance of the country.
So the focus here is on the technological system. When people hear the word “technology”, they think
of the Internet that began widespread use in the middle of the 1990s. But this is only the most recent
example. A major technology came with the development of the steam engine and then the electric
engine in the 19th century. These set-off the First Industrial Revolution. A second major technology
came with the development of standardized, interchangeable parts. This led to major innovations in
producing domestic appliances. A third major technology came with the development of the gasoline
engine in the late 19th century. This led to motorcycles, automobiles, and airplanes – a revolution in
transportation. Yet a fourth major technology may have come with the integrated circuit of the
1950s. This had such a large impact on all kinds of electronic goods and the beginning of the revolution
in communications. The Internet and the Digital Revolution of the 1990s is only the most recent major
technology. For our purposes here, I am going to group the technologies. I lump together those
innovations that followed from the development of the steam engine, of interchangeable parts, and of the
gasoline engine and call them Technological System I. And then I lump together those innovations that
followed from the development of the Internet and digital technology and call them Technological
System II. You will see the reason for these groupings as we proceed. Technological System I lasted in
the United States from about 1840 to about 1980. Technological System II has existed since the early
1980s.
Let me start with Technological System I. All of the technological breakthroughs of Technological
System I are grouped together because they all led to a type of manufacturing known as “Fordist”
because Henry Ford gets much of the credit for it. The basis of this system was the large factory.
Factories were large, expensive buildings and were filled with all kinds of large, expensive machinery. As
one example, one cigarette machine was so productive that only 15 of them were necessary to produce all
of the cigarettes that Americans would smoke in a year. Diamond Match used one machine that made and
boxed literally billions of matches. Under what was called “scientific management”, work was broken
down into specialized, repetitive steps. Partially completed standardized products would move
along moving tracks (an assembly line) to relatively unskilled workers who did simple, routine
tasks. One example I saw involved a worker in a radio factory whose job was to solder together six
connections on radios --- 8 hours a day, five days a week, for 45 years! The great expense of the
buildings and machinery led to what economists call “economies of scale”. This means that larger
companies with more machines and with larger buildings, producing large quantities of
standardized products, could produce their products at a lower cost than smaller companies. Their
significant cost advantage allowed the larger companies to out-compete the smaller companies and
eventually drive them out of business. After a period, most manufacturing industries became
dominated by a few large companies (called “oligopolies”) and competition was very limited. For
example, in 1901, there were several thousand automobile companies in the United States. But as early as
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1933, the three largest companies had come to sell 87% of all cars sold in the United States. The rest were
simply gone. That domination by 3 companies was to persist into the 1980s. In steel, there once had been
hundreds of companies. Competition was fierce. But by 1950, six giant companies came to dominate the
steel industry. In oil, by the early 20th century, hundreds of companies had been reduced to basically one,
the Standard Oil Company of John D. Rockefeller. American economic life came to be dominated by
giant companies --- besides the ones I have named, one can include AT&T in communications, DuPont
in basic chemicals, General Electric and Westinghouse in electronics, CBS, NBC, and ABC in
broadcasting, and many others. By the 1950s, fewer than 500 companies produced about half of the
entire industrial production of America. In my classes, I have asked my students to identify the
following people from the late 19th and early 20th centuries: John D. Rockefeller, Andrew Carnegie,
Henry Ford, and Chester Arthur. Nearly everyone can identify Rockefeller and Ford. Many can identify
Carnegie as the magnate in steel. They were all Big Businessmen. But almost nobody can identify
Chester Arthur. He was President of the United States!
As was said at the beginning of this Appendix, in order to survive, an economic system, such as the
one resulting from what I am calling Technological System I, must generate considerable economic
benefits. These benefits largely involved mass consumption. The “Fordist” system of manufacturing
increased the productivity of workers enormously. Some of benefit of that productivity increase came
back to the workers as higher wages. According to one estimate, by the 1960s, standards of living in
the United States were 9 times what they had been in 1800. Overall production increased so greatly
that the United States passed Britain and became the dominant country in the world by the early part of
the 20th century. As importantly, this economic system produced an enormous variety of goods and
services at lower and lower prices --- prices that could be afforded by the mass of the population.
