Sunday, August 05, 2007

The Limitations of Capitalism

Capitalism broadly stands for the system of beliefs in efficiency of self-controlled markets. The central tenet of capitalism seems to be “leave the markets alone” to the extent possible. The expectation in turn from markets is to send the right signals to right parties and to allocate resources in the most optimal manner. It is possible to debate in detail the shortcomings of this expectation as has been often shown empirically. However, I do not wish to expound on market failures. Because a study of market failures starts with the underlying assumption that markets are expected to work everywhere and then we are studying where they did not. My disagreement is with this belief. I am revisiting the more basic question of the mechanism of resource allocation.

What has prompted this is the two sided worry of the misuse of this system by the capitalists and the inadequate attention the underprivileged get in even a well functioning capitalist economy. On the former, the answer from the believers in capitalism is often in the form of regulatory frameworks built and run by the state. The response to latter is that the capitalist societies have often proven to be less hostile in treating the underprivileged than any other system. Both of these are attempts to arrive at solutions from within. However, my intuition tells me that the fundamental forces at work in a capitalist society are very likely to make both of the above basic flaws in the capitalist system and not merely ineffective operationalization of its principles in specific contexts. Take India for example. The advent of capitalistic orientation in policy making has certainly resulted in great many developments. License control raj is receding. There is greater common good being served by competition amongst private enterprises and at times even public ones. Now the question is how reliable is the hope that the effects of these developments are finally going to trickle down to the downtrodden. Also how real is the hope that eventually Indian enterprises are not going to behave like Enrons of the west. Over and above all of this, there is growing concern that materialistic progress alone will leave us as much at the risk of loss of purpose as today’s west. Can we look to evolve a better system of governance and socio-economic organization? Can we target the right parameters as measures of our success? Can we make the growth to developed country status an endeavor broader than one limited to upper middle class?

Why have markets failed India’s poor? The opportunity at the bottom of the pyramid is too risky and the risk return trade off at the top of the table is much more alluring. The enterprise with its focus on making profits can do so very well near the top of the pyramid. Only those with some dependence on bottom of the pyramid populations are making any active efforts in that direction. For others the charity through CSR is enough. There is huge amount of money and resources being deployed at the top of the pyramid in catering to the needs of the well off while the poorer sections are left without even most basic of services. Market failure anyone?

Markets will not get there. Not in the current form. The farmer suicides are an example. The revolutionary tides from the poorer sections will probably sweep the top of the pyramid sooner than the trickle down can take effect in an appreciable manner if at all. The ecosystem of the modern day economic relationships in India is very much in favor of the established ones. It also favors the gifted individuals from amongst the poorer sections. However, the large majority with little extra-ordinary talent can take or leave a limited range of options. You can do white collar jobs or take up a blue collar job if you are in the city. However, if you live in village, you can try your luck at agriculture or a small local service sector or else join the daily laborers bunch. If I am to be a profitable enterprise, I have to make the laborers work at the minimum wages possible in the given demand supply scenario. By the looks of it, the labor supply in India in the unskilled sector is going to be fairly large for a long time to come. Given this, it is unlikely that the real wages of Indian laborer in village or in city will rise in a big way. On the other hand a small section of the lower middle class is moving up through exhibition of its skills. I belong to this group. I have come much farther than any of my cousins. They send me their CVs to apply for jobs which are lower end of the white collar ones or at times even the blue collar ones. The markets have little to offer them. My services are useful because of my extra-ordinary IQ. They are not in demand because what they have on offer is rather freely available. Market has not obligation to create opportunities for them or the others who do not even know what a CV means. Market economics would generally put the argument as follows. Over time, the GDP growth would require workers in larger numbers and that would lead to increase in demand and thus higher employment as well as growth in real wages. The standards of living of these laborers will improve because the rich and poor alike would want more goods and services. In the end everyone is better off than status-quo. Agreed. However the comparison is with the status quo. I can compare it with an alternate scenario where the income distribution is such that it brings about highest amount collective utility.

This gets into the question of the relationship between consumption/resources and utility. The general theory I wish to put forward is as follows. Below the poverty line, utility and consumption/resources are directly proportional. As an individual moves up Maslow’s Hierarchy, her needs evolve and non-consumption factors enter the picture. The relationship becomes somewhat non-liner. In this phase, more consumption or asset ownership may not necessarily bring about higher levels of utility. However, for individuals in this phase, the first derivative of income and assets has a more direct bearing on the utility levels. “Moving up in life” has a stronger impact on utility levels than the absolute level of resources and consumption. There is point beyond this level where the consumption and asset ownership becomes merely a hygiene factor and the utility levels are driven very weakly by the change in the resource level. Very many other factors enter the picture the linkage is nearly lost. What one can claim with some degree of certainty is that this section of population would be miserable if it gave up its wealth but the wealth per se does not add to its utility levels much.

The marginal utility of money is more directly observable and shows clearer trends. The poor of course have the highest marginal utility for money while the richest individuals have close to zero marginal utility for money. Unless it occurs in really large chunks, few more extra rupees are not very relevant to the richest individuals. This probably would apply in % terms as well.

Given this, the market will in all likelihood create a rather sub-optimal outcome in terms of the potential utility levels achievable with the given level of resources and the actual ones realized. The actual state realized, even if is the utopia described by the market enthusiasts, will still have large income inequality and instances of extremely divergent marginal utility of money within the system. What the utopia manages to achieve effectively is a beautiful machine which is probably stable, very elegant in its operations but has unhappy cogs with little choices but to be part of the machine. The market system can in its simplest form have say 10 companies providing goods and services to the economy. These companies employ 90% of the working population while the remaining 10% own the companies. Depending on the relative scarcity of labor and capital, the owners will earn more or less than the workers. If history is any guide, the owners will earn lot more than the workers since the owners always have an option of working should they realize that they earn less as owners. This system is stable. But assume that the labor supply is such that the real wages are 1/100th of the return on a unit of capital for the owner. In essence, the owner can spend her money in spas and collectible item purchases while some children in the remaining 90% could be dying of malnutrition. The rich owner can once in a while have some pangs and pay for a few kids’ food and education and donate to some trust somewhere. The general trend however remains that the laborer is selling her time and skill and will get a price from the capital owner in line with the demand supply dynamics of the market. While the market may be a good answer to the general price discovery, applying the same principle to the incomes of a large majority of individuals participating in the market is flawed.

Market implies that the owners treat employees indifferently and strive to make a profit by offering goods and services to customers. The market economy is a well oiled machine to get the manhours from the employees, the capital from the owners and put it together to create goods and services which people in turn pay for out of their returns on time and/or capital. The system does seek stable optimality. The issue is that it seeks a systemic optimality which seems to be an end in itself. It ignores the individuals which are the whole point of it anyway. It is also structured too much in the manner of buyers and sellers – which in the end does not always lead to a socially stable and optimal result, when viewed in terms of utility. It is a system very much in favor of capitalist today since the stage of socio-economic evolution that we are in is characterized by a strong tilt of balance in favor of capital. Maybe if the tables were turned and capital was too widely available and labor is scarce, the returns on labor might exceed the returns on capital. The point however remains that the results of the market mechanism are always a good result from the point of view of systemic optimization. It does not incorporate explicitly the fact that ultimately the economic system is a means to an end which is furthering human happiness. It is a marvelously stable solution to an optimization problem that human economics is. Whether it is human enough a solution is unclear.

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