THE CAPITALIST REVOLUTION

1 September 2014 beta THE CAPITALIST REVOLUTION The capitalist revolution and how it changed the world. You will learn: That capitalism is an economic system in which goods are produced by employees and are sold on markets for a profit. That capitalism has changed living standards, the ways in which people interact, and the natural environment. The conditions that enabled capitalist economies to take off. How the Industrial Revolution also transformed the economy. That there are different ways to organise a capitalist economy. That economics is the study of how people interact with each other, and with the natural environment, in producing their livelihoods. Funded by the Institute for New Economic Thinking with additional funding from Azim Premji University and Sciences Po

2 coreecon Curriculum Open-access Resources in Economics in the 14th century the Moroccan scholar Ib n Battuta (see box) described Bengal in India as a country of great extent, and one in which rice is extremely abundant. Indeed, I have seen no region of the earth in which provisions are so plentiful. And he had seen much of the world, having travelled to China, west Africa, the Middle East and Europe. Three centuries later, the same sentiment was expressed by the 17th century French diamond merchant Jean Baptiste Tavernier who, in his Travels in India, first published in 1676, wrote of the country: Even in the smallest villages, rice, flour, butter, milk, beans and other vegetables, sugar and sweetmeats, dry and liquid, can be procured in abundance At the time of Ib n Battuta s travels India was not richer than the other parts of the world. But India was not much poorer, either. An observer at the time would have noticed that people, on average, were better off in Italy, China and England than in Japan or India. But the vast differences between the rich and the poor, which the traveller would have noted wherever he went, were much more striking than these differences across regions. Rich and poor would often have different titles: in some places they would be feudal lords and serfs, in others royalty and their subjects, slave owners and slaves, or merchants and the sailors who transported their goods. Then as now the prospects of a daughter or a son depended on where their parents were on the economic ladder. The difference in the 14th century, compared with today, was that then it mattered much less in which part of the world the son or daughter was born. IB N BATTUTA Ib n Battuta (1304-1368) was a Moroccan traveller and merchant whose travels were published in his book Rihla (The Journey). His travels, lasting 30 years, took him across north and west Africa, eastern Europe, the Middle East, south and central Asia and China. He travelled more than 70,000 miles (113,000km); much further than the distance covered by his better-known contemporary, Marco Polo (1254-1324). Fast forward to today. The people of India are far better off than they were seven centuries ago if we think about their access to food, medical care, shelter and the necessities of life; but by world standards today most are poor. On average, people in the UK are six times better off than in India. Japanese people are as rich as the British, just as they were in the 14th century, but now Americans are even better off than the Japanese, and Norwegians better off still.

UNIT 1 THE CAPITALIST REVOLUTION 3 Figure 1 tells some of the story (you can follow links from the figure to the sources of the data). The height of each line is an estimate of average living standards at the date on the horizontal axis. Income is a common measure of a person s living standards, because this represents the maximum amount of food, housing, clothing and other goods and services that the person can buy without having to borrow, that is, without going into debt or selling possessions. The average living standard of a country is simply the average income of the country: that is, the total income divided by the size of the population. Though it is widely used, income as a measure of living standards misses many of the things that money cannot buy (or that we typically do not buy) including quality of life measures such as personal security and autonomy, the quality of the environment in which we live or our access to knowledge and self-respect. Applied to an entire country, an income-only measure has further shortcomings, because the average income is not what most people experience: some of us are much richer, and some are much poorer than the average. As we will see in later units, economists and others are working on better measures to address these shortcomings. Gross Domestic Product (GDP) per capita is the measure of living standards used in the figure. GDP is a measure of the market value of the output of the economy in a given period such as a year. GDP per capita is GDP divided by the population. GDP can be measured using three different kinds of data. Statisticians estimate GDP by adding up the economy s output, or the incomes of its residents, or their expenditure in a year. If output, incomes and expenditure could be measured accurately, the three data sources would give the same estimate. Economic historians and statisticians have used historical data to construct estimates of GDP stretching back for more than 1,000 years, and these estimates help us understand how economies have evolved. To compare an economy s output per capita over time and with other countries, the market value data must be corrected for changes in prices over time, and for differences between countries, in exchange rates and relative prices. The first correction produces estimates of GDP per capita in constant prices and the second correction produces estimates of GDP per capita at purchasing power parity (PPP). GDP measures output; it does not measure well-being or the quality of life. It measures only the market value of output and excludes, for example, home-cooked meals and care of children at home by family members. On the other hand the additional fuel use caused by traffic congestion, which obviously lowers well-being, is measured as higher GDP because people spend more money on petrol. Despite these shortcomings, estimates of GDP are invaluable for understanding the economy, not least because it is a systematic measure that is widely available.

