How Capitalism Works (1): What is Economics

THE REASON THE natural and industrial resources of the world are not used to provide the abundance they are capable of producing is to be sought, not in the realm of technology, but in that of economics.

Economics is basically the study of what happens when wealth is exchanged — that is when it is either bartered for other wealth or bought and sold for money. It is not the study of the production and allocation of wealth as such, but the study of its exchange and how this affects decisions about production and allocation. Exchange is not to be confused with allocation.

Allocation (sometimes called distribution) is about the use which people make of the wealth they have produced: how much they consume immediately. How much they store for future consumption. How much they use to build up or renew their stock of tools and machines. “Allocation” is used here in preference to “distribution” because the latter has acquired other meanings which can cause confusion; it sometimes means transportation (which is really part of production)— but worse shops, which are exchange institutions, have taken to calling themselves the “distributive trade”.

In some past societies the amount and kind of wealth that was produced and allocated were decided according to some prearranged plan, even if this “plan” was just a set of tribal customs or some other unwritten code of social behaviour. Wealth was allocated directly for individual and communal use so that the sole aim of production could be said to have been direct allocation, or use.

In societies where the bulk of the wealth is exchanged after it has been produced (and before it is allocated) the production and allocation of wealth is no longer decided according to human plans or customs. The decisions are of course still made by people but within terms of reference outside of their control. Economics is the study of these terms of reference or, perhaps, of the laws or economic forces which come into operation once production for exchange becomes widespread.


An exchange institution is a body set up to take economic decisions; that is, decisions about the production and allocation of wealth in an exchange economy. A shop (where products are sold) or a bank (where money is deposited) are obvious examples. Not so obvious perhaps is the “enterprise” or firm, an institution for making decisions about the use of the large-scale, collectively-operated workplaces where the bulk of the world’s wealth is produced. The enterprise is the key modern exchange institution since, apart from the sale of human energy for wages and the purchase of consumer goods by wage-earners, exchange today takes place overwhelmingly between enterprises.

An enterprise is an institution which seeks continually to increase the monetary value of its assets (the instruments of production, the raw materials, the stocks and the cash, including the wage fund, it controls.) The monetary value of these assets is sometimes called “capital”; hence “capitalism” as the name for the modern exchange economy. The aim of inter-enterprise exchange is profit, the difference between production costs and sales receipts.

Enterprises aim to increase their capital through making profits, the ratio of the increase in capital to its original value being the rate of profit.

The internal structure of the enterprise— who makes the decisions? Who gets the profits? —varies from State to State according to their differing historical and political conditions. The two most common types of enterprise are the joint-stock company and the nationalised or state industry.

In the joint-stock company the key decisions are made by a board of directors elected by and responsible to the shareholders who supplied the money to buy the assets of the enterprise. The profits are shared between the share-holders as dividends and the directors (and sometimes the top managers) as fees and high “salaries”.

The assets of a state enterprise are usually controlled by a management board appointed by the government. Its profits can be, and are, shared in a great variety of ways. They can, for instance, simply be handed over to the government to use to pay interest to those who have lent it money. Or they could find their way into the pockets of the state-appointed managers, once again through inflated “salaries”. Or they could be used to maintain in comfort and privilege those who control the state.

What is significant about the enterprise from an economic point of view is not its internal structure but its role as the mechanism through which the laws of the market are transmitted to those who make the decisions about the production of wealth— whoever they may be and however they may be chosen. The internal structure of the enterprise could be, and in a few cases is, quite different from either private or state enterprises. The workers could elect their own management committee or workers’ council, but not even this would make any difference to the enterprise’s economic role. The workers’ council would still have to take decisions in accordance with what the market dictated. Real control by the producers over the production and allocation of wealth is not possible within an exchange economy.


The production of wealth is now a process involving millions of men and women in even,’ part of the world. What used to be the division of labour between individual skilled workers has become, with the development of modern technology, a division of the work of production between hundreds of thousands of collectively-operated workplaces (farms, plantations, mines, ships, docks, railways, factories, offices, warehouses) spread all over the world. Indeed, it is no exaggeration to say that every article produced today is the product of the world labour force co-operating within this world-wide division of labour.

Wealth production is no longer individual or local or national; it is social and worldwide. A single world society already exists but, because the workplaces of the world are controlled by enterprises, it takes the form of a world exchange economy.

The fact that there is only one, worldwide exchange economy is obscured by the political division of the world into states, each with the power to issue its own currency, impose tariffs, raise taxes and pay subsidies. The different economic policies of these states mean that conditions in the world market vary and give rise to the illusion that rather than there being one world economy there are as many “national economies” as there are states. But although states can, and do, try to change world market conditions in their favour, because of the worldwide character of the productive process they do not have the power to isolate exchange within their frontiers from exchange outside. Far from it. World market conditions are in the end the most important factor states have to take into account when formulating their policies. They, like enterprises, have to work within the terms of reference of the exchange economy. Of course, states do have the power to make laws about the production and allocation of wealth, as about any other human activity, but enforcing such law is another matter. So is their economic effect.