This made the system very popular with Americans. In the 1920s, Calvin Coolidge could state that the
“business of America is business”. And in the 1950s, Charles Wilson, upon moving from President of
General Motors to Secretary of Defense, could state that “what is good for General Motors is good for the
country”. No one argued! Giant industrial companies facing limited competition were the first pillar of
the Political Economy of Technological System I.
As was also stated earlier at the beginning of this Appendix, an economic system can also bring
great social problems. The type of economy that resulted from Technological System I had enormous
social consequences. People moved from rural areas into cities to work in the new factories. In 1870,
only 20% of Americans lived in a town with at least 8,000 people. By 1920, half did. Today, most of us
do. This urbanization brought with it urban squalor – slums, disease, crime, and so forth. People were
uprooted, losing the sense of community that they had experienced in the small towns. In this new
economic system, workers had to adhere to a strict industrial discipline. Because of the nature of
production, they had to be at work on time, stay the prescribed number of hours, and only take breaks
when allowed to do so. This was a completely new way of life for those who had been on farms. It was
reinforced through the school system where pupils were punished for being tardy, where the bells
regulated the school days, where one could not leave until the school day was over, and where one could
not even leave class without permission. Hours were long. Working conditions were harsh and often
dangerous. Child labor was not uncommon. The new economic system also generated an increase in
inequality. This inequality peaked in the 1920s as the share of income of the top 10% and the top 1% of
income earners became very high.
The leaders of the Big Businesses, the so-called “captains of industry”, seemed unaccountable for
their actions. They had little economic competition. Government was weak. They seemed to be able
to do almost anything they wanted to do. Despite the benefits of mass consumption, the problems that
resulted from the unaccountable power of the small group of Big Business leaders created a
backlash against the system. Numerous books were written describing the exploits of the so-called
“Robber Barons”. This backlash became politically significant because of the extension of democracy --
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the extension of the vote first to more and more working class males and then to women. It has been said
that as democracy became stronger, the government and the business leaders came to be afraid of
the people, instead of the other way around. This fear became especially pronounced during the Great
Depression of the 1930s. This popular backlash, expressed through the political system, ultimately led to
the four other pillars of the Political Economy of Technological System I. These were especially
brought on by the Great Depression of the 1930s. Besides Pillar #1 (Big Business), there was economic
and social regulation, labor unions, the welfare state, and Keynesian demand management. Slowly,
the federal government helped create new centers of economic power to offset the power of the giant
companies. In the late 1950s, the economist John Kenneth Galbraith called this phenomenon
“countervailing power”.
So the second pillar of the Political Economy of Technological System I was economic and social
regulation. Economic regulation, which actually began early in the 20th century, involved the creation of
a number of government agencies to set prices and therefore control profits. These government agencies
also influenced working conditions as well as safety to the public. So for example, the Civil Aeronautics
Board set airline rates, the Interstate Commerce Commission set rates for railroads and trucks, the Federal
Communications Commission controlled telephone rates, as well as radio and television, the Securities
and Exchange Commission controlled banking and finance, and so forth. The leaders of the Big
Businesses objected in public. But the regulation was set up to co-opt the leaders of the Big
Businesses; so they did not object too strongly. To co-opt the leaders of the Big Businesses, the
government agencies limited entry, allowing the Big Businesses to not have to worry about any potential
competition. The prices were set at levels that provided the companies a decent and steady profit.
Economic regulation resulted in higher prices and reduced consumer choices. But it also helped
stabilize jobs and wages and protect the economic bases of communities.
The social regulation came later. So the Food and Drug Administration (FDA) monitored food and
drug safety. The Environmental Protection Agency (EPA) monitored the environmental effects of
company behaviors. The Occupational Safety and Health Administration (OSHA) monitored worker
safety at the factories. The Federal Aviation Agency (FAA) and the National Transportation Safety Board
(NTSB) monitored airline and train safety. And so forth.
The third pillar of Political Economy of Technological System I was the growth of labor unions.
