1 Capitalism and democracy: Affluence, inequality, and the environment

1.1 Introduction

• In the past 250 years there has been an unprecedented rise in global living standards. A minority of countries have achieved affluence, while a significant majority of the world’s population has at least escaped from grinding poverty.
• At around the same time as the escape from poverty began, a new force was beginning to dominate the economy: capitalism.
• The capitalist revolution made the escape from poverty possible. It brought about advances in technology, increasing specialization, and massive increases in productive assets—capital. These three factors dramatically raised the amount that could be produced in a day’s work.
• The capitalist revolution has also been accompanied by unprecedented global economic inequalities, and growing threats to our natural environment.
• In many countries, unequal access to growing affluence led to social unrest and demands for a new political system: democracy.
• Democracy brought greater political equality among the citizens of many of the countries that adopted it, and usually had some mitigating effect on economic inequality.

A South African story

When Cyril Ramaphosa, who in 2018 became the president of South Africa, was born in 1952, under the apartheid system of racial segregation 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, owning wealth of more than $700 million.

Under apartheid, the white minority prospered. They owned the mines, factories and farms that made South Africa the richest country on the continent, and some had achieved levels of affluence similar to that seen in the richest countries in the world. But the income per capita of black South African families in the late 1980s was around 11% of that of white families. It had been stuck at this level for at least 50 years.

Resistance to apartheid was brutally repressed. Nelson Mandela, the leader of the African National Congress (now South Africa’s largest political party), which had been banned, 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?

The abolition of apartheid and the transition to a democratic political system led to some clear economic gains for the black population. Legally-imposed racial separation of schools and healthcare was ended. 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.

The nature of economic inequality in South Africa also changed.

Differences between the major population groups declined. So, if you took the income of a typical black citizen, it would be closer to that of a white citizen.

But inequalities within these groups increased dramatically. Ramaphosa’s own experience is an extreme example.

The arrival of democracy with the abolition of apartheid meant that, measured by their political rights, all South Africans became equal. But the net effect of narrowing differences between racial groups and widening inequality within them, is that the inequality of the income that South Africans receive (after payment of taxes and receipt of government transfers like unemployment benefits and pensions) did not decline in the 20 years after the end of apartheid.

Looking ahead

In this and future units, we shall revisit many of the topics raised by South Africa’s recent history, and indeed the personal experience of Cyril Ramaphosa as a political activist, union leader, business owner, and head of state.

In this unit, we first look beyond South Africa, and ask how a new form of economic organization called capitalism brought affluence, inequality, and threats to environmental sustainability as it spread across the world in the last 250 years, and how the emergence of democracy, which happened much later, both reflected and influenced the changes that capitalism brought, and is still making, to the way we live.

1.2 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 powerful 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 1.1. This allows you to place yourself in a three-dimensional visualization of the world.

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 lowest bar in the front. The average income of the richest 10% is the highest bar for that country at the back. The width of the bar corresponds to the size of the population.

decile

A subset of observations, formed by ordering the full set of observations according to the values of a particular variable and then splitting the set into ten equally-sized groups. For example, the 1st decile refers to the smallest 10% of values in a set of observations. See also: percentile.

Take China, for example. Its block is wide because of its large population. Because countries are ordered by average income, the countries immediately to China’s 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 1.1a. In Section 1.3 we discuss how the data shown in the chart allows us to make meaningful comparisons between countries and across different time periods.

Dissecting the skyscraper figure

There is a lot of information in Figure 1.1. In Figure 1.1a, we show alternative ways of looking at the skyscraper that allow you to make comparisons in a range of different ways, comparing both between and within countries. Go to the Globalinc website to see how inequality has changed since 1980. You will see countries changing positions in the global income distribution and the steepness of the ‘skyscrapers’ for most countries increasing over time.

Inequality within and between countries

The rich/poor ratio used here is similar to, but not exactly the same as, a commonly used measure of inequality called the 90/10 ratio. The 90/10 ratio is defined as the ratio between the income of the two individuals at the ninetieth and tenth percentiles. We are instead taking the ratio of the average income of the tenth (‘rich’) and first (‘poor’) deciles. The tenth decile is made up of all the people with higher income than the person at the ninetieth percentile, so its average is larger than the income of that person. The first decile is made of all the people with income less than the person at the tenth percentile, and so its average will be lower than the income of that person. Therefore, our rich/poor ratio will be a higher number than the 90/10 ratio for the same country.

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.

We can use the ratio between the heights of the front and back bars as one measure of inequality in a country. We will call it the rich/poor ratio, for obvious reasons.

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

	Rich	Poor	Rich/Poor 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

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.

While Figure 1.1 shows massive inequality across countries in 2014, it 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. We now ask, how did we get from that world to this one?

1.3 How did we get here? The hockey stick in real incomes

Before we can answer this question, we need to consider how we measure income.

Real GDP per capita: Measuring incomes at different times, and different places

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.

inflation

An increase in the general price level in the economy. Usually measured over a year. See also: deflation, disinflation.

real GDP

An inflation-adjusted measure of the market value of the output of the economy in a given period. (GDP). See also: inflation, constant prices, gross domestic product.

