Unequal scenes, Santa Fe, Mexico City

Unit 1 Capitalism: Affluence, inequality, and the environment

Introduction

Cyril Ramaphosa, the president of South Africa, was born in 1952, in Soweto. At that time Soweto was a poor township whose black residents were not allowed to live in nearby Johannesburg. Under the apartheid system of racial segregation, because he was black, he was excluded from the best schools, healthcare, and even public bathrooms. He had no right to vote.

In 2012, the year Ramaphosa became deputy president of South Africa, he had become the 29th-richest person in Africa, worth more than $700 million.

Under apartheid, in South Africa’s version of a capitalist economy, whites owned the mines, factories and farms that made it the richest country in the continent. Black families’ income per head was a tenth of that of white families, and had been stuck there for 50 years when Ramaphosa became general secretary of the National Union of Mineworkers in the late 1980s.

Resistance to apartheid was brutally repressed by the powerful white minority. At this time the leader of the African Nation Congress (now South Africa’s largest political party), which had been banned, was Nelson Mandela. Later he was to become president, but at this time he was serving a life sentence in prison.

As leader of the mineworkers’ union, Ramaphosa was part of a wave of strikes and community protests in the mid- and late-1980s that convinced many white business owners that apartheid had to go. Eventually, the government conceded defeat, releasing Mandela from prison.

Democracy, bringing the same legal rights, including voting, to people of all races, came late to South Africa. In 1994, South Africa’s first democratic election made Mandela President. Ramaphosa was elected to parliament.

What economic changes have followed?

Ramaphosa’s skills as a strategist and organizer served him well in the business world, now open to all races. He became a major owner of South African companies, including McDonalds.

Abolishing a racially segregated political system had some obvious benefits for the poor. Figure 1.1 shows how the size of the South African public old age pension received by different groups changed over the last 50 years. In 1970, for example, the pension received by a white person was more than seven times that received by a black African person. By the beginning of 1993, just before the first democratic election, all race-based distinctions in pension policy were abolished.

Apartheid and its demise: The value of South Africa’s old age pension.

Figure 1.1 Apartheid and its demise: The value of South Africa’s old age pension.

Murray Leibbrandt, Ingrid Woolard, Arden Finn, and Jonathan Argent. 2010. ‘Trends in South African Income Distribution and Poverty since the Fall of Apartheid’, OECD Social, Employment and Migration Working Papers, No. 101, OECD Publishing, Paris. Note: The names of the population groups are the official South African census terms. ‘Coloured’ is the South African term meaning people of mixed European, Asian and African origin.

The transition to a democratic political system led to economic gains for the black population. Old age pensions were equalized. For the first time, black workers were paid for their skills, which raised their wages. Schooling and healthcare were desegregated. Piped water and electricity became available to many more families. In many areas of the lives of South Africans, the indignities of racial exclusion became a thing of the past.

You might also assume that South Africa has become economically more equal. But what does this mean?

Someone who argued that this was true would point out that differences between the major population groups declined. So, if you took the typical income of a black citizen, it would be closer to that of a typical coloured citizen, which would be closer to that of a typical white citizen.

But inequalities within these groups increased dramatically. Ramaphosa’s personal journey from township to wealth is an extreme example. If we ignore race completely, 15 years after the end of apartheid, overall inequality among families in South Africa was higher—and amongst the highest in the world—than it had been under white rule.

The arrival of democracy with the abolition of apartheid, meant that measured by their political rights all South Africans became equal. But, when we measure what happened to incomes, the population has become less equal. The gap between the rich and the less well off had grown.

Extending our view beyond South Africa, we ask how a new economic system, capitalism, brought with it affluence, inequality, and threats to environmental sustainability as it spread across the world in the last two hundred and fifty years. And how the much later emergence of democracy both reflected and altered the changes wrought by capitalism. We begin with a way to represent affluence and inequality across the world by measuring average incomes. You can place yourself in this three-dimensional visualization of the world.

1.1 Affluence and income inequality

Measuring inequality

We know inequality when we see it—look at the unequal scenes in different parts of the world captured by flying a drone. We can guess that some countries or societies are more unequal than others. The drone’s eye view dramatizes this by showing very rich and very poor neighbourhoods side by side. To be confident in making comparisons of incomes within and between countries and at different periods of time, we use statistics.

Using statistics, we can measure inequality in many ways, but one of the most common is to rank everyone in the world by income, from the richest to the poorest. When we do this, we can organize the information to get Figure 1.2.

World income distribution in 2014: Countries are ranked by GDP per capita from left to right. For each country the heights of the bars show average income for deciles of the population, from the poorest 10% in the front, to the richest 10% at the back. The width of the bar indicates the country’s population.

Figure 1.2 World income distribution in 2014: Countries are ranked by GDP per capita from left to right. For each country the heights of the bars show average income for deciles of the population, from the poorest 10% in the front, to the richest 10% at the back. The width of the bar indicates the country’s population.

GCIP 2015. Global Consumption and Income Project. Bob Sutcliffe designed the representation of global inequality in Figure 1.2. A first version was published in: Robert, B Sutcliffe. 2001. 100 Ways of Seeing an Unequal World. London: Zed Books. See the interactive version of this graph on the Globalinc website.

This is a 3D visualization of global inequality, which we will call the ‘skyscraper’ figure. Countries in the world are lined up from poorest on the left, to richest on the right. For each country, the average income of the poorest 10% is the low bar in the front. The average income of the richest 10% is the higher bar for that country at the back. The width of the bar corresponds to the population.

Take China, for example. Its block is wide because of its large population. Because countries are ordered by average income, the countries immediately to its left and right have similar average incomes. But some have taller skyscrapers at the back, meaning a greater disparity between the top 10% and the rest of the population, whereas others have a less steep profile. China is coloured red, but its neighbours are yellow and green. We explain how the countries got their colours in Figure 1.2a, below.

Measuring income

When we measure something in the real world by applying a rule or set of rules to data, the number we get is a known as a statistic. The most common statistic used to measure incomes is called GDP per capita, and it’s what we used to construct Figure 1.2.

gross domestic product (GDP) per capita
A measure of the market value of the output of the economy in a given period (GDP) divided by the population.

People earn their incomes by producing and selling goods (these are things you can touch, like a loaf of bread) and services (which you can’t touch, but which you buy, like Internet access). Gross Domestic Product (GDP) is the total value of all the goods and services produced in a country in a given period, such as a year. To get GDP per capita, we divide GDP by the population of the country. GDP per capita is a measure of average annual income.

No statistic shows the whole truth, and there are other ways to measure income (tax records, for example). There are also other ways to measure living standards (such as the wage of the person halfway up the income distribution). But GDP per capita has one big advantage: statisticians have calculated it using the same rules for many countries and over long periods of time, sometimes using historical records that go back for centuries.

purchasing power parity (PPP)
A statistical correction allowing comparisons of the amount of goods people can buy in different countries that have different currencies. See also: constant prices.

But, to make Figure 1.2, we also had to do another calculation, which is to adjust GDP per capita so that we can compare countries. We used a technique called purchasing power parity, or PPP for short. Figure 1.2 uses US dollars at 2005 prices at PPP. This adjusts the statistic to reflect what $1 will buy in the local shops, even after it has been changed into local currency.

You might think that measuring only what people earn rather than what they own, and only what money can buy, doesn’t tell the whole story of affluence and inequality. You are right, and in Unit 3 we look at other ways this can be done.

Dissecting the skyscraper figure

In Figure 1.2a, we’ve taken two extreme cases. On the right-hand end is Singapore with the highest GDP per capita of the countries shown. Toward the left end, we look at Niger. We can see how income is distributed within each of these countries. Recall, the income of the poorest 10% is the height of the front bar, then the next 10%, and so on. It’s easy to compare incomes of the rich and poor using this data. We show this in a table, because the bars for Niger are all very low:

  Rich (top 10%) Poor (bottom 10%) Rich/Poor
Niger 3,453 92 37.5
Singapore 67,436 3,652 18.5

This shows that income inequality in Niger is much higher than it is in Singapore, because the gap between the richest and poorest groups is twice as large in Niger.

Dissecting the global income distribution

Figure 1.2a Dissecting the global income distribution

Singapore and Niger

The average income of the poorest 10% to the richest 10% of the population are shown for Niger and Singapore at opposite ends of the global income distribution.

Figure 1.2a-a The average income of the poorest 10% to the richest 10% of the population are shown for Niger and Singapore at opposite ends of the global income distribution.

Skyscrapers

The skyscraper bars in the back right-hand side of the figure are the richest 10% in some of the richest countries.

Figure 1.2a-b The skyscraper bars in the back right-hand side of the figure are the richest 10% in some of the richest countries.

World income distribution in 1980

The poorest countries, coloured darkest red, were Lesotho and China. The richest (darkest green) were Switzerland, Finland and the US. At that time, the skyscrapers were not as tall as they would become by 2014; the differences between the richest 10% and the rest of a country’s population were not as pronounced.

Figure 1.2a-c The poorest countries, coloured darkest red, were Lesotho and China. The richest (darkest green) were Switzerland, Finland and the US. At that time, the skyscrapers were not as tall as they would become by 2014; the differences between the richest 10% and the rest of a country’s population were not as pronounced.

World income distribution in 1990

You can see that some countries changed their ranking between 1980 and 1990. China (dark red) is now richer. Some taller skyscrapers have appeared; in other words, inequality increased in many countries during the 1980s. See the interactive figure to find individual countries, for example, to identify the country with the highest skyscraper.

Figure 1.2a-d You can see that some countries changed their ranking between 1980 and 1990. China (dark red) is now richer. Some taller skyscrapers have appeared; in other words, inequality increased in many countries during the 1980s. See the interactive figure to find individual countries, for example, to identify the country with the highest skyscraper.

World income distribution in 2014

By 2014, many countries had changed their ranking. China had grown rapidly since 1990. But the countries that were richest in 1980 (darkest green) were still near the top in 2014.

Figure 1.2a-e By 2014, many countries had changed their ranking. China had grown rapidly since 1990. But the countries that were richest in 1980 (darkest green) were still near the top in 2014.

Inequality within countries has risen

Income distributions have become more unequal in many of the richer countries; some very tall skyscrapers have appeared. In the middle-income countries, too, there is a big step up at the back of the figure; the incomes of the richest 10% are now high relative to the rest of the population. Compare China in 1980 and 2014.

Figure 1.2a-f Income distributions have become more unequal in many of the richer countries; some very tall skyscrapers have appeared. In the middle-income countries, too, there is a big step up at the back of the figure; the incomes of the richest 10% are now high relative to the rest of the population. Compare China in 1980 and 2014.

Skyscrapers

Norway and the US in 2014. As you can see, Norway has the second highest GDP per capita, but does not have a particularly tall skyscraper; this is because income is more evenly distributed in Norway than in some other rich countries.

Figure 1.2a-g Norway and the US in 2014. As you can see, Norway has the second highest GDP per capita, but does not have a particularly tall skyscraper; this is because income is more evenly distributed in Norway than in some other rich countries.

Two things are clear from the 2014 distribution. First, differences between the rich and the poor are huge within every country—the rich have much more than the poor. And secondly, there are huge differences in income between countries.

Inequality within countries

We can use the difference in height between the front and back bars as one measure of inequality in a country. It is called the 90/10 ratio, for obvious reasons. As we saw, for Singapore it was 18.5.

Using this ratio, we can rank countries by how unequal they are in 2014. In this list, even Norway—one of the world’s most equal countries—is possibly less equal than you imagined.

  Rich Poor 90/10 ratio
Botswana 24,523 169 145
Nigeria 4,449 203 22
India 4,446 223 20
US 60,418 3,778 16
Norway 45,302 8,325 5.4

Inequality between countries

Norway might be the most equal country on this list, but the average income in Norway is 19 times the average income in Nigeria. And the poorest 10% in Norway receive on average almost twice the income of the richest 10% in Nigeria.

This was not always the case. A thousand years ago, the world was flat, economically speaking; although there were differences in income between the regions of the world, the differences were small compared to what was to follow.

Recall that GDP per capita has the advantage of being able to use historical records in its calculation. We have used these figures to create the line graph in Figure 1.3. A line graph is a chart that shows the behaviour of a particular variable or variables over time. The height of each line is an estimate of average income at the date on the horizontal axis.

If you have never seen an ice-hockey stick (or experienced ice hockey) this shape is why we call these figures ‘hockey-stick curves’.