Previously employers had fought labor unions strongly and successfully. But in the 1930s, government
laws weighed in on the side of the labor unions. Ultimately, there came to be large and powerful labor
unions in automobiles, steel, and a host of other factory based industries. By 1955, about 1/3 of all
American workers belonged to a labor union. Unions gained higher wages and benefits for workers.
Unions also restricted some prerogatives of management. But the unions also provided some
benefits to the large companies. These unions provided employers with a stable workforce -- that is
with low employee turnover. The labor unions also reduced wage competition between employers,
as all would be forced to pay the same wages. No company could gain a competitive advantage over
another by paying lower wages. Collective bargaining became predictable, assuring the smooth flow of
production that the Fordist system of production required. Most importantly, labor unions brought the
workers into the capitalist system. The resistance of workers to the capitalist, industrial system of Big
Business, a large fear in the 1930s, was eliminated.
The fourth pillar of the Political Economy of Technological System I was the Welfare State. A
whole series of programs were created, mostly in the 1930s, to enhance the economic security of
citizens. The largest was Social Security, created in the late 1930s, and then enhanced by Medicare in
the mid-1960s. These enhanced security from the effects of old age. Worker income security was
improved by the creation of unemployment insurance as well as the minimum wage, both enacted in
the 1930s. Opportunities for citizens were increased greatly by the large expansion of public education,
and especially public higher education. And aid was provided that became known as “welfare”.
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Originally, this was to cushion women against the economic distress that would follow the death of a
husband. Later, it came to cushion women with children against the economic distress of divorce or
abandonment by the father. Again, as their economic insecurities subsided, people were more
accepting of Technological System I.
The rise of the Welfare State in all countries is strongly associated with the rise in the political
voice of the mass of the population. Studies consistently show that increases in the proportion of the
population who vote coincides with increases in public pensions, in public health, in social spending
overall, and in educational spending.
The fifth pillar of the Political Economy of Technological system I was Keynesian demand
management. This began in the 1960s.The idea here was that the government could use the tools of
fiscal policy to manipulate aggregate demand. Use of fiscal policy means that the government could
change its own spending or change taxes in order to reduce the possibilities of recessions or depressions.
So in the 1960s, with the economy underperforming, taxes were reduced significantly in order to get
people to buy more. It was thought that if people bought more, there would be more jobs and lower
unemployment. In the same way, in 2008, facing the prospects of recession, the government sent each
person a check for $600. Later, with the economy in a severe recession, the first major economic policy of
President Obama was to secure a large increase in government spending and a reduction in taxes. Again
the goal here was to try to get people to buy more. Greater buying was seen as the way to create more
jobs and lower unemployment.
In all, the five pillars of the Political Economy of Technological System I created a very coherent
system. Manufacturing industries were dominated by a few large corporations. Each would produce a
large volume of goods. Because their production was in large volume, they could reduce the costs of
production. With the help of economic regulation, prices were set high enough to gain substantial profits.
Some of these profits went to buy new machines and factories. Some went to management. But some
went to the workers who were organized into industrial labor unions. Jobs were steady (a result of
Keynesian demand management) and workers could expect to stay with the same company for a long
period. Incomes rose at high rates. One economist found that an average male who turned 30 in this
period would find his income (adjusted for inflation) had risen between 50% and 60% by the time
he turned 40. He also found that an average male who turned 30 in any year of this period was
earning quite a bit more than the same average male who had turned 30 ten years earlier. We were
coming to expect that each generation would be better off than the last. A middle class was being
created and enlarged. The rising incomes and the reduced costs of production allowed middle class people
to buy goods that had once been limited to wealthier people. Large numbers of middle class people owned
homes. Most owned automobiles. Most homes came with a variety of home appliances. The middle
class was happy. It is interesting that this system, once tempered by the regulation, the labor unions, the
welfare state, and Keynesian demand management had actually increased economic equality. The share
of income of the top 1%, 5% and 10% of income earners was reduced significantly from the 1930s to the
1970s. In this system, consumers did not receive the best quality nor pay the lowest possible price. Much
capital was not put to its most productive uses. Innovation was not strong. But people had security and
stability. In 1951, a top executive of a very large company made a speech in which he argued that the top
executives of companies had become “industrial statesmen” – balancing the competing interests of
consumers, shareholders, managers, workers, and the society as whole (as expressed through the
government). No one disagreed with his assessment. It surprises people today that in a survey in 1964 that
asked people if they trusted the federal government to do the right thing most of the time, ¾ of Americans
said that they did! This system worked well! So if the system worked so well, why did it not last?
