the root causes of growth under capitalism

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Cambridge Journal of Economics 2011, 1 of 24doi:10.1093/cje/beq054

The root cause of economic growth undercapitalism

Michael Joffe*

Drawing on historical and other empirical evidence, this paper provides a causalexplanation of a central question: why sustainedper capita growth occurs in capitalisteconomiesi.e. in what way capitalism differs from the market that gives it thisproperty. It describes an endogenous economic logic that is based on theinstitutional characteristics of capitalist firms in the non-financial sector, especiallythe flexibility of the inputs that they can call upon and of the size of the market thatthey can supply. This perspective naturally generates a realistic theoretical accountnot only of the source of economic growth, but also of the evolution of marketstructure, the forces that produce divergence in, for example, profit rates, a startingpoint for explaining price-setting and a language for describing firms economicpower. It draws on previous traditions, especially those based on the works of Marxand Schumpeter, but differs from them in important respects.

Key words: Growth, Capitalism, Firms, Institutions, Micro-foundationsJEL classifications: O43, P17, N10

1. Introduction

The tendency for capitalist economies to grow is one of their most characteristic

properties. The successful capitalist countries have experienced sustained per capita

growth for many decades, to an extent unparalleled in previous human history. Take-off

has occurred successively in country after country over the past 200 years. Such take-off

was not a one-off event, but rather a step change to an altered mode of operation of the

economic system, that has persisted ever since. This inexorable growth tendency has been

maintained across numerous transformations: in institutions (e.g. limited liability), marketstructure and the role of science and technology. It encompasses growth at the

technological cutting edge as well as catch-up growth in countries that have imported

technology and (sometimes) institutions.

Nevertheless, the source of growth is not well understood. The aim of this paper is to

ask, what is it about capitalism that has this effect?, and to try and answer that question by

Manuscript received 28 November 2008; final version received 17 December 2010.Address for correspondence: Imperial College, St Marys Campus, Norfolk Place, London W2 1PG,

UK; email: [email protected]

* Imperial College London, UK. I would like to thank Hasan Gu rak, Gidon Carmeli, Ben Fine, SteveKeen, Arthur Grimes and especially Geoff Hodgson for commenting on earlier versions of this paper. Theydo not necessarily agree with its content.

The Author 2011. Published by Oxford University Press on behalf of the Cambridge Political Economy Society.

All rights reserved.

Cambridge Journal of Economics Advance Access published March 22, 2011

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providing a causal analysis in terms of the properties of the capitalist firm in contrast with

individual traders.1 It deals only with the generality that capitalist economies have this

specific property; the causes of variations in growth rates between different capitalist

economies or sectors or over time are beyond the scope of the current paper. At this stage

only a verbal model is presented, the objective being to discover deep regularities.The term capitalism here is taken to mean an economic system dominated by

production that employs wage labour, in which the means of production (equipment and

materials) belong to the employer. There is also a case for including a dominant role for

financial markets in the definition, because their growth has historically been a key

precondition for corporate operation and expansion. Private ownership of the means of

production is another traditional element in the definition, but may not be a necessary

feature. These issues are discussed below. It is important to note that capitalism is not

used in an evaluative sense: the analysis would have the same validity whether one favours

or abhors the capitalist system, and whether one wishes to pursue or to limit growth.

One problem is the apparent obviousness of at least part of the account presented.

Probably some of this is widely understood intuitively and not only by economists.

However, while important aspects can be found in the literature, this intuitive un-

derstanding has not so far generated a systematic account of the endogenous causal

processes involved in the way that capitalism operates, which could be described as the

micro-foundations of growth. Such an explicit description is essential, for example to

avoid confusion of capitalism with the marketone is dynamic, the other self-

regulatingas well as to tease out which particular components of the capitalist system

are responsible for its dynamism. Moreover, it allows the explication of the main stages of

capitalist growth. As will become clear, there are several advantages in describing this

apparently obvious process explicitly.

1.1 The market or capitalism?

The modern economy is conventionally portrayed as a market economya system of

trading relations between individuals. Adam Smith provided the classic description in the

Wealth of Nations (Smith, 1776), in which he emphasised the crucial importance of the

extent of the division of labour. The structure of his argument was that under certain

institutional conditionssummarised as a system of natural libertythe economic

system would generate both stability and growth.

The stability was due to the price mechanism bringing supply and demand into balance,

as if by a hidden hand. Thus, the apparently anarchic behaviour of individuals had the

emergent property of self-regulation at the aggregate level of the market, creating an entitythat has the features of a system with endogenous causal processes, what we would now call

a balancing or negative feedback mechanism (Lowe, 1977), even though it is not formally

organised as one.2

1 The term firm is henceforth used to indicate the specifically capitalist firm, characterised by theemployment relationship (Hodgson, 1999, especially pp. 22046: The Coasean tangle: the nature of the firmand the problem of historical specificity). It also can convey a sense of agency, denoting the person/people incharge, who take/s the initiative. This is in contrast to the type of firm that consists of only one person, or justfamily labour, or an equivalent, which is variously described as sole trader, sole producer or pettyproducer depending on the context.

2 This accords with modern system concepts: systems containing feedback loops generate their own

endogenous causal processes that make them less sensitive to initial conditions. These intra-systemicprocesses can be modelled (Lowe, 1977); in addition, exogenous causal processes such as shocks anddisturbances can also exist (Forrester, 1970; Lane, 2007).

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According to Smiths verbal model, growth resulted from a cyclicalor rather,

spiralseries of causal processes. These formed a reinforcing (or positive) feedback loop,

operating through a progressive increase in the division of labour, generating endogenous

but slow growth (Lowe, 1977). The assumptions required for this model are specific to

small-scale production (Lowe, 1977), and in particular require economic power to bewidely dispersed (Harcourt, 1994).

