The governance of corporations encompasses a wide range of checks and balances that affect the monitoring and incentives of firms’ management. Sound corporate governance is particularly important when a firm’s managers are not the owners. Without appropriate corporate governance, nonowner managers might not work very hard to maximize profits for shareholders and instead might spend money on perks and pursue the quiet life—or some other goal near and dear to the hearts of the managers such as personal profit maximization involving theft or fraud. The difference between the goals of the principals (i.e., owners) and the goals of their agents (i.e., managers) is typically called the “agency problem.” Aligning the incentives of the managers so that they act in the interest of the owners rather than themselves is the core challenge of corporate governance. In their classic 1932 book, Adolf Berle and Gardiner Means warned that the separation of ownership and control in the modern corporation “destroys the very foundation on which the economic order of the past three centuries has rested . . . it is rapidly increasing, and appears to be an inevitable development” of the modern corporate system (p. 8). Many contemporary scholars, such as Jensen (1989, 1993) and Roe (1990, 1994), have voiced similar concerns but argue that the problem is not inherent in capitalism; instead, they maintain that tax incentives, antitrust policies, regulations, and political pressures to adopt antitakeover statues that protect incumbent managers have led to what Mark Roe (1994) calls “strong managers and weak owners.”1

Corporations are easier to create than to understand. Because corporations arose as an alternative to partnerships, they can best be understood by comparing these competing organizational structures. The presumption of partnership is that the investors will directly manage their own money rather than entrusting that task to others. Partners are “mutual agents,” meaning that each is able to sign contracts that are binding on all the others. Such an arrangement is unsuited for strangers or those who harbor suspicions about each other’s integrity or business acumen. Hence the transfer of partnership interests is subject to restrictions. In a corporation, by contrast, the presumption is that the shareholders will not personally manage their money. Instead, a corporation is managed by directors and officers who need not be investors. Because managerial authority is concentrated in the hands of directors and officers, shares are freely transferable unless otherwise agreed. They can be sold or given to anyone without placing other investors at the mercy of a new owner’s poor judgment. The splitting of management and ownership into two distinct functions is the salient feature of the corporation. To differentiate it from a partnership, a corporation should be defined as a legal and contractual mechanism for creating and operating a business for profit, using capital from investors that will be managed on their behalf by directors and officers. To lawyers, however, the classic definition is Chief Justice John Marshall’s 1819 remark that “a corporation is an artificial being, invisible, intangible, and existing only in contemplation of law.”1 But Marshall’s definition is useless because it is a metaphor; it makes a corporation a judicial hallucination. Recent writers who have tried to recast Marshall’s metaphor into a literal definition say that a corporation is an entity (or a fictitious legal person or an artificial legal being) that exists independent of its owners. The entity notion is metaphorical too and violates Occam’s razor, the principle that explanations should be concise and literal. Attempts by economists to define corporations have been equally unsatisfactory. In 1917 Joseph S. Davis wrote: “A corporation [is] a group of individuals authorized by law to act as a unit.”2 This definition is defective because it also fits partnerships and labor unions, which are not corporations. Economist Jonathan Hughes wrote that a corporation is a “multiple partnership” and that “the privilege of incorporation is the gift of the state to collective business ventures.”3 Economist Robert Heilbroner wrote that a corporation is “an entity created by the state,” granted a charter that enables it to exist “in its own right as a ‘person’ created by law.”4 But charters enacted by state legislatures literally ceased to exist in the mid-nineteenth century. The actual procedure for creating a corporation consists of filing a registration document with a state official (like recording the use of a fictitious business name), and the state’s role is purely formal and automatic. To call incorporation a “privilege” implies that individuals have no right to create a corporation. But why is government permission needed? Who would be wronged if businesses adopted corporate features by contract? Whose rights would be violated if a firm declared itself to be a unit for the purposes of suing and being sued or holding and conveying title to property, or that it would continue in existence despite the death or withdrawal of its officers or investors, or that its shares are freely transferable, or if it asserted limited liability for its

The corporate income tax is the most poorly understood of all the major methods by which the U.S. government collects money. Most economists concluded long ago that it is among the least efficient and least defensible taxes. Although they have trouble agreeing on—much less measuring with any precision—who actually bears the burden of the corporate income tax, economists agree that it causes significant distortions in economic behavior. The tax is popular with the person in the street, who believes, incorrectly, that it is paid by corporations. Owners and managers of corporations often assume, just as incorrectly, that the tax is simply passed along to consumers. This very vagueness about who pays the tax accounts for its continued popularity among politicians. The federal corporate income tax differs from the individual income tax in two major ways. First, it is a tax not on gross income but on net income, or profits, with permissible deductions for most costs of doing business. Second, it applies only to businesses that are chartered as corporations—not to partnerships or sole proprietorships. The federal tax is levied at different rates on different brackets of income: 15 percent on taxable income under $50,000, 25 percent on income between $50,000 and $75,000, and rates ranging from 34 to 39 percent on income above that. The lower-bracket rates benefit small corporations. Of the 4.8 million corporate tax returns filed in 1998, more than 90 percent were from corporations with assets of less than $1 million. The lower rates, however, had little economic significance. More than 91 percent of

In the world’s worst offending countries, corrupt government officials steal public money and collude with businesses to sell laws, rules, regulations, and government contracts. The World Bank reports that “higher levels of corruption are associated with lower per capita income” (World Bank 2001, p. 105). Corruption breeds poverty, and poverty kills. In other words, corruption kills. How so? Corruption sabotages economies and undermines political institutions. Its most devastating impact is on investment. By discouraging investment, corruption crushes economic growth and slashes per capita incomes. According to Mauro (1995), for example, if Bangladesh had cut corruption over the period 1960–1985 to the level of one of the world’s cleanest countries (Singapore), it would have increased its growth rate by 1.8 percentage points per year. By 1985, its per capita income would have been more than 50 percent higher. Low-per-capita-income countries suffer higher infant mortality—54 deaths per 1,000 live births in Bangladesh versus 3 per 1,000 in Singapore—and lower average life expectancies—fifty-nine years versus eighty years (U.S. Census Bureau 2000.) Another insidious way in which corruption kills is that it skews public spending away from operating budgets such as health care and toward capital budgets—military spending, for example, where bribes are easier to extract (Klitgaard 1988; Mauro 1996; Tanzi and Davoodi 1997). Corruption hurts investment in at least three ways. First, it increases the cost of doing business, which then raises the threshold revenues required for businesses to break even. Second, it causes producers, on the margin, to bribe officials rather than invest in cost-saving technology or new products. Third, if public funds end up in the pockets of government officials, taxes will be higher and public investment lower, hurting economic growth. There is an important distinction between business-to-business corruption and government corruption (Melese 2002). The former is almost always either beneficial or self-correcting, while the latter is neither. In its mildest and most benign form, business-to-business bribery facilitates communication and helps cement relationships between principals (customers) and agents (suppliers). “Facilitation payments” (anything from generous commissions to free meals and entertainment) can replace costly contingent contracts with implicit contracts that ensure quality, quantity, and meeting of schedule requirements. In such a case, business-to-business bribery has an offsetting benefit: it reduces transaction costs and greases the wheels of commerce. Bad cases of business-to-business bribery typically involve private gains with no offsetting benefits. This more sinister form is like a worm that eats into corporate profits. For instance, by concealing debt and overstating revenues, corporate managers might boost a firm’s stock price, increasing the value of their stock options. In the case of fraudulent financing and accounting, shareholders are the victims. Such corruption, if revealed early, is self-limiting because shareholders want to avoid its costs. If revealed too late, the outcome is bankruptcy. Honest and transparent market institutions are all that are required, although to say this is not to say that achieving honesty and transparency is always easy. Government corruption, in contrast, does not involve a self-correcting market mechanism. It occurs because government