The natural and industrial resources of the world are now controlled by profit-seeking private and state enterprises. In every state only a small minority can draw on these profits as a source of personal income. Whether or not they have title deeds to prove it, they are in practice the owners of the means of production. This applies equally to profit-taking politicians and managers and to shareholders and bondholders. Collectively these owners form a class with exclusive control — a monopoly — over the means of production. This class monopoly is the basis of modern society.


The personal income of those excluded from the means of production is the wage (or salary) they are paid by the enterprise which employs them. These wage-earners form a class of propertyless people since, collectively, they do not own the means of production. As individuals of course most of them do have some personal possessions and savings, but these cannot be used to produce wealth.

It is because they are members of a propertyless class that they are compelled by economic necessity to work for wages. This is the only way they can get money to buy the things they need to live. The wage relation which arises between the owning and the non-owning class is a basic feature of the present exchange economy. The use of wage-labour to produce the wealth of society signifies that human skill and energy has become an article of exchange due to the exclusion of the producers from the means of production. The existence of wage-labour means the existence of production-for-profit and vice versa: they are two aspects of the same social relationship.

The law of wages says that wage-earners tend to receive from their employer a sum of money sufficient to pay for the goods and services they have to buy in order to maintain their working skill and to raise and keep a family at the same standard. It also says that any sum of money regularly paid to wage-earners from a source other than their employer and any goods and services regularly provided free by employers or anyone else means that employers need pay wage-earners a smaller sum than they would otherwise have to.

In terms of goods and services, what this means is that other things being equal, over a given period of time the wage-earners’ standard of living is fixed at the amount of goods and services they need to maintain their skills and their families. Except within very narrow limits they can get no more and no less than this. So any attempt, say by the state, to raise their standard of living by providing free services or money payments is bound to fail. The operation of the law of wages will tend to ensure that the overall standard remains the same by causing a reduction in the sum of money paid by the employer. Similarly any reduction in the amount in a pay packet caused by increasing taxes, either on the goods they buy or directly on their wages, will be self-defeating. The law of wages will tend to bring about a corresponding increase in the sum paid by the employer.

Actually this is an oversimplified picture since the law of wages is not an automatic process; it operates only through human activities, through the struggles between the wage-earners and the profit-seeking enterprises that employ them over the size of the wage packet (or salary cheque). Indeed this struggle is the operation of the law of wages and to the extent that the wage-earners cannot, or do not, struggle then their living standards can be reduced. Other factors, like the levels of output and unemployment and the depreciation of the currency, also complicate the picture, sometimes considerably, but the broad outline remains accurate: the wage-earners’ standard of living cannot be improved by state subsidies nor can it be reduced by taxation.

This is not to say that the amount of goods and services the average wage-earner gets can never be altered at all. It can be, by two factors. First, by a change in the average skill of the worker. In the 19th century when the skilled handicraftsman was being replaced by a mass of less skilled machine-minding factory hands, often women and children, the average degree of skill did fall, and with it the wage-earners’ standard of living. In the 20th century, on the other hand, with the spread of universal education the average degree of skill, and with it the standard of living, has tended to rise. Second, the amount of goods and services needed to maintain wage-earners and their families is not something that could be calculated in precise terms by a team of doctors and scientists. Social factors enter into it too. People’s tastes and habits in regard to food, dress, housing, transport and entertainment vary from place to place and change as advancing technology makes new products available. And when, as in a prolonged period of high employment, wage-earners have come to regard as necessities what were once luxuries then what they need to maintain themselves and their families has not only changed but has also increased.

The law of wages does not rule out such changes m living standards but, by their very nature as long term trends, they are increases that cannot be brought about by the actions either of the state or of the wage earners themselves.


But why are wages fixed at a certain level? Wages are a price, the price of the skills and energies wage-earners sell to enterprises, and like all prices are not fixed arbitrarily. Prices, in a roundabout way, reflect the amount of human effort that had to go into producing an article from start to finish. So wages, the price of human energy, are an indirect reflection of the amount of work that has to be done to produce all the goods and services needed to keep a human being alive and fit to work.

Wages are the form taken in an exchange economy of the amount of wealth that must be consumed to create and maintain the supply of human energy for the work of production, while profits are the form taken by the surplus wealth produced over and above this. The restriction on the amount of wealth allocated to the class of wage earners is the inevitable outcome of human energy being an article of exchange.


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