Lesson 1 – Defining Terms: Poverty and Capitalism, Part 2

Part 2: Capitalism: Institutional Building Blocks

Download Lesson 1 .doc file – includes all figures, source citations, and appendices

Part 1:  What Is Poverty? and Who Are the Poor?

Concepts

• market
• entrepreneurship
• rule of law
• incentives
• property rights
• limited government

National Voluntary Content Standards in Economics

The background materials and student activities in lesson 1, part 2 address parts of the following national voluntary content standards and benchmarks in economics. Students will learn that:

Standard 4: People respond predictably to positive and negative incentives.

• Acting as consumers, producers, workers, savers, investors, and citizens, people respond to incentives in order to allocate their scarce resources in ways that provide the highest possible returns to them.

Standard 10: Institutions evolve in market economies to help individuals and groups accomplish their goals. Banks, labor unions, corporations, legal systems, and not-for-profit organizations are examples of important institutions. A different kind of institution, clearly defined and well-enforced property rights, is essential to a market economy.

• Property rights, contract enforcement, standards for weights and measures, and liability rules affect incentives for people to produce and exchange goods and services.

Introduction and Lesson Theme

The prevailing image of a “capitalist” may be an American businessman, but a survey of the world’s economies reveals that, like poverty, capitalism has many faces. “Capitalist” is used, in either praise or condemnation, to label many nations, and the label is claimed –whether deservedly or not – by many more. To begin a systematic analysis of whether capitalism is good for the poor requires a working agreement on just exactly what capitalism is.

In the last half of the 20^th century, courses in “comparative systems” were found in many universities, and high school textbooks routinely had chapters bearing that title. The content typically consisted of comparing and contrasting capitalism, communism, socialism, and, occasionally, fascism, each of which was conceived of as a discrete entity or “system.” Unfortunately, the usefulness of the paradigm decayed in the face of the persistence with which actual economies crossed the lines between systems.

For example, the standard textbook definition of capitalism as “a market economy in which the means of production are privately owned,” raises more questions than it answers:

• Must ALL production be private?
• Is the United States truly a capitalist economy when mass transit services in most cities are publicly funded, and 1^st-class mail is delivered by the federal government?
• How could the Soviet Union have been considered truly “communist,” when peasant farmers were allowed to sell their garden produce in open markets?

Additionally, the traditional conception of “systems” was unwieldy because it incorporated the political and governmental characteristics of nations, often without specifically addressing how those characteristics altered economic institutions.

Using an institutional definition of capitalism allows us to avoid the problems of a one-size-fits-all definition. Using the framework of institutional economics, developed by Nobel laureate and economic historian, Douglass North, allows us to identify specific institutional components of capitalism and to analyze their characteristics in particular times and places.

We begin, therefore, by asserting that capitalist economies share an identifying set of institutions, whose different manifestations in practice have a similar foundation. While it may take some careful looking to see the similarities underneath the striking differences between such places as China and the Netherlands, the United States and Uganda, or India and Argentina, these similarities do exist.

The hallmark of capitalism is the existence of a particular set of institutions governing the production and exchange of goods and services. Elements of capitalism are found in almost all nations, but the forms and degrees of capitalism vary widely.

As in part 1, the purpose of this background outline is to set the stage for the investigation by creating a common vocabulary to facilitate future discussion of poverty and capitalism.

