MIDTERMM

Chapter 3

Firms, Markets, and Income

I. Firms and Income

The owners of firms are called capitalists or business owners. The defining criterion is

that in addition to owning a firm or shares of a firm - as in the case of a corporation, capitalists

are also engaged in managing the enterprise and making decisions regarding the generation and

use of the firm’s profits. In the case of a single proprietorship the capitalist is the individual who

owns and manages the enterprise. In the case of a partnership, the capitalists would be the active

partners of the enterprise engaged in various aspects of management and allocation of profits.

And in the case of a corporation, the “capitalist” is actually a collection of individuals, the top

managerial staff – the CEOs, CFOs, Presidents, and such - that own shares of the business and

make decisions regarding production, sales, and the use of corporate profits. We can also refer to

capitalists as entrepreneurs to underscore the fact that they are the ones guiding the business and

making decisions regarding investment, production, employment, sales, and profits. But, while

all entrepreneurs are capitalists, not all capitalists are entrepreneurs. Some capitalists engage in

very little to no managerial oversight or productive economic activity, they simply live off the

dividends generated by the firms they own. We call such capitalists, rentiers.

Rentiers refer to a class of people who own property and live off the income generated

from such property but are not actively engaged in productive economic activity. In the case of

rentiers who live off corporate stock, they’re content to collect dividends and/or enjoy capital

gains without taking any significant role in the management of the business. Rentiers can also be

found owning other kinds of assets in addition to corporate stock, such as real estate and various

kinds of debt instruments such as notes, bills, and bonds. The common thread connecting this

class of people, the rentiers, is that they receive a flow of income despite not being engaged in

productive economic activity or managing such activity. The income they receive, either in the

form of dividends, interest, or rent, is due solely to the fact that they own assets such as shares of

a business, financial securities, or real estate, but are not active participants in organizing

whatever work might be necessary to make such assets productive.

The classic example of a rentier would be the aristocratic English landowner of the 18th

century who received a flow of rents from lending his land to capitalist farmers but was not

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involved in managing or producing the goods generated by the capitalist tenant. Other examples

would be contemporary trust fund babies who inherit their parent’s wealth and are entitled to a

handsome flow of property income without overseeing the properties embodied in that wealth

and often knowing little about the property and firms they own. Another example would be

wealthy bond holders who live off the interest income and capital gains provided by the

securities they own, without engaging in productive economic activity.

Of course, any one individual may very well be an entrepreneur with regard to her/his

own business but a rentier with regard to the real estate or financial assets she/he owns. Yet,

despite the existence of such overlapping patterns, it’s important to distinguish between these

two categories of owners, and treat them as separate classes of people, not only because of the

distinct motivations underlying each group, but because of the different roles they play in their

use of private property, productive activity, and flows of property income (profits, interest, and

rents).

The profits of firms are generally distributed in four broad forms: first, as income that

flows to the owners of the firms either in the form of dividends to the owners of corporate stock

or as the portion of profits that owners set aside for themselves and their families; second, as

retained earnings held in the form of cash or financial securities that generate interest income and

can be exchanged for liquidity on fairly short notice; and third, invested in maintaining the firm’s

existing capital stock in good repair, adding to or enhancing the firm’s capital stock, or investing

in a new firm. Beyond these three uses of a firm’s profits, it’s common for capitalists to use a

portion of their profits for political activity, lobbying or legal representation, for the purpose of

defending or enhancing their flow of property income; that is, using a portion of profits to

influence government into setting up a legal or regulatory environment that guarantees a flow of

rents to the firm.

The inputs that are used by firms to produce profit-generating goods consist of two broad

categories: labor and capital. Labor refers to all forms of laboring activity and should not be

thought of as being confined to the direct production and delivery of the good, the kind of work

normally carried out by the non-supervisory personnel of a firm. It includes, in addition to such

work, a wide variety of overhead work involved in the maintenance and advancement of the

firm, such as management, research and development, accounting and finance, marketing,

secretarial services, information technology, janitorial work, and security, among others. In

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short, labor refers to all of the work carried out by the employees as well as the work of the

owners or managers.

The compensation of labor we call wages, even though it’s common to make a distinction

between something called wages and something called salaries or more broadly labor

compensation. As is common in economics we will lump together all these forms of labor

compensation and call them wages. The key idea here is that wages refer to the income that

accrues to the laboring activity necessary to keep the firm going, regardless of whether it

involves the direct production and delivery of the good or various forms of overhead activity.