4 coreecon Curriculum Open-access Resources in Economics A thousand years ago the world was flat, economically speaking. There were differences in income between the regions of the world; but as you can see from Figure 1, the differences were small compared to what was to follow. There were cultural changes and scientific advances in many parts of the world over the entire period shown in the figure, but living standards began to rise in a sustained way only from the 18th century. 30,000 Living standards (GDP per capita) 25,000 20,000 15,000 10,000 5,000 UK JAPAN ITALY CHINA INDIA 0 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 2000 Figure 1. History s hockey stick: living standards in five countries (1000-2010). The figure looks like a hockey stick, and our eyes are drawn to the kink. As can be seen from the figure, the kink is less abrupt in Britain, where slow growth began around 1650. In Japan the kink is around 1870, in China around 1980, and in India even more recently. What happened to make the long flat section of the hockey stick suddenly turn upwards? The answer is what we call the capitalist revolution, which combines changes in technology with the emergence of a new economic system. This combination of new ways of producing things with new ways of organising production, and the distribution of its benefits, transformed the way of life of people across the globe. We can see from Figure 1 that this transformation did not happen everywhere at the same time. Where it did happen there was an explosion in what Adam Smith called The Wealth of Nations, in the title of his great book. This does not mean that everyone in those countries benefitted equally. In the economies that took off, many people remained (and remain) poor and economically insecure, while some made fortunes from the manual labour of other people for example, factory workers who had neither a vote nor the right to join a trade union, and as a result had little bargaining power to improve their own standard of living through the wages they earned.

UNIT 1 THE CAPITALIST REVOLUTION 5 PAST ECONOMISTS ADAM SMITH Adam Smith (1723-1790), considered by many to be the father of economics, was raised by his widowed mother in Scotland. He studied philosophy at the University of Glasgow and later at Oxford where, he wrote: the greater part of the professors have given up altogether even the pretence of teaching. He travelled widely throughout Europe, visiting Toulouse, France where because he had very little to do, he said, he had begun to write a book in order to pass away the time. It became the most famous book in economics. In An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776, Smith (1723 1790) asked: how can society coordinate the independent activities of large numbers of economic actors producers, transporters, sellers, consumers often unknown to each other and widely scattered across the world? His radical claim was that coordination among all of these actors might spontaneously arise, without any person or institution consciously attempting to create or maintain it. This challenged previous notions of political and economic organisation, in which rulers imposed order on their subjects. Even more radical was his idea that this could take place as a result of individuals pursuing their self interest: It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest, he wrote, adding that each would be led by an invisible hand to promote an end which was no part of his intention. Since then this invisible hand has been a metaphor for how markets can coordinate the self-interested pursuits of people to produce a socially desirable outcome. Smith did not think that people were guided entirely by self-interest, and he wrote a book about ethical behaviour called The Theory of Moral Sentiments, published in 1759. He also understood that the market system had some failings, especially when the ownership of property was unclear, or when markets were monopolised. People in the same trade seldom meet together, He wrote, even for merriment and diversion, but

6 coreecon Curriculum Open-access Resources in Economics the conversation ends in a conspiracy against the public; or in some contrivance to raise prices. He specifically targeted monopolies that were protected by governments, such as the British East India Company that not only controlled trade between India and Britain, but also administered much of the British colony there. He agreed with his contemporaries that government should protect the nation from external enemies and ensure justice through the police and the court system he also advocated government investment in education, and in public works such as bridges, roads, and canals. We can also see that where the capitalist revolution did not happen, or until it happened, entire countries remained comparatively poor. For the first time the world came to be made up of rich and poor nations, as well as rich and poor people. The outcome was that the amount of economic inequality among families across the world was much greater in 1975 than it had been 200 years earlier when Adam Smith was writing The Wealth of Nations. For a large number of peoples, it took independence from colonial rule before substantial improvements in people s living standards could be seen. When three centuries of British rule of India ended in 1947, according to the economist Angus Deaton [I]t is possible that the deprivation in childhood of Indians was as severe as that of any large group in history. In the closing years of British rule, a child born in India could expect to live for 27 years. Half a century later, life expectancy at birth in India has risen to 65 years. Rule by European or other colonial powers was not the only reason why many countries experienced the capitalist revolution only recently, or not at all. China had once been richer than Britain, but by the middle of the 20th century GDP per capita in China was one-fifteenth that of Britain. In contract, other countries quickly followed Britain s take-off by having their own capitalist revolutions. First came the Netherlands and Belgium, then Germany and Japan. Recently China and India, the world s two most populous nations and until recently among the poorest have experienced their capitalist revolutions and are catching up to the rich countries (see Figure 1). As a result, income inequality among all the households across the world has finally levelled off and may now be on the decline. This is happening because inequality between countries is falling even though inequality within many countries (including India, China and the US) has increased considerably during the last quarter of the 20th century.