Basically what has occurred since the 1970s is that new technologies have given consumers and
investors more and more power. The shift in power to consumers and investors has moved America
much more in the direction of being a Liberal Market Economy, as described in the chapter.
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First, consider the consumers. The new technologies of the Internet and Digital Revolution (I am
calling them Technological System II), brought extensive competition to industries that had been
dominated by the large companies and that had had very limited competition. For example, the three
American automobile manufacturers have now evolved into six dominating companies and a group of at
least a dozen others fiercely competing with one another. The three television networks have evolved into
hundreds of channels specializing in everything from movies, music and sports to religion, business, and
even the weather. The former monopoly of AT&T has been replaced by cell phones, cable phone service,
and voice-over Internet service. Chain department stores that once dominated retailing are now
competing with Big Box retailers, boutiques, and online sellers. What the new technologies have done
is to reduce the cost advantages that big companies had. Companies that are not very large are now
able to compete with the Giants. So small boutiques can now compete with large department stores. And
small mini-mills can compete with Big Steel. The case of Wal-Mart shows that size is now important
in a very different way from the past. Size does not allow Wal-Mart to raise its prices. Indeed, WalMart’s size comes as a result of its low prices! What size does is allow Wal-Mart to negotiate better deals
from suppliers. These better deals are then passed along to customers as lower prices. It is as though
Wal-Mart were a co-operative of consumers who organized collectively to get better deals from
suppliers.
Much of the shift from Technological System I to Technological System II originated with the Defense
Department. In an attempt to create weapons with their own memories, the Defense Department
developed integrated circuits on silicon wafers, the building blocks of computers. The Internet developed
within the Department of Defense out of the need for communication among researchers. It was then
called APRANET. We hear much about the new global economy. What ignited the increase in
globalization that began in the 1980s was the development of new technologies in transportation and
communications, technologies partly developed by the American government to help fight the Cold War.
In transportation, these new technologies included containers --- steel boxes each capable of holding
more than 28 tons of cargo – and the development of cargo ships and the upgrading of ports to be able
to handle container cargoes. By 2005, there were 3,500 such cargo ships carrying some 15 million
containers – that is, nearly 1 trillion pounds of cargo. Government did not develop these containers. But
it did build the ports so that the containers could be handled. As a result, the cost of transporting goods
from one part of the world to another has declined precipitously. In communications, it was the
American government that provided much of the funding for research leading to the development of fiber
optics, satellites, and automated switching equipment. Between 1995 and 2000, a great amount of cable
was laid. When the technology boom turned to a bust in 2001, there was now too much cable for the
demand. With excess cable, it became very cheap to use that cable to communicate with someone in
another country.
The decline in the cost of transporting goods and the ability to communicate worldwide at low cost has
led to the global supply chain. In the period of Technological System I, most stages of manufacturing
were performed near each other. In the period of Technological System II, goods can be produced in
many places all over the world. As an example, when you order a notebook computer from Dell on the
Internet, your order appears on a computer terminal in a factory in China. Or perhaps the factory is in
Ireland, or Malaysia, or in the USA. The factory assembles the computer to your specifications and then
ships it to you. The microprocessor comes from an Intel factory in the Philippines, or Costa Rica, or
China. The memory comes from a factory in Korea or Taiwan. The graphics card comes from China. The
cooling fan comes from Taiwan. In all, the parts are made by about 400 factories in Europe, North
America, or Asia. When you order a notebook computer from Dell, it takes them 4 days to get it made
and back to you. When you have problems with that Dell computer, you contact tech support. Of course,
you are talking to someone in Bangalore in the south of India. There are many other examples. Cisco has
34 factories around the world making its Internet-related equipment. One automobile contains parts made
25
in over 30 different countries. Such production would have been impossible before the new technologies
that lowered the costs of shipping and communication.
As noted earlier, given the low cost of shipping goods and the ability to use global supply chains,
modest sized companies can now compete with, and even out-compete, the giant companies.
