The Root Causes of Growth Under Capitalism

Cambridge Journal of Economics Advance Access published March 22, 2011
Cambridge Journal of Economics 2011, 1 of 24 doi:10.1093/cje/beq054
The root cause of economic growth under capitalism

Downloaded from http://cje.oxfordjournals.org/ at Economic Commission for Africa on March 28, 2012
Michael Joffe*
Drawing on historical and other empirical evidence, this paper provides a causal explanation of a central question: why sustained per capita growth occurs in capitalist economiesi.e. in what way capitalism differs from the market that gives it this property. It describes an endogenous economic logic that is based on the institutional characteristics of capitalist rms in the non-nancial sector, especially the exibility of the inputs that they can call upon and of the size of the market that they can supply. This perspective naturally generates a realistic theoretical account not only of the source of economic growth, but also of the evolution of market structure, the forces that produce divergence in, for example, prot rates, a starting point for explaining price-setting and a language for describing rms economic power. It draws on previous traditions, especially those based on the works of Marx and Schumpeter, but differs from them in important respects. Key words: Growth, Capitalism, Firms, Institutions, Micro-foundations JEL classications: O43, P17, N10
1. Introduction
The tendency for capitalist economies to grow is one of their most characteristic properties. The successful capitalist countries have experienced sustained per capita growth for many decades, to an extent unparalleled in previous human history. Take-off has occurred successively in country after country over the past 200 years. Such take-off was not a one-off event, but rather a step change to an altered mode of operation of the economic system, that has persisted ever since. This inexorable growth tendency has been maintained across numerous transformations: in institutions (e.g. limited liability), market structure and the role of science and technology. It encompasses growth at the technological cutting edge as well as catch-up growth in countries that have imported technology and (sometimes) institutions. Nevertheless, the source of growth is not well understood. The aim of this paper is to ask, what is it about capitalism that has this effect?, and to try and answer that question by
Manuscript received 28 November 2008; nal version received 17 December 2010. Address for correspondence: Imperial College, St Marys Campus, Norfolk Place, London W2 1PG, UK; email: m.joffe@imperial.ac.uk * Imperial College London, UK. I would like to thank Hasan Gurak, Gidon Carmeli, Ben Fine, Steve Keen, Arthur Grimes and especially Geoff Hodgson for commenting on earlier versions of this paper. They do not necessarily agree with its content.
The Author 2011. Published by Oxford University Press on behalf of the Cambridge Political Economy Society. All rights reserved.
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providing a causal analysis in terms of the properties of the capitalist rm in contrast with individual traders.1 It deals only with the generality that capitalist economies have this specic property; the causes of variations in growth rates between different capitalist economies or sectors or over time are beyond the scope of the current paper. At this stage only a verbal model is presented, the objective being to discover deep regularities. The term capitalism here is taken to mean an economic system dominated by production that employs wage labour, in which the means of production (equipment and materials) belong to the employer. There is also a case for including a dominant role for nancial markets in the denition, because their growth has historically been a key precondition for corporate operation and expansion. Private ownership of the means of production is another traditional element in the denition, but may not be a necessary feature. These issues are discussed below. It is important to note that capitalism is not used in an evaluative sense: the analysis would have the same validity whether one favours or abhors the capitalist system, and whether one wishes to pursue or to limit growth. One problem is the apparent obviousness of at least part of the account presented. Probably some of this is widely understood intuitively and not only by economists. However, while important aspects can be found in the literature, this intuitive understanding has not so far generated a systematic account of the endogenous causal processes involved in the way that capitalism operates, which could be described as the micro-foundations of growth. Such an explicit description is essential, for example to avoid confusion of capitalism with the marketone is dynamic, the other selfregulatingas well as to tease out which particular components of the capitalist system are responsible for its dynamism. Moreover, it allows the explication of the main stages of capitalist growth. As will become clear, there are several advantages in describing this apparently obvious process explicitly.
1.1 The market or capitalism?