If you have never seen an ice-hockey stick (or experienced ice hockey) this shape is why we call these figures ‘hockey-stick curves’.

History’s hockey stick

Gross domestic product per capita in five countries (1000–2015).

Figure 1.3 Gross domestic product per capita in five countries (1000–2015).

Jutta Bolt and Jan Juiten van Zanden. 2013. ‘The First Update of the Maddison Project Re-Estimating Growth Before 1820’. Maddison-Project Working Paper WP-4 (January). Stephen Broadberry. 2013. Accounting for the great divergence. 1 November. Conference Board, The. 2015. Total Economy Database.

It helps us to understand the big differences between countries today. Some countries—Britain, Italy and Japan in this figure—‘took off’ economically before 1900. They (and countries like them) are far to the right, at the richer end of the skyscraper in Figure 1.2.

But this happened recently. All countries spent most of the last thousand years in the flatlands to the left. If you want to know more, watch the short video by Hans Rosling, a statistician. It presents an animated picture of the process by which the world became so unequal, with some countries taking off and others being left behind.

Exercise 1.1 Inequality in the fourteenth century

What do you think a ‘skyscraper’ figure like Figure 1.2 would have looked like in the fourteenth century)?

Exercise 1.2 Using Excel: Income data and the 90/10 ratio

You can see the interactive graph and download an Excel spreadsheet of data that we used to create Figure 1.2 by going to the Globalinc website and clicking ‘xlsx’ where it says, ‘You can also download the data here …’.

Choose five countries that you are interested in.

  1. For each one, calculate the 90/10 ratio in 1980, 1990 and 2014. (Follow the step-by-step instructions in the walk-through in Figure 1.4 on how to do this in Excel.)
  2. Describe the differences you find between countries and the changes over time.
  3. Can you think of any explanations for these differences?

Income data and the 90/10 ratio.

Figure 1.4 Income data and the 90/10 ratio.

The data

This is what the data looks like. Column A contains country names, Column B contains the year, and Columns C to L contain the average income in each decile. Column M contains the mean income in the population, which is the mean of Columns C to L.

Figure 1.4a This is what the data looks like. Column A contains country names, Column B contains the year, and Columns C to L contain the average income in each decile. Column M contains the mean income in the population, which is the mean of Columns C to L.

Filter the data to see only the country/countries we need

To make the data easier to work with, we will apply a filter so we only see the data we need. We will filter according to the country names, given in Column A.

Figure 1.4b To make the data easier to work with, we will apply a filter so we only see the data we need. We will filter according to the country names, given in Column A.

Filter the data to see only the country/countries we need

After completing step 5, only the data for your selected country/countries is shown in the spreadsheet. Data for the other countries is still there, but hidden.

Figure 1.4c After completing step 5, only the data for your selected country/countries is shown in the spreadsheet. Data for the other countries is still there, but hidden.

Filter the data to see only the years we need

After completing step 6, our spreadsheet should look similar to the example above, with only the countries and years you are interested in.

Figure 1.4d After completing step 6, our spreadsheet should look similar to the example above, with only the countries and years you are interested in.

Calculate the 90/10 ratio for one row

We will calculate the 90/10 ratio in a new column. Rather than calculating ratios manually, you can enter the calculation as a cell formula so Excel will do it for you.

Figure 1.4e We will calculate the 90/10 ratio in a new column. Rather than calculating ratios manually, you can enter the calculation as a cell formula so Excel will do it for you.

Repeat this calculation for the rest of the rows

To calculate the 90/10 ratio for other years, instead of re-typing in the same formula again and again, you can copy the first formula to other cells.

Figure 1.4f To calculate the 90/10 ratio for other years, instead of re-typing in the same formula again and again, you can copy the first formula to other cells.

Round the calculated values to 1 decimal place

Currently the calculations are not rounded to a given number of decimal places. To change the number of decimal places shown, we need to reformat the cells.

Figure 1.4g Currently the calculations are not rounded to a given number of decimal places. To change the number of decimal places shown, we need to reformat the cells.

Round the calculated values to 1 decimal place

After step 15, the cell values will be displayed to 1 decimal place. Excel still stores the full number, but only shows the number of decimal places you specified.

Figure 1.4h After step 15, the cell values will be displayed to 1 decimal place. Excel still stores the full number, but only shows the number of decimal places you specified.

The final product

The calculated 90/10 ratios are now rounded to 1 decimal place.

Figure 1.4i The calculated 90/10 ratios are now rounded to 1 decimal place.

Exercise 1.3 Using Excel: Looking at income distributions

You will be using the same data as in Exercise 1.2 to understand the difference between the mean and the median. Follow the walk-through in Figure 1.5 on how to do the Excel parts of this exercise.

Mean and median, and bar chart.

Figure 1.5 Mean and median, and bar chart.

The data

We are using the same data as in Workout 1.2. Column A contains country names, Column B contains the year, and Columns C to L contain the average income in each decile. Column M contains the mean income in the population, which is the mean of Columns C to L. In this example, we have filtered the data to show the income deciles for our chosen country – Finland, in 2014. (see Workout 1.2 for how to do this).

Figure 1.5a We are using the same data as in Workout 1.2. Column A contains country names, Column B contains the year, and Columns C to L contain the average income in each decile. Column M contains the mean income in the population, which is the mean of Columns C to L. In this example, we have filtered the data to show the income deciles for our chosen country – Finland, in 2014. (see Workout 1.2 for how to do this).

Draw a column chart

Your column chart will look similar to the chart shown above, with income on the vertical axis and decile number (1 to 10) on the horizontal axis.

Figure 1.5b Your column chart will look similar to the chart shown above, with income on the vertical axis and decile number (1 to 10) on the horizontal axis.

Add axis titles and a chart title

Excel’s ‘Add Chart Element’ allows you to add axis titles and a chart title.

Figure 1.5c Excel’s ‘Add Chart Element’ allows you to add axis titles and a chart title.

Calculate the mean income

Excel’s AVERAGE function will calculate the mean of the selected cells.

Figure 1.5d Excel’s AVERAGE function will calculate the mean of the selected cells.

Choose one country from this list (which we will refer to as Country A): Czech Republic, Finland, Netherlands, Norway, or Slovenia. Now choose one country from this list (we refer to this as Country B): Botswana, Central African Republic, Haiti, Jamaica, or Lesotho.

  1. In Excel, filter the data so that only rows corresponding to these countries in 2014 appear.
  2. The median is the 50th percentile (or Decile 5). You can think of everyone in the population lining up according to income, and picking the person who is right in the middle of the line. What is the median income in Country A? How about in Country B?
  3. Suppose that the income in Decile 10 changed to $1 million. Would the median in either country increase, decrease, or stay the same? Why?
  4. Plot a separate vertical bar chart (called a column chart in Excel) for Country A and Country B, showing the decile on the horizontal axis and income on the vertical axis. The mean is a summary statistic that we calculate by adding all values and dividing by the number of values. You can think of the mean as what would happen if everyone in their country brought their income to the same place, and all the money was put in a pile, and the money was then shared equally between everyone. The amount that each person got would be the mean.
  5. Look at the bar charts from Question 4. In which decile would you guess that the mean amount would fall? Verify that your answer is similar to the mean income reported in Column M.
  6. Column M (labeled ‘Mean Income’) shows the mean of Columns C to L. In a new column, calculate the mean using the AVERAGE function in Excel and verify that your answer is the same (rounded to the nearest dollar).
  7. Suppose that the income in Decile 10 changed to $1 million. Would the mean income in either country increase, decrease, or stay the same? Why? Verify your answer in Excel by changing the value in the cells for Decile 10 and calculating the mean income.

Comparing income at different times, and across different countries

The United Nations collects and publishes estimates of GDP from statistical agencies around the world. We have used these statistics in Figure 1.2. We use these statistics, along with those made by economic historians, to construct charts like Figure 1.3, which compares living standards across countries and at different time periods, and looks at whether the gap between rich and poor countries has narrowed or widened over time. Before we can make a statement like, ‘On average, people in Italy are richer than people in China, but the gap between the countries is narrowing,’ statisticians and economists must try to solve three problems:

Notice how similar the last two statements are, because the challenge is similar. This is to find a set of prices to use in these calculations that will allow us to identify changes or differences in outputs, without making the mistake of assuming that, for example, if the price of something rises in one country but not in the other, then the amount of output has increased in the first country and not in the second one.

constant prices
Prices corrected for increases in prices (inflation) or decreases in prices (deflation) so that a unit of currency represents the same buying power in different periods of time. See also: purchasing power parity.
purchasing power parity (PPP)
A statistical correction allowing comparisons of the amount of goods people can buy in different countries that have different currencies. See also: constant prices.

To deal with these problems and allow comparisons to be made, statisticians use adjusted data that measures output in:

1.2 Economic growth

Between the years 1000 and 1600 in Figure 1.3, it’s hard to see what’s going on. The graph uses a ‘linear’ scale—this means that each ‘unit’ on the vertical axis represents the same amount (each $1,000 of income is represented by the same distance on the vertical axis).

In some ways, this scale doesn’t represent the experience of real people well. For example, if you are in the poorest 10% in Niger and you earn an extra $1,000, your income is now $1,092. Your life is transformed. If you’re in the poorest 10% in Singapore, and you earn an extra $1,000, your income is now $4,652. Your life is better, but mostly the same, because $1,000 is a smaller proportion of what you earn already.

Another way of looking at the data in Figure 1.3 is to consider, not just by how much income has grown over these years, but also how fast it has done so—in other words, the rate at which it has grown.

Calculating growth rates

In the media, you may have seen headlines about GDP growth, such as ‘Country A’s economy grew by 2% in 2016–2017’ or ‘Country B reports a GDP growth rate of 5% this year’. How do economists calculate these figures?

The GDP growth rate is the percentage change in GDP from one year to the next. National statistics agencies usually publish annual GDP data, which is an estimate of GDP, measured at the end of every year. Using this data, we can calculate the annual growth rate of GDP in Year t (let’s call it gt) as:

Example: If GDP at the end of this year was $3 billion, and GDP at the end of last year was $2.8 billion, then the annual growth rate of GDP this year is:

As before, a $1 billion increase in a country’s GDP would be very large if GDP was $3 billion, but not if GDP was $300 billion. For this reason, percentage changes allow us to compare GDP growth of a country in different years. That’s why we use percentages. If GDP per capita in Country A grew by 1% compared to 2% in Country B, we can say that Country B’s economy grew faster than Country A’s.

When we see growth reported, it is often reported as the average rate during a period of years. For example, knowing that GDP per capita in China grew by an average of 2.97% per year between 1952 and 1978, and 8.12% between 1978 and 2007, is much more useful than knowing the number in any year. Calculating this statistic involves more advanced mathematics. If you want to learn how to work this out, see the ‘Find out more: Compound growth rates’ below. The ‘Find out more: The rule of 70 for growth rates’ gives a simple rule of thumb that lets you calculate how many years it takes for GDP per capita to double when you know the compound growth rate.

Find out more Compound growth rates

Once we’ve calculated the annual growth rate for a particular year, how can we tell if the country’s economy has grown faster or slower than usual? One way is to compare the annual growth rate with the average annual growth rate (known as the compound annual growth rate or CAGR) over a given time period. For example, if real GDP per capita grew by 1% this year, but on average it grew by 2% over the period 1950–2010, then we can say that the economy’s growth performance this year is below average.

To calculate the compound annual growth rate, we do not take averages, but instead use the principle of compounding. We usually calculate compound annual growth rates over long periods, such as decades. As the example below shows, failing to account for compounding would give vastly different growth rate figures.

Example: If GDP per capita was $12,800 in 1950 and $42,300 in 2011, then the compound annual growth rate (CAGR) over these 61 years is:

If we instead take the average of the growth rate, then we would get:

In this example, failing to account for compounding gives an answer that is almost twice as large as the actual annual growth rate.

Find out more The rule of 70 for growth rates

Calculations involving compound growth rates are difficult to do mentally, but there is a handy rule of thumb that we can use for one particular situation. If the economy is growing at a constant rate, the number of years it will take for GDP per capita to double is approximately 70 divided by the annual growth rate:

For this reason, we refer to this approximation as the ‘rule of 70’. The rule of 70 is useful if we are looking at growth rates over long periods of time, in which case the number in the denominator is the compound annual growth rate.

Example: If the compound annual growth rate of GDP per capita is 2%, then it would take approximately 70/2 = 35 years for GDP to double.