Competition for consumers has become intense. A recent study suggests that the average American
company loses more than half of its customers every four years. So there is a constant struggle to replace
them with new customers. Since consumers have so many more choices, power has shifted from the
companies to the consumers.
Second, consider the financial investors. As late as 1970, only 16% of Americans owned any stock.
These were mostly the very wealthy. The big companies took most of their profits and reinvested them in
the same company. Today, most Americans own some stock, either directly or indirectly through
pension funds or mutual funds. This began with an act of 1974 (called ERISA) that allowed pension
funds and insurance companies to invest their funds in the stock market. Also in the 1970s, the large
stockbrokerage companies, once they were deregulated, began to offer mutual stock funds. Mutual stock
funds allow investors to pool their money so as to reduce risks and to gain the advantage of investing
expertise. Armed with the new communications technologies, these companies (as well as the other
financial companies known collectively as “Wall Street”) could buy and sell stocks at low cost. Thus
began the shift in the nature of American management. From once being “industrial statesmen”,
American managers now must focus exclusively on creating value for shareholders. Anything that
does not increase shareholder value will cause an immediate sale of the stock in large volumes, causing
the stock price to plummet. The low stock prices would make the company rife for a takeover by someone
else. Indeed, when those who rate stocks lower their rating, the odds increase by 50% that the CEO will
be fired within the next six months. It is as though investors have used the pension funds, insurance
companies, and mutual funds to form a co-operative to bargain for better deals from the
corporations they own.
The new political economy that developed with Technological System II affected all five pillars of
Technological System I. As has just been argued, the Big Businesses have been replaced by extreme
competition. Extreme competition is a big part of the philosophy of the Liberal Market Economy as
described in the chapter. But the new technologies also created the political push for economic
deregulation. This came about because the new technologies created profitable opportunities that
were being blocked by the old system of economic regulation. For example, MCI came up with a
microwave repeater network that would reduce the cost of long distance phone calls. It was blocked from
using this by the Federal Communications Commission (FCC). As a result, it, along with others, became
powerful political forces to eliminate regulation of long distance. The monopoly of AT&T was ultimately
ended by the courts in 1984. As another example, the new communications and computer technologies
created profitable opportunities for banks and other financial institutions in all kinds of new activities.
This led to a political push for financial deregulation – involving the creation of all kinds of new accounts
and new types of lending. Many of these new financial instruments have become well-known as causes of
the 2008 financial disaster. Other industries that have been deregulated included trucking, railroads, and
airlines. UPS had once been a trucking company. With deregulation, it bought a fleet of airplanes. FedEx
had been an airline. With deregulation, it bought a fleet of trucks. The competition between them, as well
as others such as DHL, has been intense. Most of this deregulation occurred under the presidency of
Jimmy Carter in the late 1970s. President Carter, a democrat, had not been an advocate for deregulation.
But the political forces opened by the new technologies became irresistible. Deregulation and limited
government involvement with companies are part of the philosophy of the Liberal Market Economy
described in the chapter.
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The new political economy has also led to a dramatic reduction in the influence of labor unions.
In the period of Technological System I, workers could expect to spend their entire careers with the same
company. They then would receive a nice pension upon retirement. The demand to create the highest
value for shareholders ended that. Corporate CEOs now get colorful names. So, Neutron Jack Welch (as
he was called) became the CEO at General Electric and laid-off more than 100,000 workers in 4 years –
25% of the company’s work force. And, Chainsaw Al Dunlap laid off half of the workers at Sunbeam.
Ford, General Motors, and IBM have laid-off tens of thousands of workers. Such behaviors would have
been unthinkable in the period of Technological System I. But now they are required. An average young
worker today can expect to have some 11 different jobs and indeed 4 different careers in a lifetime. The
drive to reduce workforces and to keep wages under control, as a way of meeting the intense
competition and as a way of pleasing the shareholders, has undermined the power of labor unions.