The only exogenous variable in Smiths model of stability and growth is preferences,

with other psychological assumptions of a broad nature also being necessary to drive the

system, such as the propensity to truck and barter (Lowe, 1977). This latter Smith

regarded as universalwhich fits with the ancient origin of trade and its widespread spatial

distribution, and distinguishes the system he described from a capitalist one, which barely

existed in 1776.

There were two other major consequences: first, there would be gains from trade as

a result of a greater variety of goods and services. Second, by enlarging the division of

labour, over time trade would lead to specialisation and specialisation in turn leads to

greater dexterity, time saving and invention [as was already recognised by Plato,

Xenophon, de Mandeville and Hume, among others (Peaucelle, 2006)].

By contrast, in a capitalist society the division of labour takes two forms: between traders

(a market), and within a firm (an authority structure). Although the Wealth of Nations starts

with a classic description of a pin factory, based on earlier French sources ( Peaucelle,

2006), the explanatory passages focus on traders who are sole producers and neglect firms.

Smith has the excuse that such individuals were still dominant in his time, factories being

rarethey only became commonplace decades later when industrial capitalism took off.

Factories, and firms more generally, quickly established themselves in England and

subsequently in many other parts of the world. Gradually they became ever more dominant

players in the economy. And it was firms that transformed both the economy and widersociety.

What is remarkable is that an explanatory tradition focussing on trade still dominates

mainstream economics, especially the neoclassical tradition, more than 200 years later.

The textbook theory of the firm is blind to its scale and its internal structure, treating large

corporations that hire and fire workers in the same way as it treats sole traders.

Thus, the lack of sufficient acknowledgement of historical specificity in Smiths work has

been continued in most of the later traditions, but without his excuse. This is particularly

surprising as J. S. Mill already described cheapeningthe novel feature of continuous

reduction in the real costs of inputsin 1848 (Mill, 1848), albeit without explaining it.

And soon afterwards, Karl Marx took the historical specificity of capitalism as central,recognising that this mode of production develops the forces of production like no other

(Marx, 1867). Something had changed dramatically: in place of an economic system

dominated by the distribution of existing resources, for example the switching of crops or

the mining of less accessible seams as described in neoclassical theory, new structures

emerged that transformed how resources were used. Scarcityin Robbins sense of limited

supply, not merely a budget constraintwas replaced by abundance in sector after sector

as capitalism developed. In the early and mid twentieth-century, Joseph Schumpeter

provided a vivid description of the dynamism and turbulence of the capitalist system

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(Schumpeter, 1911/1934, 1942). However, neither Marx3 nor Schumpeter4 provided

a causal account explaining why capitalism is uniquely dynamic, although it takes a close

reading of their works to realise this.

Also relevant is a contribution by Ronald Coase, who in 1937 asked the question, if

market trading between individuals generates the most efficient and generally optimaloutcomes, why do firms exist (Coase, 1937)? This paper has stimulated a fruitful tradition

of research, based on the importance of transaction costs, seeking to explain why firms have

the boundaries that they have (e.g. the extent of vertical integration or disintegrationthe

make-or-buy decision). However, its success in this has proved to be patchy (Poppo and

Zenger, 1998; David and Han, 2004; Carter and Hodgson, 2006), and the transaction cost

approach faces special challenges in explaining innovation and the entrepreneurial firm

(Hodgson and Gindis, 2007).5 More important, the deeper question about why firms exist

at all still remains unanswered, and is largely ignored by mainstream economics.

Moreover, the concept of the firm is rather unclear in the large literature devoted to its

study. For example, in much of the orthodox literature the firm is treated merely as

a production function. Others define it as a nexus of contracts ( Bainbridge, 2002), or as

a collection of assets without examining its internal structure (Grossman and Hart, 1986).

These limited viewpoints are effectively criticised by Hodgson (2002), who emphasises the

importance of the legal foundation of the firm. Gindis (2009) builds on this, demonstrating

that the firm is a real not a fictional entity, citing the earlier tradition of real (or natural)

entity theory. This recognised that capitalist firms possess emergent properties of collective

knowledge and capabilities, and that these have consequences, in particular that the firm

has causal powers and is a unit of selection. This perspective accords with the classic

organisational analyses that explored relationships within the firm (Berle and Means, 1932;

Penrose, 1959).

Micklethwait and Wooldridge (2003) present a short history of the firm, describing it asa revolutionary idea that gave birth to the industrial revolution. They trace the institutional

innovations that gave rise to the existence of economic entities with their own legal

personhood, a necessary condition for the emergence of specifically capitalist firms (see

section 3.2 on the key properties of firms). However, their emphasis on the joint-stock

3 Marx included an analysis of productivity growth in his verbal description of capitalism in chapter 12 ofVolume I of Capital (Marx, 1867 pp. 42938), but it was dropped when he came to introduce his formalmodel in chapter 17. There are, of course, numerous possible readings of Marx, but any of them has torecognise that his formal economic model excluded productivity growth, a fact first noted by Engels in thenineteenth century (p. 655, footnote).

4

Schumpeters writings on creative destruction and capitalist dynamism are unclear on the causalmechanism (Schumpeter, 1911/1934, 1942; Joffe, 2010). Two views can be discerned: the entrepreneur asagent of change is the better developed, and has been deservedly highly influential. However, it does notaddress the specificity of capitalist dynamism: if the existence of entrepreneurs is to be an explanation forcapitalistdynamism, why does this particular type of economic system generate entrepreneurs? And second,why should they innovate in such a way that one result is growth? Or did they occur equally frequently in, forexample, Imperial China? And, if so, why was that civilisation characterised by technical inventiveness butpatchy per capita growth? Schumpeters systemic view stresses how capitalism creates the tendency to think incertain ways, e.g. to generate innovations, but is poorly developed in his writings, and no mechanism issuggested (Joffe, 2010). In addition, Schumpeter himself denied the specificity of creative destruction tocapitalism, devoting 14 pages to equivalent processes occurring under a simple exchange economy, anisolated manorial estate, and an isolated communist society (Schumpeter, 1942).