Economists approach the analysis of crime with one simple assumption—that criminals are rational. A mugger is a mugger for the same reason I am an economist—because it is the most attractive alternative available to him. The decision to commit a crime, like any other economic decision, can be analyzed as a choice among alternative combinations of costs and benefits. Consider, as a simple example, a point that sometimes comes up in discussions of gun control. Opponents of private ownership of handguns argue that, in violent contests between criminals and victims, the criminals usually win. A professional criminal, after all, has far more reason to learn how to use a gun than a random potential victim. The argument is probably true, but the conclusion—that permitting both criminals and victims to have guns will help the criminals—does not follow. To see why, imagine that the result of legal handgun ownership is that one little old lady in ten chooses to carry a pistol in her purse. Further suppose that, of those who do, only one in ten, if mugged, succeeds in killing the mugger; the other nine miss, drop the gun, or shoot themselves in the foot. On average, the muggers are winning. But also on average, each one hundred muggings of little old ladies produce one dead mugger. Very few little old ladies carry enough money to be worth one chance in a hundred of being killed. Economic theory suggests that the number of muggings will decrease—not because the muggers have all been killed, but because some of them have chosen to switch to safer professions. If the idea that muggers are rational profit maximizers seems implausible, consider who gets mugged. If a mugger’s objective is to express machismo, to prove what a heman he is, there is very little point in mugging little old ladies. If the objective is to get money at as low a cost as possible, there is much to be said for picking the most defenseless victims they can find. In the real world, little old ladies get mugged a lot more often than football players do. Following out this line of argument, John Lott and David Mustard, in a controversial article, found that laws making it easier to get permission to legally carry a concealed firearm tended to reduce crime rates. This is one example of a very general implication of the economic analysis of conflict. To stop someone from doing something that injures you, whether robbing your house or polluting your air, it is not necessary to make it impossible for him to do it—merely unprofitable. Economic analysis can also be used to help understand the nature of organized crime. Newspapers, prosecutors, and the FBI often make organized crime sound almost like General Motors or IBM—a hierarchical organization with a few kingpins controlling thousands of subordinates. What we know about the economics of organizations makes this an unlikely description of real criminal organizations. One major limitation on the size of firms is the problem of control. The more layers of hierarchy there are between the president and the factory worker, the harder it is for management to monitor and control the workers. That is one reason that small firms often are more successful than large ones. We would expect this problem to be especially severe in criminal markets. Legitimate businesses can and do make extensive use of memos, reports, job evaluations, and the like to pass information from one layer of the hierarchy to another. But the very information that a criminal uses to keep track of what his employees are doing can also be used by a district attorney to keep track of what the criminal is doing. What economists call “informational diseconomies of scale” are therefore a particularly serious problem in criminal firms, implying that such firms should, on average, tend to be smaller, not larger, than firms in other markets. Criminal enterprises obviously are more difficult to study than ordinary ones. The work that has been done, however, such as that of Peter Reuter and Jonathan B. Rubinstein, seems to confirm what theory suggests. Criminal firms seem to be relatively small and the organization of criminal industries relatively decentralized—precisely the opposite of the pattern described in novels, movies, and the popular press. It may well be that “organized crime” is not so much a corporation as a sort of chamber of commerce for the criminal market—a network of individuals and small firms that routinely do business with each other and occasionally cooperate in their mutual interest. Economic analysis can also be used to predict the effectiveness of law enforcement measures. Consider the current “War on Drugs.” From an economic standpoint, its objective is to reduce the supply of illegal drugs, thus raising their prices and reducing the amount people wish to consume. One enforcement strategy is to pressure countries such as Colombia to prevent the production of coca, the raw material used to make cocaine. Such a strategy, if successful, would shift coca production to whatever country is next best at producing it; since coca can be grown in many different places, this shift is not likely to result in a very large increase in cost. Published estimates suggest that the cost of producing drugs abroad and transporting them to the United States represents only about 1 percent of their street price. So, even if we succeed in doubling the cost of coca—which seems unlikely, given experience with elasticity of supply of other crops—the result would be only about a 1 percent increase in the price of cocaine and a correspondingly small decrease in the amount consumed. Thus, economic analysis suggests that pressuring other countries not to produce drugs is probably not a very effective way of reducing their use. One interesting issue in the economic analysis of crime is the question of which legal rules are economically efficient. Loosely speaking, which rules maximize the total size of the economic pie, the degree to which people get what they want? This is relevant both to broad issues such as whether theft should be illegal and to more detailed questions, such as how to calculate the optimal punishment for a particular crime. Consider the question of laws against theft. At first glance, it might seem that, however immoral theft may be, it is not inefficient. If I steal ten dollars from you, I am ten dollars richer and you are ten dollars poorer, so the total wealth of society is unchanged. Thus, if we judge laws solely on grounds of economic efficiency, it seems that there is no reason to make theft illegal. That seems obvious, but it is wrong. Opportunities to make money by stealing, like opportunities to make money in other ways, attract economic resources. If stealing is more profitable than washing dishes or waiting on tables, workers will be attracted out of those activities and into theft. As the number of thieves increases, the returns from theft fall, both because everything easy to steal has already been stolen and because victims defend themselves against the increased level of theft by installing locks, bars, burglar alarms, and guard dogs. The process stops only when the next person who is considering becoming a thief concludes that he will be just about as well off continuing to wash dishes—that the gains from becoming a thief are about equal to the costs. The thief who is just on the margin of being a thief pays, with his time and effort, the price of what he steals. Thus, the victim’s loss is a net social loss—the thief has no equal gain to balance it. So the existence of theft makes society as a whole poorer, not because money has been transferred from one person to another, but because productive resources have been diverted out of the business of producing and into the business of stealing. A full analysis of the cost of theft would be more complicated than this sketch, and the social cost of theft would no longer be exactly equal to the amount stolen. It would be less to the extent that people who are particularly skillful at theft earn more in that profession than they could in any other, giving them a net gain to partly balance the loss to their victims. It would be higher to the extent that theft results in additional costs, such as the cost of defensive precautions taken by potential victims. The central conclusion would, however, remain—that we will, on net, be better off if theft is illegal. This conclusion must be qualified by the observation that, to reduce theft, we must spend resources on catching and punishing thieves. Theft is inefficient—but