The modern economy is conventionally portrayed as a market economya system of trading relations between individuals. Adam Smith provided the classic description in the Wealth of Nations (Smith, 1776), in which he emphasised the crucial importance of the extent of the division of labour. The structure of his argument was that under certain institutional conditionssummarised as a system of natural libertythe economic system would generate both stability and growth. The stability was due to the price mechanism bringing supply and demand into balance, as if by a hidden hand. Thus, the apparently anarchic behaviour of individuals had the emergent property of self-regulation at the aggregate level of the market, creating an entity that has the features of a system with endogenous causal processes, what we would now call a balancing or negative feedback mechanism (Lowe, 1977), even though it is not formally organised as one.2
1 The term rm is henceforth used to indicate the specically capitalist rm, characterised by the employment relationship (Hodgson, 1999, especially pp. 22046: The Coasean tangle: the nature of the rm and the problem of historical specicity). It also can convey a sense of agency, denoting the person/people in charge, who take/s the initiative. This is in contrast to the type of rm that consists of only one person, or just family labour, or an equivalent, which is variously described as sole trader, sole producer or petty producer depending on the context. 2 This accords with modern system concepts: systems containing feedback loops generate their own endogenous causal processes that make them less sensitive to initial conditions. These intra-systemic processes can be modelled (Lowe, 1977); in addition, exogenous causal processes such as shocks and disturbances can also exist (Forrester, 1970; Lane, 2007).
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According to Smiths verbal model, growth resulted from a cyclicalor rather, spiralseries of causal processes. These formed a reinforcing (or positive) feedback loop, operating through a progressive increase in the division of labour, generating endogenous but slow growth (Lowe, 1977). The assumptions required for this model are specic to small-scale production (Lowe, 1977), and in particular require economic power to be widely dispersed (Harcourt, 1994). The only exogenous variable in Smiths model of stability and growth is preferences, with other psychological assumptions of a broad nature also being necessary to drive the system, such as the propensity to truck and barter (Lowe, 1977). This latter Smith regarded as universalwhich ts with the ancient origin of trade and its widespread spatial distribution, and distinguishes the system he described from a capitalist one, which barely existed in 1776. There were two other major consequences: rst, there would be gains from trade as a result of a greater variety of goods and services. Second, by enlarging the division of labour, over time trade would lead to specialisation and specialisation in turn leads to greater dexterity, time saving and invention [as was already recognised by Plato, Xenophon, de Mandeville and Hume, among others (Peaucelle, 2006)]. By contrast, in a capitalist society the division of labour takes two forms: between traders (a market), and within a rm (an authority structure). Although the Wealth of Nations starts with a classic description of a pin factory, based on earlier French sources (Peaucelle, 2006), the explanatory passages focus on traders who are sole producers and neglect rms. Smith has the excuse that such individuals were still dominant in his time, factories being rarethey only became commonplace decades later when industrial capitalism took off. Factories, and rms more generally, quickly established themselves in England and subsequently in many other parts of the world. Gradually they became ever more dominant players in the economy. And it was rms that transformed both the economy and wider society. What is remarkable is that an explanatory tradition focussing on trade still dominates mainstream economics, especially the neoclassical tradition, more than 200 years later. The textbook theory of the rm is blind to its scale and its internal structure, treating large corporations that hire and re workers in the same way as it treats sole traders. Thus, the lack of sufcient acknowledgement of historical specicity in Smiths work has been continued in most of the later traditions, but without his excuse. This is particularly surprising as J. S. Mill already described cheapeningthe novel feature of continuous reduction in the real costs of inputsin 1848 (Mill, 1848), albeit without explaining it. And soon afterwards, Karl Marx took the historical specicity of capitalism as central, recognising that this mode of production develops the forces of production like no other (Marx, 1867). Something had changed dramatically: in place of an economic system dominated by the distribution of existing resources, for example the switching of crops or the mining of less accessible seams as described in neoclassical theory, new structures emerged that transformed how resources were used. Scarcityin Robbins sense of limited supply, not merely a budget constraintwas replaced by abundance in sector after sector as capitalism developed. In the early and mid twentieth-century, Joseph Schumpeter provided a vivid description of the dynamism and turbulence of the capitalist system
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(Schumpeter, 1911/1934, 1942). However, neither Marx3 nor Schumpeter4 provided a causal account explaining why capitalism is uniquely dynamic, although it takes a close reading of their works to realise this. Also relevant is a contribution by Ronald Coase, who in 1937 asked the question, if market trading between individuals generates the most efcient and generally optimal outcomes, why do rms exist (Coase, 1937)? This paper has stimulated a fruitful tradition of research, based on the importance of transaction costs, seeking to explain why rms have the boundaries that they have (e.g. the extent of vertical integration or disintegrationthe make-or-buy decision). However, its success in this has proved to be patchy (Poppo and Zenger, 1998; David and Han, 2004; Carter and Hodgson, 2006), and the transaction cost approach faces special challenges in explaining innovation and the entrepreneurial rm (Hodgson and Gindis, 2007).5 More important, the deeper question about why rms exist at all still remains unanswered, and is largely ignored by mainstream economics. Moreover, the concept of the rm is rather unclear in the large literature devoted to its study. For example, in much of the orthodox literature the rm is treated merely as a production function. Others dene it as a nexus of contracts (Bainbridge, 2002), or as a collection of assets without examining its internal structure (Grossman and Hart, 1986). These limited viewpoints are effectively criticised by Hodgson (2002), who emphasises the importance of the legal foundation of the rm. Gindis (2009) builds on this, demonstrating that the rm is a real not a ctional entity, citing the earlier tradition of real (or natural) entity theory. This recognised that capitalist rms possess emergent properties of collective knowledge and capabilities, and that these have consequences, in particular that the rm has causal powers and is a unit of selection. This perspective accords with the classic organisational analyses that explored relationships within the rm (Berle and Means, 1932; Penrose, 1959). Micklethwait and Wooldridge (2003) present a short history of the rm, describing it as a revolutionary idea that gave birth to the industrial revolution. They trace the institutional innovations that gave rise to the existence of economic entities with their own legal personhood, a necessary condition for the emergence of specically capitalist rms (see section 3.2 on the key properties of rms). However, their emphasis on the joint-stock
3 Marx included an analysis of productivity growth in his verbal description of capitalism in chapter 12 of Volume I of Capital (Marx, 1867 pp. 42938), but it was dropped when he came to introduce his formal model in chapter 17. There are, of course, numerous possible readings of Marx, but any of them has to recognise that his formal economic model excluded productivity growth, a fact rst noted by Engels in the nineteenth century (p. 655, footnote). 4 Schumpeters writings on creative destruction and capitalist dynamism are unclear on the causal mechanism (Schumpeter, 1911/1934, 1942; Joffe, 2010). Two views can be discerned: the entrepreneur as agent of change is the better developed, and has been deservedly highly inuential. However, it does not address the specicity of capitalist dynamism: if the existence of entrepreneurs is to be an explanation for capitalist dynamism, why does this particular type of economic system generate entrepreneurs? And second, why should they innovate in such a way that one result is growth? Or did they occur equally frequently in, for example, Imperial China? And, if so, why was that civilisation characterised by technical inventiveness but patchy per capita growth? Schumpeters systemic view stresses how capitalism creates the tendency to think in certain ways, e.g. to generate innovations, but is poorly developed in his writings, and no mechanism is suggested (Joffe, 2010). In addition, Schumpeter himself denied the specicity of creative destruction to capitalism, devoting 14 pages to equivalent processes occurring under a simple exchange economy, an isolated manorial estate, and an isolated communist society (Schumpeter, 1942). 5 Oliver Williamson, the foremost contributor to operationalisation of transaction cost economics (Hodgson, in Hodgson and Gindis, 2007), states that: Innovation poses special challenges. Transaction cost economics can speak to some of these but it does not have a well-rounded explanation. And again: Entrepreneurial rms are a special challenge. In terms of theoretical analysis, another generation of economists is going to have to come up with the answers.
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company and limited liability is misplaced, as these particular features were less prominent in the rst half of the nineteenth century, when Britain became the workshop of the world, than either in earlier times or after the mid-century when legal changes were introduced. Indeed, as Micklethwait and Wooldridge themselves point out, joint-stock companies were actually regarded as obsolete and inefcient at the time of the industrial revolution. With a type of organisation as complex and varied as the rm, clearly there is scope for a variety of approaches. Ultimately they need to be judged on how well they explain why rms have come to dominate successful modern economies. I argue that the market is necessary but not sufcient for the type of persistent growth seen in capitalist systems. I also argue that the characteristic organisation of capitalism is the rm. It takes many different forms, in different places and at different times, as well as in different sectors, but the properties described in this paper persist through all these transformations. The conception of what constitutes a rm centres on these properties. A complete account would analyse these properties in relation to different institutional forms, for example the separation between owners and controllers, or more generally of the differentiation of functions within management (Berle and Means 1932; Penrose 1959), but such aspects are beyond the scope of the present paper. My claim is that the institutional change that brings about a rm-based economy provides the basis for rapid innovation and technological change. This perspective is related to that of Coase in its focus on capitalist rms, but differs in its explanation of their existence and indeed their success; and it is connected to Schumpeters dynamic description, aiming in addition to provide a causal explanation: the rm as a distinct type of organisation gives capitalism specic emergent properties beyond those described by Smith for trade, and these account for its dynamism. It constitutes a second type of non-organised system.
1.2 What is growth?