5 Oliver Williamson, the foremost contributor to operationalisation of transaction cost economics(Hodgson, in Hodgson and Gindis, 2007), states that: Innovation poses special challenges. Transaction

cost economics can speak to some of these but it does not have a well-rounded explanation. And again:Entrepreneurial firms are a special challenge. In terms of theoretical analysis, another generation ofeconomists is going to have to come up with the answers.

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explaining the industrial revolution and cutting-edge growth more broadly (Mokyr, 2002;

Lipsey et al., 2003). However, it fails on grounds both of specificity and of generality. It

lacks specificity because technical change can occur without capitalist growth, as in

medieval Europe and especially in Imperial China. More important, it lacks generality: in

most economies that have undergone capitalist transformation, technical innovation wasabsent, at least in the early stages, with technology being imported.6 A complementary

account of the institutional context is required, that promotes either technological

innovation or the effective assimilation of imported technology (Nelson and Pack,

1999)and in a way that promotes growth. Furthermore, even in innovatory societies

like the USA, the growth-promoting changes in production have not necessarily been

technological in the usual sense (see next section).

The evidence shows that under certain institutional conditions, the endogenous workings

of the economic system generate self-sustaining growth. Section 2 considers evidence

relevant to this question, Section 3 proposes an account of how the institution of the

capitalist firm can generate continuing growth in the light of this evidence, and Section 4

situates this account within a wider context.

2. The historical evidence

2.1 Spatial and temporal distribution of g rowth take-off

In England, per capita growth shows a structural break at around the time of the Industrial

Revolution. The economy started expanding rapidly around 1800, if judged by the hourly

wage of building workers (Clark, 2005), or 1820 (Maddison, 2007). This tendency to grow

has been sustained ever since in England, albeit with fluctuations. Growth diffused

throughout the economy, creating and then continuously transforming mass markets in

basic necessities such as food and clothing. Subsequently, linkages were established assector after sector became involved.

US growth has followed a similar pattern, and has been close to exponential over

a similar period. The countries of Continental Europe and then various other parts of the

world have followed suit at different times. The continuous per capita growth of a set of

leading countries, a set that has gradually expanded, contrasts with other countries that

have either variable growth rates or zero growth, and this has resulted in massive

divergence (Pritchett, 1997, 2003). This change, in one country after another, has been

described as a hockey stick: the horizontal handle represents zero or slow growth, while

the upward-sloping blade represents the relentless growth of unprecedented magnitude

characteristic of capitalism (McCloskey, 2010).Any theory aiming to explain this series of transformations needs to account for

the change being persistent once it has begun, and generalisable across sectors and

6 The same arguments apply to authors whose primary purpose is not to explain growth but to explore itscharacteristics. A prime example is Pasinetti (1981), whose model of structural change is based on theassumption that growth is based on technical change plus learning. His primarily macro approach, witha major role given to responsive changes in consumption, is complementary to the bottom-up focus of thepresent paper. He has a similar view of the role of institutions in structuring economic behaviour ( Pasinetti,1981, 2007), but does not consider the specificity of capitalist growth. Ed Nells (1996) model oftransformational change also starts from a technological shift, from Craft Economy to Mass Production,stressing the multiplier effect resulting from the need to invest in order to capture economies of scale. His viewis that Smiths invisible hand no longer provides stability as it did in the Craft Economy (despite stressing

that disorderly markets are in fact relatively rare in the modern USA), thus generating cycles. This contrastswith the view set out here, that the market mechanism does operate, but has been joined by powerfuladditional forces.

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internationally, as well as across the many varieties of capitalismor at least its

successful examples. It must also be compatible with the first industrial revolution

having occurred when and where it did. If attributed to exogenous technological shocks,

these would need to have been sufficiently constant in frequency and intensity to

generate close-to-exponential growth.An institutional explanation is a likely candidate. In particular, this tendency to

inexorable growth has coincided with the growth and success of capitalist firms. Research

is needed to explain why firms having the properties described in this paper emerged in

those particular places and times, including, for example, the role of the state, and to trace

the causal pathways that led from their establishment to the degree of subsequent growth

experienced.

Economic growth in non-capitalist societies has different characteristics. A

growth spurt in England had begun earlier, in about 1640, and ended around

1740, but population growth almost kept pace with it (Clark, 2005). Similar periods

of growth were not uncommon in the millennium before the Industrial Revolution,

notable examples being in China, Japan and the Netherlands, which also proved

transient (Kelly, 1997; de Vries and van der Woude, 1997; Landes, 1998; Pomeranz,

2000). Economic historians sometimes refer to these as examples of Smithian growth,

as distinct from modern self-sustaining growth (Kelly, 1997), and their characteristics

fit quite well with the slow growth process of Smiths account referred to above

(Smith, 1776; Lowe, 1977).

Extreme international inequalities in prosperity have developed in the past two

centuries, some parts of the world having unprecedented riches, and others being stuck

in severe poverty. These sharp contrasts could have resulted from the operation of

capitalism, which is known to generate inequalities, or alternatively from the lack of

capitalism, or at least of successful capitalism, in the laggard areas. The most cautiousposition is that it could be some of each. Deciding the relative merits of these viewpoints is

an empirical not an ideological matter, and a satisfactory answer is crucially important if

global poverty and inequality are to be addressed.