If GDP per capita was growing more slowly at a rate of 1%, then it would take approximately 70/1 = 70 years for GDP per capita to double.

Optional Exercise 1.3.1 Using Excel: Calculating compound growth rates

Download and save this spreadsheet containing some of the GDP data used to make Figure 1.3.

  1. Calculate the CAGR for China, Britain, Italy, and India over the years 1950–2011. Follow the walk-through in Figure 1.6 on how to do this in Excel.

Calculating CAGR in Excel.

Figure 1.6 Calculating CAGR in Excel.

The data

Shown above is an excerpt of the data. In this example, we are using data from Japan for the years 1950–2011. Column A contains years, and Column B contains GDP per capita values.

Figure 1.6a Shown above is an excerpt of the data. In this example, we are using data from Japan for the years 1950–2011. Column A contains years, and Column B contains GDP per capita values.

Calculate the difference in years

For the CAGR calculation, we need the values for GDP per capita, and the difference in years (end year minus start year).

Figure 1.6b For the CAGR calculation, we need the values for GDP per capita, and the difference in years (end year minus start year).

Calculate the CAGR

To calculate the CAGR, we will type the CAGR formula from ‘Find out more: Compound growth rates’ into Excel, using the cells containing GDP values in 1950 and 2011.

Figure 1.6c To calculate the CAGR, we will type the CAGR formula from ‘Find out more: Compound growth rates’ into Excel, using the cells containing GDP values in 1950 and 2011.

  1. For each of these four countries, find the approximate number of years (rounding up) that it took for GDP to double its 1950 value.

    Example: In Japan, GDP was 1920.72 in 1950. Scrolling down the spreadsheet, we can see that GDP was 3986.43 in 1960, which is approximately double the value in 1950. Therefore, it took Japan roughly 10 years for GDP to double its 1950 value.

  2. Use the rule of 70 and the CAGR from Question 1 to calculate the approximate number of years required for GDP to double. Check that these numbers are close to your answer to Question 2.

A ratio scale

ratio scale
A scale that uses ratios to represent distance. For example, the ratio between 3 and 6, and between 6 and 12, is the same (the larger quantity is twice the smaller). This contrasts with a linear scale, where the distance between 3 and 6, and between 6 and 9, is the same (3). See also: linear scale.

We can directly compare growth rates across countries over time if we plot the same hockey stick data using a different scale on the vertical axis. In Figure 1.3, the scale went from 10,000 to 15,000 to 20,000 etc. by adding 5,000 at each step. Instead, in Figure 1.7, we go from 500 to 1,000 to 2,000, to 4,000 by doubling the number at each step. This is called a ratio scale. If you find this description confusing, just compare the numbers on the vertical axis of Figure 1.3 with those in Figure 1.7. Remember that we are using exactly the same data in each of these figures.

We say that the ratio scale captures growth rates. Why?

With the ratio scale, if GDP grows by the same percentage every year, or every 100 years, the graph will be a straight line. So, if GDP doubles every 100 years, the line would be straight, sloping upwards. If, instead of doubling, the level quadrupled every 100 years, the line would still be straight, but it would be twice as steep. We say the growth rate was twice as high.

So, with a ratio scale:

Using the ratio scale, we can immediately see something that was not obvious in Figure 1.3—when the hockey stick turns up, the lines for the latecomers Japan and China are much steeper than was the case in Britain or Italy. This means that their growth rates have been much faster.

History’s hockey stick: Living standards in five countries (1000–2015) using the ratio scale.

Figure 1.7 History’s hockey stick: Living standards in five countries (1000–2015) using the ratio scale.

Jutta Bolt and Jan Juiten van Zanden. 2013. ‘The First Update of the Maddison Project Re-Estimating Growth Before 1820’. Maddison-Project Working Paper WP-4 (January). Stephen Broadberry. 2013. Accounting for the great divergence. 1 November. Conference Board, The. 2015. Total Economy Database.

History’s hockey stick

There were cultural changes and scientific advances in many parts of the world over the entire period shown in the figure, but living standards only began to rise in a sustained way from the eighteenth century (1700–1799) onwards. The figure looks like a hockey stick, and our eyes are drawn to the kink.

Figure 1.7a There were cultural changes and scientific advances in many parts of the world over the entire period shown in the figure, but living standards only began to rise in a sustained way from the eighteenth century (1700–1799) onwards. The figure looks like a hockey stick, and our eyes are drawn to the kink.

Before 1800, we have less information and so there fewer data points (dots) in the graph

For the period before 1800, we have less information about GDP per capita, which is why there are fewer data points in that part of the figure.

Figure 1.7b For the period before 1800, we have less information about GDP per capita, which is why there are fewer data points in that part of the figure.

A line is drawn through the data points

For each country the data points shown at the previous step have been joined with straight lines. Before 1800, we can’t see how living standards fluctuated from year to year.

Figure 1.7c For each country the data points shown at the previous step have been joined with straight lines. Before 1800, we can’t see how living standards fluctuated from year to year.

Britain

The hockey-stick kink is less abrupt in Britain, where growth began around 1650.

Figure 1.7d The hockey-stick kink is less abrupt in Britain, where growth began around 1650.

Japan

In Japan, the kink is more defined, occurring around 1870.

Figure 1.7e In Japan, the kink is more defined, occurring around 1870.

China and India

The kink for China and India happened in the second half of the twentieth century (post-1950). GDP per capita fell in India under British colonial rule from the early seventeenth century until the mid-nineteenth century. (An even sharper decline took place in China from the beginning of the sixteenth century until the Chinese revolution ended the domination of China’s politics and economics by European nations).

Figure 1.7f The kink for China and India happened in the second half of the twentieth century (post-1950). GDP per capita fell in India under British colonial rule from the early seventeenth century until the mid-nineteenth century. (An even sharper decline took place in China from the beginning of the sixteenth century until the Chinese revolution ended the domination of China’s politics and economics by European nations).

Compare growth rates in China and Japan

The ratio scale makes it possible to see that recent growth rates in Japan and China were higher than elsewhere.

Figure 1.7g The ratio scale makes it possible to see that recent growth rates in Japan and China were higher than elsewhere.

Exercise 1.4 Using Excel: Interpreting graphs drawn using a ratio scale

Figure 1.3 used a conventional scale for the vertical axis, and Figure 1.7 used a ratio scale.

  1. For Britain, identify a period of time when its growth rate was increasing, and another period in which its growth rate was roughly constant. Which figure did you use, and why?
  2. Identify a period during which GDP per capita in Britain was shrinking (a negative growth rate) faster than in India. Which figure did you use and why?
  3. Advanced: if you studied the optional ‘Find out more: Compound growth rates’, use Figure 1.7 to identify whether Britain between 1800 and 1900 or Japan between 1900 and 2000 grew at a faster rate. Use the GDP data for Figure 1.3 to calculate the CAGR for Britain over the period 1800–1900, and for Japan over the period 1900–2000, and use these calculated growth rates to verify your answer.

Question 1.1 Choose the correct answer(s)

The GDP per capita of Greece was $22,494 in 2012 and $21,966 in 2013. Based on these figures, the growth rate of GDP between 2012 and 2013 (to two decimal places) was:

  • –2.40%
  • 2.35%
  • –2.35%
  • –0.24%
  • The GDP per capita decreased by $528. To find the growth rate divide by the 2012 GDP per capita $22,494 (and not the 2013 GDP per capita $21,966).
  • Greece’s GDP per capita decreased between 2012 and 2013, resulting in a negative growth rate.
  • The GDP per capita changed by $21,966 − $22,494 = −$528. The growth rate of GDP per capita is given by this change as a percentage of the 2012 figure: −$528/$22,494 = −2.35%.
  • The decrease in the GDP per capita of $528 is 2.35% of $22,494 and not 0.235%.

Question 1.2 Choose the correct answer(s)

The following graphs show the GDP per capita of four countries, plotted according to the linear scale and ratio scale respectively.

GDP per capita: Linear scale.

Figure 1.8 GDP per capita: Linear scale.

GDP per capita: Ratio scale.

Figure 1.9 GDP per capita: Ratio scale.

Based on this information, which of the following statements are correct?

  • Country B’s GDP per capita grew at a constant rate.
  • Over the 10 years shown, Country A’s GDP per capita grew at the fastest rate, on average.
  • Over the 10 years shown, Country D’s GDP per capita grew at the slowest rate, on average.
  • Country C’s GDP per capita grew at a constant rate.
  • Country B’s GDP per capita is a straight line on the ratio scale graph. Hence, it grew at a constant rate.
  • The GDP per capita was 100 in all countries in Year 1. By Year 10, Country C’s GDP per capita was the highest of the four countries. Therefore, Country A did not have the fastest average growth rate.
  • Even though its growth rate is increasing, Country D’s GDP per capita was the lowest in Year 10 of the four countries. Therefore, it had the lowest average growth rate.
  • Country C’s GDP per capita grew at the highest rate in the beginning, but its rate of growth decreased year by year. Hence, on the ratio scale, it is a concave curve.

What influences growth and inequality?

From Figures 1.3 and 1.4, we learned three things about growth and inequality:

Why were there leaders and laggards?

In some economies, as illustrated in Figure 1.7, substantial improvements in people’s living standards did not occur until they gained independence from colonial rule or interference by European nations:

economic system
The institutions that organize the production and distribution of goods and services in an entire economy.
capitalism
An economic system in which private property, markets, and firms play an important role.
political system
A set of principles, laws, and procedures that determine how governments will be selected, and how those governments will make and implement decisions that affect all or most members of a population.
democracy
A political system, that ideally gives equal political power to all citizens, defined by individual rights such as freedom of speech, assembly, and the press; fair elections in which virtually all adults are eligible to vote; and in which the government leaves office if it loses.

The emergence in the eighteenth century of a new economic system in Europe, called capitalism, encouraged a ‘permanent technological revolution’. In the rest of this unit, we look at how capitalism changed the world around us, and why, much later, it was followed by a new political system, democracy.

In the introduction, we saw how both capitalism and democracy influenced the lives of South Africans in the twentieth century.

South Africa was (and is) a capitalist country, and its economy continued to grow, even during apartheid, fueled in part by the mineworkers that Ramaphosa’s union represented. Whites benefited disproportionately. With the coming of democracy, many expected that the benefits of growth would be shared more equally. But we know that some stayed poor, and some did a lot better. The relationship between capitalism and democracy, and how well the economy functions, is not simple.

government
Within a given territory, the only body that can dictate what people must do or not do, and can legitimately use force and restraints on an individual’s freedom to achieve that end. Also known as: state.

As we move through the units, we will help you to see how governments can use well-designed policies to make economic outcomes better and fairer, but can be the cause of worse or unfair outcomes too.

First, we need to understand more about how a process of continuous growth emerged.

The nature and causes of economic growth

economics
The study of how people interact with each other and with their natural surroundings in providing their livelihoods, and how this changes over time.

Understanding why and how growth has occurred in the way that it has, is one of the most important questions that economists have asked. The founder of modern economics, Adam Smith, gave his most important book the title, An Inquiry into the Nature and Causes of the Wealth of Nations.2

institution
The laws and social customs governing the way people interact in society.
division of labour
The specialization of producers to carry out different tasks in the production process. Also known as: specialization.
specialization
This takes place when a country or some other entity produces a more narrow range of goods and services than it consumes, acquiring the goods and services that it does not produce by trade.
market
A way of connecting people who may mutually benefit by exchanging goods or services through a process of buying and selling.
monopoly
A firm that is the only seller of a product without close substitutes. Also refers to a market with only one seller. See also: monopoly power, natural monopoly.

Great economists Adam Smith

Adam Smith Adam Smith (1723–1790) is considered by many to be the founder of modern economics. Raised by a widowed mother in Scotland, he went on to study philosophy at the University of Glasgow and later at Oxford.

In An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776, Smith asked: how can society coordinate the independent activities of large numbers of economic actors—producers, transporters, sellers, consumers—often unknown to each other and widely scattered across the world? Previous notions of political and economic organization relied on rulers imposing order on their subjects. Smith’s radical claim was that coordination among all of these actors might spontaneously arise, without any person or institution consciously attempting to create or maintain it.

Even more radical was his idea that this could take place as a result of individuals pursuing their self-interest, rather than attempting to coordinate, cooperate or care for each other: ‘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,’ he wrote.