On the whole, those who offer their laboring services to the firms, the working class,

consists of people who own very little wealth or capital and, as a result, must offer their ability to

work in return for wage income. Obviously, if they owned enough financial and/or physical

capital (specifically a firm) to live off the property income generated from that wealth they

would not need to work for others. But they don’t. As a result, the need to find a job that will

provide, at a minimum, a flow of wages sufficient to purchase the socially necessary bundle of

goods is urgent. The exception to this generalization occurs in the case of the top managerial

strata of large firms, say corporations, where the wages of managers generally exceed what

might be thought of as appropriate compensation for labor and includes a portion of the firm’s

profits (though it isn’t measured as such in the ledgers). Thus the “salary” of top corporate CEOs

is often represented as compensation for labor, even though it would be more appropriate to

break up that “salary” into a portion that involves compensation for labor (i.e., wages) and a

portion that involves a return on the firm’s capital (i.e., profits).

This feature of capitalist societies has the effect of keeping the balance of economic

power between capitalists and workers on the side of business owners, keeping wages and

working conditions more favorable to capitalists than to workers. In their search for profits, firms

have a strong incentive to keep wages relatively low while demanding as much effort as possible

from their labor force. But the extent to which this incentive shows up in the wages and work

conditions offered by firms depends on the legal and regulatory framework created by

government, as well as the nature of competition in the labor market. LME capitalist societies

tend to provide little infrastructural support to workers and as a result, wages tend to be lower

and work conditions more onerous than in social CME societies. And in both cases, wages and

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work conditions tend to improve during periods where firms are actively competing against each

other for laborers, while deteriorating when the demand for labor diminishes or stagnates.

The firm’s capital refers to all of the assets that are owned by the firm and used by labor

to generate the goods and services for sale. It’s a huge category and is traditionally broken down

into two components: fixed and circulating. A firm’s fixed capital refers to all of the physical

structures, machines, and tools, used to carry on the production and delivery of the commodity.

It’s generally referred to as the firm’s plant and equipment. Circulating capital refers to all of the

raw materials that go into the production and delivery of the commodity, the inventory of raw

materials waiting to be used, the inventory of the commodity at various stages of production, and

the inventory of the finished commodity waiting to be sold. All of this is the physical stuff that

must be used by labor to produce a finished good and deliver it to the market.

Land, both the surface upon which buildings sit as well as the land that might be used for

primary sector activities (farming, ranching, mining, logging, etc.), occupies an important though

complicated position within the process of production. From the perspective of the firm, land is

an owned or rented asset and, as such, viewed as a part of the firm’s capital structure and/or a

necessary expense of doing business. The firm thinks of it as a form of capital since it’s owned

with the intention of using it, along with other inputs, to make a profit from producing and

selling a good. But, unlike capital goods, land is not a produced good; it is a gift of nature, and,

as such, non-reproducible. The non-reproducibility of land is the source of rents to landowners

and rising unit cost brought on by diminishing returns to land. In addition, the non-

reproducibility of land poses ecological problems of sustainability when injudiciously exploited.

Beyond the physical capital needed for production, firms also own a wide array of

financial assets. Examples of this would be the firm’s cash and demand deposits, its accounts

receivable, and the various financial securities, such as stocks and bonds, it might own and can

sell in exchange for liquidity. This too is part of the firm’s capital but unlike its physical capital,

these financial assets are used to make a wide variety of payments for the purchase of raw

materials, capital goods, the services of labor, and/or more financial assets. Additionally, the firm

has a variety of liabilities, various types of loans it has incurred in the past, which it is committed

to paying on a regular basis. The financial obligations associated with these liabilities, such as

the monthly payment on a loan, must also be paid out of the firm’s financial assets, either with

cash on hand or selling other financial assets to pay existing liabilities. The firm is always

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replenishing its financial assets with money it receives from selling its produced goods and/or

purchasing financial assets that promise a stream of interest income and/or capital gains. At the

same time, it’s drawing on this fund to pay the various financial obligations it has incurred in the

past.