Why might capitalism not be established successfully? One reason is that state policy

forbids it, as in the USSR and in pre-reforms China, or at least did not facilitate it as in much

of post-colonial Africa where African Socialism was attempted. Another is that the

conditions for success are not met. Given that the success of capitalism is coterminous with

the success of its constituent firms, this would mean the lack of widespread firms that are able

to thrive, for example due to lack of access to a market of sufficient size and buying power

and/or to lack of human and physical capital. Thus, any theory must not only recognise thespecific dynamic properties of successful capitalism, but must also allow for additional

conditions that are necessary for sustained growth to occur, and in particular to explain the

paucity of thriving firms and the slow growth in areas that remain poor (see below).

2.2 Historical changes in productivity and prices

Such descriptive spatial and temporal data do not give much indication of the

underlying processes, and for this more detailed historical evidence needs to be

examined. One example is a study of the American Northeast in the period 1820

1860 (Sokoloff, 1986). This looked at changes in productivity and prices in the

following sectors: boots/shoes, coaches/harnesses, cotton textiles, furniture/woodwork,glass, hats, iron, liquors, flour/grist mills, paper, tanning, tobacco and wool textiles.


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Within each sector, major product innovation was not involvedthe main new

product at the time would have been the railroadso this is a suitable design for

investigating the dynamics within existing product sectors. In addition, none of these

sectors was dominated by a technological breakthrough or other major process

innovation; rather they were subject to incremental change. This comprehensivewithin-sector focus, the absence of major product or process innovation and the rich

data available, make this an ideal case study.

The main finding was that sector-specific labour productivity more than doubled in all

but one of the sectors during this 40-year period when value added is taken as the measure

of output, and grew even faster if gross output is taken instead. Real wages also rose, and

total factor productivity grew almost as fast as labour productivity. Relative to the quantity

of raw materials processed, labour and capital inputs both fell, especially labour; the idea

that capital substituted for labour was not supported by the data. When high and low

capital- or machinery-intensity sectors were examined separately, larger changes were

found in the more intensive ones, but the differences were small (Sokoloff, 1986).

Increased productivity was due to a combination of:

introduction and diffusion of machinery;

increase in capital intensity (improvements not reflected in the price of capital);

changes in work organisation;

realisation of scale economies;

learning by doing;

impact of expanding markets (loss of inefficient producers and stimulation of technical

innovation).

It is noteworthy that such refinements as limited liability were not important features of

these sectors during this period.It was also found that in most of the sectors, the price index fell by approximately 40%.

Taking all the evidence together, the concept of reducing real costs describes the process

extremely well, in that the input resources and the price index both fell. A caveat is that

intensification of labour could have contributed to these changes, and that does not fall

within cost reduction.

A much more recent source of evidence is from the development of the retail sector in

developed economies. Wal-Mart in particular has been subject to detailed research.

Findings include the observation that Wal-Mart prices are typically 5%48% less than

prices for the same product in supermarkets and other conventional retail outlets

(Hausman and Liebtag, 2005). Also, a Wal-Mart store opening reduces county-levelretail employment . . . each Wal-Mart worker replaces approximately 1.4 retail workers . . .

(Neumark et al., 2007). It would be possible to discuss these findings in terms of welfare

balance, that the former is good and the latter is bad, but if the purpose is to understand the

causal processes (positive economics) the conclusion must be that a decrease in labour

costs and in price both reflect a tendency for the same service to be provided with lower

inputs.

An objection to this perspective could come from the observation that modern

corporations in the developed world rarely compete on the basis of priceor less

superficially, of costs. This is true, and reflects the historical process that has shifted

cost-cutting competition in internationally tradable items to lower cost countries such as

China. This leaves cost-based competition in such non-moveable sectors as retail andairlines. A second possible objection, specifically to the notion of the reduction of costs,

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could be that inflation has been a more prominent feature of modern economies, but this

would be to confuse money prices with real resource inputs.

3. An institutional explanation of capitalist dynamism

Why has the emergence of the firm as an institutional form led to the observed continual

reduction of real resource inputs to produce a given unit of output? Why has it also led

to an unprecedented profusion of new products? And how are these two processes

related?

The answer to the first of these questions at least is to be found in the nature of

the competitive relationship between the heterogeneous firms that constitute

a sector of capitalist production. There are two necessary conditions. First, firms

have a stable existence beyond the individuals who constitute it at any given

moment, enabling all stakeholders to have good grounds to trust in its future

continuation. Secondly, firms have two key types of flexibility, in the size of the

market that they can supply and in the combination of inputs they can bring

together. Stable existence allows agglomeration of capital, and flexibility allows

manipulation of the scale of production and of costs, which in turn imply control

over the productive methods. They also facilitate control over the product, and

therefore the introduction of new and/or better products.

3.1 The process of competitionthe relationship between firms

When firms enhance their competitiveness by reducing costs, they not only enlarge their

own existing markets but also partially or completely take over the markets of other

producers, whether these be sole traders or other firms. The same occurs with theintroduction of a successful new product, if it replaces a previous type of product produced

by a competitor. Outside the capitalist system this happens to only a minimal extent: in

a sector of petty producers who supply a particular level of effective demand, if one of them

manages, for example, to improve his onion crop or to become a superior shoe repairer, he

will prosper but is unlikely to displace the others and take over their markets. This is

because his output capacity is limited by the extent to which he can expand his inputs;

a sole trader is limited in a way that a capitalist-type firm is not.

