Discuss deindustrialization and its consequences and the relationship between deindustrialization and the emergence of local economic development planning. Your answer should be comprehensive

CHAPTER 4: THE CAPITALIST MARKET: HOW IT ACTUALLY WORKS

Final draft, August 2009

In the last chapter we examined the central virtues of capitalism as seen by its defenders and the basic way capitalism is supposed to work. Six points were especially salient:

• Capitalist markets are an expression of the value of individual freedom, organized around voluntary exchange between people; no one is forced by anyone to engage in any particular exchange.

• Free markets are an extremely effective mechanism for coordinating complex economic systems.

• Markets accomplish this remarkable result through supply, demand and the price mechanism

• Free markets result in allocative efficiency: after all the trading is done, the allocation of things is “pareto optimal” – no one can be made better off without someone being made worse off.

• Capitalist Markets create incentives for risk-taking and innovation and thus capitalism is an engine of economic growth.

• State regulations of capitalist firms and markets interferes with the free market and undermines these virtues.

This is how capitalism is supposed to work. Now let’s look at some of the problems and dilemmas of markets and capitalism. We will begin by examining the moral argument for capitalism and freedom and then turn to a range of problems with the pragmatic defense of free markets. The chapter will conclude with a discussion of how intensely competitive capitalist markets can undermine a range of social values outside of the economy itself.

I. The moral argument: How well do capitalist markets advance the value of human freedom? Individual freedom is a terribly important value, and it is a tremendous historical achievement that individual freedom has become a core value of our culture. Historically this value emerged and was strengthened, if unevenly, by the spread of market relations, and a good case can be made that capitalist development has further promoted this value. Nevertheless, capitalist markets really only affirm a very limited notion of freedom, and in certain important respects constitute an obstacle to the fuller realization of this value.

To understand this we must look more closely at the idea of individual freedom. There are two sides to the idea of freedom, sometimes referred to as “negative freedom” and “positive freedom”. Capitalism and markets have an ambiguous relationship to both of these faces of freedom.

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Negative freedom means freedom from coercion. Individuals have negative freedom when no one directly commands them to do things against their will. Individuals have autonomy to direct their own actions unless they voluntarily agree to follow the orders of someone else. A “contract” embodies this ideal of freedom: two people voluntarily agree to some kind of exchange. So long as the contract is free of force or fraud, it is an expression of negative freedom. By historical standards, capitalist markets have done a pretty good job at reducing involuntary coercion in economic life. Compare a free market economy to slavery or feudalism: in both of these sorts of economic systems the direct application of force is a central, pervasive feature of allocating people to tasks. In a capitalist market economy the allocation of people to activities is the result of the self- directed choices of persons: no one is told “you must work for this employer” or “you must buy this product.” In Milton Friedman’s famous words, within a capitalist market people are “free to choose.”1

Positive Freedom refers to the actual capacity of people to do things. This is freedom to rather than freedom from. A person has greater positive freedom if he or she can do more things, has greater capacity act in the world. Negative freedom identifies freedom solely with the act of choice, whereas positive freedom identifies it with the range of choices a person is actually able to make. Capitalism has also certainly played a pivotal role in expanding the range of choices available to many people. One needs only to compare the vast array of consumer products available today with 100 years ago to see this. And further, economic growth has improved the standards of living of a significant proportion of the population so that they have access to at least a part of the expanded range of alternatives.

With respect to both the negative and positive face of freedom, therefore, capitalism and markets can be seen as having made a real contribution. And yet, in other crucial ways, capitalism also generates and enforces considerable restrictions on both negative freedom and positive freedom for many people. Two issues are especially salient here. First, the power relations within capitalist firms constitute pervasive restrictions on individual autonomy and self-direction. At the core of the institution of private property is the power of owners to decide how their property is to be used. In the context of capitalist firms this is the basis for conferring authority on owners to direct the actions of their employees. An essential part of the employment contract is the agreement of employees to follow orders, to do what they are told. In most capitalist workplaces this means that for most workers, individual freedom and self-direction are quite curtailed.