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, real GDP.

When we measure something in the real world by applying a rule or set of rules to data, the number we get is known as a statistic. The most common statistic used to measure income is called gross domestic product (GDP) per capita.

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 make meaningful comparisons between countries and across time, we first need to make four adjustments to the GDP of a given country.

• First, and most crucially, we need to divide a country’s total GDP by its population, to derive GDP per capita: a measure of average annual income. A poor country with a large population like India may have total GDP many times higher than a rich country with a small population like Belgium—$2.66 trillion compared to $526 billion in 2017. But as economists, we are interested in the income of the typical inhabitant of a country, so correcting for population is a crucial first stage. In our example, Belgium, with a population of 11.38 million, has a much larger GDP per capita than India, with a population of 1.34 billion—$46,169 compared to $1,987.
• Second, we need to correct for changes in spending power within the country. If GDP per capita rises by 10% in units of the country’s currency, but the prices of goods and services have also risen by 10% (there has been 10% inflation), then in terms of actual spending power incomes have not risen: people can buy exactly the same goods and services with the money they earn. Economists say that in such a case, there has been no change in real incomes. So, in any historical comparison, we need to correct for inflation and calculate real GDP per capita (sometimes referred to as GDP at constant prices).
• Third, to compare GDP per capita between countries, we need to measure it in the same units. The US dollar is a commonly-used unit.
• Fourth, even after correcting for inflation, and converting into dollars, we also need to do one final adjustment, to reflect big differences in what $1 will buy in the local shops in different countries, even after it has been changed into local currency. We use a technique that is called purchasing power parity, or PPP for short.

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.

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. And economists can use historical records to apply the same rules and estimate GDP per capita over periods that go back centuries.

The hockey stick

We have used GDP statistics and the adjustments described above to create the line graph in Figure 1.2. 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, in terms of real spending power, in a given country at the date on the horizontal axis. Notice that the vertical axis is measured in units of real GDP per capita.

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 1.1.

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 1.1 would have looked like in the fourteenth century?

Exercise 1.2 Using Excel: Income data and the rich/poor 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 rich/poor ratio in 1980, 1990 and 2014. (To do this in Excel, follow the step-by-step instructions in the walk-through in Figure 1.3.)

2. Describe the differences you find between countries and the changes over time.
3. Can you think of any explanations for these differences?

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Figure 1.3 Income data and the rich/poor ratio.

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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.

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

We apply a filter so that we see only the data we need. This makes the data easier to work with. We filter using the country names in column A.

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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 it is now hidden.

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Filter the data to see only the years we need

After completing step 6 your spreadsheet should look similar to the example above, with only the countries and years you want to see.

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Calculate the rich/poor ratio for one row

We calculate the rich/poor 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.

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Repeat this calculation for the rest of the rows

You don’t need to type the same formula many times. Simply copy the formula to other cells to calculate the rich/poor ratio for other years.

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Round the calculated values to one 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.

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Round the calculated values to one decimal place

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

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The final product

The calculated rich/poor ratios are now rounded to one decimal place.

median

The middle number in a set of values, such that half of the numbers are larger than the median and half are smaller. Also known as: 50th percentile.

mean

A summary statistic for a set of observations, calculated by adding all values in the set and dividing by the number of observations.

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 1.4 on how to do the Excel parts of this exercise.

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. 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. Suppose that each country you have chosen only has 10 people, so Decile 1 is the income of the poorest and Decile 10 is the income of the richest. Using this simplification, what is the median income in Country A? How about in Country B?
3. Using the same simplification as Question 2, suppose that the income of the richest person 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.

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Figure 1.4 Bar chart showing mean incomes

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The data

We are using the same data as in Exercise 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 Exercise 1.2 for how to do this).

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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.

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Add axis titles and a chart title

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

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Calculate the mean income

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

1.4 Economic growth

Between the years 1000 and 1600 in Figure 1.2, 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 1.2 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 (real) GDP growth rate is the percentage change in (real) GDP from one year to the next. National statistics agencies usually publish annual real GDP data, which is an estimate of real GDP, measured at the end of every year. Using this data, we can calculate the annual growth rate of real GDP in year t (let’s call it $g_t$) as:

$$g_t~(\text{in %)} = \frac{\text{GDP}_t - \text{GDP}_{t-1}}{\text{GDP}_{t-1}} \times 100\%$$

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

$$g_t~(\text{in %)} = \frac{3 - 2.8}{2.8} \times 100\% = 7.14\%$$

As before, a $1 billion increase in a country’s real GDP would be very large if real GDP was $3 billion, but not if real GDP was $300 billion. For this reason, percentage changes allow us to compare real GDP growth of a country in different years. That’s why we use percentages. If real GDP 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. This is the case whether it is the growth of the economy (real GDP growth) or the growth of incomes (real GDP per capita). For example, knowing that real 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’ box about compound growth rates, below. The ‘Find out more’ box about the ‘rule of 70’ for growth rates gives a simple rule of thumb that lets you calculate how many years it takes for real 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% between 1950 and 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 real 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:

$$\begin{align*} \text{CAGR} = g~(\text{in %}) &= \bigg[\Big( \frac{\text{GDP}_{\text{2011}}}{\text{GDP}_{\text{1950}}}\Big)^{\frac{1}{61}} - 1\bigg] \times 100\% \\ &= \bigg[\Big( \frac{42,300}{12,800}\Big)^{\frac{1}{61}} - 1\bigg] \times 100\% \\ &= 2.0\% \end{align*}$$