Capitalism is thus a power struggle between competing firms. Central to its operation is

conquest by economic means, in which the weak are vanquished. One firm can replace

many of its competitors as it grows in size to become the corporate equivalent of an

empire.7

7 This process does not require increasing returns: the extension of scale can in principle occur withconstant returns. In practice, however, a large proportion of the examples of capitalist growth do involveeconomies of scale, accentuating the growth in firm size. In addition, increasing market size (buying power)facilitates a greater division of labour (specialisation) between firms, promoting cost-reducing investment thatwould otherwise not be justified. This generates increasing returns, even without intra-firm economies ofscalelarge rather than large-scale production (Young, 1928). At the whole-economy level, aggregateproduction volume determines the size of the market, introducing the possibility of cumulative causation(Young, 1928). This would accentuate the process described here, but to produce self-sustaining growth itwould require an additional element; the suggestion that elasticity could generate a chain reaction ( Young,1928) is insufficient to do this in the absence of a rise of total income, which requires induced investment to

reduce costs (Kaldor, 1972). Furthermore, the suggestion that an increase in the volume of production canincrease productivity (Verdoorns Law) has received empirical support (Harris and Lau, 1998), and thiswould also impart an additional impetus to the process described in this paper.


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More precisely, it is a struggle between firms of different relative strength, as the power

relationship can exist with no direct contact, for example a firm in Uruguay, Italy or

Zambia can go out of business simply as a result of cheaper Chinese imports. The system is

driven not only by the stick of possible extinction, but also by the carrot of possible success,

the fate of a firm being determined by its long-term profitability. It is universally agreed thatthe incentive to make a profit is critical to the future health of the firm, so much so that it is

better described as its central imperative.

It is one thing to have incentives, but the ability to respond successfully is also necessary.

The crucial questions then are, what are the sources of a firms strength, and what are the

consequences of differential strength of firms? Heterogeneity is central here: differences

between firms are inputs to and outputs ofcompetition; for empirical investigation of this, see

Haltiwanger (2000), Bartelsman et al. (2004) and Foster et al. (2008).

Firms bring different qualities to the process of competition. Where competition is

primarily through inputs and production method, the source of strength is the ability to

achieve lower costs than competitors. Unlike many power-based interpretations (Wil-

liamson, 2000), this one is non-tautological. A different source of strength is the ability to

produce a superior new product or a quality improvement that finds favour in the market.

This ranges from major product innovations such as sewing machines or mobile phones to

minor features that have product differentiation as their main aim, achieved by

a combination of branding and marketing (Chamberlin, 1933).

In turn the outcome of this process affects market structure. As has been widely

recognised, especially by evolutionary economists (Nelson and Winter, 1982; Dopfer,

2005), firms vary in the extent of their profit, resulting over time in the disappearance of

some firms and differential success among the survivors (Cabral and Mata, 2003;

Bartelsman et al. (2004).

High profitability increases the firms ability to invest and to attract high quality staff,altering its inputs so as to extend its market. The most successful firms in making a profit

have a corresponding advantage in the next round of competition, so that capital

accumulation is both a result and a cause of the firms growth in economic strengtha

positive feedback loop operating over time. Taking both these ends of the spectrum of

profitability, it means that if a market starts out as perfectly competitive, the operation of

competition systematically erodes its perfection.8

The process depends on the intensity of competition, i.e. the extent to which a firms

profit margins are threatened by the actions of its competitors. This can occur in a sector

with many or few firms, or even with only one but where new entry is possible. The

intensity can vary, for example, in the data from the American Northeast referred to earlier,many of the changes (at least in the later stages) may have been driven by the increased

effectiveness of competition brought about by the proliferating railroads.

Intensity of competition should not be confused with perfect competition in the sense

of multiple small firms, all of which are price-takers. Capitalist growth has occurred both

with this scenario and in oligopolistic settings, and large innovative leaps can occur in

sectors with relatively few large firms (Chandler, 1992) or in sectors with many

independent start-ups as in the recent growth of web-based businesses.

8 This is not a new observation: the process of concentration was known to Marx and Veblen, amongothers.

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3.2 The key properties of firms: continuity and flexibility

Firms can compete successfully if they not only continue to exist in the long-term, but also

are able to build lasting organisations with the ability to commit capital for extended

periods of time, allowing large-scale investments and the development of specialised

knowledge, relationships, reputation, etc. A necessary condition is that organisations are

allowed to have a continuing existence, independent of their members. The state, as it

developed in medieval western Europeunlike, for example, in the Islamic world ( Kuran,

2004)allowed and even fostered independent organisations with corporate legal status.

These took many forms, including cities, religious orders and universities. Eventually, this

corporate tradition led to the development of the capitalist firm, with its distinctive

economic attributes.

Long-term investment depends on the firms ability to provide a form of inheritance that

transcends individuals and families. This has been facilitated by development of legal

frameworks giving firms the status of a singular legal person that could trade as an entity in

its own right, the main practical purpose being entity protection (Blair, 2003; Hansmannet al., 2006). As a result, they are largely protected from sequestration by others, including

the state and those who might sue, and are also protected from their own share-

holdersthe mirror image of limited liability, the protection of participating individuals

from the debts of the firm, which has traditionally received more attention but which may

have played a less important role (Blair, 2003; Hansmann et al., 2006).

Entity protection has also allowed the separation of governance from the contribution of

financial capital (Blair, 2003), typically putting a small designated group of directors in

charge, and the combination of this with entity status has facilitated what Chandler has

called organizational capabilities (Chandler, 1992). Company law has altered greatly as

capitalism has developed, the changes tending to have been driven not primarily by legalinnovation but rather in response to the requirements of business people, industrial

capitalists in the case of entity protection (Blair, 2003; Hansmann et al., 2006) and

subsequently rentiers in the case of limited liability (Ireland, 2010).

The corporate form in its many varieties together with free labour, i.e. workers who have

been dispossessed or freed from their own means of production, make the employment

relation a dominant characteristic of capitalism. This allows the capitalist firm to exist in

protean manifestations: together with the firms ability to agglomerate a large quantity of

capital, the source of its material strength, some firms grow to enormous size, whereas others

are tiny. This flexibility in size is what enables imperial firms to replace large numbers of their

competitors, as with a chain-store and local retail outlets, contrasting sharply with non-

capitalist systems. It resembles the military conquest of an area farmed by smallholdingsfollowed by the establishment of latifundia, except that the conquest is achieved by economic

means, and understanding how this works is key to any explanation of capitalist dynamism.