One response to this by defenders of capitalism is that if workers don’t like what they are told to do, they are free to quit. They are thus not really being dominated since they continually voluntarily submit to the authority of their boss; they are not slaves, after all. The real freedom of individuals to quit their jobs, however, provides only an illusory escape from such domination since without ownership of means of production or access to basic necessities of life, workers must seek work in capitalist firms or state organizations, and in all of these they must surrender autonomy. It may be true that the agreement to work for a particular employer is “voluntary” in that no one commands this, 1 The expression comes from Milton and Rose Friedman in their passionate defense of capitalism, Free to Choose ( ).

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but the decision to work for some employer is not. Capitalism, therefore, violates the value of negative freedom by making it very difficult for most people to avoid being directly dominated by others in work.2

The second way in which capitalism undermines the ideal of individual freedom and autonomy centers on the massive inequalities of wealth and income which capitalism generates. These inequalities mean that some people have enormously greater capacity to act on their life plans than others, to be in a position to actually make the choices which matter to them. Large inequalities of wealth and income mean some people have much greater positive freedom than others. Of course, one can cite many wonderful rages-to- riches stories to refute this: there are people who start out with extremely limited resources and correspondingly limited options who nevertheless acquire the material conditions for expansive positive freedom. Can one say that capitalism denies people positive freedom when such opportunities exist? This is rather like observing that some people escape from prison — and undoubtedly these are the prisoners who are the cleverest and most committed to escaping — and then concluding that the people who do not escape are therefore not really in prison. Free markets inherently generate very large disparities in resources available to people. If everyone started out in the same position with the same assets and these differences were just the result of effort and choice, then perhaps it wouldn’t really contradict positive freedom. In fact, most people who accumulate great wealth started with considerable wealth and other advantages. They have greater freedom, not just more stuff, than someone born poor.

Capitalism and free markets, therefore, have contradictory effects on the value of individual freedom, whether understood in the negative or positive sense. American capitalism does relatively little to counteract these freedom-reducing processes. Employers face very weak legal restrictions on their authority over their employees, and most workers have very limited autonomy and self-direction within work. Relatively despotic forms of power over individuals within workplaces are thus common. The processes of income and wealth redistribution organized by the state are also very weak, and thus little is done to secure the positive freedom of the poor and disadvantaged. American capitalism may be defended on the moral grounds of individual freedom and liberty, but it supports only a thin understanding of this important value.

II. Problems internal to markets: inefficiency and market “failures” Defenders of free markets and capitalism as a social order do not primarily defend these institutions because they embody the moral principle of maximizing individual freedom, but rather because these institutions are also supposed to promote the general welfare. Many people may concede that markets may be unfair in some ways, that real freedom is limited for many people within capitalism, but still believe that maximally free markets

2 For a good discussion of the sense in which the employment contract, in spite of its apparently voluntary character, still reflects a form of unfreedom, see G. A. Cohen, The Structure of Proeltarian Unfreedom, Philosophy and Public Affairs 12 (1983), pp.3-33 For a discussion of the problematic relationship of managerial authority to individual freedom, see Robert Dahl, A Preface to Economic Democracy (Berkeley, University of California Press: 1985)

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based on private property are the surest route to efficiency and improvements in the general welfare.

It is certainly the case that markets are often pretty efficient and that private ownership of firms can often “deliver the goods”. But this is a seriously incomplete picture. There are many circumstances in which markets fail and important instances where they do a terrible job. Our ultimate conclusion will be that if one wants to realize to the greatest extent possible the values of efficiency, then the ideal should not be the free market of unregulated capitalism, but democratically accountable markets. In the case of Contemporary American Society this would require a dramatic revitalization of democracy and strengthening of the “affirmative state”.

In order to get to this conclusion we need to understand more systematically the problems and dilemmas of capitalist markets, and this will require more discussion of some basic ideas and concepts in economics and economic sociology. This will be the task of the rest of this chapter. This will be followed in Chapters 5-8 with a more empirical discussion of market inefficiency in several important domains of economic activity.

