Tuesday, June 16, 2009

Economic Renaissance: The beginnings of Capitalism

Despite our images of cigar-smoking robber barons in dapper suits with monocles and shiny top-hats, capitalism actually started out innocuously enough from the poor classes. Prior to capitalism your social status was largely a product of your birth. If you were born poor you were poor the rest of your life. If you were born rich you inherited everything you had through the aristocracy of your family. You were pretty much stuck where you were. Manufacturing was purely a process held in cities by the wealthy and served only the wealthy.

Eventually, however, people in rural communities started having a surplus of people. More people were being born than there were things for them to do. These people had no work in the agricultural community and were denied access by kings and nobles to manufacturing and thus became outcasts in society. Eventually, however, these poor outcasts started banding together to make small shops that would produce something. They didn't produce expensive items that only the wealthy could enjoy but instead produced things that everyone could enjoy. And thus capitalism as we know it today was born.

As celebrated economist Ludwig Von Mises put it "It was mass production to satisfy the needs of the masses."

So capitalism didn't spring forth as the result of a wealthy aristocracy finding new ways to exploit the lower classes but it was a natural extension of the lower classes finding better ways to do things and make them available to everyone. And it was the first time the lower classes would have the opportunity to dig themselves out of the circle of poverty that had gripped the poor throughout history.

But not everyone is cut out for entrepreneurship. Some people don't want to shoulder the risk or don't feel they have the guile or ability to manage a business, others simply don't want to work that hard or take on that much stress. What did these people do? Well, they still sold someone a product but this time that product was their own skill and labor.

This is an important thing to realize because the collective gasp of outrage against capitalism is almost always centered on the idea that the laborer doesn't own the product of their labor, as if they were shackled to a machine and forced to toil for rich business owners. The laborer isn't trying to own the product of his labor, he is merely exchanging his labor for money.

Remember the Principle of Voluntary Exchange? Two parties freely exchange goods or services in such a way that both parties walk away from the arrangement better off. The same applies to labor. Let's consider that the laborer makes pins in a shop for a living. If the laborer toiled in the shop making pins for himself he is not only a pin-maker but a pin-salesmen too since he has to sell the pins to someone else since he can't eat them or build a house out of them. He now has to divide his time between two tasks, even if he's only really good at one.

So, instead the laborer takes his speciality, which is making pins, and sells that speciality to someone else who will be in charge of selling the pins. In fact, that someone else secures all the materials to make pins, furnishes the tools to make the pins, and sells and distributes the pins. All the pin-maker has to do is show up and make them in exchange for money which he can use to feed and shelter himself. The pin-maker walks away from the exchange better off because he got to get maximum profit from his speciality and the pin-merchant is better off because he found someone better than he at making pins and thus could concentrate his efforts on buying the materials and selling the final product (and doing all the accounting so he can pay his taxes to the government). Both parties are better off than when they started.

Let's break it down mathematically, just to clear it up some and really illuminate this wonderful system of exchange. We'll take our two-man pin-making company and use it further.

To keep it simple, let's assume a pound of pins costs $100 to make and a dedicated laborer can make a pound of pins a day. Since labor accounts for around 70% of the cost of a product that means that $70 was required in just what was paid to the employee to produce the product. The remaining $30 is the cost of the raw materials used to create the product.

Now, socially-minded folks think that charging $100 for the product would be fair because the laborer made $70 that day and then added $30 onto it for the cost of the materials to make the pins. In a Marxist viewpoint the laborer owns the product of his labor and an entrepreneur merely exploits the employee by robbing him of his work and then charging more for the product on the shelf.

By this reckoning it is entirely unfair for the entrepreneur to charge more than $100 for his product, even though the entrepreneur also labored for the creation of that product (the money he borrows to buy the capital in order to have a facility and tools in which his employee uses, the procurement of raw materials to be used in the product since raw materials don't buy themselves, and the sale and distribution of the final product since pins don't sell or deliver themselves), under a Marxist system it is proposed that the capitalist shouldn't make any money from this labor simply because he wasn't the one lifting the hammer to build it and thus he hasn't added any value to it.

Well, maybe that's a fair enough assessment. Maybe instead the pin-maker should secure the materials, secure the capital, build the product, sell the product, and deliver the product himself, instead of just giving it over to the capitalist. Now all this work makes the worker not only the producer of pins but also the purchaser, the accountant, the salesman, and the delivery truck driver.

All of this work would require not only a great deal of skill in multiple areas but it would also require him to split his workday to accommodate all these tasks. And for his workday to be equal to his workday from when he was only a laborer working for the capitalist, he is going to have less time allotted to produce the actual product. In this sense, do you feel he should still only charge $100 for his product? He'll quickly fall behind the normal standard of living he might have enjoyed if he settled for $70 and was just a laborer because he is only getting paid for the time spent producing, not the time spent purchasing the materials, selling the product, distributing the product, and finally accounting for all the sales for taxes.

If all those tasks take an equal amount of time, then he's only making $14 for a day's work of working for himself instead of the $70 a day he made simply working for someone else. So the worker has one of three options. He can work much longer hours to produce more, he can raise his prices substantially to make up for his income gap, or he can simply settle for a paltry wage that he probably wouldn't be able to live on because if the entire economy operates that way then the prices remain high while income remains low. This is tantamount to self-imposed serfdom.

So, this is a pretty simple yet effective example about how capitalism works. The idea is that everyone walks away from the exchange better off. In the next installment I'll discuss our plucky pin-maker further and explain how the division of labor makes everyone in a society richer.

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