T. Sowell, Why capitalist economies produce at the lowest possible cost

The hope for profits and the threat of losses is what forces a business owner in a capitalist economy to produce at the lowest cost and sell what the customers are most willing to pay for. In the absence of these pressures, those who manage enterprises under socialism have far less incentive to be as efficient as possible under given conditions, much less to keep up with changing conditions and respond to them quickly, as capitalist enterprises must do if they expect to survive.

It was a Soviet premier, Leonid Brezhnev, who said that his country’s enterprise managers shied away from innovation “as the devil shies away from incense.” But, given the incentives of government-owned and governmentcontrolled enterprises, why should those managers have stuck their necks out by trying new methods or new products, when they stood to gain little or nothing if it succeeded and might have lost their jobs (or worse) if it failed? Under Stalin, failure was often equated with sabotage, and was punished accordingly. Even under the milder conditions of democratic socialism, as in India for decades after its independence, innovation was by no means necessary for protected enterprises, such as automobile manufacturing.

Until the freeing up of markets that began in India in 1991, the country’s most popular car was the Hindustan Ambassador— an unabashed copy of the British Morris Oxford. Moreover, even in the 1990s, The Economist referred to the Ambassador as “a barely upgraded version of a 1950s Morris Oxford.” A London newspaper, The Independent, reported: “Ambassadors have for years been notorious in India for their poor finish, heavy handling and proneness to alarming accidents.” Nevertheless, there was a waiting list for the Ambassador— with waits lasting for months and sometimes years — since foreign cars were not allowed to be imported to compete with it.

Under free market capitalism, the incentives work in the opposite direction. Even the most profitable business can lose its market if it doesn’t keep innovating, in order to avoid being overtaken by its competitors. For example, IBM pioneered in creating computers, one 1944 model occupying 3,000 cubic feet. But, in the 1970s, Intel created a computer chip smaller than a fingernail that could do the same things as that computer. Yet Intel itself was then constantly forced to improve that chip at an exponential rate, as rivals like Advanced Micro Devices (AMD), Cyrix, and others began catching up with them technologically. More than once, Intel poured such huge sums of money into the development of improved chips as to risk the financial survival of the company itself. But the alternative was to allow itself to be overtaken by rivals, which would have been an even bigger risk to Intel’s survival…

While capitalism has a visible cost— profit— that does not exist under socialism, socialism has an invisible cost— inefficiency— that gets weeded out by losses and bankruptcy under capitalism. The fact that most goods are more widely affordable in a capitalist economy implies that profit is less costly than inefficiency. Put differently, profit is a price paid for efficiency.

Clearly the greater efficiency must outweigh the profit or else socialism would in fact have had the more affordable prices and greater prosperity that its theorists expected, but which failed to materialize in the real world. Moreover, if in fact the cost of profits exceeded the value of the efficiency they promote, then non-profit organizations or government agencies could get the same work done cheaper or better than profit-making enterprises and could therefore displace them in the competition of the marketplace.

Yet that seldom, if ever, happens, while the opposite happens increasingly— that is, private profit-making companies taking over various functions formerly performed by government agencies or by non-profit organizations like colleges and universities. While capitalists have been conceived of as people who make profits, what a business owner really gets is legal ownership of whatever residual is left over after the costs have been paid out of the money received from customers. That residual can turn out to be positive, negative, or zero. Workers must be paid and creditors must be paid— or else they can take legal action to seize the company’s assets. Even before that happens, they can simply stop supplying their inputs when the company stops paying them. The only person whose payment is contingent on how well the business is doing is the owner of that business. This is what puts unrelenting pressure on the owner to monitor everything that is happening in the business and everything that is happening in the market for the business’ products…

To many people, even today, high profits are often attributed to high prices charged by those motivated by “greed.” In reality, most of the great fortunes in American history have resulted from someone’s figuring out how to reduce costs, so as to be able to charge lower prices and therefore gain a mass market for the product. Henry Ford did this with automobiles, Rockefeller with oil, Carnegie with steel, and Sears, Penney, Walton and other department store chain founders with a variety of products…

There is a reason why various traditional government functions, such as collecting garbage or running prisons, have increasingly been contracted out to private, profit-seeking companies. Such companies often get the job done more cheaply or better, or both. For the same reason, profit-seeking companies have increasingly taken over such functions as running college bookstores and dining halls.