Signals and Incentives: How Capitalism Coordinates Production

(Apologies for my hiatus. This is Part 8 of a series on political economy on my blog. Read the introduction to the series here. Read the previous part here.

Production is confusing. How do we coordinate the production of millions of people to fulfill their needs? (Source: VectorStock through Google Images)

Introduction

As noted in our previous posts on markets, pricing, and “freedom” in capitalism, nothing in capitalism is truly “free”. First, all economies are planned economies. Second, the ideology of “freedom” and the “free market” hides a significant lack of freedom of association and it wholly obscures the actions of the Sovereign establishing and enforcing ownership norms. So then why do we consider this system “free?” Beyond ideology, I would like to argue that capitalism is perceived as being free because (broadly speaking) it coordinates production indirectly, through an incentive structure facilitated by a signal. I will delve into this Incentives+Signal framework as it applies to capitalism in order to examine other possible arrangements of Incentives+Signals.

My Terminology

We should first distinguish between what I will call “direct” vs. “indirect” coordination.

Direct coordination can be defined as, roughly speaking, being given orders you are expected to fulfill.

An important note: Direct coordination is frequently perceived as being coercive, when it contradicts the person’s preferences. If you get kidnapped and the kidnapper tells you to rob a bank or die, this is a (particularly heinous) form of direct coordination.

Indirect coordination can be defined as, roughly speaking, the coordination of actions through the manipulation of incentives.

In other words, if I want you to do some action, I can tell you to do that action (direct coordination) or I could somehow make it so that doing that action is in your own interest (indirect coordination).

Capitalism is (at least in theory) a system of indirect coordination. It presents an incentive that many people desire, and uses a signal to direct production and consumption choices by firms (as noted in a prior piece, all economies are planned economies) and consumers. Let’s delve into this.

Capitalism’s POP!

Profit, Opportunity Cost, and Prices. That’s it. The deceptively simple incentives+signal structure underlying capitalist production.

Most people want things. Everyone at the very least *needs* certain things to stay alive. Which means accumulating money *and* using it “efficiently.” On the production side, firms desire profit. It’s what makes production “worth it”. On the consumption side, consumers desire things. But their acquisition of these things is a function of both their preferences and their income (which constrains their budget). Prices help direct production (through the profit motive) and consumption (by making opportunity costs clear to consumers). How any particular consumer or firm will interact with prices is not something I can predict, but assuming that humans are (at least in part) strategic actors (which at this point seems fairly obvious — we respond to incentives, perhaps just with different intensities), then prices can be understood as the signal that allows both firms and consumers to realize the incentivized actions of the system (pursuing profit and using money most efficiently/”maximizing utility”).

And this system works pretty well. It incentivizes innovation (although it makes no distinction between good or bad innovation, as an innovation may have deleterious social effects not properly priced into it), it prevents free riders (work or die, chucklef*ck), and it solves a series of information problems. It coordinates production, no one can dispute that. But does it do it well? This is the most important question. I am not talking about the “Does it solve information problems” question in the same sense as the debate over centralized planning vs. “free markets”. I don’t care. The question I mean to ask has a different focus: Does capitalism’s Incentives+Signal system, its price mechanism, actually fulfill capitalism’s own goals?

The Goal of the System

As noted before, the goal of the system is to maximize profit (on the firm’s end) and maximize utility (on the consumer’s end). This is coordinated by prices. Now, someone might look at this system and ask: “Is there any guarantee that pursuing profit/maximizing utility will lead to the greatest good?” Is it possible that, while the profit motive and price mechanism may incentivize fulfilling the needs/desires of people frequently, it also (in at least some cases) actually disincentivizes doing so?

The OG capitalist, Adam Smith, didn’t think so. In a quote from his seminal economic work, An Inquiry into the Nature and Causes of The Wealth of Nations, Smith describes how each individual working for his or her own personal gain, will actually lead to the greatest good for society:

“he intends only his own gain, and he is in this, as in many other cases, led by an inivisble hand to promote an end which was no part of his intention”

(Smith — The Wealth of Nations IV.ii.9)

Now, Smith did not just pull this theory out of thin air. In the early modern period (16th-18th centuries, roughly speaking), there was a relatively prominent lineage of thought that perceived God as having made the world for the happiness of human beings. More particularly, that it was our nature to be happy and that this infinitely complex world of intelocking parts was designed to facilitate our happiness. These thinkers argued that our self-love was not always a vice, and that “proper” self-love was recognizing our natural bent towards benevolence and graciousness; in other words, if we truly love ourselves and God, we will truly love all beings and our desire for our own benefit will carry over into a desire for the benefit of all. This influential line of thought can be traced through a number of early Protestants and Deists, and most notably from Shaftesbury up through Pope and to Hutcheson (who was a mentor to both Adam Smith and David Hume).