spending a hundred dollars to prevent a ten-dollar theft is still more inefficient. Reducing theft to zero would almost certainly cost more than it would be worth. What we want, from the standpoint of economic efficiency, is the optimal level of theft. We want to increase our expenditures on law enforcement only as long as one more dollar spent catching and punishing thieves reduces the net cost of theft by more than a dollar. Beyond that point, additional reductions in theft cost more than they are worth. This raises a number of issues, both empirical and theoretical. The empirical issues involve an ongoing dispute about whether punishment deters crime and, if so, by how much. While economic theory predicts that there should be some deterrent effect, it does not tell us how large it should be. Isaac Ehrlich, in a widely quoted (and extensively criticized) study of the deterrent effect of capital punishment, concluded that each execution deters several murders. Other researchers have gotten very different results. One interesting theoretical point is the question of how to choose the best combination of probability of apprehension and amount of punishment. One could imagine punishing theft by catching half the thieves and fining them a hundred dollars each, by catching a quarter and fining them two hundred each, or by catching one thief in a hundred and hanging him. How do you decide which alternative is best? At first glance, it might seem efficient always to impose the highest possible punishment. The worse the punishment, the fewer criminals you have to catch in order to maintain a given level of deterrence—and catching criminals is costly. One reason this is wrong is that punishing criminals is also costly. A low punishment can take the form of a fine; what the criminal loses the court gains, so the net cost of the punishment is zero. Criminals generally cannot pay large fines, so large punishments take the form of imprisonment or execution, which is less efficient— nobody gets what the criminal loses and someone has to pay for the jail. A second reason we do not want maximum punishments for all offenses is that we want to give criminals an incentive to limit their crimes. If the punishments for armed robbery and murder are the same, then the robber who is caught in the act has an incentive to kill the witness. He may get away, and, at worst, they can hang him only once. One final interesting question is why we have criminal law at all. In our legal system, some offenses are called civil and are prosecuted by the victim, while others are called criminal and are prosecuted by the state. Why not have a pure civil system, in which robbery would be treated like trespass or breach of contract, with the victim suing the robber? Such institutions have existed in some past societies. In fact, our present system of having the state hire professionals to pursue criminals is actually a relatively recent development in the Anglo-American legal tradition, dating back only about two hundred years. Several writers, starting with Gary Becker and George Stigler, have suggested that a movement toward a pure civil system would be desirable, whereas others, most notably William Landes and Richard Posner, have argued for the efficiency of the present division between civil and criminal law (see also law and economics). About the Author David D. Friedman is a professor of law and economics at Santa Clara University. His most recent book is Law’s Order: What Economics Has to Do with Law and Why It Matters. His Web site is www.daviddfriedman.com. Further Reading   Ayres, Ian, and John J. Donohue III. “Shooting Down the ‘More Guns, Less Crime’ Hypothesis.” Stanford Law Review 55 (2003): 1193. Online at: http://islandia.law.yale.edu/ayers/Ayres_Donohue_article.pdf. Becker, Gary S. “Crime and Punishment: An Economic Approach.” Journal of Political Economy 76 (1968): 169–217. Becker, Gary S., and George J. Stigler. “Law Enforcement, Malfeasance, and Compensation of Enforcers.” Journal of Legal Studies 3 (1974): 1–18. Benson, Bruce. The Enterprise of Law: Justice Without the State. San Francisco: Pacific Research Institute for Public Policy, 1990. Ehrlich, Isaac. “The Deterrent Effect of Criminal Law Enforcement.” Journal of Legal Studies 1 (1972): 259–276. Friedman, David. “Efficient Institutions for the Private Enforcement of Law.” Journal of Legal Studies 13 (1984): 379–397. Online at: http://www.daviddfriedman.com/Academic/Efficient_Inst_For_Priv_Enf/Private_Enforcement.html. Friedman, David. Law’s Order: What Economics Has to Do with Law and Why It Matters. Princeton: Princeton University Press, 2000. Available online at: http://www.daviddfriedman.com/laws_order/index.shtml. Friedman, David. “Private Creation and Enforcement of Law—a Historical Case.” Journal of Legal Studies 8 (1979): 399–415. Online at: http://www.daviddfriedman.com/Academic/Iceland/Iceland.html. Landes, William M., and Richard A. Posner. “The Private Enforcement of Law.” Journal of Legal Studies 4 (1975): 1–46. Lott, John, and David Mustard. “Crime, Deterrence, and Right-to-Carry Concealed Handguns.” 1997. Abstract online at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=10129. Reuter, Peter, and Jonathan B. Rubinstein. “Fact, Fancy, and Organized Crime.” Public Interest 53 (Fall 1978): 45–67.   (0 COMMENTS)

The Bond Market Association estimates that U.S. corporations had more than $4.5 trillion in bonds outstanding at the end of 2003, with debt averaging about 50 percent of equity (the value of the stock) from 1994 through 2003. Thus, corporations depend heavily on debt financing. One question that market participants or academic observers have not answered adequately, however, is how companies determine what fraction of their corporate activities should be funded through borrowing and what fraction through issuing stock. In their seminal 1958 paper, Franco Modigliani and Merton Miller initiated the modern discussion of the amount of debt corporations should use (both received the Nobel Prize for this work and other contributions to economic research). The paper is so well known that, for more than thirty years, financial economists have referred to their theory as “the M&M theory.” M&M showed that the value of a firm (and of its cash flows) is independent of the ratio of debt to equity used by the firm in financing its investments. This stunning conclusion was based on certain assumptions that are not true of the real world: there are no corporate or personal taxes, people have perfect information, individuals and corporations can borrow at the same rates, and how you pay for an asset does not affect productivity. Still, it provides a jumping-off point for a better understanding of corporate debt. Here is M&M’s famous arbitrage proof in words. Think of two firms that are identical in all respects, except that one is financed completely with equity while the other uses some combination of equity and debt. Let Ms. E buy 10 percent of the all-equity firm; she buys 10 percent of the outstanding shares. Mr. D buys 10 percent of the leveraged firm; he buys 10 percent of the shares and 10 percent of the debt. What do Ms. E and Mr. D get back for their investments? In the all-equity firm, Ms. E has a claim on 10 percent of the total profits of the firm. In the leveraged firm, however, the debt holders must receive their interest payments before the shareholders receive the remaining profits. Thus, for his share holdings, Mr. D gets 10 percent of the profits after interest payments to debt holders are subtracted. But because Mr. D also holds 10 percent of the bonds, he receives 10 percent of the profits that were paid out as interest payments. The net result for Mr. D? He receives 10 percent of the total profits, just as Ms. E does. This reasoning led M&M to argue that the leveraged firm and the all-equity firm must have the exact same value. The value of the all-equity firm is the value of the outstanding stock. The value of the leveraged firm is the value of the outstanding stock plus the value of the outstanding debt. Because the firms are identical in the level of total profits and identical in the cash payouts paid to the investors, Ms. E and Mr. D would pay identical amounts