Private sector union membership fell from over 1/3 of all workers in the early 1950s to less than 10%
today. As just one example, American automobile companies pay their unionized workers around $60 per
hour in wages and benefits. Japanese automobile companies in the United States pay their non-unionized
American workers around $40. In the past, labor unions prevented one company from gaining an
advantage over another by paying lower wages. Today, the workforce of the Big Three American auto
companies, General Motors, Ford, and Chrysler, is less than half of what it once was, and is shrinking
even more. Toyota now employs more American workers than does Ford and sells more cars worldwide
than General Motors. Labor unions were a phenomenon of the period of Technological System I but
seem much less potent in the period of Technological System II. In the period of Technological
System II, the power is with consumers and investors. The result is a labor market that functions
much more like the Liberal Market Economy described in the chapter.
The new political economy also led to an attack on the welfare state. As workers found their
incomes being reduced, their resistance to taxes increased. And as businesses found their profits held back
by increased competition, they also became a force for lowering taxes. Lowering taxes could only be
accomplished by a reduction in government spending. As a result, there has been an attack on the
Welfare State programs. On the whole, welfare state spending has not declined. That is because the
population has been aging. There is now a large constituency to maintain and even expand Social
Security and Medicare. But there have been reductions in unemployment benefits. In terms of purchasing
power, the minimum wage has been consistently lower than it was up through the 1960s. And in 1996,
there was a major reduction in welfare programs aimed at single mothers with young children. The
political push to keep taxes low has also allowed various lobbying groups to be able to defeat all attempts
to reform the American health care system. Lower taxes and lower government spending are part of the
philosophy of the Liberal Market economy described in the chapter.
Finally, the new political economy has reduced the effectiveness of Keynesian demand
management. With the world so interconnected, it is becoming harder and harder for any one country,
even one as large as the United States, to manage total spending well enough to avoid unemployment.
The recessions of 1991 and 2001 were not worse than recessions of the past. In fact, they were relatively
mild. But it did take longer to recover from them than would have been true in the past partly because
policy was less effective. In the greater recession that began in 2008, it has become increasingly apparent
that a proper policy response requires the cooperation of all of the countries affected. The United States
alone has not been able to overcome this recession (as of 2009).
As the previous period did, the Political Economy of Technological System II has generated both
benefits and problems. There is no question that consumers are better-off than before. As just one
example, it has been estimated that the people who shop at Wal-Mart save between $100 billion and $200
billion every year in total. One study estimated that, in the year 2000, travelers would have paid $20
billion more in higher airfares if Southwest Airlines had not existed. Another study estimated that cheap
imports from China, now possible with the new technologies, have saved American consumers more than
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$600 billion. Today’s average automobile costs less in terms of purchasing power than an automobile did
in 1982. And in terms of purchasing power, a color television costs about 1/10 of what it cost 40 years
ago (and is much better).
There is also no question that investors are also better-off. The Dow Jones Average of stock prices
first reached 1,000 in November of 1972. It took another 15 years to reach 2,000. Then it reached a high
of over 14,000 before falling in the recession that began in 2008. Assume someone took $100,000 in
1972, used it to buy stocks, and then went to sleep. If she woke up in 2006, she would have been worth
nearly one and a quarter million. (As of early 2009, she would be worth about $750,000.) Not a bad nap!
But there are losers as well from the new system. Among the losers are certain workers. I have
mentioned the cost cutting moves by companies – massive reductions in work forces. The workers who
lost their jobs experienced several months of unemployment. When they did find new jobs, they took an
average pay cut of around 12%. As noted before, any company that was not as cost efficient as possible
would have its stock sold by investors and therefore would see its stock price fall.
Cost cutting has come in other ways. In 1980, 74% of large and medium sized companies provided full
health insurance coverage to their workers. Today only 18% do. In 1988, 2/3 of these companies
provided health insurance to retirees. Today, this has fallen to about 1/3. A good example contrasts WalMart and Costco. Wal-Mart provides health insurance for 45% of its workers. Full-time workers have to
wait 6 months to become eligible; part-time workers have to wait up to 2 years. Once covered by
insurance, workers must pay 1/3 of the health care costs. In contrast, Costco covers 96% of its workers.
Full-time workers have to wait only 3 months to become eligible; part-time workers have to wait up only
6 months. Needless to say, Wall Street knocked Costco’s stock price down and forced its CEO to resign.