We can think of the firm as a unit of capital, a productive asset, that is expected to yield a

profit to its owners. The value of the firm, or stated differently - the value of the capital invested

in the firm, is equal to the value of the firm’s physical capital (both fixed and circulating) plus

the value of its financial assets minus the value of its liabilities. The resulting amount would be

the net worth, or value, of the firm. There are several different ways of estimating this value, but

for our purposes it’s enough to know that the firm is seen as an investment of capital which the

owners have made on the expectation that it will yield a stream of profits over time.

The minimal amount of capital that’s needed to invest in a business, and manage it

successfully, is generally beyond the reach of the average worker. To be sure, there are cases

where such things occur, but they are the exception to the rule. Most families do not own a

business firm; they instead work for those who do own a firm. This is not to say that small

artisanal businesses do not exist in capitalist societies, they do. The economic landscape is

populated with independent craftsmen who combine their skilled labor with the modest capital

they own to produce a good or service for income. Independent contractors, small family

farmers, and CPAs operating out of their home, are examples of this form of economic

organization. They lie in between the capitalist and the worker, having elements of both. They

own capital but they also work their own capital to generate a flow of income. Most of the

income that flows to this class of people is a wage (i.e., compensation for their labor), even

though they mistakenly refer to it as a profit. The return to capital, namely profit, is usually a

smaller proportion of their total income, explaining in large measure why small business owners

generally put in a lot of hours working. These “firms” have more in common with small peasant

producers or medieval craftsmen than with the profit driven firms of capitalism which is the

focus of our study. In short, a capitalist economy is not an artisanal economy, a commodity

producing society wherein most families own a modest amount of capital and provide for

themselves by using their own labor to produce and sell goods. Instead, a capitalist economy is

one wherein most families do not own a small business and are thus obligated to work for those

who do own firms.

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II. Economic freedom and creative destruction

Economic life in capitalist societies is anything but stable. These systems are continually

changing what they produce and how they produce it. The composition of the gross product,

along with its method of production and labor processes, is in a constant state of flux. The

introduction of new goods is accompanied by the introduction of the new labor processes and

techniques required for their production. Entire industries, replete with enormous factories, vast

networks of suppliers and distributors, and work forces numbering in the tens of thousands, are

created in a few short years. At the same time, unprofitable industries are abandoned, factories

and machines sold as scrap, and workers dismissed and forced to move on. The incessant

transformation in the methods of production and items of consumption bring along with them

changes in centers of political and economic power, location of cities, forms of entertainment,

nature of warfare, and styles of life. To paraphrase Joseph Schumpeter, capitalism is in a

perpetual state of creative destruction, continually breaking down unprofitable goods,

institutions, and social relations, in favor of their more profitable counterparts.

The commodity producing character of capitalist societies, that is the fact that they rely

on markets and the profit motive, is one of the major factors contributing to the kind of

dynamism implied by the phrase creative destruction. In these systems income seekers are

always moving into those activities that offer a greater flow of income, while leaving those that

offer a smaller flow. Capitalists invest greater amounts of capital into sectors that experience

greater than normal profits while emigrating out of those that experience little to no profits.

Likewise, workers migrate to those sectors which offer greater than normal wages while leaving

those which offer declining wages.

Yet, while both workers and capitalists move out of low paying areas and into high

paying areas, it is the capitalist who sets the stage for the process of creative destruction.

Whether an industry will be growing or contracting is ultimately dependent on the rate of profit

that can be earned in that industry relative to other possibilities. Since capital will only be

invested in productive capacity that promises to pay a return that is no less than what could be

earned in the next best alternative, the extent to which the productive capacity of an industry is

funded depends on the extent to which it can earn a return that is no less than the return being

earned elsewhere. If the return earned in any one industry falls short of the return earned in some

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other industry, capital will be moved out of its current commitment and into the more profitable

alternative.

In the meantime, whether labor will move from one sector of the economy to another is

dependent on the extent to which there has been a prior commitment of capital. It is not until

capital has been invested in some new sector of the economy that labor can move. Since the

production and eventual sale of output requires that workers interact with productive capacity,

the investment of financial capital into some new capacity always carries with it a

complementary demand for labor. Thus, as the tempo of capital accumulation increases in any

one sector of the economy so too does the demand for labor and, depending on the intensity of

the competition for labor, the wages of labor as well.