We begin by considering the concept of growth, and looking behind the statistics on GDP per capita. Growth as measured depends on the total activity in the economy. It can be maintained by consumption, as when US buying power kept the world economy aoat in the 199798 crisis; and it can be articially inated by debt, with both households and rms being propped up temporarily, as has been seen more recently. In the long term, however, growth has arisen from changes in the sphere of production. What happens when an economy grows? One aspect is that the types of goods and services that already exist become more abundant: a chair or a pair of shoes ceases to be a luxury item for the privileged few and becomes available to a wider market, and subsequently people can afford a larger number of such items than was previously possible. The other is that new and/or better-quality goods/services are introduced. For the rst of these, abundance, the root cause is an increase in productivity in the broadest sense. For example, the same real resources that could produce one chair 100 years ago are now able to generate several chairs. The broad sense of productivity is crucial here, as it requires focusing not merely on technological aspects of production, but on the reduction of input costs by any and all means available to a particular rm. It refers to the overall process, with a more efcient production technology being just one means of achieving it. Another consequence of higher productivity is that real wages tend to rise, while employment may fall. The key question is, what underlies long-term productivity growth? Is it exogenous, due to technological and scientic progress? This idea has its attractions, especially in
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explaining the industrial revolution and cutting-edge growth more broadly (Mokyr, 2002; Lipsey et al., 2003). However, it fails on grounds both of specicity and of generality. It lacks specicity because technical change can occur without capitalist growth, as in medieval Europe and especially in Imperial China. More important, it lacks generality: in most economies that have undergone capitalist transformation, technical innovation was absent, at least in the early stages, with technology being imported.6 A complementary account of the institutional context is required, that promotes either technological innovation or the effective assimilation of imported technology (Nelson and Pack, 1999)and in a way that promotes growth. Furthermore, even in innovatory societies like the USA, the growth-promoting changes in production have not necessarily been technological in the usual sense (see next section). The evidence shows that under certain institutional conditions, the endogenous workings of the economic system generate self-sustaining growth. Section 2 considers evidence relevant to this question, Section 3 proposes an account of how the institution of the capitalist rm can generate continuing growth in the light of this evidence, and Section 4 situates this account within a wider context.
2. The historical evidence 2.1 Spatial and temporal distribution of growth take-off
In England, per capita growth shows a structural break at around the time of the Industrial Revolution. The economy started expanding rapidly around 1800, if judged by the hourly wage of building workers (Clark, 2005), or 1820 (Maddison, 2007). This tendency to grow has been sustained ever since in England, albeit with uctuations. Growth diffused throughout the economy, creating and then continuously transforming mass markets in basic necessities such as food and clothing. Subsequently, linkages were established as sector after sector became involved. US growth has followed a similar pattern, and has been close to exponential over a similar period. The countries of Continental Europe and then various other parts of the world have followed suit at different times. The continuous per capita growth of a set of leading countries, a set that has gradually expanded, contrasts with other countries that have either variable growth rates or zero growth, and this has resulted in massive divergence (Pritchett, 1997, 2003). This change, in one country after another, has been described as a hockey stick: the horizontal handle represents zero or slow growth, while the upward-sloping blade represents the relentless growth of unprecedented magnitude characteristic of capitalism (McCloskey, 2010). Any theory aiming to explain this series of transformations needs to account for the change being persistent once it has begun, and generalisable across sectors and
6 The same arguments apply to authors whose primary purpose is not to explain growth but to explore its characteristics. A prime example is Pasinetti (1981), whose model of structural change is based on the assumption that growth is based on technical change plus learning. His primarily macro approach, with a major role given to responsive changes in consumption, is complementary to the bottom-up focus of the present paper. He has a similar view of the role of institutions in structuring economic behaviour (Pasinetti, 1981, 2007), but does not consider the specicity of capitalist growth. Ed Nells (1996) model of transformational change also starts from a technological shift, from Craft Economy to Mass Production, stressing the multiplier effect resulting from the need to invest in order to capture economies of scale. His view is that Smiths invisible hand no longer provides stability as it did in the Craft Economy (despite stressing that disorderly markets are in fact relatively rare in the modern USA), thus generating cycles. This contrasts with the view set out here, that the market mechanism does operate, but has been joined by powerful additional forces.
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internationally, as well as across the many varieties of capitalismor at least its successful examples. It must also be compatible with the rst industrial revolution having occurred when and where it did. If attributed to exogenous technological shocks, these would need to have been sufciently constant in frequency and intensity to generate close-to-exponential growth. An institutional explanation is a likely candidate. In particular, this tendency to inexorable growth has coincided with the growth and success of capitalist rms. Research is needed to explain why rms having the properties described in this paper emerged in those particular places and times, including, for example, the role of the state, and to trace the causal pathways that led from their establishment to the degree of subsequent growth experienced. Economic growth in non-capitalist societies has different characteristics. A growth spurt in England had begun earlier, in about 1640, and ended around 1740, but population growth almost kept pace with it (Clark, 2005). Similar periods of growth were not uncommon in the millennium before the Industrial Revolution, notable examples being in China, Japan and the Netherlands, which also proved transient (Kelly, 1997; de Vries and van der Woude, 1997; Landes, 1998; Pomeranz, 2000). Economic historians sometimes refer to these as examples of Smithian growth, as distinct from modern self-sustaining growth (Kelly, 1997), and their characteristics t quite well with the slow growth process of Smiths account referred to above (Smith, 1776; Lowe, 1977). Extreme international inequalities in prosperity have developed in the past two centuries, some parts of the world having unprecedented riches, and others being stuck in severe poverty. These sharp contrasts could have resulted from the operation of capitalism, which is known to generate inequalities, or alternatively from the lack of capitalism, or at least of successful capitalism, in the laggard areas. The most cautious position is that it could be some of each. Deciding the relative merits of these viewpoints is an empirical not an ideological matter, and a satisfactory answer is crucially important if global poverty and inequality are to be addressed. Why might capitalism not be established successfully? One reason is that state policy forbids it, as in the USSR and in pre-reforms China, or at least did not facilitate it as in much of post-colonial Africa where African Socialism was attempted. Another is that the conditions for success are not met. Given that the success of capitalism is coterminous with the success of its constituent rms, this would mean the lack of widespread rms that are able to thrive, for example due to lack of access to a market of sufcient size and buying power and/or to lack of human and physical capital. Thus, any theory must not only recognise the specic dynamic properties of successful capitalism, but must also allow for additional conditions that are necessary for sustained growth to occur, and in particular to explain the paucity of thriving rms and the slow growth in areas that remain poor (see below).
2.2 Historical changes in productivity and prices

Such descriptive spatial and temporal data do not give much indication of the underlying processes, and for this more detailed historical evidence needs to be examined. One example is a study of the American Northeast in the period 1820 1860 (Sokoloff, 1986). This looked at changes in productivity and prices in the following sectors: boots/shoes, coaches/harnesses, cotton textiles, furniture/woodwork, glass, hats, iron, liquors, our/grist mills, paper, tanning, tobacco and wool textiles.
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Within each sector, major product innovation was not involvedthe main new product at the time would have been the railroadso this is a suitable design for investigating the dynamics within existing product sectors. In addition, none of these sectors was dominated by a technological breakthrough or other major process innovation; rather they were subject to incremental change. This comprehensive within-sector focus, the absence of major product or process innovation and the rich data available, make this an ideal case study. The main nding was that sector-specic labour productivity more than doubled in all but one of the sectors during this 40-year period when value added is taken as the measure of output, and grew even faster if gross output is taken instead. Real wages also rose, and total factor productivity grew almost as fast as labour productivity. Relative to the quantity of raw materials processed, labour and capital inputs both fell, especially labour; the idea that capital substituted for labour was not supported by the data. When high and low capital- or machinery-intensity sectors were examined separately, larger changes were found in the more intensive ones, but the differences were small (Sokoloff, 1986). Increased productivity was due to a combination of: introduction and diffusion of machinery; increase in capital intensity (improvements not reected in the price of capital); changes in work organisation; realisation of scale economies; learning by doing; impact of expanding markets (loss of inefcient producers and stimulation of technical innovation).
It is noteworthy that such renements as limited liability were not important features of these sectors during this period. It was also found that in most of the sectors, the price index fell by approximately 40%. Taking all the evidence together, the concept of reducing real costs describes the process extremely well, in that the input resources and the price index both fell. A caveat is that intensication of labour could have contributed to these changes, and that does not fall within cost reduction. A much more recent source of evidence is from the development of the retail sector in developed economies. Wal-Mart in particular has been subject to detailed research. Findings include the observation that Wal-Mart prices are typically 5%48% less than prices for the same product in supermarkets and other conventional retail outlets (Hausman and Liebtag, 2005). Also, a Wal-Mart store opening reduces county-level retail employment . . . each Wal-Mart worker replaces approximately 1.4 retail workers . . . (Neumark et al., 2007). It would be possible to discuss these ndings in terms of welfare balance, that the former is good and the latter is bad, but if the purpose is to understand the causal processes (positive economics) the conclusion must be that a decrease in labour costs and in price both reect a tendency for the same service to be provided with lower inputs. An objection to this perspective could come from the observation that modern corporations in the developed world rarely compete on the basis of priceor less supercially, of costs. This is true, and reects the historical process that has shifted cost-cutting competition in internationally tradable items to lower cost countries such as China. This leaves cost-based competition in such non-moveable sectors as retail and airlines. A second possible objection, specically to the notion of the reduction of costs,
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could be that ination has been a more prominent feature of modern economies, but this would be to confuse money prices with real resource inputs.
3. An institutional explanation of capitalist dynamism