Wall Street loves Wal-Mart!
For many workers the period of Technological System II had led to greater economic insecurity.
Studies show that over any given two year period, about half of all American families experience some
decline in their earnings. By 2000, the decline averaged 40%, much higher than before. Several books
have been written documenting the greater stress of American life today.
We are seeing an anomaly today. Normally, wages (adjusted for inflation) increase at the same rate as
productivity increases. As workers produce more goods and services per hour, they earn correspondingly
more. Between 2000 and 2007, productivity grew well but wages (adjusted for inflation) grew very
little, if at all. On average, workers have not gained much from the new economy. Indeed, if wages
had risen as fast as productivity has risen (as is usually the case), the typical household would have earned
some $20,000 more in 2006 than it actually did. The result is growing inequality. In 1979, the top 1% of
all income earners earned about 8% of all of the income earned. By 2004, the share of the top 1%
had nearly tripled to about 22%. Even those at the 95th percentile saw only a slight rise in their incomes
while those in the 90th to 95th percentile showed no real increase at all. Virtually all of the benefits from
the increases in productivity have gone to the very wealthiest – those in the top 1% of all income
earners. Prior to 1980, the typical CEO earned 20 to 30 times the wage of a typical worker. Now the
typical CEO earns about 350 times what the average worker earns. The average CEO of a Fortune
500 company earns about $10 million per year. Top investment bankers and traders have taken home $20
million to as much as $50 million per year. In 2005, the average pay for the 26 managers of the major
hedge funds was $363 million. The highest paid of this group earned $3.5 billion in 2007. Each week,
Lee Scott, the CEO of Wal-Mart takes home about the same amount as the average Wal-Mart employee
earns in a lifetime! The descendents of Sam Walton, founder of Wal-Mart, have a combined wealth
estimated at $90 billion. That compares with the combined wealth of the poorest 40% of the American
population, at $95 billion. That is, one family has a combined wealth almost equal that of to 120 million
people. The richest 1% of Americans, some 1.5 million people, now own about 1/3 of America, more than
the bottom 90% of Americans. There is a new aristocracy. The rest of us just become cynical.
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There seems to be a persistent conflict between the economic values and the social values. In
Technological System I, the social values came to counterbalance the values of the economic values
through the development of economic and social regulation, the growth of labor unions, the development
of the welfare state, and the development of Keynesian demand management. The new Technological
System II has thus far been totally on the side of the economic values. Some important social objectives
have been undermined. First, there is the social objective of avoiding environmental degradation.
Companies that are attentive to the environment as the expense of profits are forced to change by Wall
Street. For example, PALCO was a forest products company in northern California with a 100 year
reputation for sustainable management of the forests. But it made the mistake of allowing its stock to be
publicly traded. A tycoon saw all of those trees left standing as a missed profitable opportunity. He
bought PALCO and, while making significant profits, began the clear cutting and ultimate destruction of
the forests of northern California. Businesses will only pay attention to environmental values if they
can use these for public relations and therefore increase their sales. If you watch advertising, do you
really believe that Philip Morris wants people to quit smoking?
Second, there is the social objective of community. Some people criticize Wal-Mart for ruining the
small businesses that once were the heart of many towns. These small businesses used to provide
economic opportunities for ordinary people and used to support all kinds of local community events and
activities. But of course, the small businesses were destroyed because consumers flock to Wal-Mart to
save money and perhaps to save time.
Third, there is the social objective of decency. Today entertainment companies spew out sex and
violence. Many people complain about the low moral standard in today’s entertainment. Why do the
companies do this? The answer, of course, is that there is money to be made in sex and violence.
Consumers rule. Investors in the media companies who demand higher profits rule. People who wish to
enforce standards of higher decency are on the outside.
Fourth, there is the social objective of health. Some people want fast food companies to provide
healthier and less calorific foods. They want to reduce the selling of so many sugar products to children.
At the very least, they want information as to what is in the food served by fast food places. Why do these
not happen? The answer, of course, is that consumers and investors now rule. The so-called epidemic of
obesity coincides with the period of the Technological System II. Healthier foods are provided only when
enough people care about health to make these foods profitable.
