Lecture 2: Guided Reading and Practice

The capitalist takeoff: prosperity and its shadows

Below you will find guided reading questions for the three sections you were asked to read closely, and some practice problems. Do the reading with the guided reading questions in hand, then attempt the practice problems. A recap of the lecture is in the lecture notes, and the slides are here.

Guided reading

As you read sections 1.2, 1.5, and 1.8, pause at each question and check that you can answer it before moving on.

1.2 History’s hockey stick

  1. Open the interactive version of Figure 1.1 and switch countries on and off. Can you find a country whose hockey stick has not yet tipped upward?
  2. The gist of the section is that living standards were flat for most of history and then took off. How does the section measure living standards?
  3. What does Adam Smith mean by the invisible hand?
  4. According to Adam Smith, what is a significant source of prosperity, and what constrains it?

1.5 The continuous technological revolution

  1. How does the book define technology, and what homely example does it use?
  2. What then makes a change in technology count as technological progress?
  3. How much more efficient was lighting in 1992 than 200 years earlier?
  4. Why are steam engines considered a general-purpose technology (GPT)?

1.8 Capitalist institutions

  1. How does the book define capitalism, and what are its three components?
  2. Why are markets and private property essential for firms to function?
  3. How does a centrally planned economy differ from a market economy? Give some examples of centrally planned economies.
  4. What are two ways that organizing production in firms increased worker productivity?

Practice problems

Write your answer down before you open a Solution.

Multiple choice

1. Which statement best describes what the hockey stick chart shows?

  1. Rich countries have been far ahead of poor ones for many centuries.
  2. All countries began to grow at about the same time, but at different speeds.
  3. Living standards were low and similar almost everywhere for most of the past thousand years, and the large gaps between countries opened up only in the last two centuries.
  4. Living standards have risen steadily in every country since the year 1000.
Solution

Today’s gaps are not an old feature of the world: in 1600 the five countries on the chart are nearly indistinguishable. The divergence was produced by countries starting sustained growth at different times.

2. What does Adam Smith’s invisible hand describe?

  1. Governments steering the economy through regulation of prices and wages.
  2. Self-interested individuals promoting the interest of society, though that was no part of their intention.
  3. Wealthy individuals quietly controlling prices from behind the scenes.
  4. The tendency of technology to keep improving from one generation to the next.
Solution

The invisible hand is Smith’s metaphor for the way markets coordinate the self-interested actions of individuals into outcomes that serve society. Smith’s famous illustration: we expect our dinner not from the benevolence of the butcher, the brewer, or the baker, but from their regard to their own interest. Each of them serves us because doing so serves themselves, and yet the result is that society gets fed, without anyone planning or intending it.

3. Adam Smith said the division of labour/specialisation is limited by the extent of the market. What does that mean?

  1. Only large firms are able to specialise.
  2. Specialising is only worth doing if there are enough buyers for the extra output.
  3. Governments must build canals and roads before firms can specialise.
  4. Workers can only specialise if someone trains them first.
Solution Smith’s pin factory shows that specialisation makes workers more productive: divided into separate tasks, ten workers could produce tens of thousands of pins a day, compared with a single worker on his own making just a few pins. But all those extra pins have to be sold to someone, so specialising is only worthwhile when the market is large enough to absorb the extra output. Smith mentions canals and foreign trade (option c) as ways of widening the market, not as preconditions for specialising.

4. Technological progress is defined as a change in technology that reduces the amount of resources (labour, machines, land, energy, time) needed to produce a given amount of output. A bakery makes one of the following changes. Which one is technological progress?

  1. It buys a second oven and bakes twice as many cakes.
  2. It finds a supplier whose flour is cheaper, and its costs fall.
  3. It reorganises the kitchen so the same staff bake the same cakes in three-quarters of the time.
  4. It hires a marketing firm and sells more cakes at the same price.
Solution

Hold each option against the definition. In (c) the output is the same cakes, and the resources needed have fallen: less labour and less time. Note that no new equipment was involved, which the definition allows, because it is about the process rather than the hardware. In (a) output rises, but so do the inputs used to get it, so no resource has been economised per cake. In (b) the resources used are unchanged; only their price has fallen, and a price is not part of the definition. In (d) the bakery sells more of what it was already making, and the process is untouched.

