Updated: Feb 21, 2020
Laissez faire capitalism increases inequality. Capitalism produces more wealth for a nation than any other economic system people have devised. Like any system, it, too, suffers from the law of unintended consequences. Economists describe one feature of capitalism as “reducing price to marginal cost.” Competition
causes prices to drop as businesses squeeze efficiencies out of their supply chains. By doing so, capitalism allows more people to fill more needs with less wealth than any other economic system.
Competition reduces prices.
Consider two businesses selling cell phones. If Target were selling a cell phone for $250, and Best Buy were selling the same phone for $200, no one would want to buy their phones at Target until Target reduced its price to $200 or below. Target may be buying its phones wholesale for $225. It will tell its wholesaler that it cannot make a profit unless it decreases its price to $210, so it doesn’t want to pay more than, say $200 per phone. Unless that wholesaler can decrease the price it is selling phones, Target will find another wholesaler. The wholesaler will repeat that demand, and it will flow up the supply chain: decrease your price, or I will find someone who can sell me the resource or the part cheaper. Once Target lowers its price close to Best Buy’s price, Best Buy will start demanding more efficiency out of its supply chain. Over time, this process squeezes inefficiencies out of the market.
When businesses compete, they reduce prices to “marginal cost,” which is the cost of one additional unit of output. Reducing price to marginal cost works great for cell phones, cars, copper, eggs, and bananas. Then, people can buy more resources and goods for satisfying their needs. Among the resources necessary for producing those resources and goods, labor often requires seventy percent of the cost of sending those resources and products to market. And the same principles of reducing price to marginal cost apply to labor.
Reducing Wages to Survival Levels
David Ricardo wrote in 1821 that reducing wages to marginal cost results in reducing wages to survival wages. Ricardo explained that if businesses suddenly could produce shoes and clothing at one-quarter of their cost today, the workers producing those shoes could not suddenly afford four times as many shoes and four times as much clothes; instead, competition and supply and demand would reduce workers’ wages by three-quarters of the costs of shoes and clothing. Just as businesses are competing over retail sales, laborers are competing over selling their labor to businesses. When supply exceeds demand, workers will take the best jobs that they can get for the least amount on which they can survive.
And this “survival wages” reflects day-to-day survival wages and not long-term survival wages. When a laborer is looking just to survive, he will take a job that does not pay for retirement far in the future or for health insurance or even for rainy days. So laborers will work for less than long-term survival wages, and companies will not pay long-term survival wages. In other words, laissez faire capitalism reduces the price of labor below survival wages.
As long as businesses pay below even survival wages, laborers’ wages cannot increase. But while supply of laborers often exceeds demand, the supply of capital will never exceed demand. Everyone needs capital to grow their businesses, so they compete by giving capital higher returns. Laissez faire capitalism watches capital expand. Therefore, laissez faire capitalism increases inequality by pushing down on wages and pushing up on capital returns.