Understanding the logic of capitalism: Efficiency, innovation … and inequality

Property rights in the means of production are the institutional basis of capitalism. While there is no economic theory that supports the need for the unequal distribution of property in a capitalist economy, inequality seems to be built into capitalism. As Christine Greenhalgh writes in an article published in 2005 in the Cambridge Journal of Economics, the empirical evidence from rich capitalist countries generally shows that the rich are gaining over the poor both within and between generations. “Why then”, she asks, “are there so many champions of the cause of free markets?” (p.1093).

For many greens, capitalism’s ability to deliver ecological sustainability remains in considerable doubt. Social justice is another core concern of green politics, and the suggestion that capitalism is inherently unable to deliver equality should also raise serious questions about the benefits of ‘green capitalism’. So it is interesting to pick up Christine Greenhalgh’s question and look for an answer by thinking about the most important claims usually advanced in favour of the competitive free market.

Free market advocates would begin by arguing that competition in the marketplace first of all delivers economic efficiency. This is understood in terms of: (i) efficiency in the patterns of production that meet the desires of consumers; and (ii) efficiency in the allocation of resources among competing entrepreneurs who are attempting to meet consumers’ willingness to pay by delivering goods and services at the lowest possible price.

Competitive markets are also seen to drive innovation. Innovation arises through the desire to enhance profitability by improving productivity, which is achieved by inventions and improvements that reduce production costs, enhance quality, or generate new products. William Baumol sees innovation as “mandatory, a life-and-death matter for the firm,” and the resulting pace of the development and spread of new technology as the “explanation of the incredible growth of the free-market economies” (p.1).

Let’s consider the business of innovation a little more closely. Innovation (as recorded in research and development expenditure and patent applications) is highly concentrated in pharmaceuticals, biotechnology, electronic gadgets for home and office, and the aerospace and car industries. Looking at who benefits most from these innovations, Greenhalgh finds plenty of evidence that technology responds primarily to the demands of the rich. For example, she cites evidence that “only 13 of 1240 new drugs licensed between 1975 and 1996 dealt with lethal communicable diseases that primarily afflict people from developing countries.” But this is not the outcome of some malevolent conspiracy on the part of the pharmaceutical industry – it is entirely understandable within the logic of capitalism: innovation is driven by profitability, so producers “invent more products to satisfy … higher income groups” (p.1099). Furthermore, as Greenhalgh notes, the temporary excess profits earned by innovative firms accrue to shareholders who also happen to be concentrated in higher income groups – the wealthy benefit from both sides of the deal, both as investors and consumers, leading to further concentrations of wealth.

Examining the issue of efficiency in the matching of production patterns to the desires of consumers, Greenhalgh detects another market bias in favour of the rich. The demands of the poor for basic necessities (food, water, housing and healthcare) have to compete with the demands of the rich for luxuries, and “the market makes no judgement about priority of demand, so that a basic need is not able to trump a luxury demand, whereas morally it might be thought to do so” (p.1100). For example, as far as the market is concerned, the demand of the wealthy for holiday homes and rental investment properties is considered to be no different from and no lesser priority to the demand of families seeking an affordable first home.

Moreover, luxury goods are positional goods, meaning that one of the perceived benefits of ownership of such goods is that they display status. Greenhalgh suggests that, by definition, the demand for positional goods is inexhaustible: “as each new good is introduced, there is a competition to be in the elite club of winners, one of the first owners of the latest positional good” (p.1100). A similar pattern is also seen in the demand for luxury services. For instance, in the UK, between 1975 and 1999, the share of household expenditure on services rose from 29% to 42%; and expenditure on restaurant meals rose sharply while expenditure on food for home cooking fell significantly (p.1101). Even the management of wealth itself has expanded enormously as a service industry, as the rich now look to asset managers and other agents of financial services organisations to maximise their wealth.

In effect, the efficiency of the market is in seen most clearly its attunement to the demand for luxury goods of those with the most purchasing power.