What would be the consequences of applying the principle of laissez-faire—that is, completely free markets—to money? While the idea may seem strange to most people, economists have debated the question of competing money supplies off and on since Adam Smith’s time. In recent years, trends in banking deregulation, developments in electronic payments, and episodes of dissatisfying performance by central banks (such as the Federal Reserve System in the United States) have made the question of competing money supplies topical again. Nobel laureate Friedrich A. Hayek rekindled the discussion of laissez-faire in money with his 1976 monograph Denationalisation of Money. Milton Friedman, in a 1986 article coauthored with Anna J. Schwartz, reconsidered the rationales he had previously accepted for governments to provide money. Other leading economists who have entertained the idea of laissez-faire in money include Gary Becker and Eugene Fama of the University of Chicago, Neil Wallace of Pennsylvania State University, and Leland B. Yeager of Auburn University. Two sorts of monetary competition already exist today. First, private banks and financial firms compete in supplying different brands of checkable deposits and traveler’s checks. They also compete in providing credit cards that are close substitutes for paying ready money. In a few corners of the world (Scotland, Northern Ireland, and Hong Kong), private banks still issue paper currency notes. Second, each national currency (such as the U.S. dollar) competes with others (such as euros and yen) to be the currency in which international contracts and portfolio assets are denominated. (Economists refer to paper money that is not convertible into an underlying asset, such as gold or silver, as a “fiat” currency.) Much more competition in money has existed in the past. Under “free banking” systems, private banks routinely issued their own paper currencies, or “banknotes,” that were redeemable for underlying “real,” or “basic,” monies like gold or silver. And competition among those basic monies pitted gold against silver and copper. Today, virtually all national governments regulate and limit monetary competition. They maintain government monopolies over coinage and the issuance of paper currency and to varying degrees restrict deposit banks and other financial firms, nationalize the interbank settlement system, restrict or place special taxes on holdings of gold or of foreign-currency assets, and refuse to enforce contracts denominated in alternative currencies. In developing countries, government banks sometimes monopolize the provision of checking accounts as well. Some economists recommend abolishing many or even all of these legal restrictions. They attribute significant inefficiency and instability in the financial system to the legal restrictions on private banks and to poor central-bank policy, and they view competition as a potential means for compelling money suppliers to be more responsive to the demands of money users. While many economists would like to restrict the discretion given to central banks, the small but growing number of free-banking advocates would like to abolish central banks entirely. Most mainstream economists, though, fear that a return to free banking would bring greater instability to the financial system. Proponents of free banking have traditionally pointed to the relatively unrestricted monetary systems of Scotland (1716–1844), New England (1820–1860), and Canada (1817–1914) as models. Other episodes of the competitive provision of banknotes took place in Sweden, Switzerland, France, Ireland, Spain, parts of China, and Australia. In total, more than sixty episodes of competitive note issue are known, with varying amounts of legal restrictions. In all such episodes, the countries were on a gold or silver standard (except China, which used copper). In a free banking system based on a gold standard, competing private banks would issue checking deposits and banknotes redeemable on demand for gold. In a system based on a frozen quantity of fiat dollars, as Milton Friedman and a few other economists have proposed, bank deposits and banknotes would be redeemable for government notes, as deposits are today. Competition among banks would, history indicates, compel all banks in the system to redeem their deposits and banknotes for a common basic money, such as gold or a standard paper currency issued by the government. Banks in such a system are parts of a unified currency area; “exchange rates” among them are fixed rather than floating. Citibank’s ten-dollar notes, for example, would be redeemable for ten dollars in basic money, and so would notes issued by Chase Manhattan. To attract customers, Citibank would be glad to accept deposits in Chase notes or Chase deposits, which it would then return to Chase for redemption at the clearinghouse. Given negligible risk and redemption costs (both likely under modern conditions), Citibank would even accept Chase notes at par (without a discount or fee, just as banks accept one another’s checks today). Chase would do likewise. The reason is that by agreeing to accept each other’s notes and checks at par, both Citibank and Chase would make their own money more useful, and therefore more widely accepted. This is not just abstract theorizing. We see par acceptance emerging historically among note-issuing banks. Similar competitive considerations have led banks more recently to form mutual acceptance networks for automatic teller machine cards, allowing customers of Citibank to get cash at Chase machines. Chase charges a fee for withdrawing Federal Reserve notes today, to cover its borrowing costs of carrying an inventory of Federal Reserve notes. Chase would not need to charge a fee for withdrawing Chase notes, because it has no borrowing costs in carrying an inventory of its own unissued notes. What forms of money do households and business firms ordinarily use in a free banking system? When bank-notes and checks issued by any bank in the system are accepted nearly everywhere, and when banks pay interest on deposits, the public seldom feels the need to handle basic money (gold or whatever is the asset for which bank money is redeemable). Banknotes and token coins serve the need for currency. Because banknotes do not bear interest, banks compete for customers—that is, note-holding clientele—through nonprice means. Each bank in a free banking system is constrained to limit the quantity of its liabilities (the banknotes and deposits it has issued) to the quantity the public desires to hold. When one bank accepts another bank’s notes or checks, it returns them to the issuer through a cooperative interbank clearing system for redemption in basic money or in claims on the clearinghouse. An issuing bank knows that it would suffer adverse clearings and a costly loss of reserves if too many of its liabilities came into the hands of its rivals. So banks would have to carefully manage their reserve positions (the funds they use to redeem their banknotes) even if there were no central bank setting minimum reserve requirements. Many economists (and almost everyone else) believe that a free banking system, especially one without government guarantees of deposits or banknotes, would be plagued by overissuance of banknotes, fraud, and suspensions of redeemability, all of which would give rise to runs on banks (see bank runs) and, as a result, periodic financial panics. That would happen, the thinking goes, because the inability of any one bank to meet a run would cause runs to spread contagiously until the entire system collapsed. The evidence from free banking systems in Scotland, Canada, Sweden, and other historical episodes does not support that conclusion. When free banking has existed, the interbank clearing system swiftly disciplined individual banks that issued more notes than their clients wished to hold. In other words, redeemability restrained the system as a whole. Fraudulent bankers did not find it easy to get their notes into circulation; bankers whose condition went from trusted to suspect found their notes being returned for redemption. Banks thus found that sound management was key to building a clientele. Clearinghouse associations policed the solvency and liquidity of their members. Runs on individual banks were not contagious; money withdrawn from suspect banks was redeposited in sounder ones. Proponents of free banking point out that the few historical episodes of contagious bank runs occurred in banking systems (like that of the United States after the Civil War) whose ill-advised legal restrictions weakened and blurred the distinctiveness of individual banks, so that troubles at one bank undermined public confidence in the entire system. Proponents of competing money supplies have suggested several different institutional frameworks under which a competitive system could operate. A few monetary theorists, beginning with Benjamin Klein of UCLA and Friedrich Hayek, have contemplated private competition in the supply of nonredeemable “fiat” monies. We lack historical experience with such a regime, but it is doubtful that it would survive. If banks did not have to redeem their notes, they would face a strong temptation to issue money without limit. It would be too profitable for an issuer to break any promise not to overissue and depreciate its money. In contrast, where banks must redeem their notes for something, the holder of bank-issued money has a “buy-back” guarantee against depreciation. Robert Greenfield and Leland B. Yeager, drawing on earlier work by Fischer Black, Eugene Fama, and Robert Hall, have proposed another kind of laissez-faire payments system that they claim would maintain monetary equilibrium at a stable price level. Instead of redeeming their notes for gold, silver, or government-issued paper money, banks would redeem notes and deposits for a standard “bundle” of diverse commodities. Instead of a one-dollar or one-gram-of-gold note, for example, Citibank would issue a note that could be redeemed for something worth one unit of the bundle. To avoid storage costs, people would redeem a one-bundle claim not for the actual goods that form the bundle, but rather for financial assets (e.g., treasury bonds) equal to the current market value of one bundle. There would be no basic money, such as the gold coin of old or the dollar bill of today, serving both as the accounting unit and as the redemption medium for bank liabilities. This regime also has no historical precedent. Some critics have argued that it lacks the convenience of having a standard basic money as the medium