Key Points

1. Overview: In addition to U.S. capitalism, other current and recent forms include:
   • Chinese (communist) capitalism
   • western European capitalism
   • former-Soviet republics capitalism
   • African (dictator-based) capitalism
   • The different forms share similarities and manifest significant differences.
     • Capitalist economies share a set of key institutions. However, the characteristics of the shared institutions vary greatly from one capitalist country to the next
     • In their differences lies the explanation for their differing levels of success in reducing poverty.
2. Key terms and concepts:
   • Institutions are the established behavior practices and patterns upon which the life of a community is built. Nobel laureate and economic historian Douglass North calls them “the rules of the game.” They are fixtures of people’s interactions with one another.
     • Formal institutions, like constitutions and statutory law, codify the rules under which the members of the economy interact.
     • Informal institutions and expectations of behavior are at least as important as formal institutions.
       • Doug North argues, in fact, that informal institutions may exert even more influence over behavior than formal laws. Laws may have little ability to shape behavior if they do not match up with informal but ingrained cultural and social norms.
       • Additionally, while formal laws may be changed at any time, informal institutional arrangements tend to be persistent and change very slowly.
   • Institutions influence behavior by shaping incentives.
   • Incentives are rewards and punishments for behavior.
   • Economists have long recognized that people react to incentives in predictable ways. Incentives, rather than nebulous forces like “national character,” explain observable patterns of economic decision-making.
     • North argued, by way of illustration, that if a nation’s institutions rewarded piracy, for example, then its people would face incentives to become pirates – and would do so in greater numbers than in nations without such incentives, regardless of their cultural background.
     • He also argued that institutions are not neutral: that different institutional forms may give advantages to different groups. Because that is the case, the “players” in the economy realize that changing the rules can give them an advantage, and thus they will devote resources to effect those changes.
       • Organizations such as political parties, companies, trade unions, and bureaucracies want to survive and benefit in a given institutional setting, so they will invest in trying to change the rules to increase the benefits they receive from the system. (Grossman)
       • In this sense, we must recognize that economic institutions are not immune to politics. Although Is Capitalism Good for the Poor? concentrates on the functioning of economic institutions, it is important to remember that economic institutions do not operate independently and that they are always constrained, to a greater or lesser degree, by political and governmental institutions.
3. The common set of institutions shared by capitalist economies is:
   1. markets – institutions governing voluntary exchange;
   2. entrepreneurship – institutions governing risks and rewards of organizing resources for production;
   3. property rights – institutions governing the ownership, use and transfer of private property; and
   4. the rule of law – the extent and limits of authority and privilege.
   • The characteristics of these institutions vary greatly from country to country.
     • The result is a broad spectrum of “capitalist” practices, some empowering the poor, and some holding them back.
4. Analogy: Institutions are the threads in a nation’s “social fabric.”
   • Like cloth fabrics, a social fabric is constructed of interwoven threads. Cloth threads are cotton, linen, wool, or synthetics; the threads from which a “social fabric” is woven are institutions.
   • This analogy also helps us to explain the variety in capitalist economies. Consider that even cloth fabrics made from only one type of thread may look and feel different. Cotton thread may be spun in different ways – bulky, thin, smooth, or rough – and the resulting cloth has a distinctive look and feel.
     • Similarly, any single capitalist institution (markets, private property, rule of law, or entrepreneurship) may take on various forms, depending on factors such as the culture, government, and history of the nation.
       • Markets, for example, differ in the extent of regulation and openness.
         • At one end of the spectrum are Hong Kong’s virtually unregulated markets, which provide almost all goods and services.
         • In Western Europe, markets provide most products, but the government provides health care, and many forms of communication and transportation.
         • At the other end of the spectrum, China’s markets provide few products; they are restricted to agriculture and a few government-selected manufactured goods.
5. The historical record shows that the success with which a capitalist economy deals with poverty depends on the institutional forms it adopts. Some forms of capitalism have successfully generated the economic progress that alleviates poverty. Others have failed to do so.
   • In successful capitalist nations, the institutional threads have the following distinctive characteristics:
     1. Property rights are clearly defined and secured.
        • The definition of property rights includes individuals’ rights to self (labor) and possessions
     2. The rule of law prevails within a framework of limited government
        • Note that just having democratic political institutions is not sufficient to satisfy this requirement.
     3. Markets are open and competitive.
        • Competitive interaction creates an ethic in which individuals’ choices have consequences.
     4. Entrepreneurship is fostered by incentives to invent, innovate and produce.

Conclusion

The student activity “Will the Real Capitalism Please Stand Up?” is a small-group discussion exercise to familiarize students with the range of capitalist economies, and to give them practice in identifying the institutions – markets, entrepreneurship, property rights, and rule of law – that form the foundation of capitalism.

The next 4 lessons in Is Capitalism Good for the Poor? investigate the operation of the distinctive capitalist institutions found in nations experiencing economic growth:

• Lesson 2: Property Rights and the Rule of Law
• Lesson 3: Beneficiaries of Competition
• Lesson 4: How Incentives Affect Innovation
• Lesson 5: Character Values and Capitalism.

Together, the lessons teach students to use the tools of economic reasoning to evaluate the relationship between capitalism and poverty. The lessons address the prevailing belief that capitalism oppresses the poor and reserves its benefits for the rich. They provide the data and analytical tools for students and teachers to draw their own conclusions and to answer for themselves the question, Is Capitalism Good for the Poor?

Supplemental Materials:

• Classroom Activity:  Will the Real Capitalism Please Stand Up?