Economic Institutions Of Capitalism

Economic Institutions Of Capitalism

Private Property

Private property is an institutional arrangement fundamental to capitalism. It involves the right of an individual to acquire, use, or dispose of some­thing of economic value in any legitimate way the owner wishes and the right to enjoy the economic rewards that result. Under capitalism, owner­ship of property is a matter of right. It is the responsibility of government to define the scope and nature of this right and, in the event of its violation, to enforce and protect the owner's claim. A major part of the legal system is composed of institutions for adjudicating disputes arising over the exer­cise of property rights.

Private property does not refer solely to tangible things; intangible forms of property such as contracts or patent rights are included. Contracts are legally enforceable agreements for the performance of economic ac­tivity. Since contracting for the use of land, capital, and labor services (largely, but not exclusively, in return for money income) is the means used for organizing production under capitalism, the rules of contract are an intrinsic part of the institution of private property. Of course, the right to use private property as one pleases is not unrestricted. The government reserves the right of eminent domain to secure ownership of property for which there is a compelling public need, even if the original owner would prefer not to sell. The law also limits the unfavorable effects a property owner may impose on his property. A Philadelphia home owner, for in­stance, is still forbidden to construct a "soap, candle, glue, starch, lamp­black, bone boiling or skin dressing establishment, blacksmith shop, slaugh­ter house, cattle pens, piggery, or other buildings for offensive purpose or occupation" on his property. Each technological era creates its own le­gal definition of public nuisances; present efforts to abate air, water, and noise pollution must deal with the present-day counterparts of piggeries and lampblack establishments.

One function of private property is to encourage the accumulation and conservation of wealth in the form of capital goods. The one means of capital accumulation that is wholly consistent with capitalism is the private saving of personal and corporate income. Saving presumedly will not occur extensively unless individuals and corporations have incentives to save. Failure to accumulate capital via the process of saving would probably impose a technological barrier on the growth potential of a capi­talist economy.

Given the crucial connection between private property and capital accumulation the question of intergenerational transfers of wealth through inheritance becomes important. Inheritance can be treated as an institu­tion of capitalism separate from private property or, as we choose to treat it, as one of the rights attached to private property. If the owner has a right to designate to whom property shall pass at the time of his death and if the designated individual has a legally enforceable claim to that property, then inheritance becomes a powerful mechanism for accumulat­ing wealth.

It also becomes a potential source of conflict with other values in a capitalist society. If the society claims to reward individual "merit," what is the merit of being lucky enough to have had wealthy ancestors? If the society as a whole seeks to redistribute income in the direction of greater equality through taxation, can income arising from inherited wealth be taxed without destroying the original motivation to accumulate? Even if inheritance taxes are levied, the opportunity to make substantial gifts while still living and the provision of training and education can make "equality of opportunity" a very hazy concept in a private-property economic system.
Thus it is imperative to note that even in a purely theoretical ap­proach to capitalism the right to private property cannot be regarded as completely unrestricted. Controls on the use of private property and con­flicts with other institutions of a capitalist system are as old as the institu­tion of private property itself, and with the development of capitalism they have multiplied enormously. Nevertheless, they do not negate the basic right of the owner of productive resources to employ them as he sees fit. The other institutions of capitalism derive from and depend on the cornerstone of private property to a large degree.

Freedom of enterprise is, in fact, an extension of the concept of private property. It gives the individual owner, or group of owners, the right to select the type of economic activity in which their resources will be em­ployed. In the broadest sense, freedom of enterprise is not confined strictly to economic entrepreneurship—it also includes every individual participat­ing in the operations of a capitalist system, whether as wage worker, owner of natural resources or capital, or holder of liquid financial resources.

It is a basic tenet of capitalism that the indvidual, acting alone or col­lectively, is the best judge of his own interests. Self-interest is a broad con­cept, but in the theory of capitalism it means primarily economic self-interest. This is commonly referred to as the "economic man" concept. In consumption activities the individual is assumed to maximize the satis­faction he derives from the choices he makes; in production activities the entrepreneur is assumed to maximize his profits by striving to increase revenues and decrease costs. If productive resources are directed toward their most remunerative use, there are, as we shall see, important con­sequences for the overall economic efficiency of the capitalist economic system.

The entrepreneur is assigned the key role in the capitalist economic system; he is assumed to be one who sees the opportunities, takes the risks, gathers the needed factors of production, and gains the profit or suffers the losses that result from the venture. Yet there is no intrinsic reason why a group of workers, capital owners, or landlords should not hire a manager to supervise a project and thus reserve for themselves the profits. Farmers in many Midwestern towns, for example, market their grain cooperatively and then divide the surplus remaining after expenses, including the salary of a professional manager, have been paid.

Some entrepreneurial activity is undoubtedly of the kind that the late Joseph Schumpeter placed at the center of the process of economic develop­ment—the first breakthrough in the introduction of a new product, a new technology, a new marketing scheme, a new structure of business organiza­tion, and so forth. When we look at an advanced capitalist economic sys­tem, however, we see that most economic activity is conducted by man­agers of business firms instead of by individual entrepreneurs. Most business firms, moreover, are engaged in fairly routine production and distribution processes rather than in spectacular Schumpeterian innovations.