So, it wasn’t as if capitalists needed something to justify their avarice and greed and so came up with some random new theory about how our own interests somehow “merged” into benefitting the collective good. Instead, the idea had a long lineage in both religious and secular strands of thought (and would continue to be developed up until the modern day). Now, we return to the question we posed earlier: “Does it work?”

Does Capitalism Do What it Promises?

Short answer: No.

Long answer: Welllllll, it depends. But mostly no.

So, what does it depend on? What are the variables that determine whether or not the price mechanism (and the incentives it facilitates) actually helps coordinate production and consumption such that we reach the greatest good (or even something approaching the greatest good)?

A non-exhaustive list of these variables might include both the typical assumptions of properly functioning markets (perfect information, firms and consumers without market power — market power includes the ability to change consumption and production in any manner other than price changes and the ability for a single firm to have a significant impact on prices, sufficiently large numbers of firms and consumers, low barriers to entry, etc.) as well as the interaction of other variables. The idea that the typical assumptions of properly functioning markets hold has been debunked time and time again. I instead would like to look at how the interaction of two variables, elasticity and inequality, combine to incentivize the actors within capitalism to break the promise of capitalism.

10 People Need to go to the Hospital

Let’s imagine an island where there are 10 consumers and $200 to go around amonst them. Now, this is not a very equal island: 9 of those 10 consumers each have $10. The tenth and final consumer, has the other $110.

Each of the first 9 people spend mostly on necessities. Let’s say each of them spends $3 on shelter, $2 on food, $1 on clothes, $1 on transportation, and $1 on other necessities (utilities, gas, etc.). They each are left with $2.

Now the 10th person with $110, that person is living large! The tenth person spends $15 on shelter, $10 on food, $10 on clothes, and $10 on their cars, and spends another $30 on random stuff. That person is left with $35. That last person has almost twice as much money as the first 9 combined! Putting aside questions as to whether or not this tenth person “deserves” their money, we need to examine what happens when we apply this unequal situation to a highly inelastic good within a system driven by profit.

Before I continue, I must note that “elasticity” is a concept in economics that measures the change in demand for any given change in price. In other words, if the price of some good X increases by 10%, by what % does demand change? An ‘inelastic’ good is a good where the % change in price is always greater in magnitude than the % change in demand. In other words, a price increase of 50% will lead to a reduction in demand of less than 50%.

Let’s imagine none of these people have budgeted for health care costs yet. Let’s imagine there is a procedure that costs at minimum $2 to perform in total, which is frequently deemed as necessary/important. The hospital could charge all 10 people $2 each and make no profit, OR it could charge the one rich person $10. If the procedure is important, healthcare is generally inelastic. Profit motive distorts the achievement of the social good under instances of inelasticity and high inequality.

2 Potential Criticisms

First, one might simply redefine the social good in such a way that money is an effective representation of it. In other words, an argument might be presented as “Clearly, the rich individual received more utility from the service because they spent so much money on it.” This is, of course, a silly argument. We might imagine that every single one of those 10 people would have been willing to spend $35 on the procedure if they could. The issue is that they cannot. It is quite likely some of the 9 poorer people more desperately want/need the procedure and would receive greater utility from it than the rich person did. Redefining utility in terms of money spent ignores budget constraints and confuses unconstrained preferences with constrained ones.

Second, one might argue that the rich person “deserved” their money and therefore could spend it however they wish. This is an argument I cannot give a proper response to in this post if only due to space and time constraints (I will address it in a future one), but this simply sidesteps the original promise of capitalism. If capitalism cares nothing for the common good, if individuals working in their self-interest was never going to help the common good, then what is the point of capitalism? One would need a new set of justifications (a new set of justifications that have either been underdeveloped or are lacking entirely). In a future post I intend to deconstruct this notion of the rich person “deserving” the kind of wealth disparity present in this example, but for now I believe that I have sufficiently demonstrated that capitalism does not uphold the promises it made with its “founding.”

So Now What?

We’ve determined that capitalism fails to deliver what it promises, but this doesn’t truly resolve our question: What do we want our goal to be? Do we also want the greatest social good? Certainly that is a driver (and frequently a moral and emotional justification of capitalism), but the other side of that is that we also tend to have an innate distrust of command economies. Put aside any debates over whether or not a centrally planned economy can efficiently distribute resources, and at least some of us (I believe) are left with a distrust of a centralized government making these decisions regardless of their effectiveness.

The ultimate question arises: Can we develop an incentive structure that, using a signal, can direct production towards fulfilling the desires of the people in a more effective manner than capitalism with its price signals and profit incentive AND in such a way that we do not need central planning? I believe the answer to this question is Yes. Before I present such a system, I would like to make a series of arguments in my next set of posts regarding why I believe Capitalism is not a sufficiently effective system, even from a purely logistical/functional perspective without regards to moral concerns, etc. Following this, I will articulate the philosophical underpinnings of my system and then I will present the functional logistics of it. Apologies for my hiatus. Stay tuned.

Building Post-Liberal Theory. 🌲 🏴‍☠️.