of redemption and interbank settlement. It is more likely that a deregulated and freely competitive payments system today would resemble free banking in the traditional sense. Bank money would be redeemable for a basic money produced outside the banks. To place all forms of money beyond government manipulation, the basic money could not continue to be government fiat paper unless its stock were permanently frozen (as Milton Friedman has suggested). The most plausible—and historically precedented—way to replace the government fiat dollar is to return to a private gold coin or silver coin monetary standard. But a return to the gold standard—or to any form of free banking—seems politically implausible anytime soon. Even so, recent developments have emphasized the continuing relevance of the question of competing money supplies. In Latin America and Russia, the U.S. dollar competes with local currencies for use in local markets. Twelve countries have combined to form the European Central Bank and its currency, the euro, but the United Kingdom and Sweden have thus far declined to join. Advocates of currency competition, whose ranks have included former U.K. prime minister Margaret Thatcher, are skeptical that a transnational supplier of money, no longer in competition with their national monies, will provide a higher-quality product. About the Author Lawrence H. White is the F. A. Hayek Professor of Economic History at the University of Missouri, St. Louis. Further Reading   Dowd, Kevin. The State and the Monetary System. New York: St. Martin’s Press, 1989. Friedman, Milton, and Anna J. Schwartz. “Has Government Any Role in Money?” Journal of Monetary Economics 17, no. 1 (1986): 37–62. Goodhart, Charles. The Evolution of Central Banks. Cambridge: MIT Press, 1988. Hayek, Friedrich A. Denationalisation of Money. 2d ed. London: Institute of Economic Affairs, 1978. Selgin, George A., and Lawrence H. White. “How Would the Invisible Hand Handle Money?” Journal of Economic Literature 32, no. 4 (1994): 1718–1749. White, Lawrence H. The Theory of Monetary Institutions. Malden, Mass.: Blackwell, 1999.   Related Links Economic Freedom, from the Concise Encyclopedia of Economics. Money Supply, from the Concise Encyclopedia of Economics. William Brough, The Natural Law of Money. Vera C. Smith, The Rationale of Central Banking and the Free Banking Alternative. Leonidas Zelmanovitz, Vera Smith: The Contrarian View. January 2019. Edwin Canaan, The Application of the Theoretical Apparatus of Supply and Demand to Units of Currency. Selgin on Free Banking. EconTalk, November 2008. Larry White on Hayek and Money. EconTalk, February 2010. Lawrence H. White and George Selgin, Why Private Banks and Not Central Banks Should Issue Currency, Especially in Less Developed Countries. April 2000.   (0 COMMENTS)

What Is Capital? The term “capital” refers to produced goods used to produce future goods. Even a corner lemonade stand could not exist without capital; the lemons and the stand are the essential capital that makes the enterprise operate. A recent study by Dale Jorgenson of Harvard University discovered that almost half of the growth of the American economy between 1948 and 1980 was directly attributable to the increase in U.S. capital formation (with most of the rest a result of increases and improvements in the labor force).1 Capital can also refer to technological improvements or even the spark of an idea that leads to the creation of a new business or product. In 1975, when Bill Gates decided to form a computer software company and then brought MS-DOS to market, he created capital. Investors who had the foresight to take the risk of investing in Bill Gates’s idea made fabulous amounts of money. A twenty-thousand-dollar investment in Microsoft in 1986 was worth about two million dollars in 2004. Between 1900 and 2000, real wages in the United States quintupled from around fifteen cents an hour (worth three dollars in 2000 dollars) to more than fifteen dollars an hour. In other words, a worker in 2000 earned as much, adjusted for inflation, in twelve minutes as a worker in 1900 earned in an hour. That surge in the living standard of the American worker is explained, in part, by the increase in capital over that period. The main reason U.S. farmers and manufacturing workers are more productive, and their real wages higher, than those of most other industrial nations is that America has one of the highest ratios of capital to worker in the world. Even Americans working in the service sector are highly paid relative to workers in other nations as a result of the capital they work with. In their textbook, Nobel laureate Paul Samuelson

“Capitalism,” a term of disparagement coined by socialists in the mid-nineteenth century, is a misnomer for “economic individualism,” which Adam Smith earlier called “the obvious and simple system of natural liberty” (Wealth of Nations). Economic individualism’s basic premise is that the pursuit of self-interest and the right to own private property are morally defensible and legally legitimate. Its major corollary is that the state exists to protect individual rights. Subject to certain restrictions, individuals (alone or with others) are free to decide where to invest, what to produce or sell, and what prices to charge. There is no natural limit to the range of their efforts in terms of assets, sales, and profits; or the number of customers, employees, and investors; or whether they operate in local, regional, national, or international markets. The emergence of capitalism is often mistakenly linked to a Puritan work ethic. German sociologist Max Weber, writing in 1903, stated that the catalyst for capitalism was in seventeenth-century England, where members of a religious sect, the Puritans, under the sway of John Calvin’s doctrine of predestination, channeled their energies into hard work, reinvestment, and modest living, and then carried these attitudes to New England. Weber’s thesis breaks down, however. The same attitudes toward work and savings are exhibited by Jews and Japanese, whose value systems contain no Calvinist component. Moreover, Scotland in the seventeenth century was simultaneously orthodox Calvinist and economically stagnant. A better explanation of the Puritans’ diligence is that by refusing to swear allegiance to the established Church of England, they were barred from activities and professions to which they otherwise might have been drawn—landownership, law, the military, civil service, universities— and so they focused on trade and commerce. A similar pattern of exclusion or ostracism explains why Jews and other racial and religious minorities in other countries and later centuries tended to concentrate on retail businesses and money lending. In early-nineteenth-century England the most visible face of capitalism was the textile factories that hired women and children. Critics (Richard Oastler and Robert Southey, among others) denounced the mill owners as heartless exploiters and described the working conditions—long hours, low pay, monotonous routine—as if they were unprecedented. Believing that poverty was new, not merely more visible in crowded towns and villages, critics compared contemporary times unfavorably with earlier centuries. Their claims of increasing misery, however, were based on ignorance of how squalid life actually had been earlier. Before children began earning money working in factories, they had been sent to live in parish poorhouses; apprenticed as unpaid household servants; rented out for backbreaking agricultural labor; or became beggars, vagrants, thieves, and prostitutes. The precapitalist “good old days” simply never existed (see industrial revolution and the standard of living). Nonetheless, by the 1820s and 1830s the growing specter of child labor and “dark Satanic mills” (poet William Blake’s memorable phrase) generated vocal opposition to these unbridled examples of self-interest and the pursuit of profit. Some critics urged legislative regulation of wages and hours, compulsory education, and minimum age limits for laborers. Others offered more radical alternatives. The most vociferous were the socialists, who aimed to eradicate individualism, the name that preceded capitalism. Socialist theorists repudiated individualism’s leading tenets: that individuals possess inalienable rights, that government should not restrain individuals from pursuing their own happiness, and that economic activity should not be regulated by government. Instead, they proclaimed an organic conception of society. They stressed ideals such as brotherhood, community, and social solidarity and set forth detailed blueprints for model utopian colonies in which collectivist values would be institutionalized. The short life span of these utopian societies acted as a brake on the appeal of socialism. But its ranks swelled after Karl Marx offered a new “scientific” version, proclaiming that he had discovered the laws of history and that socialism inevitably would replace capitalism. Beyond offering sweeping promises that socialism would create economic equality, eradicate poverty, end specialization, and abolish money, Marx supplied no details at all about how a future socialist society would be structured or would operate. Even nineteenth-century economists—in England, America, and Western Europe—who were supposedly capitalism’s defenders did not defend capitalism effectively because they