Capitalism and Standard of Living

This paper is meant to pique the interest of a layman interested in Economics. This paper does not delve into detail, since it was a paper I wrote for my Principles of Economics (Macro) college course during my first year studying the subject. The paper examines the relationship between the economic system of capitalism and the standard of living of a country on a very surface level.

The textbook we used in class was Principles of Macroeconomics by N. Gregory Mankiw.

"Capitalism has been called a system of greed—yet it is the system that raised the standard of living of its poorest citizens to heights no collectivist system has ever begun to equal, and no tribal gang can conceive of." - Ayn Rand

The standard of living of a country is the fundamental reason behind economic growth. Every individual wants good quality goods and services and, on top of that, individuals want to pursue their own interests. Taking that into account, the perfect formula for economic growth that results in a high standard of living while individuals pursue their own interest is Capitalism: free trade, free competition, and limited government.

Economists often disagree, but it is clear that most do agree on one thing: free trade. Free trade means not restricting imports or exports. There is a broad consensus among economists that protectionism has a negative effect on economic growth and economic welfare, while free trade and the reduction of trade barriers has a positive effect on economic growth. Free trade benefits everyone. Let’s say country X produces much better shirts than country Y, and country Y produces much better pants than country X. In economic jargon, both countries have an absolute advantage - country X in shirts and country Y in pants. Both countries need shirts and pants. Both countries could pursue inward-oriented policies and produce both items - one would be of good quality and the other one would be of inferior quality. However, the logical thing for both countries to do would be to pursue outward-oriented policies. That is, country X would focus on using its resources to make good quality shirts and country Y would focus its resources to make good quality pants and, after that, both countries would trade - exchange shirts for pants. In this way, both countries end up with (1) a higher quantity and (2) a superior quality of shirts and pants. In the words of Mankiw, trade is a type of technology. When a country exports shirts and imports pants, the country benefits as if it had invented a technology for turning shirts into pants. Therefore, a country that trades will experience the same kind of economic growth that would occur after a major technological advance; and this economic growth will increase the standard of life.

Competition is also a crucial aspect of increasing the standard of life. It is of importance because competition ensures productivity. Productivity, the quantity of goods and services produced from each unit of labor, is essentially what determines a country’s standard of living. Let’s simplify things to make them easier to understand, suppose there is a guy at a stranded island, his standard of living will be determined by how good he is at fishing, building shelter, and hunting animals. If the guy is exceptional at doing those things, he will enjoy an exceptional standard of living. On the other hand, if he is bad at doing those things, he will have a bad standard of living. In other words, a country’s productivity will determine its standard of living. In big countries, like The United States, the most effective way to make sure that people are being productive is with competition. For instance, producer X might make a shirt with better quality than producer Y. Competition will ensure that if producer Y keeps making inferior shirts, people will not buy Producer Y’s shirts, and he will eventually go out of business - and the resources he was using to make the shirts will go towards a more efficient use, maybe producer X gets the resources and makes more shirts for more people to enjoy. On the other hand, if producer Y had no competition from producer X, consumers would be stuck with low-quality shirts and therefore a lower standard of life. In the words of Milton Friedman, “competition forces producers to either put up or shut up, they either have to deliver the goods, produce something that people are willing to pay for, willing to buy, or else they have to go into a different business.”

Finally, the most important part of the formula for increasing the standard of living of a country is to have a limited government. The only thing standing between free trade and free competition is the government. For example, the government stands in between free trade when it imposes tariffs, minimum wage laws, or occupational licensure laws. All of these actions restrict free trade because it prevents individuals from making a voluntary exchange with another individual. In the case of tariffs, it prevents consumers from buying cheaper and better quality goods from abroad; in the case of minimum wage laws, it prevents an unskilful employee from selling his labor at a lower price; and in the case of occupational licensure laws, it prevents individuals from offering their services as a lawyer, a doctor, or even as a barber or a taxi driver. For similar reasons, the government also stands in between free competition when it imposes the things mentioned above. In the case of tariffs, it prevents consumers from buying better goods or services from other producers; in the case of minimum wage laws, an unskilful employee is not allowed to sell his labor lower in order to be more competitive; and in occupational licensure laws, it protects producers from outside competition. The government should act as a rule maker and umpire. It should not be a significant player in the game and it should not grant special favors to anyone. It is evident that during the 20th century all countries that had big governments had a poor standard of living compared to countries with limited government; for example, The Soviet Union compared to The United States.

During the last couple of decades, most countries have been moving towards a free market economic system. This is due to the enormous advantages that the free market has to offer. Free trade works wonders, it is a technology that lets you change one item for another item, saving up both time and resources for both individuals or countries involved. Free competition increases the standard of living because it ensures that people will always have another producer to buy from if they are not satisfied with the current one. And lastly, limited government increases the standard of living and personal freedom to heights that were not imaginable during the past 100 years. Thanks to Capitalism, the average American can now live in levels of luxury that not even the elite of the past could imagine.