We will examine five problems in the functioning of capitalist markets that can generate significant economic and social inefficiency:

1. Information failures 2. Concentrations of economic power 3. Negative externalities 4. Short time horizons 5. Public goods

1. Markets and information At the center of the idea that markets generate efficient allocations of resources is the problem of information. This is a simple point, embodied in jokes about used car salesmen describing vehicles as having been driven by little old ladies only on Sundays and aphorisms such as “buyers beware.” Basically the problem is that sellers on a market have strong interests in hiding certain kinds of information from buyers in contexts in which it is costly, if not impossible, for buyers to get the necessary information to make an optimal choice. Because of this severe information problem we have laws that regulate false advertising, and we require firms to provide certain kinds of information to consumers which they would not provide if there was a perfectly free market. Food labeling is a good example. Laws that require nutrition information on food violate the free market. Food processors would not provide this information unless forced to do so. It costs the seller something to calculate nutritional content, assemble the data, and put this on a label. Individual consumers are unlikely to have strong preferences about this information until after it is provided. And furthermore, even if there were some consumers who wanted the information, it would initially be quite costly for producers to provide this information – there are considerable economies of scale in providing the information if it is done on a wide scale rather than on a limited scale – and thus the price difference between products with and without product information would be prohibitive.

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As a practical matter, this information will be widely provided only when there regulations which require this. Such regulations violate the principles of the free market.

Laws that prevent firms from false advertising violate the logic of the market as well. In a perfectly free market, firms could make whatever claims they liked about their products. If consumers felt that it was valuable for them to know the truth, then there would be a market for better information about products, and consumers could buy that information if they wanted to. If a consumer felt that the distortions of information harmed them and amounted to fraud, then they could sue the sellers in court and the threat of suits would act as a deterrent for excessive falsehood. In any case firms would not want to distort information too much or they would lose customers. Reputation matters for firms, and thus the market itself would impose constraints on distorted information.

It is possible, therefore, to imagine a free market with no government regulations on information. In such a truly free market economy, the quality of information would depend upon the preferences of consumers for good information and their ability to pay for it, the value of reputation to sellers, and the effectiveness of threats posed by private law suits for fraud. This is an imaginable world – and indeed was more or less the way American capitalism functioned in the 19th century – but the average quality of information consumers would get in the market would be much lower in such a world than in one with good state enforced regulations on information. And if the average quality of information is lower, than the allocation of resources generated by such a market would be less efficient.

A special case of product information concerns product safety. Suppose that there were no regulations for safety standards for automobiles. Carmakers would then be free to make cars with different standards of safety. If consumers valued safety, then they would be free to pay a premium for cars designed to be safe. If some consumers were risk-takers and preferred a cheaper car, then they could buy a less safe car. A libertarian might argue that this would be a better market since it would give consumers more power, more ability to choose freely the risk/safety/cost mix that they prefer. However, one of the major problems with this scenario concerns the problem of information, since carmakers would have large incentives to hide safety problems and characterize their cars as being safer than they really are and it would be difficult for consumers to weigh the technical information to make informed decisions, and extremely difficult for them to effectively to use the courts to remedy the resulting harms.

This problem is not just hypothetical. The notorious cases of the Pinto automobile and its exploding gas tanks in the 1970s and the road instability of certain SUVs in the 1990s clearly show the problem of information failures in the “market” for automobile safety even in a world in which safety regulations exist.3 The Ford motor company realized by the late 1960s that there was a design flaw in the Pinto which, in certain accidents, caused the gas tank to explode. Ford engineers designed a retrofit which would eliminate the problem at a cost of roughly $11/car. The issue, then, was whether or not it was worth it for the company to recall all Pintos and make the change. The company did 3 The following account of the Pinto case comes from Mark Dowie, “Pinto Madness”, Mother Jones, September/October, 1977.

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the math: the safety improvement would cost $11/car and would save roughly 180 lives per year. The cost of the retrofit would be about $137 million (12.5 million vehicles x $11/vehicle). How much was a life “worth”? Ford calculated this on the basis of the likely court costs for passenger deaths and they came up with a figure of roughly $200,000 per death. They did the math and decided that it wasn’t worth making the safety change. And further, by fighting the court cases, insisting that these fiery deaths were due to driver error, and resisting legislative regulation, they could further minimize the costs of the safety problem.