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

$$\begin{align*} g~(\text{in %}) &= \frac{1}{61}\big(\frac{\text{GDP}_{\text{2011}}-\text{GDP}_{\text{1950}}}{\text{GDP}_{\text{1950}}}\big) \times 100\% \\ &= \frac{1}{61}\big(\frac{42,300-12,800}{12,800}\big) \times 100\% \\ &= 3.8\% \end{align*}$$

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 real GDP per capita to double is approximately 70 divided by the annual growth rate:

$$\begin{align*} & \text{number of years for} \\ & \text{real GDP per capita to double} = \frac{70}{\text{annual growth rate (%)}} \end{align*}$$

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 real GDP per capita is 2%, then it would take approximately 70/2 = 35 years for real GDP per capita to double.

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

Optional Exercise 1.3.1 Using Excel: Calculating compound growth rates

Download and save the spreadsheet containing some of the GDP data used to make Figure 1.2.

1. Calculate the CAGR for China, Britain, Italy, and India between 1950 and 2011. Follow the walk-through in Figure 1.5 on how to do this in Excel.

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Figure 1.5 Calculating CAGR in Excel.

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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 real GDP per capita values.

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Calculate the difference in years

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

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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.

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

   Example: In Japan, real GDP per capita was 1,920.72 in 1950. Scrolling down the spreadsheet, we can see that real GDP per capita was 3,986.43 in 1960, which is approximately double the value in 1950. Therefore, it took Japan roughly 10 years for real GDP per capita to double its 1950 value.

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

A ratio scale

ratio scale

A scale that uses distances on a graph to represent ratios. For example, the ratio between 3 and 6, and between 6 and 12, is the same (the larger number is twice the smaller number). In a ratio scale chart, all changes by the same ratio are represented by the same vertical distance. This contrasts with a linear scale, where the distance between 3 and 6, and between 6 and 9, is the same (in this case, 3). Also known as a log scale (in for example, Microsoft Excel).

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 1.2, the scale went from 10,000 to 15,000 to 20,000 etc. by adding 5,000 at each step. Instead, in Figure 1.6, 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 1.2 with those in Figure 1.6. Remember that we are using exactly the same data in each of these figures.

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

Using 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:

• A straight line means a constant growth rate.
• A steeper line means a faster growth rate.

Using the ratio scale, we can immediately see something that was not obvious in Figure 1.2—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 at that time were much faster.

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

Figure 1.2 uses a conventional scale for the vertical axis, and Figure 1.6 uses 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 real 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 1.6 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 1.2 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.

What influences growth and inequality?

From Figures 1.2 and 1.6, we learned three things about growth and inequality:

• For a very long time, living standards did not grow in any sustained way, anywhere.
• In some countries—India and China notably—per-capita income fell over long periods.
• When sustained growth occurred, it began at different times in different countries. It happened first in Britain, then in Italy and Japan (though at different rates), and finally in India and China. This led to vast differences in living standards around the world, as the video by Hans Rosling in Section 1.3 showed.

Why were there leaders and laggards?

capitalism

An economic system in which the main form of economic organization is the firm, in which the private owners of capital goods hire labour to produce goods and services for sale on markets with the intent of making a profit. The main economic institutions in a capitalist economic system, then, are private property, markets, and firms.

economic system

A way of organizing the economy that is distinctive in its basic institutions. Economic systems of the past and present include: central economic planning (e.g. the Soviet Union in the 20th century), feudalism (e.g. much of Europe in the early Middle Ages), slave economy (e.g. the US South and the Caribbean plantation economies prior to the abolition of slavery in the 19th century), and capitalism (most of the world’s economies today).

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.

In some economies (as illustrated in Figure 1.6 by China and India), substantial improvements in people’s living standards did not occur until they gained independence from colonial rule or interference by European nations:

• India: According to Angus Deaton, an economist who specializes in the analysis of poverty, when 300 years of British rule of India ended in 1947: ‘It is possible that the deprivation in childhood of Indians … was as severe as that of any large group in history’.¹ In the closing years of British rule, a child born in India could expect to live for 27 years. Fifty years on, life expectancy at birth in India had risen to 65 years.
• China: It had once been richer than Britain, but by the middle of the twentieth century, GDP per capita in China was one-fifteenth that of Britain.
• Latin America: Neither Spanish colonial rule, nor its aftermath following the independence of most Latin American nations early in the nineteenth century, saw anything resembling the hockey-stick upturn in living standards experienced by the countries in Figures 1.2 and 1.3.