In The Wealth of Nations, Smith introduced one of the most enduring metaphors in the history of economics—the ‘invisible hand’. The businessman, he wrote:

… intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to promote it.

Among Smith’s insights is the idea that a significant source of prosperity is the division of labour, or specialization. Smith illustrated this idea in a famous passage on the pin factory: ten men undertaking to make an entire pin from start to finish separately and independently: ‘certainly could not each of them have made twenty [pins], perhaps not [even] one pin in a day.’ But where the ten men each fully specialized in one or two of 18 distinct operations involved in making pins, they could produce close to 50,000 pins a day. Specialization greatly increased productivity.

Smith also observed that such specialization is constrained by the ‘extent of the market’; such an enormous number of pins would never be produced unless there were many buyers and those could only be found if the market extended far from their point of production. The pin makers themselves could not possibly need the vast quantity of pins they were able to produce. The construction of navigable canals and the expansion of foreign trade thus fostered specialization. And the resulting prosperity itself expanded the ‘extent of the market’, in a virtuous cycle of economic expansion.

But Smith did not think that people were guided entirely by self-interest, nor did he consider the market system perfect. In the same book in which he first used the phrase ‘invisible hand’, 17 years before The Wealth of Nations, he wrote:

How selfish soever man may be supposed, there are evidently some principles in his nature which interest him in the fortunes of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.3

He also saw that the market system had some failings, especially if sellers banded together to form monopolies, so as to avoid competing with each other. Smith specifically targeted monopolies that were protected by governments, such as the British East India Company that not only controlled trade between India and Britain, but also administered much of the British colony there.

He also agreed with his contemporaries that there was a role for government in a market system in protecting its nation from external enemies, and ensuring justice through the police and the court system. And Smith was an advocate of government investment in education and in public works, such as bridges, roads, and canals.

Question 1.3 Choose the correct answer(s)

Which of the following statements regarding Adam Smith are correct?

  • Adam Smith believed in the role of the government to improve societal welfare.
  • Adam Smith believed that all markets were characterized by perfect competition.
  • Adam Smith advocated that economic agents were guided entirely by self-interest.
  • Adam Smith claimed that coordination among large number of economic actors (producers, transporters, sellers, consumers), often unknown to each other, might spontaneously arise without any person or institution consciously attempting to create or maintain it.
  • He agreed with his contemporaries that government should protect the nation from external enemies and ensure justice through the police and the court system, and also advocated government investment in education and public works.
  • Adam Smith understood that the market system had some failings, especially when sellers colluded to create market power.
  • He didn’t, and he wrote about ethical behaviour in The Theory of Moral Sentiments, published in 1759.
  • This is Adam Smith’s idea of the ‘invisible hand’: ‘It is not from the benevolence of butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest, led by an invisible hand to promote an end which was no part of his intention.’

1.3 The permanent technological revolution: Engine of growth

Figure 1.3 is a ‘hockey stick’ curve; it is flat for a long time, then suddenly curves upward. We know that remarkable scientific and technological advances occurred at more or less the same time as the upward kink in the hockey stick in Britain in the middle of the eighteenth century.

technology
A process taking a set of materials and other inputs, including the work of people and machines, to produce an output.

In everyday usage, ‘technology’ refers to machinery, equipment and devices developed using scientific knowledge. In the language of economics, technology is more specific. It is a process that takes a set of materials and other inputs—including the work of people and machines—and creates an output. For example, a technology for making a cake can be described by the recipe. It specifies the combination of inputs (ingredients such as flour, and labour such as stirring) needed to create the output (the cake).

The Industrial Revolution

Industrial Revolution
A wave of technological advances and organizational changes starting in Britain in the eighteenth century, which transformed an agrarian and craft-based economy into a commercial and industrial economy.

The eighteenth century in Britain marked the beginning of a wave of technological advances and organizational changes that transformed an agrarian and craft-based economy into a commercial and industrial powerhouse. David Landes, an economic historian, wrote that the Industrial Revolution was ‘an interrelated succession of technological changes’ that transformed the societies in which these changes took place.4

During the long flat portion of Figure 1.3, traditional craft-based techniques were used in most production processes, such as hand-weaving. Some of the earliest steps in the industrial revolution were in the production of textiles, such as the spinning jenny, a machine that enabled an individual to produce multiple spools of threads simultaneously. By the time the inventor, James Hargreaves died, there were over 20,000 spinning jennys in use across Britain. The power loom, which mechanized the process of weaving cloth, was developed in the 1780s. Important new technologies were introduced in energy and transportation as well as in textiles.

The cumulative character of these developments led to them together being called the Industrial Revolution. The new era brought new ideas, new discoveries, new methods and new machines, making old ideas and old tools obsolete. These new ways were, in turn, made obsolete by even newer ones.

Technological progress

So far, we have looked at the world using incomes to compare countries, or the past with the present. This isn’t the only way we can measure change. We can ask other questions, such as: How much work does it take to stay alive? How quickly can we communicate?

technological progress
A change in technology that reduces the amount of resources (labour, machines, land, energy, time) required to produce a given amount of the output.

As technological progress revolutionized production, the time required to make a pair of shoes fell by half in only a few decades. The same was true of spinning and weaving, and of making cakes in a factory. This marked the beginning of a permanent technological revolution, where the amount of time required for producing most products fell generation after generation.

Transformational technological change is still occurring. In his TED Talk, Hans Rosling claims that we should say, ‘Thank you, industrialization’ for creating the washing machine, a device that transformed the wellbeing of millions of women.

Working less, producing more

If we work less to produce the basic things we need, technological changes create significant increases in living standards.

We can measure this trend over thousands of years. Our distant ancestors typically had nothing brighter than a campfire at night. The first great technological breakthrough in lighting from campfire came 40,000 years ago, with the use of lamps that burned animal or vegetable oils. The Babylonians (1750 BC) used sesame oil. Three thousand years later, someone invented tallow candles.

We can measure how many units of brightness (measured in lumen-hour, lm-hr) could be generated by an hour of work (or labour) over time. We know that creating light by a campfire took about 1 hour of labour to produce 17 lumen-hours, for example. Lighting has become more and efficient through gas lamps, kerosene lamps, filament bulbs, fluorescent bulbs, and so on. Compact fluorescent bulbs introduced in 1992 are about 45,000 times more efficient, in terms of labour time expended, than lights were 200 years ago.

Today, the productivity of labour in producing light is half a million times greater than it was among our ancestors around their campfires. This is an example of how growth happens.

Figure 1.10 charts this remarkable hockey-stick growth in efficiency in lighting using the ratio scale.

The productivity of labour in producing light: Lumen-hours per hour of labour (100,000 years ago to the present). The data between 1800 and 2000 are shown in the magnified segment.

Figure 1.10 The productivity of labour in producing light: Lumen-hours per hour of labour (100,000 years ago to the present). The data between 1800 and 2000 are shown in the magnified segment.

William Nordhaus. 1998. ‘Do Real Output and Real Wage Measures Capture Reality? The History of Lighting Suggests Not’. Cowles Foundation for Research in Economics Paper 1078.

Question 1.4 Choose the correct answer(s)

Figure 1.11 tabulates the productivity of labour in producing light, measured in lumen-hours per hour of labour, using different technologies.

Technology Approximate date Lumen-hours per hour of labour
Open wood fire From earliest time 17
Animal or vegetable fat lamp 38,000–9,000 BC 20
Babylonian sesame oil lamp 1750 BC 24
Tallow Candle 1800 186
Tallow Candle 1830 333
Kerosene lamp 1875–1885 4,400
Town gas (Welsbach mantle) 1885–1895 12,000
Town gas (Welsbach mantle) 1916 83,000
Electric Filament lamp 1930 96,000
Electric Filament lamp 1940 182,000
Electric Filament lamp 1950 530,000
Electric Filament lamp 1960 980,000
Electric Filament lamp 1970 1,800,000
Compact fluorescent 1992 8,400,000

The productivity of labour in producing light.

Figure 1.11 The productivity of labour in producing light.

Tables 15.2 and 15.3 from Gregory Clark. 2007. A Farewell to Alms: A Brief Economic History of the World. Princeton, NJ: Princeton University Press.

Based on this information, which of the following statements is correct?

  • The labour productivity of producing light increased roughly linearly over the years.
  • The productivity of labour in producing light using compact fluorescent technology is half a million times greater than with the Babylonian sesame oil lamp.
  • The kerosene lamp in the late 1800s was more than ten times more efficient in terms of labour productivity than the tallow candles in 1830.
  • The labour productivity of producing light roughly doubled in almost every decade between 1930 and 1970.
  • Labour productivity was roughly constant for tens of thousands of years until the 1800s, when it suddenly accelerated.
  • The ratio is 8,400,000 / 24 = 350,000 times more productive than the sesame oil lamp. The labour productivity using compact fluorescent technology is half a million times greater than using an open wood fire.
  • The increase in productivity is 4,400 / 333 = 13.2 times.
  • As shown in the table, the productivity of labour in producing light roughly doubled between 1930 to 1940, 1950 to 1960, and 1960 to 1970. Between 1940 to 1950, the productivity of labour in producing light almost trebled.

The communication revolution

The speed at which information travels today is more evidence of permanent technological revolution. The materials making up this introduction to economics were written by teams of economists, designers, programmers and editors, working together—often simultaneously—at computers in the UK, India, the US, Russia, Colombia, South Africa, Chile, Turkey, France, and many other countries. To do this, we need to be constantly in communication. Until recently, the idea that we could share information in weeks, let alone seconds, would have been a fantasy.

We know that news travelled between ancient Rome and Egypt at about 1 mile (1.6 km) per hour. It took ‘only’ 46 days for the news to reach London of a mutiny of Indian troops against British rule in 1857.

When Abraham Lincoln was elected US president in 1860, the word was spread by telegraph from Washington to Fort Kearny at the western end of the telegraph line. From there, the news was carried some 1,260 miles (2,030 km) by a relay of riders on horseback, called the Pony Express, to Fort Churchill in Nevada, at an average speed of about 7 miles (11 km) per hour. From Fort Churchill, it was transmitted to California by telegraph.

One year after Lincoln’s death, a transatlantic cable cut the time to a matter of minutes for news to travel between New York and London.

The speed at which information travelled (1000–1865).

Figure 1.12 The speed at which information travelled (1000–1865).

Tables 15.2 and 15.3 from Gregory Clark. 2007. A Farewell to Alms: A Brief Economic History of the World. Princeton, NJ: Princeton University Press.

1.4 The capitalist revolution

We’ve mentioned that South Africa is a capitalist country, as are Singapore, Liberia, Norway, and almost all the other countries in the skyscraper figure. What do we mean when we say this? In economics, ‘capitalism’ is a way of organizing society that began at around the time of the Industrial Revolution. In many ways, lives have been changed for the better. But capitalism has also been associated with extraordinary inequalities, and threats to the quality of the natural environment.

Defining capitalism

Capitalism is an economic system characterized by a particular combination of institutions.

In economics, we define a capitalist economy as any one that combines three particular institutions:

private property
The right and expectation that one can enjoy one’s possessions in ways of one’s own choosing, exclude others from their use, and dispose of them by gift or sale to others who then become their owners.
market
A way of connecting people who may mutually benefit by exchanging goods or services through a process of buying and selling.
firm
A business organization which pays wages and salaries to employ people, and purchases inputs, to produce and market goods and services with the intention of making a profit.

‘Capitalism’ can be contrasted with ‘centrally planned’ economies where the government is the key institution controlling production, and deciding how and to whom goods should be distributed. Central planning was the economic system in the Soviet Union, East Germany and many other eastern European countries prior to the end of Communist Party rule in the early 1990s. Today, there is a centrally planned economic system in the Democratic People’s Republic of Korea (North Korea).

How private property, markets, and firms combine with each other, with families, governments, and other institutions, differs greatly across countries. China and the US are both capitalist economies, but they differ in the extent to which the government influences economic affairs (as well as in many other ways).

Private property

Over history, the extent of private property has varied. In some societies, such as the hunters and gatherers who are our distant ancestors, almost nothing except personal ornaments and clothing was owned by individuals. In others, crops and animals were private property, but land was not. In other economic systems, some human beings—slaves—were private property.

capital goods
The equipment, buildings, raw materials, and other inputs used in producing goods and services, including where applicable any patents or other intellectual property that is used.

In a capitalist economy, an important type of private property is the equipment, buildings, raw materials, and other inputs used in producing goods and services. These are called capital goods. In a planned economy, the capital goods are owned by the government.

