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The Limits of the MarketThe Pendulum Between Government and Market$

Paul De Grauwe

Print publication date: 2017

Print ISBN-13: 9780198784289

Published to Oxford Scholarship Online: January 2017

DOI: 10.1093/acprof:oso/9780198784289.001.0001

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The Limits of Capitalism

The Limits of Capitalism

Chapter:
(p.11) Chapter 2 The Limits of Capitalism
Source:
The Limits of the Market
Author(s):

Paul De Grauwe

Publisher:
Oxford University Press
DOI:10.1093/acprof:oso/9780198784289.003.0002

Abstract and Keywords

The market system is an extraordinarily effective mechanism for creating material prosperity. Countries which have renounced the market system, as in the case of many previously communist regimes, have learned the hard way that it leads to stagnation and collective poverty. Capitalism, by contrast, is successful thanks to its decentralized character, whereby everyone strives for his or her own interests. The market system, however, also comes up against its limits, which arise because individual and collective rationality do not coincide. Firms which pollute the air and water may maximize their individual profit, but not the prosperity of society as a whole. The market system also awakens the cold, calculating System II in individuals, without taking into account our emotional side, System I, thus leading to internal conflict in individuals.

Keywords:   collective rationality, individual rationality, externalities, System I, System II

The success of capitalism in advancing material prosperity is overwhelming. The many attempts to organize the economy in ways other than the market mechanism have failed. The enormous difference between capitalist and communist approaches to the economy is clear from the contrast between North and South Korea, which provide us with a natural experiment for evaluating the effect of two economic organizations.

The Limits of Capitalism

Figure 2.1. Real GDP per capita in North and South Korea

Source: Angus Maddison, Contours of the World Economy, 1–2030 AD: Essays in Macro-Economic History (Oxford: Oxford University Press, 2007), p. 382, Table A.7

After the Korean War in the 1950s the country was split in two. North Korea organized its economy according to the Soviet model of central planning. South Korea adopted the principles of the market economy. The effect of this split on the material prosperity of the two countries was spectacular (see Figure 2.1). In 1950 both countries were equally poor. From the 1970s, however, per capita GDP in South Korea exploded, while in North Korea it stagnated. The consequence was that in 2007 per capita GDP in South Korea was nearly twenty times that in North Korea.

There are countless examples of the spectacular success of capitalism in generating material progress, the most obvious probably being China. When the country resolutely opted for the path of capitalism after Mao’s death, the Chinese economy began to grow at a pace of ten per cent or more per year. Today China is the second largest economy in the world and hundreds of millions of Chinese people have been raised from the depths of starvation, which claimed the lives of millions of people every year in previous millennia.

(p.12) Praise for Capitalism

Where does this capitalist success come from? That is the first question we should address, as the answer will enable us to study the central question of this chapter, why capitalism appears to have limits.

The success of capitalism is all about its decentralized character. Consumers decide autonomously how much and what to consume. Companies decide how much and what to produce. No one tells them what to do. Nevertheless these decisions are coordinated in markets where demand is confronted with supply of goods and services. If there is more demand than supply, prices rise. This has a double effect: higher prices lead consumers to buy less while encouraging companies to produce more. They do this not out of love for the consumer but out of a desire to increase their own profit. This self-regulatory mechanism eventually leads to the fulfilment of consumer demand.

This decentralized system, moreover, creates a dynamic whereby entrepreneurs are constantly searching for new products and services, (p.13) as well as cheaper production methods, again not out of love for the consumer, but in order to maximize their own profit. When new products and services catch on, entrepreneurs can make higher profits. Cheaper production methods enable them to cut costs, lower prices, and attract more consumers, again raising profits. This mechanism explains why capitalism is a system in which there is constant technological progress, forming the basis for spectacular advances in material prosperity.

The dynamics of the market system led the great eighteenth-century Scottish economist Adam Smith to the conclusion that there was effectively an ‘invisible hand’ ensuring that firms’ efforts to promote their own interests automatically lead to the promotion of general well-being. The baker who gets up at four in the morning to bake bread is not acting out of altruism; it is to increase profits. This individual calculation ensures that we have fresh bread each morning, in other words that the consumer’s well-being is served.

This insight from Adam Smith was revolutionary, effectively stating that the collective interest is best served when everyone strives to satisfy their own interests, thus reconciling individual rationality with collective rationality. What is good for the individual is good for the entire group. If that is the case, no one can really be against such a system. So why is there so much resentment, even resistance, to this system? This leads us to the question of the limits of capitalism.

Individual and Collective Rationality

The limits of a market system relate to the fact that the connection between individual and collective rationality can be severed. That connection is broken when millions of people searching for their own interest does not lead to a situation perceived to be optimal by everyone. How do such situations arise?

In this book we will explore a number of these situations. I group them into two categories. The first I call external limits. These relate to (p.14) the fact that an individual’s decisions often have a positive or negative influence on others which the individual does not take into consideration. Economists call these externalities or external effects. These are individual decisions which are not really individual because they directly affect the prosperity of others. A market system does not take these externalities into account because the actors in this system (consumers and companies) are not rewarded for doing so.