UNIT 1 THE CAPITALIST REVOLUTION 7 Many developments contributed to the capitalist revolution, but among the most important was the advance of knowledge, and its application to improving the production and distribution of goods and services. 1.1 THE PERMANENT TECHNOLOGICAL REVOLUTION remarkable scientific and economic advances occurred more or less at the same time as capitalism. As late as 1800, traditional craft-based techniques, using skills that had been handed down from generation to generation, were still used in most production processes. The new era brought new ideas, new discoveries, new methods and new machines, making old ideas and old tools obsolete. These new ways were, in turn, made obsolete by even newer ones. Although in everyday usage, technology refers to machinery, equipment and devices developed using scientific knowledge, in economics, technology is a process that takes a set of materials and other inputs including the work of people and machines and creates an output. For example, the technology for making a cake can be described by the recipe that specifies the combination of inputs (ingredients such as flour, and labour activities such as stirring) needed to create the output (the cake). Our ancestors cookbooks contained technologies much like the ones we use today: it still takes about 30 minutes to mix the ingredients and an hour to bake a cake; the combination of ingredients has hardly changed, and the cake tastes the same. Until the capitalist revolution the economy s cookbook, like the skills needed to follow its recipes, was updated only slowly and passed from generation to generation. The capitalist revolution changed that. The time required to make a pair of shoes fell by half in only two decades; the same was true of spinning and weaving. This process, called technological progress in economics, continued for generation after generation. As technological progress revolutionised production, it reduced the amount of time required to produce most products. To get some idea of the unprecedented pace of change, consider the way we produce light. For most of human history technological progress in lighting was slow. Our distant ancestors typically had nothing brighter than a campfire at night. The recipe for producing light (had it existed) would have said: gather lots of firewood, borrow a lighting stick from some other place where a fire is maintained, and start and maintain a fire.

8 coreecon Curriculum Open-access Resources in Economics The first great technological breakthrough in lighting came 40,000 years ago, with the use of lamps that burned animal or vegetable oils. We measure technological progress in lighting by how many units of brightness called lumens could be generated by an hour of work. One lumen is approximately the amount of brightness in a square metre of moonlight. One lumen-hour (lm-hr) is this amount of brightness lasting an hour. For example, creating light by a campfire took about 1 hour of labour to produce 17 lm-hr, but animal fat lamps produced 20 lm-hr for the same amount of work. In Babylonian times (1750 BC) the invention of an improved lamp using sesame oil meant that an hour of labour produced 24 lm-hr. Technological progress was slow: this modest improvement took 7,000 years. Three millennia later, in the early 1800s, the most efficient forms of lighting (using tallow candles), provided about nine times as much light for an hour of labour as had the animal fat lamps of the past. But the advent of capitalism and the technological explosion that followed meant that lighting became more and more efficient with the development of town gas lamps, kerosene lamps, filament bulbs, fluorescent bulbs and other forms of lighting. Today compact fluorescent bulbs are about 45,000 times more efficient, in terms of labour time expended, than lights were 200 years ago. Today the productivity of labour in producing light is half a million times greater than it was among our ancestors around their campfire. Figure 2, below, charts this remarkable hockey-stick growth in efficiency in lighting. 8,000,000 Lumen-hours per hour of labour 6,000,000 4,000,000 2,000,000 200,000 150,000 100,000 50,000 0 1800 1850 1900 1950 0 100,000 80,000 60,000 Years ago 40,000 20,000 The present Figure 2. The productivity of labour in producing light: Lumen-hours per hour of labour (100,000 years ago to the present). An hour of labour produced 17 lumen-hours of light 100,000 years ago; 4,000 years ago, an hour of work produced 25 lumen-hours. It was a considerable improvement, but undetectable given the scale on the figure necessary to show more recent improvements.

UNIT 1 THE CAPITALIST REVOLUTION 9 By reducing the amount of work time it takes to produce the things we need, technological changes have been accompanied by significant increases in living standards. Wherever and whenever capitalism took hold, people s incomes and consumption levels began to rise. Although the rises were sometimes followed by short-term declines, over a long period there have been substantial improvements in living standards. Figure 3 is an index of the average real wage of skilled craftsmen in London between the years 1264 and 2001. The term real means that the money wage (say, six shillings per hour at the time) in each year has been adjusted to take account of changes in prices between different time periods. The result of this adjustment represents the real buying power of the money they earned. Before capitalism, fluctuations in the real wage were often the result of changes in the size of the population, and hence in the number of people looking for work. For example, the increase in the real wage in the century after 1350, shown in Figure 3, followed peasant rebellions which succeeded in raising rural incomes because landlords had to accept some of the peasants demands due to a shortage of labour. The labour shortage was in turn a result of the massive loss of life resulting from bubonic plague (known as the Black Death) that hit London and other European cities in 1348. The shortage of labour and political unrest combined had increased the bargaining power of workers. When population recovered in the 15th century, labour again became abundant, and you can see in the figure that wages fell. DISCUSS 1: CAPITALISM AND THE INDUSTRIAL REVOLUTION Give one or more reasons why the permanent technological revolution occurred with the beginnings of capitalism, and not earlier. Around the middle of the 19th century real wages for many people, such as the London craftsmen represented in this figure, rose dramatically. As with the wage increase following the bubonic plague 500 years earlier, the wage increases reflected the rising bargaining power of workers, which had increased for both economic and political reasons. Workers and their advocates demanded and won reforms, for example limiting the length of the working day and the use of child labour in factories. Massive demonstrations by the Chartists and others demanded political reforms. The Reform Act of 1867 doubled the number of adult males entitled to vote (although women of all classes and rural workers still did not have the right). Along with these political reforms, a simple economic fact aided workers in their quest for higher wages: the rapid expansion of factory employment had exhausted the supply of new workers for