Private property may be owned by an individual, a family, a business, or some entity other than the government. And some things that we value are not private property, for example, the air we breathe and most of the knowledge we use cannot be owned or bought and sold.

Question 1.5 Choose the correct answer(s)

Which of the following are examples of private property?

  • computers belonging to your college
  • a farmer’s land in the Soviet Union (under Communist Party rule)
  • shares in a company
  • a worker’s skills
  • Although computers owned by the college may be used by many students, they are still property of the college, which requires payment (tuition) for access and can exclude their use by non-students.
  • In the Soviet Union, your land could be transferred to others by the state and hence was not private property.
  • Shares in a company represent a claim to that company’s future profits; this claim can be sold, gifted, or realized as the owner wishes. Shares represent income to which non-shareholders are not entitled.
  • While intellectual property is private property (of your company, your university or yourself), your skills in general are not disposable to others for their ownership.

Markets

One of the changes that was underway during Adam Smith’s life, but has greatly accelerated since, is specialization in the production of goods and services. As Smith explained, we become better at producing things when we each focus on a limited range of activities. This is true because of:

But people will not specialize unless they have a way to acquire the other goods they need.

competition
No definition available.

Markets are a means of transferring goods or services from one person to another:

Markets are competitive, but also cooperative. Each of us, pursuing our private objectives, can work together, producing and distributing goods and services in a way that, while far from perfect, is in many cases better than the alternatives.

Exercise 1.5 The poorest man’s cottage

‘The poorest man may in his cottage bid defiance to all the forces of the Crown. It may be frail, its roof may shake; the wind may blow through it; the storms may enter, the rain may enter—but the King of England cannot enter; all his forces dare not cross the threshold of the ruined tenement.’ – William Pitt, 1st Earl of Chatham, speech in the British Parliament (1763).

  1. What does this tell us about the meaning of private property?
  2. Does it apply to people’s homes in your country?

Exercise 1.6 Markets and social networks

Think about a social networking site that you use, for example Facebook. Now look at our definition of a market.

What are the similarities and differences between the social networking site and a market?

Question 1.6 Choose the correct answer(s)

Which of the following are examples of markets?

  • wartime food rationing
  • auction websites such as eBay
  • touts selling tickets outside concert halls
  • sale of illegal arms
  • The transfer of goods and services that occur in a centrally planned economy as a result of government orders is not a market.
  • An auction-based market is still a market, just one in which the pricing mechanism works through bidding as opposed to a negotiated or listed price.
  • A resale market is still a market, even though the goods in question have already been sold once before.
  • An illegal market is still a market in the economic sense.

Firms

Private property and markets predate capitalism. In a capitalist economy, firms became the predominant organizations for the production of goods and services. Firms are created to make a profit and are owned by private individuals who pay others to work there.

These are some examples of what economists call firms: restaurants, banks, large farms that pay others to work there, industrial establishments, supermarkets, and internet service providers.

These are productive (and important), but are not firms: businesses in which most or all of the people working are unpaid family members, non-profit organizations, employee-owned cooperatives, and government-owned entities (such as railways and power or water companies).

Continuous change

share
A part of the assets of a firm that may be traded. It gives the holder a right to receive a proportion of a firm’s profit and to benefit when the firm’s assets become more valuable. Also known as: common stock.

For working people, capitalism has increased the pace of change. One reason is that a successful firm can grow in a few years from just a few employees to a global company with hundreds of thousands of customers and employing thousands of people. They can do this because they are able to hire additional employees on another type of market: the labour market. They can borrow money or sell shares in the firm to finance the purchase of the capital goods they need to expand production.

Firms can die in a few years too. This is because a firm that does not make profits will not have enough money (and will not be able to borrow money) to continue employing and producing. The firm shrinks, and some of the people who work there lose their jobs.

Contrast this with a family farm, which is not a firm. If the farm is successful, the family will be better off than its neighbours, but expansion will be limited. If, instead, the family is not very good at farming, it will simply be less well off than its neighbours, but as long as the family can feed itself, it will not ‘go out of business’ in the way that a failing firm might. Government bodies also tend to be more limited in their capacity to expand if successful, and are usually protected from failure if they perform poorly.

Capitalism as an economic system

Figure 1.13 shows that the three parts of the definition of a capitalist economic system are nested concepts. The left-hand circle describes an economy of isolated families who own their capital goods and the goods they produce, but have little or no exchange with others.

Capitalism: Private property, markets and firms.

Figure 1.13 Capitalism: Private property, markets and firms.

Historically, economies like the left-hand circle have existed, but have been much less important than a system in which markets and private property are combined (the middle circle). Private property is an essential condition for the operation of markets: buyers will not want to pay for goods unless they can have the right to own them. In the middle circle, most production is done either by individuals (shoemakers or blacksmiths, for example) or in families (for example, on a farm). Before 1600, many of the economies of the world were like this.

Furthermore, capitalism is an economic system that can combine centralization with decentralization. On the one hand, it concentrates power in the hands of owners and managers of firms who are then able to secure the cooperation of large numbers of employees in the production process. On the other, it limits the power of those owners and other individuals, because they face competition to buy and sell in markets.

So, when the owner of a firm interacts with an employee, he or she is ‘the boss’. But when the same owner interacts with a potential customer, he or she is simply another person trying to make a sale, in competition with other firms. It is this unusual combination of competition among firms, and concentration of power and cooperation within them, that accounts for capitalism’s success as an economic system.5

Exercise 1.7 Firm or not?

Using our definition, explain whether each of the following entities is a firm by investigating if it satisfies the characteristics that define a firm. Research the entity online if you are stuck.

  1. John Lewis Partnership (UK)
  2. a family farm in Vietnam
  3. your current family doctor’s office or practice
  4. Walmart (US)
  5. an eighteenth-century pirate ship
  6. Google (US)
  7. Manchester United plc (UK)
  8. Wikipedia

Capitalism and creative destruction

entrepreneur
A person who creates or is an early adopter of new technologies, organizational forms, and other opportunities.

The first adopter of a new technology in a capitalist economy is called an entrepreneur. When we describe a person or firm as entrepreneurial, it refers to a willingness to try out new technologies and to start new businesses.

Joseph Schumpeter was an economist who argued that the dynamism of capitalism was due to the creation of technological improvements by entrepreneurs. The profits made by the first firm to produce a product at a lower cost, for example, or to bring a new product to the market will not last forever. Other firms, noticing that entrepreneurs are making more profits, will eventually adopt the new technology. They will also reduce their costs and their profits will increase.

creative destruction
Joseph Schumpeter’s name for the process by which old technologies and the firms that do not adapt are swept away by the new, because they cannot compete in the market. In his view, the failure of unprofitable firms is creative because it releases labour and capital goods for use in new combinations.

As more firms introduce the new technology—say, for producing cloth—the supply of cloth to the market increases and the price will start to fall. This process will continue until everyone is using the new technology, at which stage prices will have declined to the point where no one is earning higher profits than in other lines of business. The firms that stuck to the old technology will be unable to cover their costs at the new lower price for cloth, and they will go bankrupt. Schumpeter called this creative destruction.

Great economists Joseph Schumpeter

Joseph Schumpeter

Joseph Schumpeter (1883–1950) developed one of the most important concepts of modern economics: creative destruction.

Schumpeter brought to economics the idea of the entrepreneur as the central actor in the capitalist economic system. For Schumpeter, creative destruction was the essential fact about capitalism: old technologies and the firms that do not adapt are swept away by the new, because they cannot compete in the market by selling goods at a price that covers the cost of production. The failure of unprofitable firms releases labour and capital goods for use in new combinations.

This decentralized process generates a continued improvement in productivity, which leads to growth, so Schumpeter argued it is virtuous.6

Both the destruction of old firms and the creation of new ones take time. The slowness of this process creates upswings and downswings in the economy. Read Schumpeter’s ideas and opinions in his own words7 8 and an online essay about his work by Robert Skidelsky, a historian of economic thought.9

Schumpeter was born in Austro–Hungary, but migrated to the US after the Nazis won the election in 1932 that led to the formation of the Third Reich in 1933. As a young professor in Austria, he had fought and won a duel with the university librarian to ensure that students had access to books. He also claimed that, as a young man, he had three ambitions in life: to become the world’s greatest economist, the world’s greatest lover, and the world’s greatest horseman. He added that only the decline of the cavalry had stopped him from succeeding in all three.

1.5 Capitalism and growth: Cause and effect?

We have seen that the institutions associated with capitalism have the potential to make people better off, through opportunities for both specialization and the introduction of new technologies. We have also seen that the permanent technological revolution coincided with (was associated with) the emergence of capitalism. But can we conclude that capitalism actually caused the upward kink in the hockey stick?

We should be sceptical when anyone claims that something complex (capitalism) ‘causes’ something else (increased living standards, technological improvement, a networked world, or environmental challenges).

But we do want to make causal statements in economics if possible—to understand why things happen, or to devise ways of changing something so that the economy works better. We would like to be able to say that policy X is likely to cause change Y. For example, an economist might claim that: ‘If the central bank lowers the interest rate, more people will buy homes and cars’.

natural experiment
An empirical study exploiting naturally occurring statistical controls in which researchers do not have the ability to assign participants to treatment and control groups, as is the case in conventional experiments. Instead, differences in law, policy, weather, or other events can offer the opportunity to analyse populations as if they had been part of an experiment. The validity of such studies depends on the premise that the assignment of subjects to the naturally occurring treatment and control groups can be plausibly argued to be random.

In science, we support the statement that X causes Y by understanding the relationship between cause (X) and effect (Y), and we perform experiments to gather evidence that measure changes in X and in Y. But an economy is made up of the interactions of millions of people. We cannot measure and understand them all, and it is rarely possible to gather evidence by conducting experiments (though in Units 2 and 3, we will give examples of the use of conventional experiments in one area of economics). So how can economists explore cause and effect? Sometimes, the things we simply observe in the world—so-called ‘natural experiments’—can help us investigate.

Natural experiments to identify cause and effect

We can observe that capitalism emerged at the same time as, or just before, both the Industrial Revolution and the upward turn in our hockey sticks. This might suggest that capitalist institutions were among the causes of the era of continuous productivity growth. Putting this in scientific language, the observation would be consistent with the hypothesis (or theory) that they were. But the emergence of a free-thinking cultural environment known as The Enlightenment also predated or coincided with the upturn in the hockey sticks.

Economists and historians disagree on the causes of the Industrial Revolution. You can find out why they disagree by reading this discussion about why the Industrial Revolution happened first in the eighteenth century, and why it happened on an island off the coast of Europe.

So, was it institutions, culture, both, or some other set of causes? One method for investigating a question like this is called a natural experiment. We can use this method when something changes in real life in such a way that there is a change to one group (the ‘treatment’ group), but another similar group stays the same (the ‘control’ group). We can then compare what happened to the two groups. Natural experiments are used to test hypotheses in many fields of study, including the one that began the science of epidemiology.

Because we cannot change the past, even if it were practical to conduct experiments on entire populations, we rely on natural experiments. In this interview, Jared Diamond, a biologist, and James Robinson, a professor of government, explain.

There is a natural experiment that has allowed us to evaluate whether capitalist institutions were indeed a cause of rapid economic growth. The setting for the natural experiment is the coexistence of two different economic systems in the west and east of Germany after the end of the Second World War.

At the beginning of Unit 3, we consider a second natural experiment, assessing the hypothesis that when women gain political power, public policy changes in ways that improve the health of children.

Capitalism and central planning

At the end of the Second World War, Germany was divided into two separate countries with different economic systems—centrally planned in the east, capitalist in the west.

The introduction of centralized planning in East Germany under Communist Party rule saw private property, markets and firms virtually disappear. Decisions about what to produce, how much and in which plants, offices, mines and farms were taken not by private individuals, but by government officials. The officials managing these economic organizations did not need to follow the principle of capitalism and produce goods and services that customers would buy at a price above their cost of manufacture.

A political boundary, the ‘Iron Curtain’, as Winston Churchill, the British Prime Minister, described it in 1946, divided Germany. It separated two populations that until then had shared the same language, culture, and capitalist economy.

In 1936, before the Second World War, living standards in what later became East and West Germany were the same, and firms in the East German provinces of Saxony and Thuringia were world leaders in automobile and aircraft production, chemicals, optical equipment and precision engineering.

