Why Capitalism, Although Unfair, Kinda Works?-- Part 2

This is the second part in the series of the discussions that I am having with my Dad about Capitalism and its features. Read first article here:

Why Capitalism, Although Unfair, Kinda Works? - Part 1

Dad: All right! Let’s start from where we left-off. You were going to answer why people and society don’t do anything about the unfairness that the capitalist system brings.

Me: Right! But first, let us continue discussing by setting up a hypothetical scenario just like what we did the last time.

So, imagine you are in a world with 50 consumers and there are many producers that are making shoes. For whatever reasons, the producers have made 99 right shoes and 1 left shoe. Our task in hand now is to distribute these shoes to 50 consumers.

Dad: Wait a minute!!! If there is only 1 left shoe, this means only 1 person out of 50 can wear a full pair of shoes right?

Me: Exactly! So, with that fact in mind, in the communist system, what will happen is that the government would take all the shoes and throw away 98 right shoes and take 1 right shoe and 1 left shoe and finally, try to distribute that pair “fairly” among 50 people.

Dad: What does “fairly” mean here? Because, anyway I look at it, it is already decided that only one person will get to wear a full pair of shoes. How is that “fair”?

Me: That’s a good question, Dad. So, fairly here just means that the probability of any one person getting the pair of shoes is equal.

Dad: So, are you talking about a random lottery?

Me: That’s exactly right. The government, with the use of a lottery, will randomly pick one consumer to wear the shoes. The consumer will pay the amount for the shoes. And finally, the government will redistribute that revenue from shoes to all the producers equally amongst the producers.

Dad: Okay, and what happens in a Capitalist system?

Me: We again have to remind ourselves that there is only one person out of 60 people who can wear the pair of shoes. In Capitalism, that consumer would be the one with the greatest willingness to pay.

Dad: Now, I guess I can bring back that concept of unfairness that we had earlier discussed. Because willingness to pay obviously will be the highest among the richer people.

Me: Yes, you are right. And actually, there is one more thing that determines a higher willingness to pay i.e., one’s need for that good/service. We are getting close to the root of the unfairness problem. For example, firefighters are going to pay more for the shoes than a person who is going to a ballet. And of course, as you pointed out already, the richer people are willing to pay more for the shoes compared to the poorer people.

Dad: Yeah but in between the two, I think the amount of money one is willing to pay comes out at the top.

Me: I think so too. And, from that, we can now also conclude that the likelihood that the one person who will get to wear that one pair of shoes will also be the richest person in the world.

Dad: Exactly, see the unfairness. It turns out I really don’t like this Capitalist system.

Me: Hold on a second Dad! Let us not conclude anything yet. There is another party who faces the wrath of unfairness on the other side as well i.e., the side of the producer, meaning that the producer who made that one left shoe will get almost all the proceeds from the sale of the pair.

Now, remember that in the communist system, the government took all the shoes made by the producers, did a lottery and sold the shoe, collected the revenues, and distributed the proceeds equally among all the producers.

Dad: All right! If these are the outcomes of the two political systems, then I really do not get why Capitalism is still around. The communist system works far better. I mean it’s fair to all the people in society.

Me: You think so? Al right then! Tell me what happens the next day?

Dad: What do you mean the next day?

Me: That scenario we imagined just now. That was Day 1, but we have a whole life to live. So, what happens tomorrow?

Dad: Well, I guess the same right? I mean, in the communist system, the producers will again produce a certain quantity (author’s note: it can be any quantity, does not have to be as extreme as 99 right and 1 left | The only assumption here is that the producers do not have a precise information about the market demand which I think is a fair assumption to make) of shoes (it can be any good, I am just continuing the shoe example from above), the government will again take it, do a lottery and distribute the revenue equally among all the producers.

And, in the case of a capitalist society, the producers will produce goods (presumably not equal to the equilibrium demand), the consumer with highest amount of resources (richest person) will pay huge money for it. The producer who has the scarce good will get most of the rent, if not all.

Me: You are exactly right about the communism and exactly wrong about the capitalism! A very important insight and the whole foundation of capitalism is going to follow now. Listen carefully Dad. This is the concept of incentives.

Under the capitalist society, at the end of Day 1, when the good is sold to the richest person in the open market. The market participants see that the producer who made that left shoe got the big bucks. Now, the next day, the producers will have a huge incentive to produce more left shoes because they know that the left shoes are going for huge money in the market and we all know how much everybody loves to have more moneyJ.

Dad: Okay! But, what if there are too many left shoes produced now? Can that happen?

Me: Sure, that can happen. It might very well be the case that at the end of Day 2, the right shoes are the one that is scarce and it might yield higher price in the market. It depends on the producers’ ability to make precise forecasts about the demand for the right and left shoes. So, in this way, as the days pass by, the price of the shoes change depending on the number of left and right shoes produced. 

However, one thing is for sure, eventually we will see an equilibrium in the market where the producers are producing equal amount of right and left shoes (in our scenario, 50 left and 50 right shoes).

Dad: The number of shoes produced shall be eventually equal because the prices of left and right shoes in the market are equal. Did I get it right?

Me: That’s right. And, that’s exactly the beauty of open and competitive market. Its because of this competition among producers to earn more by producing something that the market/society needs, the prices of goods fall.

Dad: I see. If that’s the case, then all the people can eventually buy the shoes and wear them right? I mean it will not always be only the rich people because eventually because of the incentives and competition the prices of goods will fall enough that an average person can afford it.

Me: Now, tell me, does it still sounds unfair to you?

Dad: I have to think a bit about that. Perhaps, I was too quick to judge. Let’s continue this discussion next time.

Me: Sure!

Bivek Neupane is a recent graduate of MSc. Finance and Economics. He specialized in quantitative finance and research. After spending half a year as an intern in the quant team of Allianz Global Investors Frankfurt, he has taken the role of Management and Strategy Consultant in the in-house Consulting entity of the Allianz Group. Currently, he is also actively researching Machine Learning applications in the Nepalese stock market. If you have any questions, do not hesitate to contact him. You can connect with him via LinkedIn , his blog or e-mail.