Firms are able to do this because of another aspect of flexibility: what resources they use,

how they use them, and what they are used for. A firm can alter its inputs, notably the

number and type of workers, wage rates etc., and/or introduce a new production process,

to try and maintain or enhance its market position by reducing costs. If not limited by, for

example, legislation and/or trade union power, workers can be hired or sacked with little

notice, and their wages can be driven down as far as market conditions allow. Alternatively

a firm can introduce new products more easily than other organisational forms can,

because of flexibility in opening and closing plants, radically altering the nature of theirworkforce, and so on.


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These options are not generally available in other ways of organising production. The

only way that a petty producer, such as a handloom weaver in early nineteenth century

England, could reduce costs was to pay himself lower wages, and the same is true of

present-day sole traders such as peasant farmers. Their flexibility in the number of workers

is typically limited by their family circumstances, and they are similarly limited in theirchoice of production methods. Traders (merchants) whose costs are dominated by the

merchandise itself are in a similar position of lacking flexibility; they can reduce the costs of

their goods only if they are able to put pressure on existing suppliers or to source from

a cheaper one, and they may also be able to reduce other costs such as those of transport,

for example. In a world of petty production and trade, change is therefore mainly

incremental. Traders largely take the stock of product as given, with only an indirect

influence via suppliers willingness to supply. Petty producers are similarly limited by the

stock of their materials, labour time, skills and production methods.

In contrast, the scope of a capitalist firm is limited only by the abilities of the people who

are taking the initiative: their imagination and competencemanagerial capacity (Penrose,

1959)and their access to resources. These resources include the availability of

a workforce with particular types of skill and other types of tacit knowledge, as well as

equipment and other more tangible assets. The ability to buy in the appropriate range of

labour and equipment is central to capitalist firms success.

Thus, capitalist firms have direct control over the volume of production, not being limited by

fixed stocks of product, skills, etc. as petty producers and traders are, as long as they can

purchase what is needed. The degree of flexibility varies from firm to firm, from sector to sector

and in different historical times and places (e.g. for institutional reasons). But the unifying

feature of capitalist production is that across all the dramatic changes that have occurred, for

example in market structure and in the role of science and technology, it is composed of firms

that have this characteristic of potential flexibility both in scale and in inputs.These key properties of the firm not only span the different organisational forms that

have occurred in capitalist societies, but are also compatible with different types of

ownership. Even the public sector, as with township-village enterprises in China (Qian,

2003) and state-owned enterprises in Vietnam (Ngu, 2002), can function as capitalist

firms if they are allowed to do sothis is the main difference from pre-reform

organisations, and from the factories of the former USSR. Intermediate forms also exist,

for example cooperatives, which have some similarities to capitalist firms but may be

expected to have less flexibility and which have been observed to have lower growth rates

(Gagliardi, 2009).

It is also sometimes possible for firms to control their supply chains sufficiently tohave the same characteristic of flexibility. This has occurred in retailing, for example, so

it is not simply a question of direct control over employed labour in a hierarchical

authority structure (Cox et al., 2002). It may be that the ability of supermarket chains, for

example, to dominate their suppliers itself originated in their ability to reduce costs,

thereby enabling them to attain a powerful position in relation both to competitors and

suppliers.

3.3 Motivation and consequences at firm level

The central role of profit in the success of the firm does not imply that profit

maximisation is necessarily operating as an aim: it is possible that a firm aiming to maximiseprofit could be less successful than one that does not, if the latter firm has other attributes

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that give it an edgethe outcome of competition is a matter of consequences not of

motivation.

The distinction between motivation and consequences is important more generally.

Motivation, the combination of carrot and stick, is central for the individual firm.

However, to understand the causes of growth we need to focus also on the consequences,both at the level of the firm and at the aggregate levels of the sector and the whole economy.

A parallel distinction underlies the structure of Adam Smiths argument that differentiates

the motivation of the trader from its consequence: 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 (Smith, 1776).

The unintended consequences at the level of the individual firm arise simply from its

being in business, and are contributions that it makes to the wider economy. Among the

most important are:

provision of goods and/or services;

generation of profit and therefore accumulation of capital;

employment of workers and payment of wages, thereby providing buying power for

other companies products.

Simple aggregation applies here, that the economy-wide consequences are simply

the sum of the firm-level effectsexcept that in the case of wages, a lower wage bill

helps to keep costs down, benefiting the individual firm, whereas a higher wage bill

contributes more buying power to other sectors of the economy, a form of

externality. But at the aggregate level, unintended consequences give the system

its distinct properties.

3.4 How cost reduction worksthe sector level and the wider economy

Each firm pursues lower unit costs, attempting to maintain and improve its competitive

position. Other firms in the same sector are similarly engaged, so that profit margins are

constantly squeezed by the successes of ones competitors. An arms race takes place,9

aptly described by Lewis Carroll as running as fast as one can in order to stay in the same

place (the Red Queen effect; Carroll, 1872).

A firm can use many different types of strategy to try and reduce its unit costs. Taking the

example of a manufacturing firm (the question of generalisation outside manufacturing

will be considered later), these include:

9 In a literal arms race, the military expenditure of one country leads its adversary(ies) to respond byincreasing their own military budget, which in turn generates still more spending in the first country, a cyclethat in principle can continue indefinitely. Any temporary advantage an individual country may enjoy isquickly eroded, but at the aggregate level the overall effect is a build-up of armaments. Arms races can be ofa leaderfollower type, in which one country is always in the lead, or alternatively leap-frogging can occur.The concept of an arms race has been widely applied to other situations, and has been especially successful inevolutionary biology (Dawkins, 2009). In the current context, an arms race means that a companysinvestment threatens the profitability of its competitor(s), leading to a response in kind. The analysis putforward in this paper has been modelled in the System Dynamics software package Vensim, generating thefollowing simulations (Joffe, 2009):d with petty production (no control over costs), introduction of a productivity shock produces a step change

in costs but no further changes;d

capitalism (both firms can control costs) leads to an indefinitely continuing fall in costs and prices for bothfirms, which quickly exceeds the initial productivity shock;d with one of each type, the capitalist firm takes market share from the petty producer.