10 coreecon Curriculum Open-access Resources in Economics the factories coming from poor farmers and women working at home for a pittance. The only way factory owners could now get workers was to pay them more. The dramatic increase in wages was far from the only consequence of the capitalist revolution. London craftsman real wage (Rebased to 1850 = 100) 800 700 600 500 400 300 200 100 0 1200 1300 1400 1500 1600 1700 1800 1900 2000 Figure 3. Real wages over seven centuries: craftsmen (skilled workers) in London (1264-2001). 1.2 a connected world in july 2012 the korean hit Gangnam Style was released. By the end of 2012 it had been the bestselling song in 33 countries, including Australia, Russia, Canada, France, Spain and the UK. With 2 billion views by the middle of 2014, Gangnam Style became the most watched video on YouTube. Even British Prime Minister David Cameron and US President Barack Obama tried the dance. The permanent technological revolution has produced a connected world. Gagnam Style Everyone is part of it. The materials making up this introduction to economics were written by teams of economists, designers, programmers and editors, working together often simultaneously at computers in the UK, India, the US, Russia, Colombia, South Africa, Chile, Turkey, France and many other countries. If you are

UNIT 1 THE CAPITALIST REVOLUTION 11 online, some of the transmission of information occurs at close to the speed of light. While most of the commodities traded around the globe still move at the pace of an ocean freighter, about 21 miles (33km) per hour, international financial transactions are implemented in less time than it took you to read this sentence. The speed at which information travels provides more evidence of the novelty of the capitalist epoch and its permanent technological revolution. By comparing the known date of a historical event with the date at which the event was first noted in other locations (in diaries, journals or newspapers) we can determine the speed at which news travelled. When Abraham Lincoln was elected US President in 1860, for example, the word was spread by telegraph from Washington to Fort Kearny,which was at the western end of the telegraph line. From there the news was carried by a relay of riders on horseback called the Pony Express, covering 1,260 miles (2,030km) to Fort Churchill in Nevada, from where it was transmitted to California by telegraph. The process took seven days and 17 hours. Over the Pony Express segment of the route, the news travelled at 7 miles (11km) per hour. A half-ounce (14 gram) letter carried over this route cost $5, or the equivalent of five days wages. From similar calculations we know that news travelled between ancient Rome and Egypt at about 1 mile (1.6km) per hour, and 1,500 years later between Venice and other cities around the Mediterranean it was, if anything, slightly slower. But, a few centuries later, as Figure 4 shows, the pace began to quicken. It took only 46 days for the news of a mutiny of Indian troops against British rule in 1857 to reach London, and readers of the Times of London knew of Lincoln s assassination only 13 days after the event. One year after Lincoln s death a transatlantic cable cut the time for news to travel between New York and London to a matter of minutes. The speed of news (miles per hour) 12 10 8 6 4 2 0 12 MPH: News of Lincoln's assassination travels across the US (1865) 7 MPH: News of Lincoln's election reaches west coast of US from Washington DC in east (1860) 3.7 MPH: News of the Indian mutiny reaches London from Delhi (1857) 2.7 MPH: News of battle of Trafalgar, off coast of Spain, reaches London (1805) 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 1 MPH: Between Egypt and Italy (50-222) 1 MPH: Between Venice and Damascus, Alexandria, Lisbon and Palermo (1500) Figure 4. The speed at which information travelled (1000 to 1865).

12 coreecon Curriculum Open-access Resources in Economics 1.3 THE GROWTH OF POPULATION AND THE GROWTH OF CITIES alongside technological progress and rising standard of living, population has grown rapidly. For most of the last 12,000 years the population of the world grew slowly, if at all, with increases in good years followed by declines in response to climatic adversity and other disasters. Figure 5 shows the evolution of world population from the year 1000 onwards. In a few countries, population started to grow rapidly 200 years ago, but the world s population took off in the 20th century with the development and spread of improved sewerage, clean water, and other public health measures. While the number of people in the world continues to grow, the pace of growth is slowing (see Figure 6). The demographic transition refers to the slowdown in population growth as the fall in death rates is balanced by a fall in birth rates associated with the desire for fewer children in some cases, combined with public policies discouraging larger families, as in China. 8,000 7,000 World population (millions) 6,000 5,000 4,000 3,000 2,000 1,000 0 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 2000 Figure 5. Capitalism and world population (1000-2010)

UNIT 1 THE CAPITALIST REVOLUTION 13 With the increased productivity of labour in agriculture, fewer farmers were required to feed the non-farming population. Higher labour productivity means that on a given piece of land, more output could be produced by each farmer. People left farming to pursue other occupations, resulting in another change: the growth of cities. Before capitalism, most people lived in the countryside interacting with just a handful of people mostly family and neighbours. In the last few centuries, however, people have been drawn or, in some cases, pushed into cities. City life is a drastic change, as everyday life is populated by dozens or even hundreds of strangers. Average Annual Growth Rate % 2.0 1.5 1.0 0.5 1910 1930 1950 1970 1990 2010 Figure 6. How the world s population growth in the 20th century rose and fell. Tokyo, the world s biggest urban area, is home to 34 million people. That s four times as many people living in one city today as existed in the entire world 11,000 years ago, at the time humans first took up farming. In 1900, nine of the 10 largest cities in the world were in Europe or North America Tokyo was the exception. Today, with the global spread of capitalism, nine of the 10 are in Asia or Latin America, with New York the odd one out. Tokyo: Birds-eye view In 1850 there were only three cities with populations exceeding 1 million people London, Paris, and Beijing but, as Figure 7 demonstrates, by 2013 there were more than 500 cities of this size. Figure 7 Cities with more than 1 million inhabitants (2013).