did not understand it. They came to believe that the most defensible economic system was one of “perfect” or “pure” competition. Under perfect competition all firms are small scale, products in each industry are homogeneous, consumers are perfectly informed about what is for sale and at what price, and all sellers are what economists call price takers (i.e., they have to “take” the market price and cannot charge a higher one for their goods). Clearly, these assumptions were at odds with both common sense and the reality of market conditions. Under real competition, which is what capitalism delivered, companies are rivals for sales and profits. This rivalry leads them to innovate in product design and performance, to introduce cost-cutting technology, and to use packaging to make products more attractive or convenient for customers. Unbridled rivalry encourages companies to offer assurances of security to imperfectly informed consumers, by means such as money-back guarantees or product warranties and by building customer loyalty through investing in their brand names and reputations (see advertising, brand names, and consumer protection). Companies that successfully adopted these techniques of rivalry were the ones that grew, and some came to dominate their industries, though usually only for a few years until other firms found superior methods of satisfying consumer demands. Neither rivalry nor product differentiation occurs under perfect competition, but they happen constantly under real flesh-and-blood capitalism. The leading American industrialists of the late nineteenth century were aggressive competitors and innovators. To cut costs and thereby reduce prices and win a larger market share, Andrew Carnegie eagerly scrapped his huge investment in Bessemer furnaces and adopted the open-hearth system for making steel rails. In the oil-refining industry, John D. Rockefeller embraced cost cutting by building his own pipeline network; manufacturing his own barrels; and hiring chemists to remove the vile odor from abundant, low-cost crude oil. Gustavus Swift challenged the existing network of local butchers when he created assembly-line meatpacking facilities in Chicago and built his own fleet of refrigerated railroad cars to deliver low-price beef to distant markets. Local merchants also were challenged by Chicago-based Sears Roebuck and Montgomery Ward, which pioneered mail-order sales on a money-back, satisfaction-guaranteed basis. Small-scale producers denounced these innovators as “robber barons,” accused them of monopolistic practices, and appealed to Congress for relief from relentless competition. Beginning with the Sherman Act (1890), Congress enacted antitrust laws that were often used to suppress cost cutting and price slashing, based on acceptance of the idea that an economy of numerous small-scale firms was superior to one dominated by a few large, highly efficient companies operating in national markets (see antitrust). Despite these constraints, which worked sporadically and unpredictably, the benefits of capitalism were widely diffused. Luxuries quickly were transformed into necessities. At first, the luxuries were cheap cotton clothes, fresh meat, and white bread; then sewing machines, bicycles, sporting goods, and musical instruments; then automobiles, washing machines, clothes dryers, and refrigerators; then telephones, radios, televisions, air conditioners, and freezers; and most recently, TiVos, digital cameras, DVD players, and cell phones. That these amenities had become available to most people did not cause capitalism’s critics to recant, or even to relent. Instead, they ingeniously reversed themselves. Marxist philosopher Herbert Marcuse proclaimed that the real evil of capitalism is prosperity, because it seduces workers away from their historic mission—the revolutionary overthrow of capitalism—by supplying them with cars and household appliances, which he called “tools of enslavement.”1 Some critics reject capitalism by extolling “the simple life” and labeling prosperity mindless materialism. In the 1950s, critics such as John Kenneth Galbraith and Vance Packard attacked the legitimacy of consumer demand, asserting that if goods had to be advertised in order to sell, they could not be serving any authentic human needs.2 They charged that consumers are brainwashed by Madison Avenue and crave whatever the giant corporations choose to produce and advertise, and complained that the “public sector” is starved while frivolous private desires are being satisfied. And having seen that capitalism reduced poverty instead of intensifying it, critics such as Gar Alperovitz and Michael Harrington proclaimed equality the highest moral value, calling for higher taxes on incomes and inheritances to massively redistribute wealth, not only nationally but also internationally.3 Capitalism is not a cure for every defect in human affairs or for eradicating all inequalities, but who ever said it was? It holds out the promise of what Adam Smith called “universal opulence.” Those who demand more are likely to be using higher expectations as a weapon of criticism. For example, British economist Richard Layard recently attracted headlines and airtime with a startling revelation: money cannot buy happiness (a cliché of song lyrics and church sermons).4 He laments that economic individualism fails to ensure the emotional satisfactions that are essential to life, including family ties, financial security, meaningful work, friendship, and good health. Instead, a capitalist society supplies new gadgets, appliances, and luxuries that arouse envy in those who cannot afford them and that inspire a ceaseless obsession with securing more among those who already own too much. Layard’s long-range solutions include a revival of religion to topple the secularism that capitalism fosters, altruism to obliterate selfishness, and communitarianism to supercede individualism. He stresses the need, near-term, for robust governmental efforts to promote happiness instead of the minimalist night-watchman state that libertarian defenders of capitalism favor. He argues that low taxes are harmful to the poor because they give government inadequate revenue to provide essential services to the poor. Higher taxes really would not harm the well-to-do, he says, because money and material possessions are subject to diminishing marginal utility. If such claims have a familiar ring, it is because Galbraith made the same points fifty years ago. Virtually all the new criticisms of capitalism are old ones repackaged as stunning new insights. One example is the attack on “globalization” (the outsourcing of service, manufacturing, and assembly jobs to foreign sites where costs are cheaper). It has been denounced as union busting, exploitative, and destructive of foreign cultures, and is damned for the loss of domestic jobs and the resulting erosion of local tax revenues. Identical complaints were voiced two generations ago when jobs began flowing from unionized New England textile factories to nonunionized southern textile mills, and then to offshore sites such as Puerto Rico. Another “new” line of attack on capitalism has been launched by law professors Cass Sunstein and Liam Murphy and philosophers Stephen Holmes, Thomas Nagel, and Peter Singer.5 They lament that in societies based on self-interest and private property, wealth earners oppose rising taxes, preferring to spend their money on themselves and leave inheritances for their children. This selfish bias leads to an impoverished public sector and to inadequate tax revenues. To justify governmental claims for higher taxes, these writers have revived an argument—attacking the legitimacy of private property and inheritance—that was advanced by institutionalist economists during the New Deal era. Government, they assert, is the ultimate source of all wealth, and so it should have first claim on wealth and earnings. “Is it really your money?” Singer asks, citing economist Herbert Simon’s estimate that a flat income tax of 90 percent would be reasonable because individuals derive most of their income from the “social capital” provided by technology and by protections such as patents and copyrights, and by the physical security afforded by police, courts, and armies rather than from anything they personally do. If the “fruits of capitalism” are merely a gift of government, it is an argument that proves too much. By the same logic, individuals might be enslaved if they were not protected by government, so conscription (servitude for a brief period) would be entirely unobjectionable, as would the seizure of privately owned land to turn it over to new owners if their uses would yield higher tax revenues—exactly the basis of a 2005 Supreme Court ruling on “eminent domain.” Another persistent criticism of capitalism—the attack on corporations—harkens back to the 1930s. Critics like Ralph Nader, Mark Green, Charles Lindblom, and Robert Dahl focus their fire on giant corporations, charging that they are illegitimate institutions because they do not conform to the model of small-scale, owner-managed firms that Adam Smith extolled in 1776.6 In fact, giant corporations are fully consistent with capitalism, which does not imply any particular configuration of firms in terms of size or legal form. They attract capital from thousands (sometimes millions) of investors who are strangers to each other and who entrust their