5. Countries with more doctors per person have longer life expectancy. Does this mean training more doctors would lead to people living longer?

  1. The correlation is too weak to mean anything.
  2. Richer countries can afford both more doctors and better food, housing, and sanitation.
  3. Life expectancy cannot be measured accurately.
  4. A correlation always shows causation.
Solution

Correlation is not causation. Richer countries can afford more doctors, and they can also afford clean water, better housing, and safer workplaces, all of which also lead to higher life expectancy. So the two numbers would rise together even if doctors made no difference at all. The story can also run the other way round: a healthier, wealthier population is one that can afford to train doctors in the first place.

Short answer

6. According to the reading, what explains the early take-off of the western economies shown on the hockey stick chart?

Solution

An important part of the answer is two changes that happened around then, both of which raised the productivity of an individual worker.

  1. Technological progress. A continuous wave of new technologies in textiles, energy, and transport, beginning with the Industrial Revolution and not stopping since.
  2. Capitalism, which worked in two ways. Firms competing with each other in markets had strong incentives to adopt and develop the new technologies, and to invest in capital goods that a small family enterprise could never have afforded, so the second change is what carried the first into use. And firms employing many workers, together with markets that came to link the whole world, allowed specialisation on a scale never seen before, which lets a firm produce more with the same number of employees.

7. Most countries today are capitalist by the definition we used: they have private property, markets, and firms. So why do living standards still differ so enormously between them?

Solution

Two broad reasons:

Colonisation. In China and India, living standards actually fell during the period when western Europe was taking off, and substantial improvement did not come before they gained independence from colonial rule or from interference by European nations.

Institutions, government, and politics. Capitalism is not one thing. Private property, markets, or firms may work badly or be poorly protected. Governments differ enormously in how well they regulate them and in what they provide: infrastructure, education, and the rule of law. Not all capitalist economies are equally successful, which is why the same three institutions produce very different outcomes in different places.

8. Why do carbon emissions have the same hockey-stick shape as income? What connects the two?

Solution

The link is the Industrial Revolution, and the technological progress that followed it. The same wave of new technologies that raised output was built on harnessing energy from burning carbon: coal for the steam engine and the factories it powered, then oil and gas. So the thing that produced the rise in living standards is the thing that produced the emissions. Producing more meant burning more, the two lines climbed together, and northern hemisphere temperatures followed.

9. In class we looked at a chart of West and East Germany from 1950 to 1989. What point was that chart making?

Solution

Trying to answer the question “Did capitalism cause prosperity?” is tricky. The reading shows that the takeoff in living standards coincided with the spread of capitalism, but that is only a correlation. It could have been something else that caused both or that prosperity led to capitalism rather than the other way around.

To do better than a correlation you want an experiment, but you cannot run one on a country. Germany after 1945 is the next best thing, a natural experiment: living standards in the two parts were the same in 1936, and they shared a language, a history, and a population. Then one half got capitalism and the other central planning. By 1989 income per person in the East was less than half that in the West. This presents some evidence that the difference in economic institutions was a factor in the divergence of living standards.

10. Capitalism’s three institutions are not independent of one another. Could a market work if nothing were private property? Could a firm exist without markets?

Solution

A market could not work without private property as to sell something you must own it. If nobody holds those rights, there is nothing to transfer and no reason to pay.

A firm could not exist without markets, and it also needs private property. It needs markets on two sides. It buys its inputs on markets, including hiring workers in the labour market, and it sells its output on markets at a price that has to more than cover what production cost, since that is where its profit comes from. And it needs private property because someone must own the buildings, equipment, and other capital goods it produces with, and own the output as well.