14 coreecon Curriculum Open-access Resources in Economics 1.4 environmental destruction as production has soared, so too have both the use and degradation of our natural environment. With the development of capitalism, elements of the ecological system such as air, water, soil, and weather have been altered more radically than at any time in human history. Figure 8 presents evidence that activities that involve our use of fossil fuels coal, oil, and gasoline have profoundly affected our natural environment. After having remained relatively unchanged for many centuries, increasing emissions of carbon dioxide into the air during the 20th century have brought about perceptible increases in the northern hemisphere s average temperatures (Figure 8a) and resulted in measurably larger amounts of carbon dioxide in the earth s atmosphere (Figure 8b). Figure 8c shows that carbon dioxide emissions from fossil fuel consumption have risen dramatically over the past 250 years. Figure 8a shows that average temperatures of the earth fluctuate from decade to decade. Many factors cause these fluctuations, including volcanic events such as the Mount Tambora (1815) eruption in Indonesia. Mount Tambora spewed so much ash that the Earth s temperature was reduced, and 1816 became known as the year without a summer. Deviation from 1961-1990 mean temperature 0.6 0.4 0.2 0-0.2-0.4-0.6-0.8 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 2000 Figure 8a. Fluctuations in northern hemisphere temperature over the long run (1000-2006).

UNIT 1 THE CAPITALIST REVOLUTION 15 400 350 300 250 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 2000 Atmospheric CO2, parts per million Figure 8b. Carbon dioxide in the atmosphere (1010-2010). Millions of metric tons of Carbon 10,000 8,000 6,000 4,000 2,000 0 1700 1750 1800 1850 1900 1950 2000 Figure 8c. Global carbon emissions from fossil fuel burning (1750-2010). In the last century, average temperatures have risen in response to increasingly high levels of greenhouse gas concentrations. These have resulted from the CO2 emissions associated with the burning of fossil fuels. The likely consequences of global warming are far-reaching: melting of the polar ice caps, rising sea levels that may put large coastal areas under water, and potential changes in climate and rain patterns that may destroy the world s food-growing areas.

16 coreecon Curriculum Open-access Resources in Economics climate change The causes, and the reality, of climate change are now not widely disputed in the scientific community. The Intergovernmental Panel on Climate Change (LINK) is the authoritative source for research and data. The likely consequences of global warming are far-reaching: melting of the polar ice caps, rising sea levels that may put large coastal areas under water, and potential changes in climate and rain patterns that may destroy the world s food-growing areas.the long-term physical and economic consequences of these changes, and the appropriate policies that governments could adopt as a result, are discussed in detail in Unit 18. 1.5 capitalism how can we explain the shift from a world in which living conditions improved or deteriorated when the weather changed, or when there was an epidemic, to an era when most of the time each generation was noticeably, and predictably, better off than the previous one? For many of us, our great grandparents lived in a world of family and neighbours; yet we encounter dozens of complete strangers in the course of the day. We use methods of communication, household equipment, entertainment devices, transport, and ways of shopping and banking that our great-grandparents could hardly have imagined. If we were forced to give a one-word answer, it would be capitalism. Capitalism is an economic system: it is a way of organising how we produce and distribute the goods and services that make up our livelihood. Two characteristics define this economic system. First, the people who produce goods and services are employed for wages or salaries. This means that they are paid for the time they work for their employer. This could be an hourly or monthly wage or an annual salary. They do not own the goods they Wage labourers at a Bata shoe factory

UNIT 1 THE CAPITALIST REVOLUTION 17 produce, and they work under the direction of their employer. We use the term wage labour to describe this characteristic. The novelty of wage labour is illustrated by an example. Before capitalism, craftsmen purchased leather and transformed it into shoes, which they then sold. But the shoes produced by workers in a capitalist shoemaking company belong to the owners of the firm, not to the workers. In other types of economic system, those producing the goods were slaves who of course did not own what they produced, and worked under the direction of a slave owner. They were not paid in cash, but they were provided with food and shelter. In other economic systems farmers own what they produce and direct their own labour, but in some cases pay rent for the land they work, if it was not their own. None of these systems uses wage labour, and are not capitalism. In many economic systems, instead of being paid a wage for a specific period of working time, people are paid for each product they make for example, for the number of lines of text they proofread on the Mechanical Turk website (LINK). This form of work organisation is called piece-rate; it is not wage labour. The second characteristic of capitalism is that those who direct the production process do so with the intention of making a profit by selling the output that the workers have produced at a price that exceeds the cost of producing it. We call this characteristic production for profit. This is characteristic of other economic systems as well: in the above example, slave owners profited from the cotton or sugar that their slaves produced; self-employed farmers or shoemakers want to sell their products at a profit. But, in the past, most production was not undertaken for a profit. Our distant ancestors hunted wild animals and gathered wild plants. They were not for sale. They were for their own consumption, and to share with the other members of their group. In a capitalist economy, the owner of the company that hires the workers not only owns the profit but also bears the risk of the venture: if it fails the employer will get no profits and will have lost outgoings on machinery, equipment, premises and the like. The employer is obliged to pay wages, input costs and taxes before taking any revenue as profits. Centuries ago, landowning elites in many parts of the world directed their serfs, or other unfree labour, to produce goods to enhance the elite s luxury and power. The goods were not for sale. Under communist rule during the 20th century, firm managers directed the work of employees who were paid wages, but the intention was not to sell the goods for profit. The goal of production was to meet the requirements of a centrally determined plan. The plan dictated what firms had to produce. Thus these were not capitalist economies. Figure 9 summarises these distinctions.