The emergence in the eighteenth century in Europe of a new way of producing goods and services, called capitalism, progressively came to be the dominant economic system in rich countries. This 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 explained how both capitalism and democracy influenced the lives of South Africans in the twentieth century.

South Africa was (and is) an economy in which capitalism plays a crucial role 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, in principle, 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

Great economists 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.

institution

The laws and informal rules that regulate social interactions among people and between people and the biosphere, sometimes also termed the rules of the game.

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 narrower range of goods and services than it consumes, acquiring the goods and services that it does not produce by trade.

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 one another 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 one another: ‘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.

market

A way that people exchange goods and services by means of directly reciprocated transfers (unlike gifts), voluntarily entered into for mutual benefit (unlike theft, taxation), that is often impersonal (unlike transfers among friends, family).

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

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.

He also saw that the market system had some failings, especially if sellers banded together to form monopolies, so as to avoid competing with one another. Smith specifically targeted monopolies that were protected by governments, such as the British East India Company—a monopoly created by the government—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. Smith was also an advocate of government investment in education and in public works, such as bridges, roads, and canals.

1.5 The permanent technological revolution: Engine of growth

Figure 1.2 is flat for a long time, and 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 capital goods (such as 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 capital goods (such as 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 1.2, 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.

While the Industrial Revolution was the impetus for the upturn of the hockey stick in Britain, it was not a one-off event: the process of technological innovation has been more or less continuous since then.

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.

Producing more with less work

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

Nobel prize-winner William Nordhaus measured this trend over thousands of years, by looking at the resources required to create light. 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. Since then, lighting has become more and more efficient through gas lamps, kerosene lamps, filament bulbs, fluorescent bulbs, and so on.

Today, the productivity of labour in producing light is half a million times greater than it was among our ancestors around their campfires. To put this in perspective, Figure 1.9 shows how much time it would have taken, starting 100,000 years ago, to produce the same amount of light as a modern low-energy lightbulb produces in one hour. It is in the shape of the hockey sticks that we saw when we were investigating growth of income, but now it is one that has been turned to face downwards, because the units (hours of work) are getting smaller. What would have taken a week’s work 100,000 years ago now takes just a fraction of a second, at least in a modern economy like the US.

Time saved in creating light is time that can be used to produce other goods and services. This is an example of how growth happens.

1.6 Another engine of growth: More machines and tools per worker

While Figure 1.9 paints a striking picture of how little labour is required to produce light in a modern economy, it is not a picture that applies to everyone in the world. For many people in poor countries, often with no access to grid electricity, providing even basic light in the home still absorbs a significant fraction of their incomes. This is because the ‘technology’ of light—as defined by economists—is not useful unless it is combined with what we call ‘technology’ in everyday speech: light bulbs, power cables, power plants, and the resources to pay for and maintain them.

capital goods

The durable and costly non-labour inputs used in production (machinery, buildings) not including some essential inputs, e.g. air, water, knowledge that are used in production at zero cost to the user.

Economists call the goods required to produce other goods and services ‘capital goods’.

While the Industrial Revolution in Britain was driven by technology (in the economist’s sense), it could only be implemented by a large increase in the amount of capital goods in the economy. This is shown in Figure 1.11, which shows the path traced by the increase in output per worker when capital goods per worker increased in Britain, starting in the middle of the eighteenth century.

If we want to understand the hockey stick, it is important first to understand the nature of capital goods. First, because capital goods do not fall from the sky: all countries that have successfully moved from poverty to affluence have done so, of necessity, by accumulating large amounts of capital. We will also see that a crucial feature of capitalism is who owns and controls the capital goods in an economy.

1.7 The capitalist revolution

capitalism

An economic system in which the main form of economic organization is the firm, in which the private owners of capital goods hire labour to produce goods and services for sale on markets with the intent of making a profit. The main economic institutions in a capitalist economic system, then, are private property, markets, and firms.

Capitalism is a way of organizing production—and with it, much of society—that began at around the time of the Industrial Revolution. Since then, we have seen that, the lives of much of humanity have been massively transformed. But capitalism, while it has produced affluence on an unprecedented scale, 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, by which we mean:

• An economic system is a way of organizing the production and distribution of goods and services in an entire economy.
• Institutions are the different sets of laws and social customs regulating production and distribution in different ways in families, private businesses, markets and government bodies.

We define a capitalist economy as one that combines three particular institutions:

private property

Something is private property if the person possessing it has the right to exclude others from it, to benefit from the use of it, and to exchange it with others.

market

A way that people exchange goods and services by means of directly reciprocated transfers (unlike gifts), voluntarily entered into for mutual benefit (unlike theft, taxation), that is often impersonal (unlike transfers among friends, family).

firms

Economic organizations in which private owners of capital goods hire and direct labour to produce goods and services for sale on markets to make a profit.

• private property
• markets
• firms

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’—in which, for the most part, capital goods are privately owned, can be contrasted with ‘centrally planned’ economies where the government owns all or nearly all of them, and is the key institution controlling production, and deciding how and to whom goods and services 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.