Why has the emergence of the rm as an institutional form led to the observed continual reduction of real resource inputs to produce a given unit of output? Why has it also led to an unprecedented profusion of new products? And how are these two processes related? The answer to the rst of these questions at least is to be found in the nature of the competitive relationship between the heterogeneous rms that constitute a sector of capitalist production. There are two necessary conditions. First, rms have a stable existence beyond the individuals who constitute it at any given moment, enabling all stakeholders to have good grounds to trust in its future continuation. Secondly, rms have two key types of exibility, in the size of the market that they can supply and in the combination of inputs they can bring together. Stable existence allows agglomeration of capital, and exibility allows manipulation of the scale of production and of costs, which in turn imply control over the productive methods. They also facilitate control over the product, and therefore the introduction of new and/or better products.
3.1 The process of competitionthe relationship between rms

When rms enhance their competitiveness by reducing costs, they not only enlarge their own existing markets but also partially or completely take over the markets of other producers, whether these be sole traders or other rms. The same occurs with the introduction of a successful new product, if it replaces a previous type of product produced by a competitor. Outside the capitalist system this happens to only a minimal extent: in a sector of petty producers who supply a particular level of effective demand, if one of them manages, for example, to improve his onion crop or to become a superior shoe repairer, he will prosper but is unlikely to displace the others and take over their markets. This is because his output capacity is limited by the extent to which he can expand his inputs; a sole trader is limited in a way that a capitalist-type rm is not. Capitalism is thus a power struggle between competing rms. Central to its operation is conquest by economic means, in which the weak are vanquished. One rm can replace many of its competitors as it grows in size to become the corporate equivalent of an empire.7
7 This process does not require increasing returns: the extension of scale can in principle occur with constant returns. In practice, however, a large proportion of the examples of capitalist growth do involve economies of scale, accentuating the growth in rm size. In addition, increasing market size (buying power) facilitates a greater division of labour (specialisation) between rms, promoting cost-reducing investment that would otherwise not be justied. This generates increasing returns, even without intra-rm economies of scalelarge rather than large-scale production (Young, 1928). At the whole-economy level, aggregate production volume determines the size of the market, introducing the possibility of cumulative causation (Young, 1928). This would accentuate the process described here, but to produce self-sustaining growth it would require an additional element; the suggestion that elasticity could generate a chain reaction (Young, 1928) is insufcient to do this in the absence of a rise of total income, which requires induced investment to reduce costs (Kaldor, 1972). Furthermore, the suggestion that an increase in the volume of production can increase productivity (Verdoorns Law) has received empirical support (Harris and Lau, 1998), and this would also impart an additional impetus to the process described in this paper.
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More precisely, it is a struggle between rms of different relative strength, as the power relationship can exist with no direct contact, for example a rm in Uruguay, Italy or Zambia can go out of business simply as a result of cheaper Chinese imports. The system is driven not only by the stick of possible extinction, but also by the carrot of possible success, the fate of a rm being determined by its long-term protability. It is universally agreed that the incentive to make a prot is critical to the future health of the rm, so much so that it is better described as its central imperative. It is one thing to have incentives, but the ability to respond successfully is also necessary. The crucial questions then are, what are the sources of a rms strength, and what are the consequences of differential strength of rms? Heterogeneity is central here: differences between rms are inputs to and outputs of competition; for empirical investigation of this, see Haltiwanger (2000), Bartelsman et al. (2004) and Foster et al. (2008). Firms bring different qualities to the process of competition. Where competition is primarily through inputs and production method, the source of strength is the ability to achieve lower costs than competitors. Unlike many power-based interpretations (Williamson, 2000), this one is non-tautological. A different source of strength is the ability to produce a superior new product or a quality improvement that nds favour in the market. This ranges from major product innovations such as sewing machines or mobile phones to minor features that have product differentiation as their main aim, achieved by a combination of branding and marketing (Chamberlin, 1933). In turn the outcome of this process affects market structure. As has been widely recognised, especially by evolutionary economists (Nelson and Winter, 1982; Dopfer, 2005), rms vary in the extent of their prot, resulting over time in the disappearance of some rms and differential success among the survivors (Cabral and Mata, 2003; Bartelsman et al. (2004). High protability increases the rms ability to invest and to attract high quality staff, altering its inputs so as to extend its market. The most successful rms in making a prot have a corresponding advantage in the next round of competition, so that capital accumulation is both a result and a cause of the rms growth in economic strengtha positive feedback loop operating over time. Taking both these ends of the spectrum of protability, it means that if a market starts out as perfectly competitive, the operation of competition systematically erodes its perfection.8 The process depends on the intensity of competition, i.e. the extent to which a rms prot margins are threatened by the actions of its competitors. This can occur in a sector with many or few rms, or even with only one but where new entry is possible. The intensity can vary, for example, in the data from the American Northeast referred to earlier, many of the changes (at least in the later stages) may have been driven by the increased effectiveness of competition brought about by the proliferating railroads. Intensity of competition should not be confused with perfect competition in the sense of multiple small rms, all of which are price-takers. Capitalist growth has occurred both with this scenario and in oligopolistic settings, and large innovative leaps can occur in sectors with relatively few large rms (Chandler, 1992) or in sectors with many independent start-ups as in the recent growth of web-based businesses.
8 This is not a new observation: the process of concentration was known to Marx and Veblen, among others.
The root cause of economic growth under capitalism 3.2 The key properties of rms: continuity and exibility