Because of the imposition of different economic systems on these two parts of what had been the same country, this is a suitable setting for using the natural experiment method. West Germany is the control group and East Germany the treatment group. The hypothesis is that imposing a planned economic system on East Germany would affect its performance relative to that of West Germany.

The validity of this comparison as a natural experiment depends on the idea that the two Germanys differed in just one way that might affect their economic growth, namely their economic institutions.

Figure 1.14 shows the different paths taken by these and two other economies from 1950. It uses the ratio scale. By the time the Berlin Wall fell in 1989 and East Germany abandoned central planning, its GDP per capita was less than half of that of capitalist West Germany.

The two Germanies: Planning and capitalism (1950–89). West German GDP grew faster than East German GDP between 1950 and 1989.

Figure 1.14 The two Germanies: Planning and capitalism (1950–89). West German GDP grew faster than East German GDP between 1950 and 1989.

Conference Board, The. 2015. Total Economy Database. Angus Maddison. 2001. ‘The World Economy: A Millennial Perspective’. Development Centre Studies. Paris: OECD.

The East German Communist Party forecast in 1958 that material wellbeing would exceed the level of West Germany by 1961. The failure of this prediction was one of the reasons that the Berlin Wall separating East from West Germany was built in 1961. Neither did East Germany’s planned economy catch up to West Germany over the decades that followed.

Notice from Figure 1.14 that West Germany started from a more favourable position than East Germany in 1950. Yet in 1936, before the war began, the two parts of Germany had virtually identical living standards. Both regions had achieved successful industrialization. East Germany’s relative weakness in 1950 was not mainly because of differences in the amount of capital equipment or skills available per head of the population, but because the structure of industries in East Germany was more disrupted by splitting the country than was the case in West Germany.10

From Figure 1.14, we can see that some capitalist economies that had even lower per capita income than East Germany in 1950 fared far better. By 1989, Spain had closed part of the gap and the Japanese economy (which had also suffered war damage) had, with its own particular combination of private property, markets, and firms, along with a strong government coordinating role, actually caught up to West Germany.

We cannot conclude from the German natural experiment that capitalism always promotes rapid economic growth, while central planning is a recipe for relative stagnation. Indeed, the Soviet Union’s centrally planned economy grew considerably faster between 1928 (when central planning was introduced there) and 1980 than the economies of some capitalist countries at similar levels of development (you will be able to see this in Figure 1.15). We can infer that during the second half of the twentieth century, the divergence of economic institutions mattered for the livelihoods of the German people.

Question 1.7 Choose the correct answer(s)

Look again at Figure 1.14, which shows a graph of GDP per capita for West and East Germany, Japan and Spain between 1950 and 1990. Which of the following statements is correct?

  • Having a much lower starting point in 1950 was the main reason for East Germany’s poor performance compared to West Germany.
  • The fact that Japan and West Germany have the highest GDP per capita in 1990 implies that they found the optimal economic system.
  • Spain was able to grow at a higher growth rate than Germany between 1950 and 1990.
  • The difference in East and West Germany’s performance proves that capitalism always promotes rapid economic growth, while central planning is a recipe for stagnation.
  • Japan had even lower starting point than East Germany and yet was able to catch up with West Germany by 1990.
  • Different economic systems can be successful. The Japanese economy had its own particular combination of private property, markets, and firms, along with a strong government coordinating role, which was different to the West Germany system.
  • The growth rate of an economy’s GDP per capita can be inferred from the steepness of its curve when plotted on a ratio scale graph, as done here. The fact that the slope of Spain’s curve from 1950 to 1990 is greater than that of either West or East Germany indicates that it grew at a faster rate.
  • In economics, one cannot use only one piece of evidence to ‘prove’ a theory. What we can infer here is that, during the second half of the twentieth century, the divergence of economic institutions mattered for the livelihoods of the German people.

1.6 Varieties of capitalism: Institutions and growth

Not every capitalist country is the kind of economic success story exemplified in Figure 1.3 by Britain, later Japan, and the other countries that caught up, or in the post-Second World War catch-up shown in Figure 1.14. This explains why the left-hand end of the skyscraper diagram (Figure 1.2) is so much poorer than the right-hand end.

An example: in 1950, GDP per capita in South Korea was the same as in Nigeria. Both were capitalist countries. By 2013, South Korea was ten times richer by this measure.

Many of the economies at the left-hand end of Figure 1.2 have been capitalist for many years, but remain poor. Why might this be?

Again, there are many causes. One of the most important is that there are many varieties, and qualities, of capitalism. Figure 1.15 tracks the fortunes of a selection of countries across the world during the twentieth century on a linear scale. It shows, for example, that in Africa, the success of Botswana in achieving sustained growth contrasts sharply with Nigeria’s relative failure. Both are rich in natural resources (diamonds in Botswana, oil in Nigeria), but differences in the quality of their institutions—the extent of corruption and misdirection of government funds, for example—may help explain their contrasting trajectories.

developmental state
A government that takes a leading role in promoting the process of economic development through its public investments, subsidies of particular industries, education and other public policies.

South Korea’s take-off occurred under institutions and policies sharply different from those prevailing in Britain in the eighteenth and nineteenth centuries. The most important difference is that the government of South Korea (along with a few very large corporations) played a leading role in directing the process of development, explicitly promoting some industries, requiring firms to compete in foreign markets and also providing high quality education for its workforce. The term developmental state has been applied to the leading role of the South Korean government in its economic take-off, and now refers to any government playing this part in the economy. Japan and China are other examples of developmental states.11

Divergence of GDP per capita among latecomers to the capitalist revolution (1928–2015). Between 1928 and 2015, the GDP of South Korea grew much more than that of Argentina, Russia (the former Soviet Union), Brazil, Botswana and Nigeria.

Figure 1.15 Divergence of GDP per capita among latecomers to the capitalist revolution (1928–2015). Between 1928 and 2015, the GDP of South Korea grew much more than that of Argentina, Russia (the former Soviet Union), Brazil, Botswana and Nigeria.

Jutta Bolt, and Jan Juiten van Zanden. 2013. ‘The First Update of the Maddison Project Re-Estimating Growth Before 1820’. Maddison-Project Working Paper WP-4 (January).

From Figure 1.15 we also see that, in 1928, when the Soviet Union’s first five-year economic plan was introduced, GDP per capita was one-quarter of the level in Argentina, similar to Brazil, and higher than in South Korea. Central planning in the Soviet Union produced steady but unspectacular growth for nearly 50 years, such that GDP per capita in the Soviet Union outstripped Brazil by a wide margin and even overtook Argentina briefly just before Communist Party rule there ended in 1990.

Some researchers question the validity of historical GDP estimates such as this outside of Europe, because the economies of these countries were so different in structure.

The contrast between West and East Germany demonstrates that one reason central planning was abandoned as an economic system was its failure, in the last quarter of the twentieth century, to deliver the improvements in living standards achieved by some capitalist economies. Yet the varieties of capitalism that replaced central planning in the countries that had once made up the Soviet Union did not work so well either. This is evident from the pronounced dip in GDP per capita for the former Soviet Union after 1990.

Question 1.8 Choose the correct answer(s)

Look again at Figure 1.15. Which of these conclusions is suggested by the graph?

  • The Communist Party rule in the former Soviet Union before 1990 was a complete failure.
  • The contrasting performances of Botswana and Nigeria illustrate that rich natural resources alone do not guarantee higher economic growth, but that higher quality institutions (government, markets, and firms) may also be necessary.
  • The impressive performance of South Korea’s economy implies that other countries should copy their economic system.
  • The evidence from the Russian Federation and the former Soviet Union after 1990 shows that the replacement of central planning by capitalism led to immediate economic growth.
  • The former Soviet Union actually had much higher growth rates than Brazil, and its GDP per capita even briefly overtook Argentina’s just before the Communist Party rule ended in 1990.
  • Both Nigeria and Botswana are rich in natural resources; however, Nigeria’s growth is hindered by pervasive corruption and illegal business practices, whereas Botswana is often described as the least corrupt country in Africa and boasts one of the world’s highest average GDP growth rates.
  • South Korea was a developmental state where the government and a few very large corporations played a leading role in directing the process of development. This does not necessarily mean that this system is optimal for all countries.
  • GDP per capita of both countries fell after 1990. This is due to their private property not being secure, the markets not being competitive and their firms not operating competitively in their newly capitalist economy. This abrupt transition from a distinctly non-capitalist economy to a capitalist system is often referred to as ‘shock therapy’.

1.7 Varieties of capitalism: Growth and stagnation

The lagging performances of some of the economies in Figure 1.15 demonstrates that the existence of capitalist institutions is not enough, in itself, to create a dynamic economy—that is, an economy bringing sustained growth in living standards. Two sets of conditions contribute to the dynamism of the capitalist economic system: economic conditions and political conditions (government and the way it functions).

Economic conditions for capitalist dynamism

Where capitalism is less dynamic, the explanation might be that:

Combinations of failures of the three basic institutions of capitalism mean that individuals and groups often have more to gain by spending time and resources in lobbying, criminal activity, and other ways of shifting the distribution of income in their favour. They have less to gain from the direct creation of economic value.12

Capitalism is the first economic system in human history in which membership of the elite often depends on a high level of economic performance. As a firm owner, if you fail, you are no longer part of the club. Nobody kicks you out, because that is not necessary; you simply go bankrupt. Market competition provides a mechanism for weeding out those who underperform.

Of course, if they are initially very wealthy or very well connected politically, owners and managers of capitalist firms survive and firms may stay in business despite their failures, sometimes for long periods or even over generations. Losers sometimes survive. But there are no guarantees; staying ahead of the competition means constantly innovating.

Political conditions for capitalist dynamism

capitalist revolution
Rapid improvements in technology combined with the emergence of a new economic system.

Government is also important. We have seen that in South Korea, for example, governments have played a leading role in the capitalist revolution. And in virtually every modern capitalist economy, governments are a large part of the economy, accounting in some for more than half of GDP. But even where government’s role is more limited, as in Britain at the time of the Industrial Revolution, governments still establish, enforce and change the laws and regulations that influence how the economy works. Markets, private property and firms are all regulated by laws and policies.

For innovators to take the risk of introducing a new product or production process, their ownership of the resulting profits must be protected from theft by a well-functioning legal system. Governments also adjudicate disputes over ownership and enforce the property rights necessary for markets to work.

too big to fail
Said to be a characteristic of large banks, whose central importance in the economy ensures they will be saved by the government if they are in financial difficulty. The bank thus does not bear all the costs of its activities and is therefore likely to take bigger risks. See also: moral hazard.

Competition law and policy is also important. As Adam Smith warned, by creating or allowing monopolies such as the East India Company, governments may also dull the spur of competition. If a large firm is able to establish a monopoly by excluding all competitors, or if a group of firms is able to collude to keep the price high, the incentives for innovation and the discipline of prospective failure will be reduced. This is still true today. Some banks are considered to be too big to fail and are bailed out by governments when they might otherwise have failed, as was the case for banks in the global financial crisis of 2008–2009.

As well as supporting the institutions of the capitalist economic system, the government provides essential goods and services, such as physical infrastructure, education and national defence. In subsequent units, we investigate why government policies may also make good economic sense in areas such as sustaining competition, taxing and subsidizing to protect the environment, influencing the distribution of income, and the creation of wealth.

These are the conditions that together make possible a successful capitalist revolution that, first in Britain and then in some other economies, transformed the way that people interact with each other and with nature in producing their livelihoods.

In a nutshell, capitalism can be a dynamic economic system when it combines:

Question 1.9 Choose the correct answer(s)

Capitalism as an economic system can be dynamic and successful if:

  • it allows failing firms to go bankrupt.
  • it allows successful firms to gain market power.
  • profits are claimed by the capitalists.
  • the government is absent.
  • The ‘stick’ that leads to constant need for innovation is an important feature of the discipline of the market.
  • Once a firm becomes a monopoly, the incentives for innovation and the discipline of prospective failure will be dulled, leading to the economy becoming less dynamic.
  • Capitalists own the capital required to run firms. Their ownership of the profits is the ‘carrot’ that leads them to take the risk of introducing new products or production processes.
  • The government is required to establish the legal framework under which private properties are protected and the markets operate freely. It also provides essential goods and services, such as physical infrastructure, education, and national defence.