Wall Street is very hard on companies that might try to be socially responsible. Some of the companies
that have been seen as socially responsible, Dayton Hudson, Levi Strauss, Body Shop, Ben and Jerry’s,
either have had to end their socially responsible acts or have been taken over by other companies. On the
other hand, tobacco companies and oil companies have had no difficulty raising money from investors.
Investors care about returns, not social responsibility. Personally, I have bought into two mutual funds
that limit their investments to socially responsible companies. I am one of only 2% of American investors
who do this. I would have earned much more if I had bought stock in Exxon Mobil! In the new economy,
socially responsible behaviors will occur only when they also lead to higher profits. In the current
economic system, acting as a consumer is the only avenue of political expression available to most
people. Every time you buy a product, you are in effect voting for a whole set of values. Only if enough
people act on these values to make them profitable will companies follow.
This Appendix has provided an explanation for the original development of the Liberal Market
Economy, the changes that moved in the opposite direction up to 1980, and the changes that have
enhanced the Liberal Market Economy since 1980. Up to 2008, there has been general acceptance of the
current Liberal Market Economy. As is the period before 1980, most people like what the system has
brought them as consumers. And in this new period, many people also like what the system has brought
them as investors. But we are in internal conflict. The consumer in us wants Wal-Mart prices. But the
employee in us wants Costco benefits. The investor in us wants Wal-Mart profits. But the citizen in us
wants more concern for our communities and our environment. The consumer in us wants lower prices.
But we still prefer to speak to a real person when we call a company. We are at about the same stage as
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we were in about 1930 whereby our economic system is providing great benefits for consumers and for
investors but our political system, our democracy, is failing to provide those results we need as citizens. A
shift to social values can occur only when a large number of citizens demand it and create vehicles for
political influence. On this matter, the contrast between the two political parties could not be greater. One
party talks much about consumer values and investor values. The other party is talks much about social
values. One party argues correctly that acting in favor of social values will hurt consumers and investors.
The other party argues correctly that acting in favor of consumer and investor values hurts social values.
Given that there is a new administration, it remains to be seen whether there will be changes in the
direction of citizen values or whether the current Liberal Market Economy will continue as is.
Practice Quiz:
1. Which of the following is an example of a capital good?
a. Land Owned by an Avocado Grower
c. A Truck Owned by UPS
b. The Carpenters Who Build a House
d. Money in the Bank Account
2. The United States fits best which of the following categories?
a. A Capitalist Market Economy
c. A Socialist Market Economy
b. A Capitalist Command Economy d. A Socialist Command Economy
3. “Using the least possible amount of the factors of production to produce products” is the definition of
which of the following goals?
a. Allocative Efficiency
c. Equity
b. Productive Efficiency
d. Full Employment
4. Which of the following is NOT one of the values that are the basis of Liberal Market Capitalism?
a. Individualism
c. The Protestant Ethic
b. Social Darwinism
d. Producer Sovereignty
5. According to Adam Smith, the sole aim and purpose of production is
a. consumption
c. to be able to pay taxes
b. the make a profit
d. salvation
6. According to the Invisible Hand Theory, the purpose of prices is to
I. Guide resources toward their most desired uses
II. Guide consumers to economize on relatively scarce resources
a. I only b. II only c. Both I and II d. Neither I nor II
7. Which of the following is NOT acceptable under laissez faire?
a. The government should own automobile companies
b. The government should provide public goods
c. The government should subsidize goods that have positive externalities
d. The government should tax goods that have negative externalities
8. According to Say’s Law, if for some reason people are buying too little,
a. wages would rise c. real interest rates would fall
b. prices would rise d. the unemployment would continue
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9. In the theory of market capitalism, people’s wages are determined by
a. the amount they are able to take from other people
b. the value of the goods and services they produce
c. the strength of their labor unions
d. the minimum wage laws
10. Which of the following is sometimes seen as a weakness of Market Capitalism?
a. Lack of competition at times
b. Economic insecurity
c. Recessions
d. Inequality
e. All of the above
Answers: 1. C
2. A
3. B
4. D
5. A
6. C
7. A
8. C
9. B
19. E