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Firms can compete successfully if they not only continue to exist in the long-term, but also are able to build lasting organisations with the ability to commit capital for extended periods of time, allowing large-scale investments and the development of specialised knowledge, relationships, reputation, etc. A necessary condition is that organisations are allowed to have a continuing existence, independent of their members. The state, as it developed in medieval western Europeunlike, for example, in the Islamic world (Kuran, 2004)allowed and even fostered independent organisations with corporate legal status. These took many forms, including cities, religious orders and universities. Eventually, this corporate tradition led to the development of the capitalist rm, with its distinctive economic attributes. Long-term investment depends on the rms ability to provide a form of inheritance that transcends individuals and families. This has been facilitated by development of legal frameworks giving rms the status of a singular legal person that could trade as an entity in its own right, the main practical purpose being entity protection (Blair, 2003; Hansmann et al., 2006). As a result, they are largely protected from sequestration by others, including the state and those who might sue, and are also protected from their own shareholdersthe mirror image of limited liability, the protection of participating individuals from the debts of the rm, which has traditionally received more attention but which may have played a less important role (Blair, 2003; Hansmann et al., 2006). Entity protection has also allowed the separation of governance from the contribution of nancial capital (Blair, 2003), typically putting a small designated group of directors in charge, and the combination of this with entity status has facilitated what Chandler has called organizational capabilities (Chandler, 1992). Company law has altered greatly as capitalism has developed, the changes tending to have been driven not primarily by legal innovation but rather in response to the requirements of business people, industrial capitalists in the case of entity protection (Blair, 2003; Hansmann et al., 2006) and subsequently rentiers in the case of limited liability (Ireland, 2010). The corporate form in its many varieties together with free labour, i.e. workers who have been dispossessed or freed from their own means of production, make the employment relation a dominant characteristic of capitalism. This allows the capitalist rm to exist in protean manifestations: together with the rms ability to agglomerate a large quantity of capital, the source of its material strength, some rms grow to enormous size, whereas others are tiny. This exibility in size is what enables imperial rms to replace large numbers of their competitors, as with a chain-store and local retail outlets, contrasting sharply with noncapitalist systems. It resembles the military conquest of an area farmed by smallholdings followed by the establishment of latifundia, except that the conquest is achieved by economic means, and understanding how this works is key to any explanation of capitalist dynamism. Firms are able to do this because of another aspect of exibility: what resources they use, how they use them, and what they are used for. A rm can alter its inputs, notably the number and type of workers, wage rates etc., and/or introduce a new production process, to try and maintain or enhance its market position by reducing costs. If not limited by, for example, legislation and/or trade union power, workers can be hired or sacked with little notice, and their wages can be driven down as far as market conditions allow. Alternatively a rm can introduce new products more easily than other organisational forms can, because of exibility in opening and closing plants, radically altering the nature of their workforce, and so on.
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These options are not generally available in other ways of organising production. The only way that a petty producer, such as a handloom weaver in early nineteenth century England, could reduce costs was to pay himself lower wages, and the same is true of present-day sole traders such as peasant farmers. Their exibility in the number of workers is typically limited by their family circumstances, and they are similarly limited in their choice of production methods. Traders (merchants) whose costs are dominated by the merchandise itself are in a similar position of lacking exibility; they can reduce the costs of their goods only if they are able to put pressure on existing suppliers or to source from a cheaper one, and they may also be able to reduce other costs such as those of transport, for example. In a world of petty production and trade, change is therefore mainly incremental. Traders largely take the stock of product as given, with only an indirect inuence via suppliers willingness to supply. Petty producers are similarly limited by the stock of their materials, labour time, skills and production methods. In contrast, the scope of a capitalist rm is limited only by the abilities of the people who are taking the initiative: their imagination and competencemanagerial capacity (Penrose, 1959)and their access to resources. These resources include the availability of a workforce with particular types of skill and other types of tacit knowledge, as well as equipment and other more tangible assets. The ability to buy in the appropriate range of labour and equipment is central to capitalist rms success. Thus, capitalist rms have direct control over the volume of production, not being limited by xed stocks of product, skills, etc. as petty producers and traders are, as long as they can purchase what is needed. The degree of exibility varies from rm to rm, from sector to sector and in different historical times and places (e.g. for institutional reasons). But the unifying feature of capitalist production is that across all the dramatic changes that have occurred, for example in market structure and in the role of science and technology, it is composed of rms that have this characteristic of potential exibility both in scale and in inputs. These key properties of the rm not only span the different organisational forms that have occurred in capitalist societies, but are also compatible with different types of ownership. Even the public sector, as with township-village enterprises in China (Qian, 2003) and state-owned enterprises in Vietnam (Ngu, 2002), can function as capitalist rms if they are allowed to do sothis is the main difference from pre-reform organisations, and from the factories of the former USSR. Intermediate forms also exist, for example cooperatives, which have some similarities to capitalist rms but may be expected to have less exibility and which have been observed to have lower growth rates (Gagliardi, 2009). It is also sometimes possible for rms to control their supply chains sufciently to have the same characteristic of exibility. This has occurred in retailing, for example, so it is not simply a question of direct control over employed labour in a hierarchical authority structure (Cox et al., 2002). It may be that the ability of supermarket chains, for example, to dominate their suppliers itself originated in their ability to reduce costs, thereby enabling them to attain a powerful position in relation both to competitors and suppliers.
3.3 Motivation and consequences at rm level