Another outcome of the ever-expanding demand for positional goods and services is competition for skilled labour between innovating firms and human services organisations in health and education. This competition for labour is problematic because health and education are heavily reliant on human labour and are not open to much in the way of the substitution of labour by technological innovation. As a result, even though they are necessities that have real value to rich and poor alike, the increase in labour costs means that, over time, services such as health and education become progressively more expensive relative to other goods.

A further complicating factor is that equality of access to health and education is seen as desirable and necessary for all citizens, so these services are usually provided by the state. This means that they are constantly subject to public expenditure constraints in the face of their ever-increasing real cost, leading to “the familiar twin problems of underpayment of their skilled workers and rationing of the inadequate supply” (p.1102). Given that a healthy present-day workforce and a well-educated future workforce are both critical to an advanced capitalist economy, applying expenditure constraints to health and education makes little sense. Greenhalgh makes the point well: “constraining expenditure in medical services is analogous to an agricultural economy failing to mend fences and protect the harvest; underspending in education is analogous to an agricultural economy eating its seed corn” (p.1102).

So, to rephrase Greenhalgh’s question from the opening paragraph of this piece, why would we persist in our attachment to an economic system that unavoidably delivers persistent and pernicious inequality? Perhaps it is because capitalism is ecologically sustainable. Certainly not, if it requires “the continuing conversion of non-renewable energy and materials into a mix of consumer goods and waste products.” However smart the technology, basic physics dictates that this process can never be transformed into any kind of “clean perpetual-motion machine” (p.1094).

If it can’t deliver sustainability, maybe capitalism is delivering increased happiness? Again, no. Happiness in western countries and Japan is not increasing over time, “despite considerable growth in real per capita income”. That’s because it is relative income that matters to most people, not absolute income; in addition, as incomes rise, so do aspirations. In fact, in the US, “aspirations seem to have run ahead of incomes” and measures of happiness have fallen over the last 25 years (p.1093).

In the light of these failings, our attachment to capitalism on the basis of luxury-oriented efficiency and innovative power seems perverse. Just where is this sort of efficiency and innovation taking us? We need to rethink some of the key assumptions that underpin our economy, and so Christine Greenhalgh concludes her article with some far-reaching proposals.

Rethinking property rights: Leasehold ownership of durable goods for fixed periods under restrictive covenants is suggested to “raise rates of utilisation to minimise environmental depletion” (p.1102). This provides an opportunity for censure of leaseholders if goods are not used or are used inappropriately. (Collective ownership of property is not unusual in capitalist societies: sports centres, schools and universities are very commonplace examples.)

The temporary private monopoly afforded by intellectual property rights is not the best incentive to innovation; an instant return to inventors, with no temporary monopoly period, would be the best solution. This proposal could be implemented in areas of significant social benefit, whereby the state would buy out the patent of, for example, a new drug and distribute the knowledge to any producer, who would then supply the drug at marginal cost. Such a system would stimulate further socially beneficial innovations.

Rethinking taxation: More progressive taxation of income is justified because the consumption demands of the rich achieve little, if any, addition to happiness. An annual wealth tax, limits on inheritance, and progressive taxes on non-essential physical assets (eg, second cars, second homes) are proposed.

Differential product taxation is needed to give priority to the production of goods and services that use renewable inputs and non-polluting techniques, and meet basic needs. Every product group must be rated and taxed according to its “world heritage cost” and its “inequity cost” (p.1104).

High charges on energy consumption and waste disposal are also proposed, one of the consequences being to reduce the cost of essential labour-intensive services relative to capital- and resource-intensive production. Finally, rather than the present deductibility of the cost of advertising as a business expense, the taxation of advertising is advocated.


Christine Greenhalgh (2005) Why does market capitalism fail to deliver a sustainable environment and greater equality of income? Cambridge Journal of Economics 29, 1091-1109.

William Baumol (2002) The free-market innovation machine: Analysing the growth miracle of capitalism. Princeton University Press.

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