The opposite set of circumstances takes place in those sectors of the economy where the

profit rate is falling. In these declining sectors capitalists will be liquidating their investments by

selling portions, or all, of their now unprofitable capacity. Factories, office buildings,

warehouses and machinery will be put to some other use or sold as scrap. Capitalists will be

incurring losses and, depending on the severity of the downturn, closing down their firms and

declaring bankruptcy. At the same time, the demand for labor will be falling, unemployment

rates will be rising, and wages will be falling.

Beyond all of this, there is another aspect to this process that is not captured in the above

descriptions, something that goes beyond the relatively simple act of moving capital and labor in

and out of existing industries. The most critical feature of the process of creative destruction is

that it involves the commitment of capital to the creation of goods that are currently non-existent.

The capitalist does not sit back and wait for market signals, such as differential profit

opportunities, to tell him or her when and where to invest. The capitalist is an aggressive creature

who goes out and creates the environment needed to generate the greater profits. He or she is

continually testing the market, seeing if this or that version of the good, or some new-fangled

gizmo, might provide a better return.

This is the entrepreneurial, innovative, aspect of capitalist behavior. The capitalist-

entrepreneur commits capital to the creation of goods that are currently non-existent but that,

hopefully, will be bought in prodigious amount once it hits the market. There is of course a risk

involved in such an undertaking, the newly created good may turn out to be a dud - an Edsel, and

destine the capitalist to future losses; but, if it is something consumers take a fancy to, the

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capitalist will be in the fortunate position of being the sole provider of the good. He or she will

have achieved a monopoly position and, in consequence, be able to capture monopoly profits.

The problem is that, in the context of a relatively free and open market system, any new

monopoly position which is captured by some entrepreneur will always be subject to attack by

other capitalists also wishing to cash in on the profits. Copycat versions of the good will begin to

appear on the market vying for a share of the income which previously went to the innovating

capitalist. As competition from other invading capitalists heats up and the market share of the

innovator begins to shrink, the entrepreneurial capitalist will begin to search, once again, for

other, "new and improved," products to create and sell.

Capitalist competition thus involves an on-going search for the monopoly profits that

might be captured from the introduction of some new good. The aggressive, entrepreneurial,

capitalist is continually investing a portion of his or her profits into researching and developing

some new commodity that offers the promise of greater profits. As a result, capitalist societies

are always being bombarded by new commodities, new productive techniques, or new ways of

delivering an existing commodity. While much of this competition leads to the introduction of all

sorts of frivolous and ultimately useless things, it is also responsible for the introduction of

genuinely useful items. A testament to this is the enormous variety of goods, such as the

automobile, the vacuum cleaner, television, the refrigerator, radio, air conditioning, the

microwave oven, and personal computer, that workers in advanced capitalist societies consider

socially necessary items of consumption.

III. Free competitive markets

The creative destruction characteristic of capitalist societies is largely the result of a

political economic system that encourages economic freedom; a system that allows individuals

and firms to pursue their search for income any way they see fit, so long as it doesn’t interfere

with the right of others to do the same. Adam Smith first expressed this idea in the latter half of

the eighteenth century.1 The thesis he proposed is that a nation’s wealth and income, the volume

and variety of goods it produces, will be enhanced if it pursues a policy of economic freedom.

1. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations. Edited with introduction, marginal summary and enlarged index by Edwin Cannan. New York: The Mod

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He supported this thesis by noting that the volume of products generated by a society is

related to the degree to which its labor force is subdivided into differing occupations and

industries. The more intricate a society’s division of labor, the greater the volume and variety of

goods it can produce. The specialization of labor that comes from an increased division of labor

has the effect of increasing labor’s productivity, that is, it increases the amount of gross product

generated per worker. Societies with a wide range of industries and occupations, and further

subdivisions within each of these, generate more output per worker and, as a result, have a higher

material standard of living. In contrast, a less intricate division of labor is characteristic of

societies whose material conditions are meager. And while a nation’s income could be improved

through state mandated activities forcing a greater subdivision upon its labor force, Smith

believed that a more intricate division of labor was best achieved when individuals were given

the freedom to search for income any way they deemed fit.