Centrally planned economies describe one extreme, which has largely disappeared—almost the only exception is North Korea (Democratic People’s Republic of Korea). Another contrast is with an economic system defined as a slave economy, where most of the work is done by people who are not hired for wages but, instead, like the land on which they work, are the property of another person. In a capitalist economic system, like Germany or India, labour done in firms is not the only form of work. There is also unpaid work in the home and work done by government employees such as teachers and police officers, people working for themselves (for example, some electricians, shopkeepers and lawyers) and, in the past, the work of slaves.

How private property, markets, and firms combine with one another, and with families, governments, and other institutions, differs greatly between countries. We shall, for example, refer to both China and the US as capitalist economies, because both share many of the characteristics of capitalism. But they differ greatly in the extent to which the government influences economic affairs (as well as in many other ways). Furthermore—and importantly—no economic system in the world today can be described as ‘pure’ capitalism. Even in the US, for example, only between two-thirds and three-quarters of GDP is produced by what we would call capitalist enterprises.

Private property

Over history, the extent of private property has varied. In some societies, such as the hunters and gatherers who were 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.

Private property may be owned by an individual, a family, a business, or some entity other than the government. Yet 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, bought, or sold.

Markets

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

• They are reciprocated: Unlike gifts and theft, one person’s transfer of a good or service to another is directly reciprocated by a transfer in the other direction (either of another good or service as in barter exchange, or money, or a promise of a later transfer when one buys on credit).
• They are voluntary: Both transfers—by the buyer and the seller—are voluntary because the things being exchanged are private property. The fact that the exchange takes place means that it must be beneficial in the opinion of both parties. In this, markets differ from theft, and also from the transfers of goods and services in a centrally planned economy.
• In most markets there is competition: A seller charging a high price, for example, will find that buyers prefer to buy from other competing sellers.

Markets may be competitive, but they are 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?

An economist’s definition of a ‘firm’ is not captured well by the segmentation of GDP data that records production in the economy. For example, according to the Bureau of Economic Analysis, in 2017, 57% of US GDP was produced by nonfinancial corporate business, plus financial businesses; 75% was produced by what it calls the ‘business sector’, which also includes unincorporated businesses. The rest of GDP was produced by the household and nonprofit sectors, and state and local governments.

Firms

Private property and markets both predate the hockey stick by many centuries. So we need something else to help us understand the transition to rising living standards illustrated by the hockey stick: 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 organizations are some examples of what economists call firms: restaurants, banks, large farms that pay labourers to work on them, industrial establishments, supermarkets, and internet service providers.

These organizations are productive (and important), but are not firms: businesses in which most or all of the people who do the work are unpaid family members, non-profits, employee-owned cooperatives, and government-owned entities (in some countries, the railways, power or water companies are owned by the government).

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.

The ability to adapt quickly has allowed an acceleration in one of the changes that was underway during Adam Smith’s life, but has greatly accel­erated since, namely 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 for the following reasons:

• Learning by doing: We acquire skills as we produce things.
• Difference in ability: For reasons of skill, or natural surroundings such as the quality of the soil, some people are better at producing some things than others.

But people will not specialize unless they have a way to acquire the other goods they need, thus we need the combination of firms and market.

Capitalism as an economic system

Figure 1.12 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.

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.

Only with the emergence of firms in the late eighteenth century were all the components of the capitalist system in place.

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, the owner is ‘the boss’. But when the same owner interacts with a potential customer, they are 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

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 do sometimes survive, but there are no guarantees; staying ahead of the competition means constantly innovating.

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 (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 that 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 words⁷⁸ 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.

Capitalism and the accumulation of capital goods

Just as the capitalist system provides strong incentives for innovation, it also rewards those who invest in the new machinery and other capital goods.

Because of the changing technologies, there were many profit opportunities for those producing with new technologies, as well as for those who financed and built the factories and machines embodying it. In this respect, capitalism differed not only in its dynamism, but also in the security of its property rights, so that those investing in the new capital goods could be confident that their property could not be confiscated either by the government or by others.

1.8 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. This is strong circumstantial evidence—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), just because we can see there is a correlation.

If you want to explore how to distinguish causation and correlation in the real world, why not attempt a practical project from our online resource Doing Economics?

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.’

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 (although in Units 2 and 3, we will give examples of the use of experiments in economics).

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.

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 upturn. Putting this in scientific language: the observation would be consistent with the hypothesis that capitalist institutions were a cause of continuous productivity growth. But the emergence of a free-thinking cultural environment known as The Enlightenment also predated or coincided with the upturn in the hockey sticks.

Figure 1.13 uses arrows to represent causal relationships. Before the eighteenth century, living standards were more or less the same every year. Afterwards, they grew constantly. Many economists and historians explain what happened in this way:

• The permanent technological revolution was the result of a change in both culture and institutions.
• The subsequent shift to growing affluence was the result of both capitalism and new technologies.

The arrows indicate causal relationships. So the picture represents the idea that institutions and culture were two of the causes of the permanent technological revolution that began in the Industrial Revolution. This simple picture is an example of what is called an ‘economic model’.