The same basic story was repeated in the 1990s when certain sport utility vehicles were found to be unstable on curves and had a tendency to roll over. The manufacturers denied this was a problem, blamed drivers, and fought court cases. This occurred in a context where there was considerable machinery of safety regulation in place. Imagine how serious the safety problems would become in the absence of such safety regulations and requirements for information reporting.

2. Concentrated economic power Another premise of the defense of the virtues of free market is that individuals and firms do not really accumulate large amounts of power in the market: everyone enters into exchanges as individual, voluntary actors, making choices freely. They may have different purchasing power, and this means that they may have different sets of choices, but no one has the kind of power in which they can impose their will on others.

What is power? There are many answers to this question, but one simple one it that power is the ability to get your way even against the objections or resistance of others. This is the ability to impose your will on others. If you announce in the newspaper that you have a stereo to sell for $100, everyone who reads the ad is completely free to say no to your offer. You have no power over anyone. This is one of the virtues of market exchanges and is why many people believe that markets are the enemy of power and domination; they are the realm of free, autonomous, voluntary action.

The problem is that free markets tend to lead to concentrations of wealth in the form of personal fortunes and, even more significantly, the large mega-corporation. It is an inherent feature of market dynamics that winners in competition will tend to become larger and larger, and when they become very large they exert real power inside of the market (as well as in the political arena). Microsoft, Wal-Mart, Exxon, Boeing, and many other corporations do not just make things and sell them on a market; they shape the market through their exercise of power. The large corporation is not just like the corner grocery store, but bigger; it has the ability to make strategic choices that massively affect the lives of people and communities, the choices they face and the kinds of lives they can lead. Microsoft is notorious in this regard: it is so big that it can force people to buy products that they don’t want by bundling them with their windows operating system, and they can force computer companies to install their entire suite of programs rather than individual components. Wal-Mart forces suppliers to squeeze their workers wages to ruthlessly cut costs. Wal-Mart is so big in many markets that suppliers simply cannot refuse to comply with its demands. Wal-Mart is not just a “price taker” that responds to the prices of products in an impersonal market; it is a “price maker”, using power to shape prices in the market. General Motors, when it was one of the largest corporations in

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the world, used its power to purchase urban electric rail systems and convert them to buses thus, as we will see in Chapter 6, expanding the potential market for automobiles. Many many other examples could be given. In all these ways, concentrations of economic power undermine the efficiency-generating dynamics of markets.

The power of the large corporation is enhanced by the increasingly global character of capitalist production and markets. Large corporations have the ability to locate their facilities anywhere in the world. This means that when they face regulations they do not like or employees that demand higher wages than they want to pay, multinational corporations have the option of moving their production elsewhere. Small local firms do not have this ability and are thus weaker in their dealings with other local actors. Because large firms have the power to use threats to get their way they have competitive advantage over small firms. This again reduces the efficiency properties of markets.

3. Negative externalities Negative externalities are all the side-effects of an activity that have negative effects on others. Positive externalities are side-effects that benefit others. Playing a loud boombox in a park generates negative externalities on bystanders who prefer quiet; planting flowers in one’s front yard crates positive externalities for passers-by who enjoy their beauty. Negative and positive externalities, therefore, are an inherent feature of social activity.

The problem of negative externalities is one of the most pervasive sources of inefficiency in capitalist markets. If these were just random perturbations, noise in the system, then perhaps one might think that negative and positive externalities would more or less balance each other out: the unchosen harms on people caused by negative externalities would be neutralized (in the aggregate at least) by the unchosen benefits of positive externalities. The problem is that in capitalism negative externalities are not random deviations from a “perfect market.” Rather, there are strong incentives on firms to engage in practices which generate them. Let us see why this is the case.

Capitalist firms do not simply produce goods and services for the market; they attempt to do so in a way that maximizes profits. Profits are basically the difference between price at which things are sold and the costs paid by the firm of their production. Therefore a central part of maximizing profits is maximizing the difference between such costs and selling price, and one way to do his is to lower costs. But note: what matters here are only the costs actually experienced by the firm, not the total costs of production. In many contexts, an effective way of reducing such costs faced by the firm is, in one way or another, to displace costs onto others. One way of doing this is to increase negative externalities.