This belief derived from his assumption that humans are always seeking ways to improve

their material condition and that, because of their inquisitive nature, are forever tinkering with

their material environment coming up with better tools and technologies. Thus, in their search for

income, individuals apply their labor and/or capital to those activities that seem to offer the

highest economic reward. Workers will seek out occupations and industries that offer the highest

wage, while capitalists will invest in those industries that offer the greatest profit. At the same

time, entrepreneurs will invest in the development of technologies that offer the possibility of

future monopoly profits, creating in their wake entirely new spheres of work while

simultaneously enhancing the productivity of labor.

But the extent to which the nation’s labor can be subdivided in this fashion depends on

the extent to which there is a ready market for the growing volume of goods. The introduction of

a new product will increase the flow of income only if there is a demand for the good; that is,

only if the workers and capitalists in the other industries are able and willing to part with a

portion of their income. Exchange and market activity is thus tied to the manner in which the

division of labor evolves as individuals seek to improve their income. The production and sale of

new goods is dependent on their demand, which in turn is facilitated through the production and

sale of other goods. Thus, the tempo at which goods can be produced and sold is constrained by

the rate at which market demand grows.

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A free economic system thus provides the context through which the division of labor can

evolve into ever more complex forms, reflecting, at one and the same time, the application of

productivity enhancing technologies as well as the level and composition of demand that

emerges from the generation and distribution of income.

Adam Smith viewed this thesis as applicable to the long-term, a characterization of a

society’s likely economic outcome over a period of a generation or two, or more. It was not

viewed as a short-term prescription intended to improve the economic position of society within

a couple of years. Nor was the argument intended to suggest that income would grow

uninterruptedly without episodes of stagnation or depression. Additionally, the thesis said

nothing about whether the nation’s income would be distributed equitably or whether it would be

sufficient to insure a survival flow of income. Indeed, Smith assumed that over the long term,

workers would earn wages that were no greater than the subsistence minimum needed to

reproduce another generation of workers; implying that, at any one point in time, some workers

would be earning below subsistence wages, counterbalanced by those earning above subsistence

wages. He also assumed that the distribution of wealth and income would remain unequal,

reflected in his characterization of economic growth as a process wherein the nation’s income

grows despite a stable class structure.

It must also be emphasized that this thesis was not intended to suggest that beneficial

outcomes would automatically emerge from a free for all, a system unhindered by law,

government, and civility. The institutional environment, as well as the specification of what was

meant by economic freedom, was critical to his belief that economic growth would be the likely

outcome of a nation organized along the lines of economic freedom. At a minimum it assumed

that the pursuit of economic gain would not be carried out by infringing on the right of others to

do the same. It also assumed an economic environment that was sufficiently open and

competitive that it prevented any one capitalist, or coalition of capitalists, from gaining control

over the market. Indeed, he was suspicious of the business class, warning against their self-

interested tendency to conspire against the public good. And lastly, as implied in his discussion

of public infrastructure, his championing of the individual’s right to seek income assumed access

to the means by which such a right can be exercised and made credible.

The economic growth that Smith thought would occur from the adoption of a system of

economic freedom was driven primarily by his assumption that humans are forever seeking to

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improve their material condition. But this is, at best, a contentious proposition. Historical and

anthropological examples exist of entire cultures that are driven by concerns other than material

gain. And even within capitalist societies one can find people who, despite the materialist

inclinations of such cultures, are indifferent to the pursuit of wealth.

It could be argued, therefore, that the economic growth that is characteristic of capitalist

societies is not so much the result of giving free reign to some presumed natural inclination to

pursue wealth and income, but rather the result of a specific culture (namely a capitalist or

bourgeois culture) that socializes its members to adopt the pursuit of material gain as a symbol of

success and social rep ute. While this undoubtedly plays a role in the long-term economic

expansion characteristic of capitalist societies, there is, as well, another factor, one that is more

immediate and impinging on the economic survival of business, that also accounts for the

system’s growth. This other, more immediate factor involves the nature of capitalist competition.

In a free economic system, the profit that any one capitalist can capture from the sale of

goods is always under the ever-present threat, or actuality, of attack from other capitalists

seeking to sell the same, or similar, goods. The loss of market share, and the corresponding loss

of profit which such an attack represents, induces the capitalist to divert a portion of his or her

profit into the development of new and better goods or more efficient technologies. If the

capitalist fails to invest at the proper rate, or neglects the search for new products, better delivery

systems, or more efficient technologies, the business could die as more aggressive capitalists

invade the market with new goods. Market competition, and the need to keep the business viable,

has the effect of inducing capitalists and managers to invest portions of the firm’s profit in new

capacity and better technology.

