For most, an economy is perfect because it allows many participants the ability to interact with each other, share information, and allocate resources to the most productive portions of society. The common view is that the market creates the best of all possible worlds since it aligns its goal (the most production) with its structure (allow individuals to maximize their production given their inputs). It is because of this view, that we typically think of any problems in a capitalist society as self-correcting in the long-run. Abstractly, how could any system which has a goal of maximizing utility fail at that if it freely allows all participants to follow their natural tendency of maximizing their own utility.
The problem arises, typically, in the interaction of the participants and how those individuals can influence the system to maximize their utility at the expense of others. In this way, the system begins to decrease utility as the marginal benefit of one individual given one unit of resource is less than another. In a perfect market this is thought not to happen since the pricing element helps to equate the utility of each participant and allows those that value resources higher, to buy at a higher price. One reason why this does occur is that for the market to function all individuals need the ability to trade otherwise they have no way to participate.
Each participant has available two resource types to trade—capital or labor. Similarly, each individual has two types of things in which they own—consumption units and investment units (for later consumption). In capitalism, typically individuals first trade themselves for resources and then as they save those resources, are able to transact with resources in order to allow the current resources to grow over time. The growth of an economy is typically thought to occur from one major factor—science/technology.
As technology and science develop, the amount of resources that capital creates is larger. For each investment unit put into the system, more units come out and general prosperity occurs. These developments mean that capital begins to earn higher and higher returns and thus causes a subset of society to gain even more resources out from their investment in. Capital begins to become consolidated as a the more resources an individual has the more they are to take a chance (higher risk) on any new venture which may create more units out than are initially put in.
Over time, with some individuals having a large amount of capital, there are two investment decisions they can choose—one is to consumer and the other is to invest. Consumption naturally declines the value and existence over time as the capital is used, while investment grows value creating more objects from the inputs. Meanwhile the propensity to consume of any one individual is typically capped since there are only so many units of an item that can be consumed. While this may push up the price of some individual units (luxury items) quite high, it typically does not create more items since the consumption of the individual is somewhat rationally capped (how many units of corn, housing, jewels can one consume at one time). Similarly the value to society as a whole of high priced units such as jewels and yachts is less due to the fact that these objects are non-productive and becoming increasingly consolidated. Without transaction these units have a lower probability of being augmented.
In choosing then to invest a large amount of the capital saved, the individual must transact with others in order to gain resources from them (since in capitalism resources are a zero-sum game—each resources you own cannot be owned by another individual). As consolidation of resources occurs, the individual investor gains more physical capital and now must endeavor to capture the human capital within the market. This occurs mainly because the capital owner has already acquired the physical resources of another and must now move to capture the one resources it cannot fully own (at least not currently)—the individual.
In terms of an example, I may for years transact with you to gain possession of your items either in bartering the physical item or gaining the monetary value of your item. After awhile, some individuals have gained more from the items they have transacted and some individuals have gained less. I may take the piece of wood you give me and build a house that yields me more resources while you may take a piece of corn from me and consumer it leading the degradation of the unit. Naturally over time, some people win and other lose, and as some people gain more resources to transact they have a greater probability of winning as opposed to losing since they have more units in the game. This is what causes capital to become consolidated amongst fewer hands.
For the losers, they continue to lose their current capital as the units they own become degraded or destroyed. At the end of it, they are left with only one last thing to transact with, themselves. The winners have only one last incentive towards transacting with the losers, that is to gain any possible future resources the losers may have earned by transacting themselves. For the winners, there exists only two ways to transact with the losers in order to gain more resources, one is to employ them to augment the current capital, and the other is to lend the losers money in an attempt to contractually obligate the losers into giving their future revenue streams to the winners (if those streams are ever to occur).
This system continues to occur unimpeded because each participant is maximizing their own utility without regards to the utility of the whole system. Each new resource unit is worth less to the individual who has a ton of them, than it is worth to the individual who has none. Each person maximizes to the best of their ability their outcomes given their inputs.
As capital replaces labor as the augmenter of capital (since technology allows for capital to create more capital without the aid of labor), the society moves towards less investment in labor and more investment into capital since it is more productive. Over time, capital owners lose their need to transact with labor as labor has less potential for future resource gain as capital replaces labor in its function to augment capital. Many resources created for the benefit of many now are “less productive” because they represent consumption units which the majority of labor have nothing to transact with anymore since they have been replaced.
In this way, the best of all possible worlds is lost since the system itself no longer affirms the maximization of societal utility, but rather the maximization of individual utility. This may very well be the reason that more advanced economies have lower birthrates since the consolidation of capital within the free market system only allows for fewer individuals being able to transact and exist.
This may be a naturally better world since we cannot assume that lower populations are a bad thing. However, it does bring up one problem, it is incredibly hard to say how much better (worse) or society may be for the contribution (lack of contributions) of one individual. What if Einstein’s parents chose not to have children? Until capital is able to fully function as a human would, the natural loss of population that occurs as society consolidates wealth can actually be very detrimental. But without knowing what other worlds were possible, we may always be stuck seeing this as the best of all possible worlds.
Similarly, the problems we see currently of wealth consolidation, large debt burdens, and market failure can be traced fundamentally back to the problem outlined above. As labor becomes replaced by capital, more people own less in equity and most contractually obligate themselves to others through debt. The capital owners have so much capital that their diligence and risk aversion decline and capital is more foolishly allocated towards riskier investments in the hope to gain more potential returns (since in investing we always think that higher risk means higher returns when we really should be saying that higher risk means we should require higher returns). As time goes on, and the future resource gains of those who contractually obligated themselves with debt declines, individuals begin to default on their debt causing the investors to realize they allowed the wrong people to borrow at cheaper rates and investors begin to balk at transacting due to their current resource loss. The most problematic factor of the whole situation is that it is not due to some exogenous factor that will hopefully go away and allow a perfectly functioning system to progress. This problem is endemic to the system and involves a rethinking of how capitalism operates in order to insure that society does not destroy utility as opposed to creating it.
1 response so far ↓
JD // April 28, 2009 at 10:09 pm |
The model outlined above implicitly makes an erroneous assumption: that people live forever. You point out that capital is really a measure of deferred consumption. If people die eventually (as they do), they will want to convert that capital into some sort of consumption.
Now, there are decreasing marginal returns to consumption. That translates into decreasing marginal returns on capital–which presents a big challenge for the model laid out above.
However, the human desire to secure success for one’s progeny complicates matters. Many people choose to ‘consume’ their accumulated capital by bequeating it to their children. To the extent that evolutionary urges result in this, my previous comments about eventual consumption are effectively without consequence. Individuals won’t accumulate capital as you describe, but lineages become the new agents, meaning it doesnt matter that individuals don’t.
This can all be fixed with a very high estate tax, which is basically a tax on a certain form of consumption (leaving capital in a will) in order to discourage it so that agents fully internalize the costs (the long-term downsides of concentration of capital) that lead to market failure.