The modern corporation is the institutional form in which freedom of enterprise most often manifests itself in the real world. And yet the pure theory of capitalism has no specific role for the corporation to perform; it is regarded simply as a collective form of "economic man" intent on profit maximization like the solitary, decision-making entrepreneur. The reason for this seeming oversight is contained in the next essential institu­tion of theoretical capitalism, the competitive market. We will have more to say about the economic role of the modern corporation.

Competitive Markets

Capitalism, as a concept, assumes the existence of competition in markets where factors of production are bought or leased, as well as in consumer-goods markets. Competition refers to the existence of independent buyers and sellers for a given product or service; no one is coerced either to buy or to sell at the prevailing market price. This price, which is assumed to fluctuate up or down in response to changes in underlying supply and de­mand conditions, serves two crucial functions.

The rationing function tends to allocate goods and services to those who are willing to pay the prevailing price. Willingness depends on the intensity of desire and the purchasing power of the prospective customer. Many college professors would be "in the market" for a Rolls Royce if the price were one-tenth of the current level; the rationing function of price signals tends to cause professors to seek out other modes of trans­portation. Factors of production are similarly rationed among those pro­ducers who are able to make more efficient use of productive resources. Those who "can't afford" to hire more workers or rent more land at the going factor prices are excluded from the utilization of scarce resources.

The motivating function of prices also operates in both product and factor markets. The rising price of a commodity for which demand has in­creased alerts prospective new producers of possible profit opportunities in that area. Existing multiproduct firms can shift resources into activities with favorable price signals. Declining prices may squeeze profit levels for some firms to a point at which they will shift to other products or even go out of business completely. The punishment meted out by competitive capitalist markets to producers who misjudge demand for a new product, are sjow in adopting a new production technique, or suffer adverse effects of an unforeseeable change in consumer preferences is often understated. There must be losers as well as winners in order for participants in competi­tive markets to adapt to changing conditions. When markets fail to func­tion effectively in capitalist economies, it is often because producers have found some way of insulating themselves from the harsh consequences of an unfavorable market situation.

Factor prices also serve—more effectively than most people realize— to affect career choices and the uses to which land and capital are put. Falling birth rates signal prospective obstetricians toward psychiatry or other medical specialties for which continued demand seems assured; farm­land is turned into shopping centers; more new investment goes into the trucking industry than into railroads. Specialized occupational skills already acquired are often less easily shifted into other areas of employment (as barbers and aerospace engineers have discovered in recent years); an ad­justment lag may exist in factor markets during which resources are tem­porarily unemployed while market forces work themselves out.

One more aspect of competitive markets warrants discussion. Adam Smith's famous pin factory served to illustrate the specialization of pro­duction activities that large-scale markets allow. This division of labor per­mits those who control factors of production to channel them into most productive uses. Human labor, especially, can stick to one line of work where skills and practice can be brought to bear—imagine the wastefulness of training someone to perform a single brain operation, for example. Bene­fits from the division of labor arise only because the operation of a market economy provides a regular supply of goods and services. We would each become a combination farmer, weaver, lawyer, and so forth, with result­ing losses in specialized talents and skills, if we did not trust the market system to provide those needs. The chaos arising from a disruption of elec­tric service or from a transportation strike shows the web of human inde­pendency spun by a market economy.


Despite the presumption of a general absence of governmental interference in a smoothly functioning theoretical capitalist economy, it should be stressed that the system cannot operate without the aid of a government possessing sovereign powers. In this sense government per se is an institu­tion of capitalism, and its role as such should be understood.

Milton Friedman, a forceful and intellectually consistent adherent of a minimal role for government in economic affairs, nevertheless advances this extensive roster of activities:

A government which maintained law and order, defined property rights, served as a means whereby we could modify property rights and other rules of the economic game, adjudicated disputes about the interpreta­tion of the rules, enforced contracts, promoted competition, provided a monetary framework, engaged in activities to counter technical monopolies and to overcome neighborhood effects widely regarded as sufficiently important to justify government intervention, and which supplemented private charity and the private family in protecting the irresponsible, whether madman or child—such a government would clearly have important functions to perform.
This list shows that government involvement is essential to preserve social values. Without regulatory measures, there is danger that a capitalist system based on individual self-interest could run amok, degenerating into a disorderly scramble in which neither the values of the society nor the rights of the individual would be safeguarded. Restrictions on the institutions of capitalism, even in its purest theoretical form, are essential to keep those institutions from destroying themselves.

Government intervention in a capitalist economy is never "neutral" because it always has different impacts on various individuals. Antipollu­tion laws that provide recreational benefits or decrease medical costs for consumers, for example, impose economic hardships on producers. The point to remember is that once government performs its necessary functions such as defining property rights, it is possible for competitive markets to operate in such a way as to achieve efficient results. Firms liable for dam­ages caused by pollution may choose to install control devices, to compen­sate those affected, or to change locations; potential victims can choose to limit their exposure, to collect deliberately for injuries incurred, or to move elsewhere. The economic role of government under theoretical capi­talism resembles decisions concerning traffic rules—it matters less whether traffic drives on the right or left than that a single rule is selected and con­sistently enforced.