The central role of prot in the success of the rm does not imply that prot maximisation is necessarily operating as an aim: it is possible that a rm aiming to maximise prot could be less successful than one that does not, if the latter rm has other attributes
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that give it an edgethe outcome of competition is a matter of consequences not of motivation. The distinction between motivation and consequences is important more generally. Motivation, the combination of carrot and stick, is central for the individual rm. However, to understand the causes of growth we need to focus also on the consequences, both at the level of the rm and at the aggregate levels of the sector and the whole economy. A parallel distinction underlies the structure of Adam Smiths argument that differentiates the motivation of the trader from its consequence: 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 (Smith, 1776). The unintended consequences at the level of the individual rm arise simply from its being in business, and are contributions that it makes to the wider economy. Among the most important are: provision of goods and/or services; generation of prot and therefore accumulation of capital; employment of workers and payment of wages, thereby providing buying power for other companies products. Simple aggregation applies here, that the economy-wide consequences are simply the sum of the rm-level effectsexcept that in the case of wages, a lower wage bill helps to keep costs down, beneting the individual rm, whereas a higher wage bill contributes more buying power to other sectors of the economy, a form of externality. But at the aggregate level, unintended consequences give the system its distinct properties.
3.4 How cost reduction worksthe sector level and the wider economy
Each rm pursues lower unit costs, attempting to maintain and improve its competitive position. Other rms in the same sector are similarly engaged, so that prot margins are constantly squeezed by the successes of ones competitors. An arms race takes place,9 aptly described by Lewis Carroll as running as fast as one can in order to stay in the same place (the Red Queen effect; Carroll, 1872). A rm can use many different types of strategy to try and reduce its unit costs. Taking the example of a manufacturing rm (the question of generalisation outside manufacturing will be considered later), these include:
In a literal arms race, the military expenditure of one country leads its adversary(ies) to respond by increasing their own military budget, which in turn generates still more spending in the rst country, a cycle that in principle can continue indenitely. Any temporary advantage an individual country may enjoy is quickly eroded, but at the aggregate level the overall effect is a build-up of armaments. Arms races can be of a leaderfollower type, in which one country is always in the lead, or alternatively leap-frogging can occur. The concept of an arms race has been widely applied to other situations, and has been especially successful in evolutionary biology (Dawkins, 2009). In the current context, an arms race means that a companys investment threatens the protability of its competitor(s), leading to a response in kind. The analysis put forward in this paper has been modelled in the System Dynamics software package Vensim, generating the following simulations (Joffe, 2009): d with petty production (no control over costs), introduction of a productivity shock produces a step change in costs but no further changes; d capitalism (both rms can control costs) leads to an indenitely continuing fall in costs and prices for both rms, which quickly exceeds the initial productivity shock; d with one of each type, the capitalist rm takes market share from the petty producer.
9
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use of a technology with higher productivity to produce more units with the same resources; downward pressure on wages and/or employment levels; providing poor working conditions, and cutting corners on health and safety; sourcing of lower cost materials; superior organisation; mergers and acquisitions with elimination of overlaps; running at full capacity and thereby minimising xed costs. Such cost reduction can involve innovation in a technological sense, but this is by no means the only method. There are multiple ways, with cost reduction as the nal common path. For growth, the important consequences are at the level of the sector. Each rms costcutting is a contribution to a continual reduction in costs in the sector as a wholealthough the term contribution should not be seen as implying any more benevolence than in the case of the butcher, the brewer or the bakerit is an unintended consequence of how the system operates. In this way, a given output requires a constantly falling input of resources over successive waves of cost reduction. Just as Smiths hidden hand operates as an unintended consequence at the level of the market, the rm is here seen as embodying the emergent property that makes capitalism distinct and, specically, more dynamic than other economic systems. It should already be clear that there are two ways in which this happens: (i) replacement of the less efcient rms and (ii) survivors behavioural response to lower their costs. Historically, the greater dynamism of capitalism in each geographical area starts when other forms of organisation begin to be replaced by capitalist rms that are able to undercut them, as when the English handloom weavers were driven into destitution by the more efcient factories in the early nineteenth century. The process does not end with lower unit costs. A second effect of competition is to exert downward pressure on margins, so that the price also falls. With the same real wage, the consumer can now afford to buy more: thus a price fall increases the buying power of workers in other sectors, making them richer. In this way, cost-and-price reduction in each sector increases the prosperity of the rest of the economy. In other words, it releases buying power. Over time, as this process occurs in many sectors, society becomes more prosperous, the distribution of prosperity depending on the income distribution. After some decades, the economy is transformed into the mass-consumption type of capitalism (see Section 4.2 on Staging). The trajectory of each sector depends not only on this process of ever-greater efciency, but also on the market. At the new lower price, the quantity demanded increases until the market becomes saturated; saturation is superseded when the next round of cost reduction occurs. In addition, a sector can be affected by exogenous developments in other sectors, for example, ones that render its product obsolete. At the aggregate level of the whole economy, the most important unintended consequences are: increased buying power as a result of the previous level of consumption now costing less; capital accumulation; to the extent that cost-cutting results in higher labour productivity, less labour is required for the same output, and despite higher quantities being produced, eventually is likely to fall for the sector as a whole.
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It is convenient to think in terms of the release of resources from old sectors over time: the generation of extra buying power and capital, and a tendency for labour to be extruded. In particular, as industries mature in terms of efciency, saturation and outdatedness, labour is released, and unemployment results if new sectors do not become available to provide suitable new employment opportunities.
3.5 Price-setting and divergence

The above account treats costs as primary, in that lower unit costs mean a rm has greater strength relative to competitors in that product line, giving it the initiative. It then has an important decision on how much of the advantage to pass on to consumers, a decision that jointly determines price and mark-up. It also strongly inuences the consequent change in quantity sold, although this depends on other factors as well, such as marketing strategy. It would be possible to model the optimal decision in relation to the price elasticity of demand for the product, but in the real world the rms future success depends on its strategic planning under conditions of radical (Knightian) uncertainty. The best decision may in fact be quite different from the static optimum, as is illustrated by the possibility of such strategies as predatory pricing and the use of loss leaders. This perspective therefore provides a starting point for a causal account of how prices are set by the rm that has the initiative, one that requires the dynamic Red Queen context of real competition as a process to be considered, not a short-term optimum. It explains why Smiths idea of a natural price, around which actual prices uctuate but to which they always tend to return (Smith, 1776), does not apply to capitalist systems; rather, the price level is constantly falling in real terms. More generally, this approach departs from the neoclassical focus on convergence. In the case of prot rates it predicts a divergent force, corresponding to rms heterogeneity in the outcome of the competitive process, which counteracts their well-known tendency to converge as capital ows towards more productive uses. The latter on its own would predict tight clustering around zero, the average return on capital, whereas the observed distribution is rather widely dispersed (Farjoun and Machover, 1983).
4. Generalisability 4.1 Other strategies and their consequences