savings to the managerial expertise of others in exchange for a share of the resulting profits. In an influential 1932 book, The Modern Corporation and Private Property, Adolf A. Berle Jr. coined the phrase “splitting of the atom of ownership” to lament the fact that investment and management had become two distinct elements. In fact, the process is merely an example of the specialization of function or division of labor that occurs so often under capitalism. Far from being an abuse or defect, giant corporations are an eloquent testimonial to the ability of individuals to engage in large-scale, long-range cooperation for their mutual benefit and enrichment (see corporations). As noted earlier, the freedoms to invest, to decide what to produce, and to decide what to charge have always been restricted. A fully free economy, true laissez-faire, never has existed, but governmental authority over economic activity has sharply increased since the eighteenth century, and especially since the Great Depression. Originally, local authorities fixed the prices of necessities such as bread and ale, bridge and ferry tolls, or fees at inns and mills, but most products and services were unregulated. By the late nineteenth century governments were setting railroad freight rates and the prices charged by grain elevator operators, because these businesses had become “affected with a public purpose.” By the 1930s the same criterion was invoked to justify price controls over milk, ice, and theater tickets. One piece of good news, though, is that a spate of deregulation in the late 1970s and the 1980s eliminated price controls on airline travel, trucking, railroad freight rates, natural gas, oil, and some telecommunications rates. Simultaneously, from the eighteenth century on, government began to play a more active, interventionist role in offering benefits to business, such as tax exemptions, bounties or subsidies to grow certain crops, and tariff protection so domestic firms would devote capital to manufacturing goods that otherwise had to be imported. Special favors became entrenched and hard to repeal because the recipients were organized while consumers, who bore the burden of higher prices, were not. Once safe from foreign competition behind these barriers to free trade, some U.S. producers—steel and auto manufacturers, for example—stagnated. They failed to adopt new technologies or to cut costs until low-cost, low-price overseas rivals—the Japanese, especially—challenged them for their customers. They responded initially by asking Congress for new favors—higher tariffs, import quotas, and loan guarantees—and pleading with consumers to “buy American” and thereby save domestic jobs. Slowly, but inevitably, they began the expensive process of catching up with foreign companies so they could try to recapture their domestic customers. Today, the United States, once the citadel of capitalism, is a “mixed economy” in which government bestows favors and imposes restrictions with no clear or consistent principles in mind. As the formerly communist countries of Eastern Europe struggle to embrace free-market ideas and institutions, they can learn from the American (and British) experience about not only the benefits that flowed from economic individualism, but also the burden of regulations that became impossible to repeal and trade barriers that were hard to dismantle. If the history of capitalism proves one thing, it is that the process of competition does not stop at national borders. As long as individuals anywhere perceive a potential for profits, they will amass the capital, produce the product, and circumvent the cultural and political barriers that interfere with their objectives. About the Author Robert Hessen, a specialist in business and economic history, is a senior research fellow at Stanford University’s Hoover Institution. Further Reading   Berger, Peter. The Capitalist Revolution. New York: Basic Books, 1986. De Soto, Hernando. The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else. New York: Basic Books, 2000. Easterbrook, Gregg. The Progress Paradox: How Life Gets Better While People Feel Worse. New York: Random House, 2003. Folsom, Burton W. Jr. The Myth of the Robber Barons: A New Look at the Rise of Big Business in America. 3d ed. Herndon, Va.: Young America’s Foundation, 1996. Hayek, F. A., ed. Capitalism and the Historians. Chicago: University of Chicago Press, 1953. Hessen, Robert. In Defense of the Corporation. Stanford: Hoover Institution Press, 1979. Landes, David S. The Wealth and Poverty of Nations: Why Some Are So Rich and Some So Poor. New York: Norton, 1999. McCraw, Thomas K. Creating Modern Capitalism. Cambridge: Harvard University Press, 1997. Mises, Ludwig von. The Anti-capitalistic Mentality. Princeton: Van Nostrand, 1956. Mueller, John. Capitalism, Democracy, and Ralph’s Pretty Good Grocery. Princeton: Princeton University Press, 2001. Norberg, Johan. In Defense of Global Capitalism. Washington, D.C.: Cato Institute, 2003. Pipes, Richard. Property and Freedom. New York: Alfred A. Knopf, 2000. Rand, Ayn. Capitalism: The Unknown Ideal. New York: New American Library, 1966. Reisman, George. Capitalism. Ottawa, Ill.: Jameson Books, 1996. Rosenberg, Nathan, and L. E. Birdzell Jr. How the West Grew Rich: The Economic Transformation of the Industrial World. New York: Basic Books, 1987. Seldon, Arthur. The Virtues of Capitalism. Indianapolis: Liberty Fund, 2004.   Footnotes 1. Herbert Marcuse, “Repressive Tolerance,” in Robert Paul Wolff, Barrington Moore Jr., and Marcuse, A Critique of Pure Tolerance (Boston: Beacon Press, 1969).   2. John Kenneth Galbraith, The Affluent Society (Boston: Houghton Mifflin, 1958); Vance Packard, The Hidden Persuaders (New York: D. McKay, 1957).   3. Gar Alperovitz, “Notes Toward a Pluralist Commonwealth,” in Staughton Lynd and Alperovitz, Strategy and Program: Two Essays Toward a New American Socialism (Boston: Beacon Press, 1971); Michael Harrington, Socialism Past and Future (Boston: Little, Brown, 1989).   4. Richard Layard, Happiness: Lessons from a New Science (New York: Penguin Press, 2005).   5. Stephen Holmes and Cass Sunstein, The Cost of Rights (New York: Norton, 1999); Liam Murphy and Thomas Nagel, The Myth of Ownership (New York: Oxford University Press, 2002); Peter Singer, The President of Good and Evil (New York: Dutton, 2004).   6. Ralph Nader and Mark Green, Taming the Giant Corporation (New York: Norton, 1976); Charles Lindblom, Politics and Markets (New York: Basic Books, 1977); Robert Dahl, A Preface to Economic Democracy (Berkeley: University of California Press, 1985).   Related Links Division of Labor, from the Concise Encyclopedia of Economics.  Ethics and Economics, from the Concise Encyclopedia of Economics.  Fascism, from the Concise Encyclopedia of Economics.  Joseph Alois Schumpeter biography, from the Concise Encyclopedia of Economics.  Dwight R. Lee, Can Capitalism Survive? Ben Rogge on Capitalism’s Future. February 2019. Arnold Kling, Capitalism and Inequality. November 2016. Arnold Kling, How Democratic Capitalism Works. November 2019. Pedro Schwartz, Capitalism and its Names. November 2016. McCloskey on Capitalism and the Bourgeois Virtues. EconTalk, March 2008. Daron Acemoglu on Inequality, Institutions, and Piketty. EconTalk, November 2014. Rebecca Henderson on Reimagining Capitalism. EconTalk, June 2020. Branko Milanovic on Capitalism, Alone. EconTalk, May 2020. (0 COMMENTS)

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary. —Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776)1 Public policy’s traditional hostility to cartels is rooted in the view, summarized by eighteenth-century economist Adam Smith, that rival sellers will almost always prefer to raise their prices in unison than to aggressively compete for customers by undercutting each other’s prices. But this statement tells only half the story. The same profit motive that entices sellers to want to collude also creates strong and sometimes uncontrollable temptations to “cheat” on a cartel. This is because any individual seller can usually garner a larger share of the market and earn larger profits by undercutting the cartel’s price. If enough other sellers behave in this way, however, then attempts to raise prices artificially will fail under the collective weight of cheating.2 To understand whether or when a cartel can avoid this problem, economists have studied two questions: (1) Why have cartels proven much more effective in some settings than in others? and (2) Why in many industries have cartels proven impossible to form in practice? In an influential article addressing these questions, Nobel laureate George Stigler identified two principal hurdles for any successful cartel: first, reaching a consensus on the terms of coordination, and, second, establishing a system to detect and punish cheating against those terms. These twin hurdles have proven to be higher in some industries than in others, and in many settings, sellers have found them insurmountable. Consensus can take the form of an explicit agreement to coordinate prices, an unwritten understanding to limit competition, or simply a mutual recognition that all firms would be better off if they restrained their competitive impulses and stabilized prices. Whatever form the consensus takes, cartel members must do more than simply agree on what price to charge; they also must close off all other avenues of