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use of a technology with higher productivity to produce more units with the same

resources;

downward pressure on wages and/or employment levels;

providing poor working conditions, and cutting corners on health and safety;

sourcing of lower cost materials; superior organisation;

mergers and acquisitions with elimination of overlaps;

running at full capacity and thereby minimising fixed costs.

Such cost reduction can involve innovation in a technological sense, but this is by no means

the only method. There are multiple ways, with cost reduction as the final common path.

For growth, the important consequences are at the level of the sector. Each firms cost-

cutting is a contribution to a continual reduction in costs in the sector as a wholealthough

the term contribution should not be seen as implying any more benevolence than in the

case of the butcher, the brewer or the bakerit is an unintended consequence of how the

system operates. In this way, a given output requires a constantly falling input of resourcesover successive waves of cost reduction. Just as Smiths hidden hand operates as an

unintended consequence at the level of the market, the firm is here seen as embodying the

emergent property that makes capitalism distinct and, specifically, more dynamic than

other economic systems.

It should already be clear that there are two ways in which this happens: (i) replacement

of the less efficient firms and (ii) survivors behavioural response to lower their costs.

Historically, the greater dynamism of capitalism in each geographical area starts when

other forms of organisation begin to be replaced by capitalist firms that are able to undercut

them, as when the English handloom weavers were driven into destitution by the more

efficient factories in the early nineteenth century.

The process does not end with lower unit costs. A second effect of competition is to exert

downward pressure on margins, so that the price also falls. With the same real wage, the

consumer can now afford to buy more: thus a price fall increases the buying power of

workers in other sectors, making them richer. In this way, cost-and-price reduction in each

sector increases the prosperity of the rest of the economy. In other words, it releases buying

power. Over time, as this process occurs in many sectors, society becomes more

prosperous, the distribution of prosperity depending on the income distribution. After

some decades, the economy is transformed into the mass-consumption type of capitalism

(see Section 4.2 on Staging).

The trajectory of each sector depends not only on this process of ever-greater efficiency,

but also on the market. At the new lower price, the quantity demanded increases until themarket becomes saturated; saturation is superseded when the next round of cost reduction

occurs. In addition, a sector can be affected by exogenous developments in other sectors,

for example, ones that render its product obsolete.

At the aggregate level of the whole economy, the most important unintended

consequences are:

increased buying power as a result of the previous level of consumption now costing less;

capital accumulation;

to the extent that cost-cutting results in higher labour productivity, less labour is

required for the same output, and despite higher quantities being produced, eventuallyis likely to fall for the sector as a whole.

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It is convenient to think in terms of the release of resources from old sectors over time: the

generation of extra buying power and capital, and a tendency for labour to be extruded. In

particular, as industries mature in terms of efficiency, saturation and outdatedness, labour

is released, and unemployment results if new sectors do not become available to provide

suitable new employment opportunities.

3.5 Price-setting and divergence

The above account treats costs as primary, in that lower unit costs mean a firm has greater

strength relative to competitors in that product line, giving it the initiative. It then has an

important decision on how much of the advantage to pass on to consumers, a decision that

jointly determines price and mark-up. It also strongly influences the consequent change in

quantity sold, although this depends on other factors as well, such as marketing strategy.

It would be possible to model the optimal decision in relation to the price elasticity of

demand for the product, but in the real world the firms future success depends on its

strategic planning under conditions of radical (Knightian) uncertainty. The best decision

may in fact be quite different from the static optimum, as is illustrated by the possibility of

such strategies as predatory pricing and the use of loss leaders. This perspective therefore

provides a starting point for a causal account of how prices are set by the firm that has the

initiative, one that requires the dynamic Red Queen context of real competition as

a process to be considered, not a short-term optimum. It explains why Smiths idea of

a natural price, around which actual prices fluctuate but to which they always tend to

return (Smith, 1776), does not apply to capitalist systems; rather, the price level is

constantly falling in real terms.

More generally, this approach departs from the neoclassical focus on convergence. In the

case of profit rates it predicts a divergent force, corresponding to firms heterogeneity in theoutcome of the competitive process, which counteracts their well-known tendency to

converge as capital flows towards more productive uses. The latter on its own would

predict tight clustering around zero, the average return on capital, whereas the observed

distribution is rather widely dispersed (Farjoun and Machover, 1983).

4. Generalisability

4.1 Other strategies and their consequences

The introduction of new products has similar properties to cost reduction, in that theresults differ at the level of the individual firm and in the aggregate. When a firm

successfully introduces a new product, a new pharmaceutical for example, it has

a temporary monopoly and consequently earns a good level of profit (Schumpeter,

1942). This lasts until other firms manage either to imitate the product, which depends on

the institutional and legal context such as patent law, or to produce something that in turn

supersedes it. Once the patent expires, we are back in the cost-cutting world, in this case of

generic drugs.