The improved capacity and technology made available through this investment process,

enhances the productivity of labor and the nation’s material condition of life. But it depends on

the structure of competition. A system of economic freedom that puts no restraint on the

concentration of economic power in the hands of a small number of capitalists, can lead to a

reduction in economic growth as a result of the declining investment induced by the security

made possible by monopoly power. That is, the achievement of a monopoly position,

unthreatened by the possibility of attack from other capitalists, can lead to a reduction in

investment spending. Thus, productivity enhancing growth requires a specific type of economic

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freedom, one that encourages competitive markets while remaining vigilant of the monopolizing

proclivities of capitalists.

IV. Markets, money, and brokers

In capitalist societies virtually all markets involve the exchange of goods for money. The

value of all goods is expressed in terms of money, and very few markets, clearly none of the

significant ones, involve the direct exchange of one good for another. Before anyone can

purchase a good, they must first obtain money; and money can only be acquired through the

selling of some other good or borrowing it in the financial markets.

The evolution of capitalism is intimately associated with the evolution of money, or more

broadly, finance. Financial markets are the vehicles through which loans are issued and money is

created.2 These markets are quite large and actually consist of a wide variety of sub-markets.

While we need not examine the financial markets at this point, it’s enough to know that it is

through the financial markets that money is made available for the buying and selling of things.

In particular, a significant fraction of the investment spending that takes place in a capitalist

society is financed through the money that can be borrowed or purchased through the financial

markets.

The reproduction of a capitalist economy thus requires not only well functioning labor

and product markets, but also well-functioning financial markets. It can be argued that the

behavior of the labor and product markets is dependent on how well the financial markets are

operating. After all, the amount of financial capital, and thus physical capital, labor power, and

material inputs to be made available for the production of goods is dependent on the terms at

which money can be borrowed on the financial markets.

There is one last institutional feature of markets that should be discussed; this involves

brokerage activity. Very few markets, with the labor market being the major exception, involve

the direct interaction of ultimate buyers with the firms producing the good. The majority of

markets, and virtually all product markets, rely on intermediaries whose sole function is to

facilitate the transfer of goods for money. Retailing is one such example. The goods purchased

through a retail store, like a supermarket, are seldom produced at the store. Instead, they are

offered for sale as a result of the brokerage activity of the store.

2. This is explained in chapter 13.

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The broker's function is to bring together buyers and sellers, to find buyers for suppliers,

and suppliers for buyers. The broker serves as the mechanism through which supply and demand

is adjusted to each other. In the process, brokers capture income by charging a fee for their

service or marking up the price of the goods they trade. Those who engage in this activity do not

always refer to themselves as brokers; they may, instead, carry other names such as retailers,

wholesalers, or dealers. And while this form of market behavior tends to emerge spontaneously,

not all brokerage activity is informal. Some forms of brokerage activity, as in real estate and

finance, are often formalized by requiring licenses, certificates, and/or formal training.

V. The Classical Circular Flow and the Profit Share

In this section we’ll develop a simple model of a capitalist economy that highlights the

relationship between wages and profits on the one hand, and consumption and investment on the

other. To keep things simple, the model ignores the role of government and foreign trade, and

assumes only two classes of people: capitalists and workers. The capitalists own the firms and

hire workers to produce and sell goods with the aid of the machines and materials made available

by the firms. The capitalists then use the revenue generated from that sale to pay for the wages of

the workers, keeping the remainder in the form of gross profits. Of course, for any one firm there

would also be the expenditures incurred for the use of materials and services bought from other

firms. But for the economy as a whole, these expenditures are ultimately reduced to either wages

or profits because the expenditures of any one firm must end up as the income of the workers and

capitalists of other firms.

The workers spend their wages on the purchase of necessities - the commodities needed

to maintain a socially necessary standard of living. If their wages are large enough, they might

also engage in surplus consumption and save a portion of their wages. But, while individual

workers may save, for the class as a whole saving out wages is relatively small and can, for

purposes of theory, be ignored. The reason for this is that workers’ saving is primarily used to

finance their own future consumption; so that, at any moment in time most of the saving being

generated by one group of workers is roughly counterbalanced by the debt financed consumption

(beyond their wages) of another group of workers. Thus, when viewed from the perspective of

the entire economy, it is not unreasonable to claim that the wages of the working class are spent

on the purchase of consumer goods. The only real distinction would involve a determination of

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the proportion of workers’ consumption going to socially necessary consumption and surplus

consumption.