18 coreecon Curriculum Open-access Resources in Economics Figure 9. Capitalism defined. Most of the world s economies are capitalist today, and even in those where centralised planning continues to play a role such as China and Vietnam wage labour and production for profit are major features of the economy. There are many forms of capitalist economy in the world today, each with distinctive ways of organising production and distribution. All are characterised by the employment of wage labour for the purpose of making profits. Below, we will see that different types of capitalist economy have different institutions that determine the distribution of the output of the economy among its participants and hence the degree of economic inequality. We will also see that some capitalist nations have sustained rapid growth in living standards, while others have not. Capitalism, like slavery, centralised planning, and the other examples in Figure 9 is one of many economic systems. In the course of history, capitalism has coexisted with many political systems. A political system determines how governments will be selected, and how those governments will make and implement decisions that affect all or most members of a population. Democracy is one political system, defined by individual rights such as freedom of speech and the press, fair elections in which virtually all adults are eligible to vote and in which the loser leaves office. Capitalism emerged long before democracy, but since the spread of democracy over the past century most major capitalist economies are now governed by democratic political systems. Yet even in the recent past, capitalism has coexisted with undemocratic forms of rule, as in Chile from 1973-90, in Brazil from 1964-85, and in Japan until 1945. In contemporary China, much of the economy is organised along capitalist lines yet the system of government is not a democracy. In most countries today, however, capitalism and democracy coexist, each system influencing how the other works.

UNIT 1 THE CAPITALIST REVOLUTION 19 Like capitalism, democracy comes in many forms. In some the head of state is elected directly by the voters; in others it is an elected body, such as a parliament, that elects the head of state. In some democracies there are strict limits on the ways in which individuals can influence elections or public policy through their financial contributions; in others private money has great influence through contributions to electoral campaigns, lobbying, and even illicit contributions, such as bribery. 1.6 how capitalism explains the great hockey stick of history the capitalist system of economic organisation, combining wage labour and production for profit, coincided with the development of new technologies. The wave of technological development began in Britain in the 18th century, and its cumulative character led to it being called the Industrial Revolution. In the new economic system, large numbers of workers were employed in one firm for the first time. The firm sold the goods it produced in competition with other firms, and if it was successful it made a profit for the firm s owners, after paying wages and other costs. The owners had a lot to gain by introducing new technology to keep up with the competition and, if possible, get a step ahead. Capitalism works through incentives in the form both of carrots (reward for success) and sticks (punishment for failure). Greater profit is the carrot for the owner of a firm. Getting a good job or a promotion is the carrot for the worker. The threat of going out of business if the firm fails is the stick for the business owner. Losing one s job is the stick for the worker. In the capitalist system, people with wealth (or the ability to borrow) take the risk of introducing new technologies and entering new markets, and win profit if the risk pays off. Capitalism and rapid technological development go together. The reason: capitalism was the first economic system in human history in which membership of the elite depended on a high level of economic performance. The elite of a capitalist economy the owners of these firms and their managers might inherit the wealth that gives them a start, but remaining in the club of its elite requires that they produce goods that people want to buy at a lower price than the competition. As a firm owner, if you fail, you are no longer part of the club. Nobody kicks you out, because that is not necessary: you simply go bankrupt. This is the greatest innovation of the capitalist revolution. It is greater than its astounding technical progress or any of the other changes measured by our hockeystick graphs. It also, in part, explains them: the owner of a slave plantation who was not very good at growing cotton retained his status. He was a less-than-averagelywealthy slave owner; but still an undisputed member of the elite. A feudal lord who