Within a particular line of business, therefore, at the aggregate level firms once again find

themselves in an arms race. The result is a profusion of new productsthis leads to

expansion in product diversity and, in due course, supersession of obsolete products. A

similar process operates for products of superior quality, leading to an aggregate-levelquality improvement. For example, automobiles have become more reliable over time, as


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well as accumulating various features including alarms, central locking, remote locking,

airbags, satellite navigation systems, etc.10

However, not all the strategies that firms use in their competitive struggle have growth-

promoting aggregate effects. Those that primarily involve market share of one firm as

against the others in the same sector, such as brand loyalty, do not contribute to aggregategrowth. It is the difference between non-zero-sum and zero-sum games. Thus it is

important not to confuse the range of profit-generating strategies open to firms with the

range of processes that contribute to growth; the latter is a subset of the former. It is

a mistake to equate a firms success with a long-term contribution to economic growth.

4.2 Staging

Of the two major sources of growth, cost reduction can be regarded as primary because it

does not require any other process to make it possible. In contrast, new products would be

difficult to introduce were it not for the release of capital and labour, and especially of

buying power, that cost reduction makes possible. This may be a major reason why product

innovation becomes so vibrant as capitalism takes hold. The relationship between the two

types of process is analogous to the way that non-agricultural occupations were able to

increase during the Middle Ages, because increasing agricultural productivity meant that

not everyone was needed to produce food and fibre.

This analysis suggests an important distinction between the mode of operation of early

(or low-income) capitalism and late (or high-income) capitalism (Solow, 2006). For

countries that have not yet embarked on self-sustaining growth, the former is more relevant

as it is the usual source of catch-up growth. In this early version, costs dominate: it is the

relationship of productivity to costs that provides the opportunity to embark on growth. At

this initial stage, downward pressure on costs greatly restricts wages in capitalistenterprises, so that workers incomes do not rise; regimes tend to be authoritarian,

maintaining order. (The converse is not necessarily true: only a sub-set of low-wage and

authoritarian societies manage to have a high productivity to cost ratio, and thus

a competitive advantage that leads to convergence with the already-developed world.)

Then later in the process of growth, this advantage is gradually eroded by rising per capita

income.

Growth typically starts with the appearance of capitalist firms in a small number of

sectors, sometimes in only one. Firms cost advantage quickly leads to their dominating the

sector(s). As real input costs and prices fall in each capitalist sector, the release of buying

power in other sectors provides an economic linkage between sectors. It may be that the

difference between economies with self-sustaining growth and those with transient growth

accelerations (Hausmann et al., 2004) is such that a critical mass is reached. However, this

effect of buying power only operates in the presence of capitalist production, as is

illustrated by its failure to happen in seventeenth century Netherlands, despite an

embarrassment of riches (Schama, 1987).

We have already examined the evidence of how this process operated in the USA

(without the authoritarian regime in that instance) in 182060. More recent examples

include the East Asian tigers starting in the 1960s, and subsequently other parts of eastern

10 In addition, as a corollary of the abundance generated by capitalist production, the limiting factor

becomes ability to find markets for the product. This can lead to the creation of products with an artificiallylow life-span, e.g. by fashion, built-in obsolescence, etc. This could be seen as reducing quality, therebyintroducing a countervailing force.

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and southern Asia. Their catch-up growth has some important characteristics: usually they

started after the introduction of policy measures that were pragmatic, outward-looking and

included a major strategic role for the state. It is clearly an important research task to

understand which features of such measures have been effective. They were seldom

introduced using textbook economicsindeed the wrong relative prices were deliberatelyinduced in South Korea (Amsden, 1989). And textbooks have learnt little from their

dramatic successes, although there have been attempts to interpret the evidence from the

viewpoint of neoclassical economics (Rodrik, 2007).

The export orientation of these countries means that they could establish and

maintain very high growth rates: effectively they have been able to import the buying

power of the rich world. In addition, they imported technology from more advanced

economies. This was fully paid for, so that improvements not reflected in the price of

capital (Sokoloff, 1986) were not prominent. The implication is that technological

progress occurred without a rise in total factor productivity (Lipsey and Carlaw, 2004).

This could explain the observation that global economic growth in recent decades has

mainly occurred in two clusters: one with physical capital growth in certain regions, and the

other with total factor productivity growth plus an interaction of initial human capital with

physical capital growth (Durlauf et al., 2008). The latter would appear to describe the

already-developed world, whereas East Asian catch-up growth has been characterised by

rapid capital accumulation, plus growth in the quantity and quality of labour input,

without an increase in total factor productivity (Young, 1995; Felipe and McCombie,

2003).

High-income capitalism, on the other hand, is innovation-based and occurs where

human capital is high. Investment is characterised by innovative methods of productive

technique and/or organisation, and new or higher-quality products are commonplace. In

the societies where it happens, several features have already become established, most ofthem being consequences of earlier capitalist growth. They include a tendency to oligopoly,

highly developed science and technology and economies of scale (Penrose, 1959; Baumol,

2002; Reinert, 2007), together with the small-family, high-human capital pattern that

emerges following the demographic transition (Galor, 2005). Each imparts an additional

impetus to capitalist growth, a positive feedback loop, which has led some observers to

attribute capitalist dynamism to one of these features.

4.3 Generalisability outside manufacturing

The above description is based on manufacturing, but may well be more general, invitingthe question, what other sectors have similar properties?. The historical record shows that

agriculture has followed a path similar to industry, at least in rich societies. The

development of retailing makes it clear that a similar dynamic must be operating in this

sector too. The example of Wal-Mart has already been referred to, and in earlier times

similar processes led to the rise of chain stores and supermarkets in America, Europe and

elsewhere. Such developments are continuing, with the rise of internet-based sales

companies such as Amazon.

The example of retail corporations such as Wal-Mart in using cost-cutting provides

a clear illustration of a principle that is quite general: their increase in market powerto an

extent that approaches monopoly in many locationsgoes with lower not higher prices.

This reverses the conventional logic found in mainstream economics, that givena monopoly position a firm will extract higher prices; whilst that is true, it does not allow


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the root causes of growth under capitalism

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