Economists and historians disagree on the causes of the Industrial Revolution. You can find out why they disagree by reading a 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 our growing affluence caused by institutions, culture, both, or something else? One method for investigating a question like this is called a ‘natural experiment’, in which we can identify two groups:

• A ‘treatment’ group: This group undergoes a change. Other attributes of the group remain constant.
• A ‘control’ group: This group was similar to the treatment group before the experiment, and the treatment does not occur in this 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 an interview, Jared Diamond, a geographer, and James Robinson, a professor of government, explain the method.

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.

Capitalism and central planning

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.

You can read more about Winston Churchill’s ‘Iron Curtain’ speech on history.com.

At the end of the Second World War, Germany was divided into two countries. 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.

This separation introduced two different economic systems.

While West Germany returned to market-based capitalism, in East Germany the Communist Party introduced a system of centralized planning that 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.

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.

We can represent the logic of this natural experiment with a visual model, like the one in Figure 1.13. Figure 1.14 shows that in contrasting the two Germanies, one possible influence on their growth is ‘held constant’: German culture was common, but the institutions differed between East and West Germany. As in the previous figure, the arrows indicate causal relationships.

Figure 1.15 shows the outcome of this natural experiment. It shows the different paths taken by them, and two other economies, from 1950. We have used a ratio scale to show the rate of growth.

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, which separated East and West Germany, was built in 1961. East Germany’s planned economy never caught up with West Germany.

Notice from Figure 1.15 that West Germany did start from a more favourable position than East Germany in 1950, because the structure of the industries in East Germany was more disrupted by splitting the country than was the case in West Germany.¹⁰ But this difference was not mainly because of differences in the amount of capital goods, or skills per head of the population (and, as we noted above, before the war, living standards in the East and West had been similar).

So, following that disruption, we would have expected East Germany to have caught up with West Germany. But Figure 1.15 shows that, instead, the gap between the two lines widened (which on a ratio scale means that the ratio of incomes increased). By the time the Berlin Wall fell in 1989, and East Germany abandoned central planning, its real GDP per capita was less than half of that of capitalist West Germany.

The validity of this comparison as a natural experiment depends on the idea that East and West Germany differed in just one way that might affect their economic growth: their economic institutions. So, consider the second half of the twentieth century. Figure 1.15 suggests strongly that the imposition of central planning in East Germany—compared to what would have happened if East Germany had used the same capitalist system as West Germany—slowed the growth in income of East German people.

We cannot conclude from the German natural experiment that capitalism always promotes rapid economic growth, or that central planning is always a cause of economic stagnation. There is evidence pointing in both directions:

• From Figure 1.15, we can see that some capitalist economies that had even lower real 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 caught up to West Germany.
• But we will see in Figure 1.16 that the Soviet Union’s centrally planned economy grew considerably faster between 1928 (when central planning was introduced there) and 1980 than the economies of many capitalist countries that were at similar levels of development in 1928.

But, while both comparisons are interesting, neither is a natural experiment: many factors influenced the outcomes in these countries, so we cannot isolate the impact of capitalism. Natural experiments in economics, in which two groups are similar beforehand, there is one treatment, and other factors are held constant, are rare. This is why, in economics, it is hard to make strong causal statements.

1.9 Varieties of capitalism: Institutions and growth

Not every capitalist country is the kind of economic success story exemplified in Figure 1.2 by Britain, later Japan, and the other countries that caught up, or in the post-Second World War catch-up shown in Figure 1.15. This explains why the left-hand end of the skyscraper diagram (Figure 1.1) is so much poorer than the right-hand end.

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

Many of the economies at the left-hand end of Figure 1.1 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 1.16 tracks the fortunes of a selection of countries across the world during the twentieth century. 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). Differences in the quality of their institutions—the amount of corruption and misdirection of government funds, for example—may help explain their contrasting trajectories.

South Korea’s take-off in the middle of the twentieth century occurred under institutions and policies different from those in Britain in the eighteenth and nineteenth centuries. The most important difference was that the government of South Korea (along with a few 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.

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.

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

From Figure 1.16 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 real GDP per capita in the Soviet Union outstripped Brazil by a wide margin—and even overtook Argentina briefly—before Communist Party rule in the Soviet Union ended in 1990.

The contrast between West and East Germany demonstrates that one reason central planning was abandoned as an economic system was a failure to deliver the improvements in living standards that some capitalist economies had achieved. Yet the countries that had once made up the Soviet Union replaced central planning with many varieties of capitalism. These did not work so well either. We can see this from a sudden dip in real GDP per capita for the former Soviet Union after 1990.

Economist Lisa Cook of Michigan State University asks why the transition to capitalism in Russia in the 1990s did not spark a wave of innovation. She documents the late 19th century inventions contributed by African American inventors, including gas masks, traffic lights, and light bulb technology and how this burst of innovations was cut short by a wave of attacks and anti-black mob violence. Her insights on the political and economic conditions under which innovation will flourish are relevant to understanding the vast differences across the world today in the extent of innovation.