The introduction of new products has similar properties to cost reduction, in that the results differ at the level of the individual rm and in the aggregate. When a rm successfully introduces a new product, a new pharmaceutical for example, it has a temporary monopoly and consequently earns a good level of prot (Schumpeter, 1942). This lasts until other rms manage either to imitate the product, which depends on the institutional and legal context such as patent law, or to produce something that in turn supersedes it. Once the patent expires, we are back in the cost-cutting world, in this case of generic drugs. Within a particular line of business, therefore, at the aggregate level rms once again nd themselves in an arms race. The result is a profusion of new productsthis leads to expansion in product diversity and, in due course, supersession of obsolete products. A similar process operates for products of superior quality, leading to an aggregate-level quality improvement. For example, automobiles have become more reliable over time, as
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well as accumulating various features including alarms, central locking, remote locking, airbags, satellite navigation systems, etc.10 However, not all the strategies that rms use in their competitive struggle have growthpromoting aggregate effects. Those that primarily involve market share of one rm as against the others in the same sector, such as brand loyalty, do not contribute to aggregate growth. It is the difference between non-zero-sum and zero-sum games. Thus it is important not to confuse the range of prot-generating strategies open to rms with the range of processes that contribute to growth; the latter is a subset of the former. It is a mistake to equate a rms success with a long-term contribution to economic growth.
4.2 Staging
Of the two major sources of growth, cost reduction can be regarded as primary because it does not require any other process to make it possible. In contrast, new products would be difcult to introduce were it not for the release of capital and labour, and especially of buying power, that cost reduction makes possible. This may be a major reason why product innovation becomes so vibrant as capitalism takes hold. The relationship between the two types of process is analogous to the way that non-agricultural occupations were able to increase during the Middle Ages, because increasing agricultural productivity meant that not everyone was needed to produce food and bre. This analysis suggests an important distinction between the mode of operation of early (or low-income) capitalism and late (or high-income) capitalism (Solow, 2006). For countries that have not yet embarked on self-sustaining growth, the former is more relevant as it is the usual source of catch-up growth. In this early version, costs dominate: it is the relationship of productivity to costs that provides the opportunity to embark on growth. At this initial stage, downward pressure on costs greatly restricts wages in capitalist enterprises, so that workers incomes do not rise; regimes tend to be authoritarian, maintaining order. (The converse is not necessarily true: only a sub-set of low-wage and authoritarian societies manage to have a high productivity to cost ratio, and thus a competitive advantage that leads to convergence with the already-developed world.) Then later in the process of growth, this advantage is gradually eroded by rising per capita income. Growth typically starts with the appearance of capitalist rms in a small number of sectors, sometimes in only one. Firms cost advantage quickly leads to their dominating the sector(s). As real input costs and prices fall in each capitalist sector, the release of buying power in other sectors provides an economic linkage between sectors. It may be that the difference between economies with self-sustaining growth and those with transient growth accelerations (Hausmann et al., 2004) is such that a critical mass is reached. However, this effect of buying power only operates in the presence of capitalist production, as is illustrated by its failure to happen in seventeenth century Netherlands, despite an embarrassment of riches (Schama, 1987). We have already examined the evidence of how this process operated in the USA (without the authoritarian regime in that instance) in 182060. More recent examples include the East Asian tigers starting in the 1960s, and subsequently other parts of eastern
10 In addition, as a corollary of the abundance generated by capitalist production, the limiting factor becomes ability to nd markets for the product. This can lead to the creation of products with an articially low life-span, e.g. by fashion, built-in obsolescence, etc. This could be seen as reducing quality, thereby introducing a countervailing force.
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and southern Asia. Their catch-up growth has some important characteristics: usually they started after the introduction of policy measures that were pragmatic, outward-looking and included a major strategic role for the state. It is clearly an important research task to understand which features of such measures have been effective. They were seldom introduced using textbook economicsindeed the wrong relative prices were deliberately induced in South Korea (Amsden, 1989). And textbooks have learnt little from their dramatic successes, although there have been attempts to interpret the evidence from the viewpoint of neoclassical economics (Rodrik, 2007). The export orientation of these countries means that they could establish and maintain very high growth rates: effectively they have been able to import the buying power of the rich world. In addition, they imported technology from more advanced economies. This was fully paid for, so that improvements not reected in the price of capital (Sokoloff, 1986) were not prominent. The implication is that technological progress occurred without a rise in total factor productivity (Lipsey and Carlaw, 2004). This could explain the observation that global economic growth in recent decades has mainly occurred in two clusters: one with physical capital growth in certain regions, and the other with total factor productivity growth plus an interaction of initial human capital with physical capital growth (Durlauf et al., 2008). The latter would appear to describe the already-developed world, whereas East Asian catch-up growth has been characterised by rapid capital accumulation, plus growth in the quantity and quality of labour input, without an increase in total factor productivity (Young, 1995; Felipe and McCombie, 2003). High-income capitalism, on the other hand, is innovation-based and occurs where human capital is high. Investment is characterised by innovative methods of productive technique and/or organisation, and new or higher-quality products are commonplace. In the societies where it happens, several features have already become established, most of them being consequences of earlier capitalist growth. They include a tendency to oligopoly, highly developed science and technology and economies of scale (Penrose, 1959; Baumol, 2002; Reinert, 2007), together with the small-family, high-human capital pattern that emerges following the demographic transition (Galor, 2005). Each imparts an additional impetus to capitalist growth, a positive feedback loop, which has led some observers to attribute capitalist dynamism to one of these features.
4.3 Generalisability outside manufacturing

The above description is based on manufacturing, but may well be more general, inviting the question, what other sectors have similar properties?. The historical record shows that agriculture has followed a path similar to industry, at least in rich societies. The development of retailing makes it clear that a similar dynamic must be operating in this sector too. The example of Wal-Mart has already been referred to, and in earlier times similar processes led to the rise of chain stores and supermarkets in America, Europe and elsewhere. Such developments are continuing, with the rise of internet-based sales companies such as Amazon. The example of retail corporations such as Wal-Mart in using cost-cutting provides a clear illustration of a principle that is quite general: their increase in market powerto an extent that approaches monopoly in many locationsgoes with lower not higher prices. This reverses the conventional logic found in mainstream economics, that given a monopoly position a rm will extract higher prices; whilst that is true, it does not allow
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for the way the monopoly position was arrived at. If it was achieved by cost-cutting, then the dominant company is likely to be the one charging lower not higher prices. This is readily observed in retailing, where displacement of small shops by supermarkets and chains is clearly evident, but present in manufacturing and probably other sectors as well. The same logic also makes clear that size itself is not necessarily an advantage; rather, size and inuence are both consequences of being in a position of relative strength, whether through low costs or through new productsexcept in sectors where economies of scale impart a substantial positive feedback impetus. It is not immediately clear that the same description applies in non-nancial services other than retailing. On one hand, the continuing dynamism of the US economy, in which services have largely replaced manufacturing, suggests that the processes are at least partly similar to those described for manufacturing. On the other hand, it is difcult to see how such services as personal (one-to-one) care can be analysed in this waythey are inherently more akin to petty production. Clearly the term services is highly heterogeneous in these terms. For example, in services such as a hotel or a language class, where xed costs dominate, full occupancy/attendance (analogous to full capacity in industry) plays a central role. Consideration of this issue requires an analysis of the different sources of prot in different types of service industry, the strategies available and their aggregate-level effects, but this is beyond the scope of the present paper. Similarly, sectors in primary production that have a limited stock of product, such as mining and oil/gas, with limited exibility of supply, follow the market logic of a scarce resource. Capitalist cost-cutting logic only applies where there is scope for substantial reduction in input costs. And housing has its own characteristics: building methods are subject to cost reduction as well as to product innovation and quality improvement, but housing has a strong positional element in that land prices reect the degree of desirability of different locationsa major zero-sum component.
4.4 The nancial sector and the state