20 coreecon Curriculum Open-access Resources in Economics managed his estate poorly was just a shabby lord. But the owner of a firm that could not produce goods that people would buy, at prices that more than covered the cost, was bankrupt and a bankrupt owner is an ex-owner. For the carrot mechanism of the capitalist system to function, the business owner has to know that the rewards for risk-taking will come to him or her, and not be confiscated by the government or by criminals stealing his or her property. For the stick mechanism to operate there have to be opportunities for competitors, such as new start-up firms, to produce and sell products. Uncompetitive businesses have to be allowed to fail rather than being bailed out, or to be bought by people with better ways of using the firm s assets. Therefore, to thrive, capitalism also requires sufficient order in society for the wealthy to risk their capital. Investing in the buildings, machinery and equipment to create workplaces that employ large numbers of people is risky, because the expected profits will materialise long after the investments have been made. Investors need a legal framework and a judiciary that will respect the owners property rights, and their right to manage their assets. They need confidence that the government will not steal the capital they sink in a factory and that other businesses, such as their suppliers, will honour their contracts. 1.7 Varieties of capitalism: Output and income across countries some capitalist economies have been very successful in raising living standards, while others have been less so. The new way of making a living (a fortune for some, a pittance for others) has, as we have seen, changed the world in many ways. But many parts of the world got capitalism withut the technological revolution or experienced the revolution belatedly. Italy, for example, had thriving textile industries, banking, and international trade by the 14th century, and was much richer than either Britain or Japan. But, 500 years later, economic historians estimate that Italian living standards, as measured by GDP per capita, had fallen. Figure 10 tracks the fortunes of a selection of countries across the world during the 20th century. In 1928, when the Soviet Union s first five-year economic plan was introduced, living standards were similar to those in Brazil, and considerably higher than in Korea. Central planning in the Soviet Union produced steady but unspectacular growth for nearly 50 years. Capitalism is able to produce faster growth in living standards but it does not always do so; compare Brazil and South Korea with the Soviet Union in Figure 10.

UNIT 1 THE CAPITALIST REVOLUTION 21 25,000 Living standards (GDP per capita) 20,000 15,000 10,000 5,000 SOUTH KOREA FORMER USSR BRAZIL BOTSWANA NIGERIA 0 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Figure 10. Divergence of living standards among countries (1928-2010). An important reason why central planning was later abandoned as an economic system is its failure in the second half of the 20th century to deliver the improvements in living standards achieved by some capitalist economies. Even so, it was a surprise to the citizens of the former Communist countries that, when capitalism replaced central planning, their living standards declined. Figure 10 illustrates this in the case of the former Soviet Union during the 1990s. This shows how difficult it is to create effective capitalist economic institutions, as well as a government that functions well enough to support them. Abandoning central planning did not guarantee countries would progress to the upward slope of the hockey stick. In Africa, Figure 10 shows that the success of Botswana in achieving sustained growth contrasts sharply with Nigeria s relative failure. As we shall see in later units in the course, differences in government and the legal system help explain why capitalism functions better in some countries than in others. Differences in institutional quality, for example, account for the contrasting growth and stagnation of Botswana and Nigeria.

22 coreecon Curriculum Open-access Resources in Economics 1.8 varieties of capitalism: inequality and public policy we have seen that the capitalist revolution, with its late starters (China, India, Botswana, Korea), and nonstarters (Nigeria), led to increasing disparities in average living standards across countries since 1820. As the late starters have begun to catch up, this is a trend that in recent years has slowed or even reversed. Within countries we have a different picture. Figure 11 shows a measure of inequality for the US (since the 18th century), Britain and the Netherlands over the same time period. The data shows a more or less continuous decline in income inequality in the Netherlands since the middle of the 18th century. In Britain and the US inequality rose during the early 19th century, and then fell until the closing decades of the 20th century, after which it increased again.. 0.65 0.60 Gini Coefficient 0.55 0.50 0.45 0.40 BRITAIN US NETHERLANDS 0.35 0.30 1730 1750 1770 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010 Figure 11. Income Inequality in the US, Britain and the Netherlands (1730-2010). The measure of inequality shown, called the Gini coefficient after its creator, Italian statistician Corrado Gini (1884-1965), indicates how much disparity there is in income, or another measure of living standards, across the population. If everyone has the same income, so there is no inequality, the Gini coefficient takes a value of 0. The maximum inequality, a value of 1, means a single individual receives all the income. In later units we explain how to measure the Gini coefficient. To get a feel for the degree of inequality associated with different values of the Gini coefficient, think of a pie that will be divided in two pieces. The Gini coefficient

UNIT 1 THE CAPITALIST REVOLUTION 23 measures how unequally you divide it. If G stands for the Gini coefficient, then the fraction of the pie going to the person who gets the smaller piece is: (1-G)/2 If G is zero, the smaller piece is half the pie: there is no inequality. When G = 1, the size of the smaller piece is zero. The person with the larger piece gets everything. Figure 12 shows four examples. On the left is the case where the Gini equals 0, so the smaller piece is actually as big as the other piece; the second picture illustrates a Gini equal to 0.2, which is similar to measures of income inequality in Denmark. The size of smaller piece is 0.4: the person who gets the smaller slice gets two-fifths of the pie. The third picture represents a Gini of 0.6, which could represent South Africa. In this case, the smaller piece is 0.2, that is, one-fifth of the pie. In the fourth case, when the Gini equals 1, the plate is empty. The entire pie goes to one person. Of course, there are no countries in which the richest person gets all of the income, because the others would not survive. There are also no countries in which the pie is equally divided. G=0 G=0.2 G=0.6 G=1 Figure 12. Measuring inequality by the Gini coefficient: the size of the smaller piece when two people share a pie. discuss 2: A measure of inequality Consider a landlord, and the farmer who works his land and pays rent. In a year the farmer can produce grain (net of the grain that is set aside as seeds for the next crop) that will provide 10,000,000 calories when it is consumed. The crop is divided between the farmer and the rent paid (in grain) to the landlord. For the farmer and his family to survive they need 2,000,000 calories per year. We can describe the inequality between the landlord and the farmer s family by the Gini coefficient of the grain produced. If the landlord charges a rent, in grain, equivalent to 6,000,000 calories, what is the resulting Gini coefficient? What is the largest Gini that is consistent with the survival of the farmer and his family?