1.10 Varieties of capitalism: Growth and stagnation

The lagging performances of some of the economies in Figure 1.16 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
• political conditions—in other words, government and the way it functions.

Economic conditions for capitalist dynamism

Where capitalism is less dynamic, economists usually look for failures in the three components of the capitalist system, private property, markets, and firms:

• Private property must be secure: There is less dynamism if there is weak enforcement of the rule of law and contracts, or expropriation either by criminal elements or by government bodies.
• Markets must be competitive: If markets fail to offer the carrots, and wield the sticks that make a capitalist economy dynamic through creative destruction, dynamism suffers.
• Firms should not be owned and managed by people who survive because of their connections to government or their privileged birth: Capitalism is dynamic when owners or managers succeed because they are good at delivering high-quality goods and services at a competitive price. This is more likely to be a failure when the other two factors above are not working well.

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

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. In some, their spending on goods and services as well as on transfers like unemployment benefits and pensions, accounts for more than half of GDP. But even where the government’s role is more limited, as in Britain at the time of the Industrial Revolution, it still establishes, enforces, and changes 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 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 are 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 later 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 one another and with nature in producing their livelihoods.

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

• Private incentives for cost-reducing innovation: These are derived from market competition and secure private property.
• Public policy supporting these conditions: Governments enforce laws and provide regulation.
• Public policy that supplies essential goods and services: These may not be provided in sufficient quantities by private firms, and include education and basic research.

1.11 Capitalism, inequality, and democracy

The story of Cyril Ramaphosa that introduced this unit illustrates the complex relationship between capitalism, inequality, and democracy. After a quarter of a century of democratic rule by the African National Congress, overall inequality in South Africa had not fallen. While the different racial groups became more equal, this was offset by increasing inequality within groups, including the emergence of a rich and powerful black elite. Ramaphosa was a leader in the struggle for democracy. He then became a very successful capitalist. Since 2018, as president of South Africa, he faced the challenges of delivering higher living standards and more equal outcomes in a democratic country.

Capitalism and inequality

As the South African case shows, 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 1.17 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 1.17, you can see that wealth inequality increased until around the First World War.

In many countries around this time, first males without property and then women gained the right to vote. In all the countries shown in Figure 1.17, inequality of wealth began to fall following the advent of democracy.

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

Inequality and democracy

In the nineteenth century, 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:

• Gives equal political power to all citizens: This power is defined by individual rights such as freedom of speech, assembly, and the press.
• Selects political leaders by means of elections: In these elections, virtually all adults are eligible to vote, and the governing party leaves office if it loses.

In many societies throughout human history, the rich have elected representatives to govern them. This satisfied the second condition above, but is not considered democracy in the modern sense of the word 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 very successful variants of the capitalist economic system, 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, with each system influencing how the other works.

Figure 1.18 shows that democracy is a recent arrival in human history: in virtually all countries prior to the twentieth century, women and those without property were excluded from voting.

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, such as education, to all groups.

As with 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 payments such as bribery.

The connections between capitalism, democracy, affluence and inequality are illustrated by the contrasting role of the government in four affluent, democratic, capitalist countries with modest levels of economic inequality:

• Japan and South Korea: Governments play an important role in setting the direction of their economies, but the amount collected in taxes and paid by the government to the less well off to reduce inequality is relatively low. The inequality of market incomes is relatively low in these countries.
• Denmark and Sweden: Payment of taxes (and benefits received from the government) reduce the inequality in how much money people have to spend by half.

1.12 Capitalism, growth and environmental sustainability

The capitalist revolution has also transformed 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 1.19 shows that the economy is part of a larger social system, which is itself part of the biosphere. People interact with one another, and also with nature, in producing their livelihood.

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 real GDP per capita. Also contributing to our increased impact on the environment has been the ability of the capitalist economy to support a vast increase in the earth’s population, which at over 7 billion in the early twenty-first century, was more than ten times higher than at the start of the eighteenth century. Projections shown in red in Figure 1.20 are that population will continue to grow but at a slower rate.

Climate change and 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 it is spending more than its income. Similarly, the environment may be unsustainable if the damage we are doing to it is not offset by its own capacity to restore itself, aided by policies to support environmental recovery.

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. Figure 1.21 and 1.22 illustrate what has been happening.

We can see from Figure 1.21 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.

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 1.22 presents evidence of our increased use of fossil fuels—coal, oil, and natural gas—and of a profound change in the natural environment. Figure 1.22 also shows that CO₂ emissions from fossil fuel consumption have risen dramatically since 1800.

The likely consequences of global warming are far-reaching—melting of the polar ice caps, rising sea levels that would put large coastal areas under water, and changes in climate and rain patterns that would 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 1.21. 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

A downloadable spreadsheet contains the temperature data used to make Figure 1.21. Using this data, recreate Figure 1.21. Follow the walk-through in Figure 1.23 on how to draw this graph in Excel.

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Figure 1.23 Plotting line graphs of temperature over time.

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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.

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Draw a line chart

Your line chart will look similar to the chart shown, 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).

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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.