In the meantime, capitalists are also spending their income on the purchase of consumer

goods. A portion of this consumption is socially necessary since capitalists do undertake

productive overhead work. But in addition, capitalists engage in surplus consumption and saving.

However, unlike workers, and because of their relatively high per capita income¸ the saving

undertaken by the capitalist class is used to finance investment spending. That is, capitalists use

their saving out of gross profits to purchase new capital goods that in turn increase the productive

capacity of their firms or develop new firms and industries. This increased productive capacity

made possible by this investment then serves as the basis from which more output and income is

generated in the future.

The capitalist's investment spending consists of two types: first, the depreciation

expenditures associated with the replenishment of the capital goods used up in production, and

second, the purchase of new capital goods, net investment spending, intended to increase the

productive capacity of the firms or to create new firms. The sum of depreciation expenditures

and net investment is gross investment.

It’s important to note that capitalists may or may not spend their profits wisely. It’s

conceivable that they may spend all of their gross profits on consumption, in which case they’ll

be neglecting the productive capacity of their firms, causing the capital of their firms to gradually

deteriorate over time. But, short of war or a prolonged depression, where productive capacity is

reduced as a result of bombardment or neglect due to negative profits, firms are generally trying

to maintain their productive capacity in good running order. For that reason, we’ll be assuming

that capitalists are dutifully setting aside a portion of their gross profits to replenish the capital

structure of their firms, leaving the remainder for consumption and net investment.

The value of the gross product generated by the nation’s firms will be equal to the sum

of the wages of labor and the gross profits of capital. In the meantime, total spending on the

output of the firms will equal the sum of consumption spending on the part of workers plus the

consumption and gross investment spending on the part of capitalists. Since we’re assuming that

workers spend all their wages on purchasing consumer goods, that must mean that whether or not

the firms are able to sell the entirety of the gross product will ultimately depend on the spending

pattern of capitalists. If they spend all of their gross profits on consumption and gross

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investment, then the value of the gross product (aggregate supply) will equal the value of total

spending (aggregate demand) and the firms will have sold all of the gross output generated

during that time period. Since the demand for their output matches their supply, the firms will

continue producing and selling the same volume of output and hiring the same number of

workers.

However, the net investment spending taking place during the current time period will

begin to show up, in the near future, in the form of increased capacity. This in turn will require

the hiring of more workers to make that extra capital productive. Gross product will grow as a

result of the increased productive capacity - the new capital and the laborers needed to work that

capital. The output generated by the new capacity will generate income (wages and profits) that

will, once again, be spent on consuming and investing the extra output. So long as workers keep

spending all their wages on consumer goods and capitalists continue spending their profits on

consumption and investment goods, the system will keep growing over time with aggregate

supply matching up with aggregate demand.

In reality capitalist economies seldom, if ever, grow in such a smooth fashion, with

aggregate supply matching aggregate demand. The usual scenario is for aggregate supply to fall

short of aggregate demand, as during a business expansion; or for aggregate supply to be in

excess of aggregate demand, as during a business contraction. But since our purpose here is to

focus on the broad structural features of capitalism, we’ll assume that aggregate supply is

growing at the same pace as aggregate demand. This makes it easier to understand the forces

responsible for the growth which capitalist economies are known for.

This model can be summarized algebraically. We start by noting that the value of gross

output (gross income) can be represented as

𝑌 = 𝑊 + Π𝑔, (1)

where Y represents gross income, W represents the wages of the employed labor force, and Πg

represents gross profits. The spending on the part of workers and capitalists can be represented as

𝐸 = 𝐶𝑤 + 𝐶𝑘 + 𝐼𝑔, (2)

where E represents total expenditures, Cw represents consumption spending by workers, Ck

represents consumption spending by capitalists, and Ig represents gross investment spending on

the part of capitalists.