24 coreecon Curriculum Open-access Resources in Economics Going back to Figure 11, we see that three centuries ago the Netherlands had a Gini coefficient of 0.63, but over the following centuries the degree of inequality declined to 0.42. This would be like the size of the smaller slice of the pie increasing by a little over 50%. In the US, inequality rose from the time of the Declaration of Independence in 1776 until the Civil War in 1860, and then declined for the next century, only to rise again in recent years. Inequality of income in the US, as measured by the Gini coefficient, is now slightly higher than it was when slavery existed, on the eve of the American Civil War. The inequality measures in Figure 11 do not take account of taxes paid to the government and income transfers received by households from the government (such as old age pensions, unemployment benefits and disability benefits.) For most of the period shown in Figure 11, these payments to and from the government had little effect on inequality. Taxes and transfers were very limited. Since the 1950s however, these payments have become an important part of how much a family can spend, so when comparing countries in recent years we measure inequality in what is called disposable income: that is, a family or individual s income after paying taxes and receiving transfers from the government. Figure 13 shows countries ordered from left to right from those with the lowest inequality of disposable income as measured by the Gini coefficient to the most unequal. The range is from a Gini of 0.2 in Denmark to 0.6 in South Africa and the representation of the Gini coefficient in Figure 12 helps convey the difference in inequality across this set of countries. We can see that among the most unequal rich countries are the US and the UK, while Denmark and Norway are among the most equal. In between are countries like South Korea, Taiwan, Belgium and Germany. Many poorer nations are very unequal, with Gini coefficients around 0.5; for example, Colombia. Gini of disposable income (various years, 2003-11) 0.6 0.5 0.4 0.3 0.2 0.1 0.0 2004 2005 2011 2004 2004 2004 2004 2004 2004 2000 2005 2010 2011 2006 2003 2004 2010 2004 2004 2004 2004 2004 2004 2009 2011 2004 2010 2009 2009 2010 Denmark Sweden Iceland Finland Norway Netherlands Czech Republic Austria Germany Belgium France Japan Taiwan Korea Australia Ireland Spain Canada Poland Greece Italy UK US Israel Russia Mexico Brazil China Colombia South Africa Figure 13. Differences in inequality of disposable income among economies.

UNIT 1 THE CAPITALIST REVOLUTION 25 The policies resulting in modest levels of inequality in South Korea, Belgium, Germany and Taiwan differ. In some, incomes received as wages and profits before the payment of taxes and transfers are very unequal. For example, Gini coefficients for income before taxes and transfers in Germany and Belgium are as high as in Colombia. This means that there are substantial differences among the people of Germany and Belgium in the things that determine how much income, before taxes and transfers, each of them gets. These differences include the ownership of incomeearning assets such as buildings, land or factories, someone s education, or the other determinants of success in a high-paying job. Unlike the case of Colombia, in Germany and Belgium taxes and transfers reduce the inequality in disposable income to half of the inequality before taxes and transfers. The reason is that transfers go mostly to the less well off, and taxes are a larger fraction of the income of the rich than the poor. Some poorer countries with high levels of economic inequality have adopted tax and transfer policies that are designed to reduce inequality in disposable income. Brazil in the 21st century is an important example. South Korea and Taiwan are the opposites of Belgium and Germany. In these countries, taxes and transfers hardly affect the distribution of income at all, because they are paid and received nearly in proportion to income before taxes and transfers. Inequality in disposable income is limited because the Korean and Taiwanese people differ less in what they own or in the value of what they bring to the labour market. Like the equalising effect of government policies in Belgium and Germany, the relatively equal distribution of income before taxes and transfers in these two countries is, in part, the result of government policies. In the middle of the 20th century large land holdings were broken up and distributed to farmers with little or no land. Also, both countries have high-quality public education systems. Figure 14 summarises the comparisons among countries. The columns refer to differences in the degree of inequality in individual income earning assets such as skills, ownership of buildings, factories, land and other things contributing to an individual s income before taxes and transfers. The rows refer to differences in the extent to which taxes and government transfers of income have the effect of substantially equalising the distribution of disposable income.

26 coreecon Curriculum Open-access Resources in Economics Figure 14. Inequality of income before and after taxes and transfers: The average Gini coefficient shown in each cell refers to disposable income (that is, after taxes and transfers). Discuss 3: GLOBAL AND NATIONAL INEQUALITIES COMPARED Briefly explain how it is possible for income inequality among households in the world to decline at the same time as income inequality within the two most populous poor economies has increased. 1.9 Economics and the economy in the units that follow we will introduce you to how a capitalist economy works, using the tools of economics. Economics is the study of how people interact with each other and with their natural surroundings in producing their livelihoods, and how this changes over time. Our definition of the economy, and therefore of economics, has three parts.