The classical example of this is pollution. We will discuss this in more detail in the next chapter, but the basic point is simple enough: it is cheaper for a factory to dump pollutants into a river or the air than to dispose of them in a nonpolluting manner. But polluting the environment imposes costs on other people – for example communities downstream from a source of water pollution have to spend resources to clean the water, and air pollution increases medical bills and the frequency with which homeowners have to repaint their houses. If a firm was either forced to install technologies that would prevent the pollution or pay for all of these displaced costs, then their costs of production

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would increase significantly. An individual firm, therefore, would be at a competitive disadvantage if it did so out of the moral principle that it was wrong to displace costs on other people. Displacing such costs on others is therefore perfectly rational behavior for a capitalist firm engaged in profit maximizing competition.

Another important type of negative externality centers on the investment decisions of corporations. Consider a firm that decides to move production to Mexico because it will have a higher rate of profit there than in the United States. Many firms that have moved production away from the U.S. did so not because the plants in the US were losing money – they were making a profit — but because they could make higher profits elsewhere. This is a perfectly rational economic decision on the part of the corporation given what counts as a “cost” in their calculations. However, there are many significant social costs of this decision which do not appear as “costs” to the corporation and which, if the firm had to cover these, would change the profit maximizing strategy, For example, when a large factory moves abroad this often triggers a decline in home values in the abandoned community. This can have a devastating economic impact on these homeowners even if they themselves were not employees of the firm in question. These costs to homeowners are not included in the investment decisions of the firm owners. If they were, plant closing would not be profitable. To see this, suppose that the plant in question were owned by all of the people in the affected community rather than by an outside corporation. In this case the impact of moving the factory on home values would not be a negative externality, but a negative “internality” – it would be experienced as a cost to the people making the decision. Even if the direct production costs were lower in Mexico, in this situation it would not be viewed as a way of increasing profits.

This, then, is the important lesson about negative externalities: in making investment decisions the owners of firms look at the costs and benefits of alternative choices, but only certain costs are counted. Some costs are displaced onto other people, so they do not appear in the bottom line of the firm. This means that the ordinary price mechanism of a competitive market cannot lead to optimal allocations even in the restricted sense of allocative efficiency. Efficient allocations in a market only happen when prices are closely linked to the true total costs of producing things. But if firms can displace significant costs on others, then prices no longer reflect true costs, and allocations based on those prices are no longer efficient. Negative externalities pervasively muck up this process.

4. Short time horizons The idea of “time horizons” refers to the length of time into the future that figures in decisions people make in the present. A particularly important issue in this regard is the extent to which the interests and welfare of future generations are taken into consideration in investment and consumption decisions made today. Highly competitive, free markets have the effect of shortening the time horizons of most investors. Capitalist firms compete for investments. Investors look to firms that give the highest rates of return in the relatively short term. Even investors with relatively long time horizons are concerned about the likely rates of return over a relatively short period – a decade or so perhaps – not fifty or a hundred years. This means that investment projects that would take many decades to generate a return are very unlikely to be undertaken. The result is

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that investments generated through competitive markets cannot give significant weight to the welfare of future generations since this will generally not be the short-run profit- maximizing business strategy.

The problem of energy conservation is a good example. The price of oil in the world at any given time broadly reflects the costs of extracting oil and the market demand for its products. The fact that in the future the costs of extracting oil will become much more expensive due to depletion of the resource and thus it will be much more expensive to produce a given level of supply is not reflected in current market prices. The prices individuals face in the market when they make individual consumption choices around gasoline consumption thus do not reflect the costs to future generations. As a result, unless an individual is very self-conscious about these issues, individual consumption choices will only reflect immediate personal needs. The market itself cannot solve this problem. It is only through public deliberation and collective political choices that the longer term future can significantly affect present decisions and economic allocations, both in terms of broad patterns of investment and of consumption.

5. The problem of public goods. What is a “public good”? Without going into technical details, as a first approximation a public good is something which provides benefits to people even if they did not voluntarily contribute to producing it. Or, to put it slightly differently, a public good is something which, if produced, is difficult to exclude people from consuming. The classic example is national defense. Suppose national defense was paid for by voluntary contributions rather than taxes. The national defense that was provided by this means would benefit those people who did not contribute, not just those who did. Public sanitation and public health, public b

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