1.8 Capitalism, inequality, and democracy

Capitalism and inequality

Dynamic capitalism is a system of winners and losers. The creative destruction of the permanent technological revolution rewards successful innovators with wealth unknown even to royalty in the past. Those with wealth—whether acquired by inheritance, exploiting the trading opportunities of the new global trading system, or as the rewards for successful innovation—are in a position to hire labour to make a profit, thereby perpetuating and even enhancing their wealth before passing it on.

The result is that, in many countries for which data is available, capitalism ushered in an era of increasing inequality of wealth. We know how rich the very rich were at this time, because even centuries ago they needed to pay taxes, so someone recorded their incomes and wealth.

Figure 1.16 shows the fraction of all wealth held by the richest 1% for all countries on which long-run data is available.1314 In most of the countries in Figure 1.16, you can see that wealth inequality increased until around the First World War.

In all the countries shown in Figure 1.16, the advent of democracy early in the last century—when first males without property and then women gained the right to vote—was followed by a significant decline in the inequality of wealth (shown by the reduction in the wealth share of the richest 1%).

economic inequality
Differences among members of a society in some economic attribute such as wealth, income, or wages.

In our ‘Economist in action’ video, Thomas Piketty, an economist and author of the bestseller Capital in the Twenty-First Century, examines economic inequality from the French Revolution until today, and explains why careful study of the facts is essential.15

Share of total wealth held by the richest 1% (1740–2011).

Figure 1.16 Share of total wealth held by the richest 1% (1740–2011).

Adapted from Figure 19 of Daniel Waldenström and Jesper Roine. 2014. ‘Long Run Trends in the Distribution of Income and Wealth’. In Handbook of Income Distribution: Volume 2a, edited by Anthony Atkinson and Francois Bourguignon. Amsterdam: North-Holland. Gaining political power, according to O’Brien, was the route to gaining a larger slice of the economic pie, not the other way around.

Question 1.10 Choose the correct answer(s)

In the ‘Economist in action’ video, which of the following were NOT among the reasons that Piketty gave for the fall in the incomes of the very rich during the twentieth century?

  • the First World War
  • the Great Depression
  • the Russian Revolution
  • the Second World War
  • Nationalization of assets during the World Wars is one of the reasons Piketty gives.
  • Economic recession is one of the reasons Piketty gives.
  • Although political change can affect the distribution of wealth in a country, Piketty does not mention the Russian Revolution in the video.
  • Nationalization of assets during the World Wars is one of the reasons Piketty gives.

Inequality and democracy

Faced with increasing inequality, farmers, industrial workers, and the poor sought a way to protect their standards of living. They engaged in strikes (often brutally suppressed) and some wrecked the machines that had put them out of work. In 1848, there were attempted revolutions against the monarchy in Sicily, France, Germany, Italy, and the Austrian Empire. At the same time, Karl Marx was writing The Communist Manifesto, advocating revolution by workers to end the capitalist economic system.

Many demanded the right to vote as a means of gaining more influence over the government that, at the time, for the most part protected the economic interests of the well off. A greater share of political power, they reasoned, would allow them to claim a larger share of the output and wealth of the rapidly growing economies.

One of the leaders of the movement to extend voting and other political rights to workers and the other less well off, James Bronterre O’Brien, told the people:

‘Knaves will tell you that it is because you have no property, you are unrepresented. I tell you on the contrary, it is because you are unrepresented that you have no property …’16

In the late nineteenth and early twentieth centuries, the wealthy in many countries concluded that extending democracy might be prudent, much as the leaders of the South African government were to conclude a century later.

Democracy is a political system, that ideally:

In many societies throughout human history, the rich have elected representatives to govern them. This is not considered democracy because the less well-off were typically excluded. This happened in ancient Athens, for example, where there were also many slaves.

Capitalism emerged in Britain, the Netherlands, and in most of today’s high-income countries long before democracy. In no country were most adults eligible to vote prior to the end of the nineteenth century (New Zealand was the first).

Even in the recent past, capitalism has coexisted with undemocratic governments, as in South Africa before 1994, Chile from 1973 to 1990, in Brazil from 1964 to 1985, and in Japan until 1945. The economies of contemporary China and Vietnam are variants of the capitalist economic system—and very successful ones at that—but their systems of government are based neither on the individual political rights nor the inclusive and fair elections that define democracy. In many countries today, however, capitalism and democracy coexist, each system influencing how the other works.

Figure 1.17 shows that democracy, as defined by all three of the characteristics (rule of law, civil liberties, and inclusive fair elections), is a recent arrival in human history.

Democracy appeared in just a few countries at the beginning of the twentieth century, but has spread rapidly since then. In many cases, for example in South Africa, it was the threat of popular unrest and even revolution that pushed the wealthy and powerful to extend political rights and access to public services like education to all groups.

The advance of democracy in the world.

Figure 1.17 The advance of democracy in the world.

Center for Systemic Peace. 2016. Polity IV annual time series; Inter-parliamentary union. 2016. ‘Women’s Suffrage’. Initial periods of democracy of less than five years are not shown in the chart.

Like capitalism, democracy comes in many forms, and these vary in the extent to which the democratic ideal of political equality among all citizens is realized. In some democracies, there are strict limits on the ways in which individuals can influence elections or public policy through their financial contributions; in others, private money has great influence through contributions to electoral campaigns, lobbying, and even illicit contributions such as bribery.

These differences even among democracies are part of the explanation of why the government’s importance in the capitalist economy differs so much among nations:

In all four of these countries—under quite different political conditions—the capitalist economy functions well over the very long term, delivering increasing living standards on average with modest levels of economic inequality.

1.9 Capitalism, growth and environmental sustainability

The capitalist revolution has also challenged our environment.

To sustain our livelihoods, humans have always relied on the physical environment and the biosphere, which provide essentials for life such as air, water and food. The environment and biosphere—the collection of all living things—provide the raw materials that we use in the production of other goods, the air we breathe, our food—in short, the physical necessities of life.

Figure 1.18 shows that the economy is part of a larger social system, which is itself part of the biosphere. People interact with each other, and also with nature, in producing their livelihood.

The economy is part of society, which is part of the biosphere.

Figure 1.18 The economy is part of society, which is part of the biosphere.

Through most of our history, humans have regarded natural resources as freely available in unlimited quantities. But elements of the environment such as air, water, soil, and climate have been radically altered by how we have interacted with nature to produce our livelihoods.

Since the advent of capitalism, our impact on the environment has rapidly grown as we extract more from it, and introduce more into it. This has occurred as a byproduct of capitalism’s success in raising material living standards, shown in the hockey sticks for GDP per capita. Also contributing to our increased impact on the environment has been the ability of the capitalist economy to support vastly more people than inhabited the planet just three centuries ago.

This accelerating impact has raised the question of whether our environment can be sustained in the future. If this is not the case, then humanity is living on borrowed time, literally pursuing policies, living life styles and organizing our economy in ways that, if continued, will undermine the natural basis of our livelihoods.

This possibility raises the question of environmental sustainability. We say that something is sustainable if it can be continued indefinitely into the future. For example, we may say that a family’s financial position is not sustainable if they are spending more than they are taking in as income. Similarly, the environment may be unsustainable if the damage we are doing to it is not offset by its own restorative capacity, aided by policies to support environmental recovery.

Climate change

The most striking effect of our activity on the natural environment is climate change. The authoritative source for research and data about climate change is the Intergovernmental Panel on Climate Change. Here, two graphs illustrate what has been happening.

We can see from Figure 1.19 that, while the average temperature of the earth fluctuates from decade to decade, there have been perceptible increases in the northern hemisphere’s average temperatures from 1900 onwards.

Northern hemisphere temperatures over the long run (1000–2006).

Figure 1.19 Northern hemisphere temperatures over the long run (1000–2006).

Michael E. Mann, Zhihua Zhang, Malcolm K. Hughes, Raymond S. Bradley, Sonya K. Miller, Scott Rutherford, and Fenbiao Ni. 2008. ‘Proxy-based reconstructions of hemispheric and global surface temperature variations over the past two millennia’. Proceedings of the National Academy of Sciences 105 (36): pp. 13252–13257.

The human causes and the reality of climate change are no longer widely disputed in the scientific community. These have mostly resulted from the CO2 emissions associated with the burning of fossil fuels.

Figure 1.20 presents evidence of our increased use of fossil fuels—coal, oil, and natural gas—and of a profound change in the natural environment. Figure 1.20 also shows that CO2 emissions from fossil fuel consumption have risen dramatically since 1800.

Carbon dioxide in the atmosphere (1010–2010) and global carbon emissions from burning fossil fuels (1750–2010).

Figure 1.20 Carbon dioxide in the atmosphere (1010–2010) and global carbon emissions from burning fossil fuels (1750–2010).

Years 1010–1975: David M. Etheridge, L. Paul Steele, Roger J. Francey, and Ray L. Langenfelds. 2012. ‘Historical Record from the Law Dome DE08, DE08-2, and DSS Ice Cores’. Division of Atmospheric Research, CSIRO, Aspendale, Victoria, Australia. Years 1976–2010: Data from Mauna Loa observatory. T. A. Boden, G. Marland, and Robert J. Andres. 2010. ‘Global, Regional and National Fossil-Fuel CO2 Emissions’. Carbon Dioxide Information Analysis Center (CDIAC) Datasets.

The likely consequences of global warming are far-reaching—melting of the polar ice caps, rising sea levels that may put large coastal areas under water, and potential changes in climate and rain patterns that may destroy the world’s food-growing areas.

Exercise 1.8 How much difference does a couple of degrees make?

Between 1300 and 1850, there were a number of exceptionally cold periods, as you can see from Figure 1.19. Research this so-called ‘little ice age’ in Europe and answer the following:

  1. Describe the effects of these exceptionally cold periods on the economies of the affected countries.
  2. Within a country or region, some groups of people were exceptionally hard hit by the climate change, while others were less affected. Provide examples.
  3. How ‘extreme’ were these cold periods compared to the temperature increases since the mid-twentieth century and those projected for the future?

Exercise 1.9 Using Excel: Plotting line graphs of temperature over time

This spreadsheet contains the temperature data used to make Figure 1.19. Using this data, recreate Figure 1.19. Follow the walk-through in Figure 1.21 below on how to draw this graph in Excel.

Plotting line graphs of temperature over time.

Figure 1.21 Plotting line graphs of temperature over time.

The data

This is what the temperature data looks like. Column A has time (in years), Column B has temperature deviations, and Column C contains the average northern hemisphere temperature. We will be using Columns A and B to make the line chart.

Figure 1.21a This is what the temperature data looks like. Column A has time (in years), Column B has temperature deviations, and Column C contains the average northern hemisphere temperature. We will be using Columns A and B to make the line chart.

Draw a line chart

Your line chart will look similar to the chart shown above, with temperature deviation on the vertical axis and time on the horizontal axis. Notice that the numbers for time are not correct (they should be years).

Figure 1.21b Your line chart will look similar to the chart shown above, with temperature deviation on the vertical axis and time on the horizontal axis. Notice that the numbers for time are not correct (they should be years).

Change the horizontal axis variable to years

To change the horizontal axis labels to years, we need to add the values in Column A to the line chart.

Figure 1.21c To change the horizontal axis labels to years, we need to add the values in Column A to the line chart.

Change the horizontal axis variable to years

The current horizontal axis labels are the numbers 1, 2, 3, and so on. To change these labels to years, we need to edit the labels.

Figure 1.21d The current horizontal axis labels are the numbers 1, 2, 3, and so on. To change these labels to years, we need to edit the labels.

Change the horizontal axis variable to years

After Step 10, the horizontal axis labels will be changed to the years 1000–2006.

Figure 1.21e After Step 10, the horizontal axis labels will be changed to the years 1000–2006.

Move the horizontal axis to the bottom of the chart

By default, the horizontal axis is positioned at the vertical axis value of 0. To move it to the bottom of the chart (as in Figure 1.19), we have to change the axis position. After Step 12, your chart will look similar to Figure 1.19.

Figure 1.21f By default, the horizontal axis is positioned at the vertical axis value of 0. To move it to the bottom of the chart (as in Figure 1.19), we have to change the axis position. After Step 12, your chart will look similar to Figure 1.19.

Add axis titles and a chart title

Label the horizontal and vertical axes as in Figure 1.19, and give your chart the same title.

Figure 1.21g Label the horizontal and vertical axes as in Figure 1.19, and give your chart the same title.

Technological progress can help

The relationship between the economy and the environment shown in Figure 1.18 is two-way. We use natural resources in production, which may in turn affect the environment we live in and its capacity to support future production. But the permanent technological revolution, which brought about dependence on fossil fuels, may also be part of the solution to today’s environmental problems.

