Why is capitalism under attack?

A friend of mine passed along an article entitled “Capital is up for Scrutiny at Top Business Schools”.

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I started to write a post about the, let’s call it “the Elected curriculum”, seeping into business schools and evidently into medical and law schools as well.

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But then I stopped writing that essay. I realized that the topic was much more than a debate about what is taught in certain schools. Not to say that is not important but that there were deeper issues, particularly related to capitalism.

From a recent survey, many Americans have a positive view of socialism and a surprisingly less positive (tending towards negative) view of capitalism. In fact, for those aged 18-29, more have a positive view of socialism than of capitalism.

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Of course survey results can be viewed in many ways, but this support among the relatively young is worth considering, both in terms of it origins and consequences.

What is the basis for this criticism of capitalism? To what extent is capitalism a failed system? That is, as a way to organize economic activity, has capitalism not provided outcomes that we as a society desire?

Or is it just a matter of perceptions? In which case, the problem is more with the vast group of Professors of Economics (I take my share of the blame) who have failed in bringing to light the gains from an economic system based upon capitalism.

A Parable of Capitalism

As always, it is useful to think of these issues in a simple model. There are two economic agents involved in a costly race ( a competition). The winner of the race (the innovator) gets a prize (profits) and the loser gets nothing. Despite the costs (the disutility of effort) incurred during the race, both of these agents are willing to compete.

But there is only a single winner and that agent receives the entire prize. This prize, of course, is key as it provides the incentive to put forth the costly effort in the first place. The bigger the prize, the more effort each of the competitors will supply.

Of course, in a big economy there are many such races taking place. They are specific to goods, to locations and to time. Losers in one race can win another. And so it goes…

This is pure capitalism. We all benefit from these races through: (i) innovation in the wide variety of goods we get to consume, (ii) low prices for those goods since some of the innovation is reflected in more productive technologies. Just think about your basket of consumption goods today compared to 10 or 20 years ago.

But there are dangers lurking that we need to keep in mind. We can use this parable to see both the virtues and the failings of capitalism and thus the concerns apparent from the survey.

Inequality of Outcome

In this contest there is clearly equality of opportunity but not equality of outcome. Capitalism produces winners, but it also produces losers.

Judged ex post, solely from the perspective of the distribution of income, capitalism, in this extreme form, generates inequality. The difference in the income between losers and the winner of a race can be quite large. And with this comes pressure to redistribute the pie, taking away from the winner and giving to the loser.

Now here is the big question: is there a cost to this redistribution? The answer is a bit complicated and returns us to a past theme of expectations and commitment.

To go to one extreme, suppose that neither agent in the race thought that once the race was completed there would be redistribution. That is, the winner anticipated receiving the full prize and the loser anticipated zero. Then, as described above, they would put forth lots of effort to win the race, with the anticipated differential as the prize as the incentive. When, ex post, the redistribution arises, they would be completely surprised. But the redistribution would not have any effect on their effort during the race because the redistribution was a complete surprise. Even if the political pressure towards redistribution ex post is so extensive that the prize is shared equally, this will not impact the incentives for the agents in the race.

At the other extreme, suppose everyone understood that regardless of the outcome of the race, the proceeds would be equally shared. With this in mind, the incentive to put forth effort is reduced. On the margin, the benefit of the effort is shared equally so that the effort level where marginal cost and marginal benefit are equalized would be much lower.

In this case, the consequence of the anticipated redistribution is that the size of the pie is much smaller. But the small pie is not the failing of capitalism but rather the inability to limit ex post redistribution.

The solution, it seems, is that society find the compromise between providing incentives and redistribution. This is more a political issue: the role of economics is to make clear that this tradeoff exits. And, it is important that once the compromise is found it is made clear to all participating in the contest along with an iron-clad guarantee that ex post, after the race, there will be no further redistribution whatever the political pressure.

Inequality of Opportunity

In the parable, both of the players had an equal opportunity to compete. If this is not the case, then a very qualified person may not have been in the race. This is clearly a social loss.

A leading example is education. Higher ability individuals usually gain more from education. And with this education they compete. But if there are barriers to obtaining the education in the first place, then there is a misallocation of talent and capitalism has failed.

The remedy though does not come from additional redistribution ex post. Rather, it must get at the heart of the problem: the inability to compete. In the context of the education example. this is why it is so important for a society to provide equal access to opportunities to accumulate human capital.