Let us clarify this with an example, to which we will return in detail in later chapters. If a company produces steel, it also produces harmful chemicals which it releases into the air or water. This is a cost borne by people outside the steel company. For instance, nearby residents may inhale harmful chemicals, so that their health suffers and they die prematurely. Those who do not die immediately become ill and less productive, and so on. None of these costs are taken into account when the company calculates the cost of a tonne of steel, so the price of the steel will not reflect these external costs. In fact the steel is cheaper than it should be, resulting in excessive demand. This leads to the important conclusion that what is good for the individual steel manufacturer and for individual buyers of cheap steel is bad for many other people. Individual rationality does not coincide with collective rationality.

We will investigate a number of other examples of such external effects which lead to a discrepancy between individual and collective rationality. When they diverge sufficiently this causes resistance to a system which is not succeeding in guaranteeing prosperity for all. Individual success is then insufficient to maintain support from society for the market system.

Systems I and II

There is a second category of situations which lead to a rift between individual and collective rationality. These are the internal limits of the free market system.

(p.15) The free market system appeals to individual rationality, the calculation aimed at determining an individual person’s best interest. The market system is therefore based on an image of humanity which economists term ‘homo economicus’, applied to individuals who are constantly calculating what best serves their own interests.

Psychologists, however, have discovered that every individual possesses another dimension at odds with the calculating aspect of their character. A well-known representative of this stance is Daniel Kahneman, an Israeli psychologist who won the Nobel Prize for Economics in 2002 for his groundbreaking work on the influence of irrational behaviour on the economy. He developed the idea that there are two systems at work in our brains.1 System I relates to intuitive, emotional behaviour and is the oldest in evolutionary terms, governing emotions of fear, panic, euphoria, sympathy, disgust, and so on. It is also the system which regulates emotions such as love and the desire for fairness.

System II is the rational, calculating part of the human mind. It is the system which causes us to weigh up what is best for our well-being, making a cost-benefit analysis before we come to a decision. In contrast with System I, which can lead to very quick decisions (fear of danger causes us to run away immediately, for example), System II is slow. Under System II we line up many different factors which might affect our well-being before coming to a decision. That requires time and effort. Often we are unwilling to make that effort. According to Kahneman, System II is ‘lazy’, which can lead to individuals potentially making insufficiently rational calculations and being led by System I (the emotional system) in decision-making processes.

The two systems are connected, requiring balance. Antonio Damasio2 has shown that if individuals work with the rational system (System II) alone, without generating any emotion (System I), they also make very poor decisions which work against their own interest. The two systems constantly interact. If one gains the upper hand at the expense of the other, things go wrong.

(p.16) We now come to the core of the internal limits of the market system. This mainly calls on the rational System II inside us. There is nothing wrong with that per se, but the fact that the market almost exclusively uses System II leads to an internal conflict in individuals. An individual encouraged to activate just one system, while setting the other aside, feels unhappy and unable to develop properly as a human being. Being asked to develop their skills as homo economicus, and rewarded by the market with a good income, does not make people happy. Their many other desires, such as love and fairness, are not satisfied by the way they are rewarded by the market. In fact the market system is completely indifferent to these desires (although see Box 2.1, in which we point out that clever marketers have discovered the importance of System I, using it to sell their products).

A distributional problem also arises. In a pure market system only individual performance is rewarded. People who cannot perform because they are sick or disabled receive nothing and are essentially left to die. The market system is indifferent to this outcome. Whether the distribution of income is fair or not is of no importance to the market system. For many people who are well rewarded by the market, this leads to an internal conflict between System I, which also recognizes a sense of fairness, and System II, which is content with the outcome of the system.

In some sense the limits of the market system are more fundamental here. We call these limits internal because the pressure of the market to appeal to our rational side and to switch off our emotions, including our sense of fairness, does not make us happy. The collective outcome of the market system clashes with our individual experience of happiness. Again, there is a discrepancy between individual rationality (in this case in the sense of individual happiness) and collective rationality. The market system therefore does not necessarily lead to the greatest possible happiness for everyone. (p.17)

In Conclusion

The market system is an extraordinarily effective mechanism for creating material prosperity. Countries which have renounced the (p.18) market system, as in the case of many previously communist regimes, have learned the hard way that it leads to stagnation and collective poverty. Capitalism, by contrast, is so successful thanks to its decentralized character, whereby everyone strives for his or her own interests.

The market system, however, also comes up against its limits, which arise because individual and collective rationality do not coincide. Firms which pollute the air and water may maximize their individual profit, but not the prosperity of society as a whole. The market system also awakens the cold, calculating System II in individuals, without taking into account our emotional side, System I, thus leading to internal conflict in individuals.

In Chapters 2 to 4 I will systematically investigate these various limits of the market system, gaining further insight into the question of why it is so unpopular with many people.

Notes:

(1.) See Kahneman’s bestsellerThinking Fast and Slow (London: Allen Lane, 2011). See also <http://www.amacad.org/binaries/video/streamPlayer.aspx?i=188>.

(2.) Antonio Damasio, Descartes’ Error: Emotion, Reason, and the Human Brain (New York: Putnam, 1994).

(*) Vance Packard, The Hidden Persuaders (London: Longmans, Green, 1957).