Look back at Figure 1.10, which shows the productivity of labour in producing light. The vast increases shown over the course of history and especially since the mid-nineteenth century occurred largely because the amount of light that could be produced per unit of heat (for example from a campfire, candle, or light bulb) increased dramatically.

In lighting, the permanent technological revolution brought us more light for less heat, which conserved natural resources—from firewood to fossil fuels—used in generating the heat. In today’s world, advances in technology may allow us to produce more of our energy from less polluting sources with a greater reliance on wind, solar and other renewable sources.

Question 1.11 Choose the correct answer(s)

Which of the following variables have followed the so-called ‘hockey-stick’ trajectory—that is, little to no growth for most of history followed by a sudden and sharp change to a positive growth rate?

  • GDP per capita
  • labour productivity
  • inequality
  • atmospheric CO2
  • GDP per capita grows slowly or not at all in economies prior to industrialization, whereupon it begins to grow at an ever-increasing rate.
  • Labour productivity grows slowly or not at all in economies prior to industrialization, whereupon it begins to grow at an ever-increasing rate.
  • There is no unidirectional trend in inequality over time. While early hunter-gatherer tribes were undoubtedly almost perfectly equal, economies in the modern era have varied from highly equal to highly unequal.
  • See Figure 1.20. The growth in atmospheric CO2 began from the mid-nineteenth century as a consequence of the burning of fossil fuels with the spread of technologies introduced in the Industrial Revolution.

Question 1.12 Choose the correct answer(s)

Figure 1.19 (reproduced below) shows the northern hemisphere’s temperature since year 1000, reported as the deviation from the 1961–1990 mean temperature.

Deviation from the 1961–2000 mean temperatures.

Figure 1.19 Deviation from the 1961–2000 mean temperatures.

Based on this information, which of the following statements is correct?

  • The 1961–1990 mean temperature was 0.2 to 0.6 degrees higher than the temperatures between 1450 and 1900.
  • The negative numbers on the graph indicate that the temperature consistently fell between 1100 and 1900.
  • A consistent rise in temperature is only a post-1980 phenomenon.
  • The consistent rise in temperature after 1980 suggests that temperatures will continue to rise in every year following 2000.
  • The graph shows that the temperature between 1450 and 1900 was 0.2 to 0.6 degrees below the 1961–1990 mean temperature.
  • The vertical axis variable shows the difference between the temperature at a given time and the mean temperature in 1961–1990. Negative numbers on the graph indicate that the temperature during those years was consistently below the 1961–1990 mean.
  • There are earlier instances where the temperature rose consistently over a period, for example the early 1900s.
  • It is true that temperatures have been rising consistently since 1980, but this alone does not suggest that temperature will continue to rise in every following year. There are many factors that affect temperature in any given year, making it difficult to predict exactly what the temperature will be in the future. The presence of many factors is the reason why temperature fluctuates from year to year, as you can see in the earlier parts of the graph.

Democracy and the challenge of environmental sustainability

In many countries, the advent of democracy—and especially the extension of the vote to those without property and to women—saw a reduction in economic inequality because it gave more political power to the less well off. Organizations of the less well off—labour unions and political parties—used this power to alter laws and government policies so as to advance their own economic interests.

The relationship between democracy and the challenge of environmental sustainability is not as simple as the one between democracy and addressing the problem of growing inequality. This is true for two reasons:

Both of these reasons why democracy may be limited in how it addresses the challenge of environmental sustainability are examples of something you will encounter throughout this course called external effects. External effects arise when actions taken by a person have consequences—benefits or costs—that are felt by others.

It is not surprising, therefore, that we cannot show you a figure similar to 1.13 in which environmental damages declined following the extension of the vote to most adults in many countries. In fact, Figures 1.16a and 1.16b show just the opposite.

Democracy is not powerless when addressing the environment. Many long-standing democratic nations—many in northern Europe, for example—are outstanding in the ways they have provided local environmental amenities and restricted carbon emissions. But it is also true that democratic India performs less well on any environmental scorecard than undemocratic China, a country that has become a global leader in green technology.

Taking account of its level of income, Australia—where most people got the vote very early—stands out for its protection of the local environment. This is something about which Australian voters have a direct interest and which parallels the reasons why democracy sometimes addresses the problems of inequality. Democracy can empower those who will benefit if inequality or local environmental damage is reduced. But Australia is far from exemplary in its CO2 emissions, whose effects on the environment are global not local. The Australian case highlights the limits of national democratic governments in achieving global environmental sustainability.

1.10 Conclusion

economic inequality
Differences among members of a society in some economic attribute such as wealth, income, or wages.
capitalist revolution
Rapid improvements in technology combined with the emergence of a new economic system.
economic system
The institutions that organize the production and distribution of goods and services in an entire economy.
capitalism
An economic system in which private property, markets, and firms play an important role.
private property
The right and expectation that one can enjoy one’s possessions in ways of one’s own choosing, exclude others from their use, and dispose of them by gift or sale to others who then become their owners.
market
A way of connecting people who may mutually benefit by exchanging goods or services through a process of buying and selling.
firm
A business organization which pays wages and salaries to employ people, and purchases inputs, to produce and market goods and services with the intention of making a profit.
division of labour
The specialization of producers to carry out different tasks in the production process. Also known as: specialization.
specialization
This takes place when a country or some other entity produces a more narrow range of goods and services than it consumes, acquiring the goods and services that it does not produce by trade.
creative destruction
Joseph Schumpeter’s name for the process by which old technologies and the firms that do not adapt are swept away by the new, because they cannot compete in the market. In his view, the failure of unprofitable firms is creative because it releases labour and capital goods for use in new combinations.
government
Within a given territory, the only body that can dictate what people must do or not do, and can legitimately use force and restraints on an individual’s freedom to achieve that end. Also known as: state.
democracy
A political system, that ideally gives equal political power to all citizens, defined by individual rights such as freedom of speech, assembly, and the press; fair elections in which virtually all adults are eligible to vote; and in which the government leaves office if it loses.
political system
A set of principles, laws, and procedures that determine how governments will be selected, and how those governments will make and implement decisions that affect all or most members of a population.
gross domestic product (GDP) per capita
A measure of the market value of the output of the economy in a given period (GDP) divided by the population.
purchasing power parity (PPP)
A statistical correction allowing comparisons of the amount of goods people can buy in different countries that have different currencies. See also: constant prices.
ratio scale
A scale that uses ratios to represent distance. For example, the ratio between 3 and 6, and between 6 and 12, is the same (the larger quantity is twice the smaller). This contrasts with a linear scale, where the distance between 3 and 6, and between 6 and 9, is the same (3). See also: linear scale.
natural experiment
An empirical study exploiting naturally occurring statistical controls in which researchers do not have the ability to assign participants to treatment and control groups, as is the case in conventional experiments. Instead, differences in law, policy, weather, or other events can offer the opportunity to analyse populations as if they had been part of an experiment. The validity of such studies depends on the premise that the assignment of subjects to the naturally occurring treatment and control groups can be plausibly argued to be random.
economics
The study of how people interact with each other and with their natural surroundings in providing their livelihoods, and how this changes over time.

Beginning with a look at economic inequality, both between and within countries, we have analysed the ‘hockey stick’ trajectories for GDP per capita, labour productivity, connectivity, global climate change and its primary source, carbon emissions. The hockey stick kinks occur at different times for different countries and are associated both with the emergence of the permanent technological revolution and the capitalist revolution. Affluence, global inequality, and environmental degradation have often accompanied change in the economic system.

Capitalism is an economic system defined by three nested characteristics: private property, markets, and firms. Firms and markets made the division of labour and specialization possible on an unprecedented scale. Further contributing to increases in the productivity of a day of labour, the process of creative destruction incentivizes cost-reducing innovation.

Capitalism is a system of winners and losers both within nations and across the globe, and this, along with creative destruction, contributes to inequality.

The combination of centralization within firms and decentralization via competition in markets makes it a unique and dynamic system. Both economic and political conditions, including what the government does as an economic actor, contribute to a capitalist system’s dynamism. Important conditions are the security of private property, the provision of basic research and education, and the leadership of firms determined by merit rather than inheritance.

The rising inequality at the time of the capitalist revolution is a factor that contributed first to demands for and later to the spread of democracy, a political system characterized by the rule of law, civil liberties and inclusive fair elections. Various forms of capitalism exist—some dynamic and some not, some alongside democratic governments and others not.

We have added economic measures such as GDP per capita and purchasing power parity (PPP). We have seen how the ratio scale is useful for comparing growth rates in charts. To address the challenge of knowing when something like capitalism may cause something like economic growth we have introduced a natural experiment, where treatment and control groups occur naturally.

Capitalism and democracy continue to evolve, to change each other, to revolutionize the world and to affect your everyday life. Economics will help you understand these changes and show you ways that you—with others—can participate in this constant process of change.

1.11 Doing Economics: Measuring climate change

In this unit, we discussed climate change as one of the effects of the rapid economic growth that happened in most countries since the Industrial Revolution. Climate change is an important issue for policymaking, since governments need to assess how serious the problem is and then decide how to mitigate it.

Suppose you are a policy advisor for a small island nation. The government would like to know more about the extent of climate change and its possible causes. They ask you the following questions:

  1. How can we tell whether climate change is actually happening or not?
  2. If it is real, how can we measure the extent of climate change and determine what is causing it?

Go to Doing Economics Empirical Project 1 to work on this problem.

Learning objectives

In this project you will:

  • use charts and summary measures to discuss the extent of climate change and its possible causes
  • use line charts to describe the behaviour of real-world variables over time
  • summarize data in a frequency table, and visualize distributions with column charts
  • describe a distribution using mean and variance
  • use scatterplots and the correlation coefficient to assess the degree of association between two variables
  • explain what correlation measures and the limitations of correlation.

1.12 References

  1. Jean Drèze and Amartya Sen. 2013. An Uncertain Glory: India and its Contradictions, Princeton, NJ: Princeton University Press, p. 2 

  2. Adam Smith. (1776) 2003. An Inquiry into the Nature and Causes of the Wealth of Nations. New York: NY: Random House Publishing Group. 

  3. Adam Smith. 1759. The Theory of Moral Sentiments. London: Printed for A. Millar, and A. Kincaid and J. Bell. 

  4. David S. Landes. 2003. The Unbound Prometheus: Technological Change and Industrial Development in Western Europe from 1750 to the Present. Cambridge: Cambridge University Press. 

  5. Paul Seabright. 2010. The Company of Strangers: A Natural History of Economic Life (Revised Edition). Princeton, NJ: Princeton University Press. 

  6. Joseph A. Schumpeter. 1949. ‘Science and Ideology’. The American Economic Review 39 (March): pp. 345–59. 

  7. Joseph A. Schumpeter. 1997. Ten Great Economists. London: Routledge. 

  8. Joseph A. Schumpeter. 1962. Capitalism, Socialism, and Democracy. New York: Harper & Brother. 

  9. Robert Skidelsky. 2012. ‘Robert Skidelsky-portrait: Joseph Schumpeter’. 

  10. Hartmut Berghoff and Uta Andrea Balbier. 2013. ‘From Centrally Planned Economy to Capitalist Avant-Garde? The Creation, Collapse, and Transformation of a Socialist Economy’. In The East German Economy, 1945–2010: Falling behind or Catching Up? Cambridge: Cambridge University Press. 

  11. World Bank, The. 1993. The East Asian miracle: Economic growth and public policy. New York, NY: Oxford University Press. 

  12. Daron Acemoglu and James A. Robinson. 2012. Why Nations Fail: The Origins of Power, Prosperity, and Poverty. New York, NY: Crown Publishing Group. 

  13. Facundo Alvaredo, Anthony B. Atkinson, Thomas Piketty, Emmanuel Saez, and Gabriel Zucman. 2016. ‘The World Wealth and Income Database (WID)’

  14. Anthony B. Atkinson and Thomas Piketty, eds. 2007. Top Incomes Over the Twentieth Century: A Contrast between Continental European and English-Speaking Countries. Oxford: Oxford University Press. 

  15. Thomas Piketty. 2014. Capital in the Twenty-First Century. Cambridge, MA: Harvard University Press. 

  16. Alfred Plummer. 1971. Bronterre: A Political Biography of Bronterre O’Brien, 1804–1864. Toronto: University of Toronto Press.