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Since we’re assuming that gross income is equal to total expenditures (or stated

differently, aggregate supply is equal to aggregate demand), then it must be that

𝑊 + Π𝑔 = 𝐶𝑤 + 𝐶𝑘 + 𝐼𝑔. (3)

And since workers spend all their wages on consumption (i.e., W = CW), it must be the case that

capitalist profits are equal to the sum of their own consumption and gross investment. That is,

Π𝑔 = 𝐶𝑘 + 𝐼𝑔. (4)

In short, the gross profits of the capitalist class depend on their own expenditures. But, as

we will soon see, it is investment spending that is primarily responsible for the growth in

productive capacity as well as the profits of the capitalist class. This idea might be easier to grasp

by rewriting equation 4 in a way that should seem more familiar. Subtracting Ck from both sides

of that equation provides us with

Π𝑔 − 𝐶𝑘 = 𝐼𝑔, (5)

or

𝑆𝑘 = 𝐼𝑔, (6)

since 𝑆𝑘 = 1 − 𝐶𝑘, or 𝑆𝑘 = (1 − 𝑐𝑘) ∙ Π𝑔, where ck represents the propensity to consume out of

profits, ck = Ck/Π𝑔.

Equation 6 can be restated as

𝑠𝑘 ∙ Π𝑔 = 𝐼𝑔, (7)

where sk represents the propensity to save out of profits (i.e., sk = 1-ck,).

Note that equations 6 and 7 state the well-known macroeconomic proposition that

equilibrium, where aggregate supply equals aggregate demand, requires that saving be equal to

investment.

The act of saving money can take on numerous forms, which will be explored later, but at

this point we can simplify the argument by imagining that saving involves the purchase of

interest earning financial assets, such as bonds. Income that is saved, that is not consumed, is

used to purchase a bond that guarantees a flow of interest income over a span of time. This

contrasts with those who borrow money by issuing new bonds promising to pay interest over

time. Thus, the savers are buying bonds, while the borrowers are selling bonds. We can thus

think of equations 6 and 7 as stating that one group of capitalists is saving money by buying

bonds, while another group of capitalists is borrowing money by selling bonds. The capitalists

who are selling bonds are using the borrowed money to purchase capital goods. The increased

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output made possible by the growth in productive capacity, which was financed by the borrowed

money, generates a greater flow of income from which to pay the interest charges on the

borrowed funds. Thus, if saving equals investment, then the demand for bonds matches the

supply of bonds, the saving by one group of capitalists matches the borrowing by another group

of capitalists, and bond holders (the rentier savers) are receiving a flow of interest income. In the

remainder of this chapter, unless otherwise noted, we’ll be assuming that saving is always

matched by investment, which is another way of saying that the demand for bonds is equal to the

supply of bonds.

Now, if we divide both sides of equation 7 by the propensity to save out of profits, sk, we

end up with

Π𝑔 = ( 1

𝑠𝑘 ) ∙ 𝐼𝑔 , (8)

which states that gross profits, for the capitalist class as a whole, depends on their investment

spending, given their propensity to save. Assuming a stable propensity to save, which in the short

run is generally true, the profits of the capitalist class depend on the amount of investment

spending they undertake. This is the well-known profit equation of Michal Kalecki, who

summarized its meaning by noting that workers spend what they earn, while capitalists earn what

they spend.

It’s important to understand that this proposition applies to the capitalist class as a whole

and not to the individual capitalist. There is never any guarantee that the investment spending of

any one capitalist will eventuate in the hoped-for profits; yet, for the system as a whole this does

occur. The reason for this is that the investment spending that is taking place at any moment in

time is always generating a stream of income flowing to the industries producing the new capital

goods being demanded by the investing capitalists, and the income which the capital goods

industries receive from that investment spending is in turn spent on the purchase of goods

generated from the consumer goods industry, setting into motion a spiral of spending and

production that ultimately exceeds the initial spurt of investment spending.

In macroeconomics this idea is called the multiplier. In equation 8, the multiplier is the

inverse of the propensity to save out of profits, that is 1/sk. So, if the propensity to save out of

profits is 0.5, then the multiplier must be 2 (2 = 1/0.5), and gross profits will always be 2 times

the level of gross investment spending. That is, and given this simple example, if the capitalist

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class is investing $100 then this sets into motion a flow of production and income that eventuates

in profits being $200.

More complicated models that allow for workers saving, do not alter the fundamental

conclusion; namely, that profits depend on the amount of investment spending capitalists

undertake. The major difference is that the value of the multiplier will now differ as a result of

workers’ saving.