potential competition that could threaten the cartel’s ability to increase prices. In general, therefore, a cartel must also reach consensus on what level of services to offer, what grades of quality to produce, and how to ensure that product upgrades and new product introductions do not prompt a resurgence of competition. While building consensus might appear to be a relatively straightforward task, actual experience suggests otherwise. According to one study, failure to reach a consensus has caused the demise of roughly one out of every four attempted cartels.3 Experience has also shown that successful cartels often find it necessary to adopt complicated and sometimes cumbersome rules to restrain competitive impulses. For example, participants in the famous electrical equipment conspiracy of the 1950s and 1960s not only fixed prices but also had to agree on how to allocate market shares and divide up the largest customers. The vitamin cartel of the 1990s, whose prosecution led to the largest antitrust fines in U.S. history, involved sellers who not only fixed prices but also rigged bids, divided up customers, and set sales quotas. The need to add layer upon layer of cartel rules not only directly complicates the process of building consensus; it also increases the likelihood that the government will learn of the illegal actions. Once formed, a cartel must then remain vigilant against “cheating” from within its ranks and competition from outside. Experience has shown that, very frequently, the greatest threat comes from entry into the industry by sellers who choose not to follow the cartel’s pricing lead. For example, an entrant might find it more profitable to undercut the cartel price if it believes it can attract a substantial number of customers. Entry has been responsible for breaking up cartels in industries ranging from ocean shipping to oil to railroads. A somewhat less prevalent cause of breakups has been underpricing by cartel participants themselves. Internal cheating has undermined cartels operating in electric turbines and railroad transportation, among other industries, when sellers could not resist the temptation to quickly capture a large share of the market by discounting their price to a select group of major customers. Requiring audits of participants’ sales, creating financial incentives for customers to report price discounts offered to them, and setting up systems to monitor emerging threats of entry are among the tools that can help cartels detect cheating. If cheating is detected, it must then be punished to discourage repeat occurrences. Sellers will be discouraged from cheating only if their temporary gains from underpricing the cartel are outweighed by the longer-term cost of punishment. Punishment can take many forms, ranging from other sellers targeting price discounts at the offender’s customers, to cutting the offender’s allocated sales quota, all the way to suspending the cartel’s activities for some period. In almost all instances, however, punishment will be costly not only to the offender but also to the sellers who mete out the penalties. Discipline will work, therefore, only when the cartel members believe it would be costlier to turn a blind eye to sporadic cheating than to mete out punishment as a lesson for the future. The fact that many cartels have fallen victim to cheating suggests either that the punishment was inadequate or that cartel members recognized the futility of punishment. Economists have identified a range of conditions that tend to make forming and defending a cartel harder in particular industries, and practically impossible in some. By analyzing cartel experiences within and across industries, economists have learned that cartels tend to be less likely to form and less likely to endure in industries where: 1. Numerous small sellers currently are producing 2. Additional sellers could begin producing at relatively low start-up cost and with little delay 3. The products being sold are complex 4. A small number of large customers each purchases relatively infrequently 5. Each customer is accustomed to negotiating for its own individual price and other terms of service 6. New products or new production methods are developed frequently To supplement these “economic” hurdles to cartel operation, governments also can take additional measures to discourage industry cartels from forming. Antitrust laws in the United States and some other countries expose cartels to criminal and civil penalties. The wave of recent high-profile cartel indictments, leading in many cases to large fines and prison sentences for corporate executives, suggests that antitrust laws may have a substantial deterrence effect. Yet, at the same time, the continuing stream of prosecutions also suggests that deterrence remains incomplete. In other instances, however, government policies have purposefully facilitated industries’ efforts to cartelize. During the Great Depression, for example, the National Recovery Administration (NRA) imposed “Codes of Fair Competition” that exempted cartels from antitrust penalties to stop “destructive price-cutting.” Throughout the late 1930s, government-encouraged cartels flourished in literally hundreds of industries ranging from steel and textiles to beer and pasta. Several of these cartels survived long after the NRA codes were struck down, which suggests that the government’s actions “taught” sellers how to collude to the long-term detriment of consumers. Governments both at home and abroad also have facilitated agricultural cartels by establishing marketing boards that specify price floors or production ceilings (quotas) for particular crops. In some industries, governmental facilitation of cartel activity has been unintentional. An infamous example originated from a decision in the early 1990s by the Danish Competition Council to collect and publish transaction prices for sellers of ready-mix concrete. Following publication of the price information, customers wound up paying 15 to 20 percent more for concrete. The government’s actions made pricing more transparent among supposedly competing sellers and thereby facilitated their efforts to detect and punish those sellers who sought to undercut the cartel’s fixed price. Unwitting facilitation of cartels also occurs in government procurement auctions. In an effort to discourage political corruption, many governments announce winning and losing bids after such auctions. However, this practice also broadcasts the identity of cheating sellers to members of the cartel, and thus unintentionally facilitates the detection and punishment of price cutters.4 Notwithstanding governments’ occasional sponsorship of cartels, historical experience indicates that cartels remain rare in most industries. Even though the United States has granted broad antitrust immunity to exporting industries, for example, fewer than 5 percent have sought to fix prices to customers abroad.5 The reluctance of most sellers to attempt a conspiracy to raise prices—even with their government’s blessing—suggests that the economic hurdles to successful cartel operation remain high. About the Author Andrew Dick is a Vice President in the Competition Practice of CRA International and formerly was the acting chief of the Competition Policy Section in the U.S. Department of Justice’s Antitrust Division. Further Reading Introductory   “After Centuries of Ripping Off Consumers, Cartels Are Suffering a Crackdown from the World’s Competition Authorities.” Economist, April 3, 2003. Dick, Andrew R. “Identifying Contracts, Combinations and Conspiracies in Restraint of Trade.” Managerial and Decision Economics 17 (1996): 203–216. Levenstein, Margaret C., and Valerie Y. Suslow. “What Determines Cartel Success?” Journal of Economic Literature 44, no. 1 (2006): 43–95. Posner, Richard A. Antitrust Law: An Economic Perspective. Chicago: University of Chicago Press, 1976. Chap. 4.   More Advanced   Albaek, Svend, Peter Mollgaard, and Per B. Overgaard. “Government-Assisted Oligopoly Coordination? A Concrete Case.” Journal of Industrial Economics 45 (1997): 429–443. Baker, Jonathan B. “Identifying Cartel Policing Under Uncertainty: The U.S. Steel Industry, 1933–1939.” Journal of Law and Economics 32 (1989): S47-S76. Dick, Andrew R. “When Are Cartels Stable Contracts?” Journal of Law and Economics 39 (1996): 241–283. Scherer, Frederick M., and David Ross. Industrial Market Structure and Economic Performance. Boston: Houghton Mifflin, 1990. Chap. 7. Stigler, George J. “A Theory of Oligopoly.” Journal of Political Economy 72 (1964): 44–61.   Footnotes 1. For a contrary view, see “Benign Conspiracies,” Economist, April 9, 1997.   2. Economists refer to this breakdown of cartel pricing as a prisoners’ dilemma.   3. Margaret C. Levenstein and Valerie Y. Suslow, “What Determines Cartel Success?” Journal of Economic Literature 44, no. 1 (2006): 43–95.   4. See Armen A. Alchian, “Electrical Equipment Collusion: Why and How,” in Armen A. Alchian, Property Rights and Economic Behavior, vol. 2 of The Collected Works of Armen A. Alchian (Indianapolis: Liberty Fund, 2006), pp. 429–436.   5. Andrew R. Dick, “When Are Cartels Stable Contracts?” Journal of Law and Economics 39 (1996): 241–283.   Related Links Labor Unions, from the Concise Encyclopedia of Economics. OPEC, from the Concise Encyclopedia of Economics. Charles W. Baird, Labor Day Is Not Union Day. September 2009.   (0 COMMENTS)