The Environment

The race described above has a particular feature: there are no environmental effects. This is not the case for most productive activities. The environment is impacted by us as individuals and the firms that produce the goods and services that we consume.

So imagine in the race described above that there was an environmental by-product (pollution) of the individual efforts chosen in the race. The particular form of the pollution is immaterial.

A firm produces and pollutes the air and impacts others as a by-product: economists call this an externality. The issue for capitalism is not the externality per se but rather whether the firm paid for the right to impact others. That is, what matters is whether the individual firm internalizes the full impact of their effort on the environment. Usually this is not the case. The markets needed to purchase the right to pollute are almost non-existent. Government regulation is a poor substitute.

The outcome is pollution in excess of the socially efficient level. The point is not about whether the socially efficient level is zero or not. Rather, it is the fact that with inadequate markets and regulations, the level of pollution in a market system can be inefficiently high.

This is clearly a problem of capitalism. It might be a problem “for” capitalism as well to the extent that competing economic systems support an efficient level of pollution.

Market Power

Advocates to capitalism rely on competition. Ideally, this takes the form of a market with many sellers of an identical product. Prices are bid down to the marginal cost of production. Even if there are only two sellers, the outcome of their interaction (through price competition) can be drive prices down to marginal cost.

But we observe many markets with only a single seller. In fact, this was an outcome of the race described above. The race itself was very competitive with the two players each providing effort to win the prize. But that prize might be the right to monopolize a market. If you interpret the race as taking place between two pharmaceutical companies each striving to create a particular drug, then the winner earns a patent protected right to be the exclusive supplier to a product.

The patent system is designed to create a balance. By protecting ideas it creates market power for the winner of the race. But that protection is not forever, thus limiting the market power of the victor.

Sharing the Gains

One other point to keep in mind is that we all potentially share the gains of the winners. We do so through the ownership of the various competing firms. To the extent that these are publicly held companies and for those individuals owning shares of these companies, the gains of winning a race are broadly shared. The image of a small group of capitalists surrounded by a large group of workers is simply not the right picture of a modern capitalist economy.

What are the viable alternatives?

The failure of capitalism merits the consideration of alternative economic systems that can better “deliver the goods”. Should we seriously be considering alternatives? If so, what are they?

At the other extreme of the capitalism depicted above is a system of centralized control. Taken literally, this amounts to a planned economy in which literally every economic decision is undertaken by the government.

Reality lies between this and the pure model of capitalism. Even in the most centrally planned economics (think of Russia and China years ago), there was still some flexibility and so semblance of competition. And even in the most capitalist societies, there is a large role of the government in regulation and redistribution.

So the alternatives to the current system, say in the US, is not a revolution. Broad discussions about the virtues of two extreme systems are fun for academic debate, but in the end that is not what we as a society are deciding. Rather, the action is, as always, at the margin. How far do we push redistribution? What steps do we take to expand the benefits of the various economic races without diminishing incentives?

What is to be done?

In the end, two points emerge.

First, the key remains the trade-off between equality and efficiency. The equality part has both ex ante and ex post components. Equality of opportunity is hard to argue against. Equality of outcomes is expensive through the reduction in incentives.

Second, social discussion needs to be focused on this tradeoff. Here are some steps we can take.

First, as educators we can do a better job of evaluating capitalism. By this I do not mean simply trying to sell it as an economic system. Instead, greater emphasis ought to be paid on exploring alternative economic systems. In the classroom let’s engage in a broad discussion of capitalism versus its alternatives.

Second, in the political arena, we somehow need to find a way to debate both costs and benefits of the various forms of redistribution. It seems like one side of the debate stresses the recipients of some form of redistribution while the other only sees the costly incentives. We have lost the capability to put both costs and benefits on the same table.

I always thought that a virtue of a simplified tax system, such as a flat tax, is that it does focus political debate on redistribution versus incentives. Loosely speaking, the intercept of the tax function captures redistribution and the slope the incentive effects. But that is a topic for another essay.

Part of the problem is that the set of people who can gain from some type of government program are easy to identify while the incentive costs are much harder to be specific about. Take a social program leads to an extra 50 billion in the deficit. Who exactly will pay for this increase in spending? Somebody in some future generation will have higher taxes, but who represents them now?

1. New York Times, “Capitalism is up for Scrutiny at Top Business Schools”, Nov. 28, 2022, page B1.

2. I am just reading, finally, Woke Racism by John McWhorter who argues for this terminology.

3. This comes from the Pew Research Center.