The role of nancial institutions in capitalist dynamism also needs to be unpicked. The distinction between the role of zero-sum and non-zero-sum strategies within manufacturing makes clear that the mere fact of a rms success does not necessarily imply that its strategies have contributed to aggregate dynamism. The implication is that the undoubted success of nancial rms in making prots, and enriching many of its participants, does not of itself mean that the nancial sector has played a major role in stimulating long-term growth. Similarly, a contribution to employment, liquidity and the balance of payments affects the current economic situation, but this is not the same as a causal effect on growth. The root cause of capitalist growth lies within the real economy. In so far as the capital market has facilitated the processes described above in the non-nancial sector, for example providing funds for investment in labour-saving technology, there is a prima facie case for the role of nance capital in capitalist dynamism. Plausible mechanisms include raising the investment level and enhancing efcient capital allocation. The issue is, to what extent such mechanisms actually operate in practice. Studies of sources of nance show that start-ups in new industries often rely on local nancial networks (OSullivan, 2007) and venture angels (Bhide, 2006) in a large variety of times and places, and that established companies tend to use retained prots for investment (OSullivan, 2007). Detailed case studies indicate highly diverse patterns,
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including foreign direct investment, so that generalisations are hazardous (OSullivan, 2007). Loan capital does play an important role in the nancing of many rms, but sometimes this may merely be propping up unviable rms. The evidence on the relationship between growth and the level of nancial development at national level is unclear. The causal relationship could be in either direction or both, so that studies need to be able to specify which comes rst. They also need to avoid omitted variable bias by including factors that could inuence both growth and nancial development. In general, the level of nancial development is found to have a positive effect on economic growth (Luintel and Mosahid, 1999; Levine et al., 2000; Calderon and Liu, 2003; Aghion, 2006), but this varies from country to country (Ang and McKibbin, 2007) and is notably absent in the case of China (Liang and Teng, 2006). One type of economic institution that deserves particular mention is the stock exchange, often loosely equated with a capitalist system by non-economists. The example of seventeenth-century Amsterdam indicates that the possession of a stock exchange was not sufcient to catalyse a change from trade-based growth to the type of capitalism that subsequently emerged in England. Indeed, in the early eighteenth century the Dutch sought foreign outlets for their abundant capital, a century after the foundation of the Amsterdam Stock Exchange (de Vries and van der Woude, 1997; Landes, 1998). Similar remarks apply to banking, which emerged even earlier. The role of capital market institutions in capitalist dynamism is therefore unclear: even if they are necessary, they are far from sufcient. For the topic addressed in this paper, the causes of dynamism in a particular type of economic system, capitalism may therefore not be a good term to characterise the system! Nevertheless, capital does play a vital role because investment is important, especially in new technology. If the above account is true, the way capital is used is at least as important as its quantity (and efciency of the capital market may be comparatively unimportant). This would mean that capital accumulation is causal for market structure, but its causal impact on growth is mediated through the effectiveness of the investment decisionthis can only be known ex post for an individual decision, but could be regarded as a parameter at group levelas a national characteristic for example. A full discussion of the role of the state is beyond the scope of this paper. It is worth noting, however, that unlike arguments based around market distortion or failure, in this perspective the state sector is not necessarily a brake on growth. This accords with the empirical evidence (Bleaney et al., 2001; Lindert, 2004). The state may, for example, facilitate the economy in many ways that go far beyond the minimal night watchman functions of maintenance of order, enforcement of contracts and macroeconomic management. These could include institutional and legal support for the existence of rms in ways that encourage prosperity, as well as the judicious use of tariffs, scal policy etc, that played an important part in the early growth of now-developed economies (Chang, 2003, 2007). It can also introduce amplifying positive feedback into the system, the most obvious way being by improving human capital (Bleaney et al., 2001), for example via education (You and Chang, 1993) or publicly funded healthcare (Lindert, 2004). The evidence on social transfer programmes impact on growth is unclear (Bleaney et al., 2001; Lindert, 2004). The state also contributes to technological development, a recent major example being the internet. And in certain circumstances public sector companies can be dynamic, as long as they are expected to function in capitalist style. It would be an error, therefore, to expect countries with a large state sector, as in the Nordic countries and China, to be less dynamic.
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5. Conclusion
This paper has attempted to provide a causal explanation of the main components of growth under capitalismabundance plus product diversity and qualityin terms of the institutional properties of the rm. It is argued that the sustained dynamism characteristic of capitalist economies, or at least the successful ones, derives from the properties of rms in the real economy (the non-nancial sector). The market is seen as necessary but not sufcient. The hallmark of capitalism is a hybrid of market and non-market organisation: exchange between rms takes place in a market, but within each rm the market is replaced by an authority structure. It is this combination, market relations between rms, that is the root cause of capitalist growth. Like the attribution of growth to the market, this is necessary but not sufcient, because some capitalist economies have not shown consistent dynamism. The difference is that the hybrid explanation is more specic, corresponding as it does with the spatio-temporal pattern of economic growth. An important test of it will be whether the same explanatory categories can account for the examples of non-dynamic capitalist societies, for example in twentieth-century Latin America. Returning to Coases question, why rms survive, the answer is clear: economies composed of rms vastly out-perform, erode and destroy any other type. Firms not only survive, they tend to displace sole traders such as handloom weavers and corner shops. This invites a different question: if markets per se are not responsible for capitalist growth, do they deserve to be treated with the quasi-religious awe that is widespread in economics? The analysis has drawn on empirical evidence at different historical stages that displays a degree of repeatability and consistency, strongly suggestive of deep regularities that persist despite profound changes in rm size, market structure and many other characteristics. It is a system with endogenous causal processes but, like the price mechanism, it is not formally organised. It is also an open system, sucking in labour, raw materials, energy, etc. as inputs and spewing out products, promotions and pollutants as outputs. In addition, the endogenous causal processes can be inuenced by additional exogenous forces. The causal account of the underlying process presented here, based on an empirical synthesis, has the status of a hypothesis. It is an example of description at a deeper level feeding into basic theory, which has been highly successful in biology and other sciences, but a tradition of which has been lacking in economics (Joffe, 2011). At this stage only a verbal model is presented, based on simple assumptions, aiming at internal consistency and intuitive plausibility as well as empirical adequacy. This description of the inner dynamic of capitalism naturally generates a realistic theoretical account of (i) the source of economic growth, (ii) the evolution of market structure and (iii) a starting point for explaining price-setting. It also explains (iv) the forces that produce divergence in, for example, prot rates, for which mainstream economics provides only the corresponding convergent forces. It is complementary to evolutionary accounts of technical change.11 The explanatory account of growth presented in this paper provides micro-foundations, not in terms of individuals but at the emergent level of capitalist rms, which is appropriate given that capitalist dynamism is not a human universal. Its basis is competition seen as a struggle between competitors that are heterogeneous and in particular that have unequal strength, and for the rms that succeed it accounts for the
11 One way of thinking about this is in terms of the relationship between structure and content: the present paper analyses the structure for which evolutionary economics provides the content.
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growth of their economic power. It explains how under capitalist conditions trade benets relatively strong rms, for example those having lower costs, providing a language for describing the victory of the strong over the weak. In this way, free trade can be seen as the removal of safeguards for the less powerful, thereby providing a rationale for the right kind of protection for early development and infant industries. Hence it accords with the observation that almost all currently successful capitalist economies were protectionist in their early stages (Chang, 2003). Smiths classic description of the market showed how the interaction of trading individuals led to the emergent property of convergence towards a stable equilibrium, through the aggregate-level operation of supply and demand, as if by a hidden hand (Smith, 1776). In this paper I have argued that under capitalism, the rm embodies a second kind of emergent property, and that its operation leads to aggregate-level growth. Unlike earlier trade-based economic systems, capitalism has two hidden hands.
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The Root Causes of Growth Under Capitalism

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Cambridge Journal of Economics Advance Access published March 22, 2011

Cambridge Journal of Economics 2011, 1 of 24 doi:10.1093/cje/beq054

The root cause of economic growth under capitalism

1.1 The market or capitalism?

The root cause of economic growth under capitalism

The root cause of economic growth under capitalism

1.2 What is growth?

The root cause of economic growth under capitalism

2.2 Historical changes in productivity and prices

The root cause of economic growth under capitalism

3. An institutional explanation of capitalist dynamism

3.1 The process of competitionthe relationship between rms

3.3 Motivation and consequences at rm level

The root cause of economic growth under capitalism

The root cause of economic growth under capitalism

3.5 Price-setting and divergence

4. Generalisability 4.1 Other strategies and their consequences

The root cause of economic growth under capitalism

4.3 Generalisability outside manufacturing

4.4 The nancial sector and the state

The root cause of economic growth under capitalism

The root cause of economic growth under capitalism

The root cause of economic growth under capitalism

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