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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.

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Change the horizontal axis variable to years

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

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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 1.21), we have to change the axis position. After Step 12, your chart will look similar to Figure 1.21.

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Add axis titles and a chart title

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

Technological progress can help

Figure 1.19 shows the economy embedded in the biosphere and the physical environment. The relationship 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 1.9, 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 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.

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 more complex than the one between democracy and addressing the problem of growing inequality. This is true for two reasons:

• National costs and global benefits: Democracy is a form of government of a nation, and while the citizens of a nation may adopt policies to protect the environment of that particular nation—its lakes and streams, its green spaces—they may have little incentive to protect the global environment, particularly if they will bear the costs and a great many others share in the benefits.
• Effect on future generations: Democratic citizens today are making decisions affecting people who may not be born for hundreds of years. These future generations do not have a vote.

external effect

When a person’s action confers a benefit or cost on some other individual, and this effect is not taken account of by the person in deciding to take the action. It is external because it is not included in the decision-making process of the person taking the action. Positive effects refer to benefits, and negative effects to costs, that are experienced by others. A person breathing second-hand smoke from someone else’s cigarette is a negative external effect. Enjoying your neighbour’s beautiful garden is a positive external effect. Also known as: externality. See also: incomplete contract, market failure, external benefit, external cost.

Both reasons for 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 an action taken by a person has consequences—benefits or costs—that are felt by others and which are not taken into account by the person taking the action.

In the light of the nature of the external effects—spilling across national borders and across generations—it is not surprising that we cannot show you a figure similar to Figure 1.12 in which environmental damages declined following the extension of the vote to most adults in many countries. Nevertheless, many long-standing democratic nations—many in northern Europe, for example—are exemplary in the ways they have provided local environmental amenities and restricted carbon emissions.

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 (as shown, for example, by the data in Figure 20.25b in The Economy). 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.

1.13 Conclusion

Beginning with a look at economic inequality, both between and within countries, we have analysed hockey-stick trajectories for real GDP per capita, labour productivity, global climate change and its primary source, carbon emissions. The kinks in the hockey sticks 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 work, 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 and the provision of basic research and education.

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 introduced economic statistics and measures such as real 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, in which treatment and control groups occur outside the laboratory.

Capitalism and democracy continue to evolve, to change each other, to revolutionize the world, and to affect your everyday life. As a result of the environmental external effects of economic decisions, both capitalism and democracy are challenged to find ways to avert catastrophic climate change. Economics will help you understand these changes and show you ways that you—with others—can participate in this constant process of change.

1.14 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?
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 chart
• 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.

1.15 References

Consult CORE’s Fact checker for a detailed list of sources.

• Acemoglu, Daron, and James A. Robinson. 2012. Why Nations Fail: The Origins of Power, Prosperity, and Poverty. New York, NY: Crown Publishing Group.
• Alvaredo, Facundo, Anthony B. Atkinson, Thomas Piketty, Emmanuel Saez, and Gabriel Zucman. 2016. The World Wealth and Income Database (WID).
• Atkinson, Anthony B., and Thomas Piketty, eds. 2007. Top Incomes Over the Twentieth Century: A Contrast between Continental European and English-Speaking Countries. Oxford: Oxford University Press. 
• Berghoff, Hartmut, 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.
• Churchill, Winston. 1946. ‘Iron Curtain’ speech.
• Deaton, A. 2013. The Great Escape: health, wealth, and the origins of inequality. Princeton: Princeton University Press.
• Drèze, Jean, and Amartya Sen. 2013. An Uncertain Glory: India and its Contradictions. Princeton, NJ: Princeton University Press: p. 2.
• Landes, David S. 2003. The Unbound Prometheus: Technological Change and Industrial Development in Western Europe from 1750 to the Present. Cambridge: Cambridge University Press.
• Piketty, Thomas. 2014. Capital in the Twenty-First Century. Cambridge, MA: Harvard University Press.
• Plummer, Alfred. 1971. Bronterre: A Political Biography of Bronterre O’Brien, 1804–64. Toronto: University of Toronto Press.
• Schumpeter, Joseph. (1943) 2003. Capitalism, Socialism and Democracy. pp. 167—72. Routledge.
• Schumpeter, Joseph A. 1949. ‘Science and Ideology’. The American Economic Review 39 (March): pp. 345–59.
• Schumpeter, Joseph A. 1997. Ten Great Economists. London: Routledge.
• Seabright, Paul. 2010. The Company of Strangers: A Natural History of Economic Life (Revised Edition). Princeton, NJ: Princeton University Press. 
• Skidelsky, Robert. 2012. ‘Robert Skidelsky-portrait: Joseph Schumpeter’.
• Smith, Adam. 1759. The Theory of Moral Sentiments. London: Printed for A. Millar, and A. Kincaid and J. Bell.
• Smith, Adam. 1776. An Inquiry into the Nature and Causes of the Wealth of Nations. New York: NY: Random House Publishing Group.
• World Bank, The. 1993. The East Asian miracle: Economic growth and public policy. New York, NY: Oxford University Press.