Captialism Mechanics

July 23, 2021

Let's review several necessary ingredients in a capitalist system.

1. Scarcity of capital. Capitalism doesn't function optimally with too much capital. There has to be competition for capital resources to flush out bad ideas and eliminate mediocre performers. With too much capital there is no competitive pressure improving the system.

2. Choices. The best decisions get made by those closest to the problem. This is why a parent can choose the best school for their child but a state agency cannot, or why you can design and structure your own life optimally. Freedom of choice matters.

3. Low barriers to entry. The lower the barriers to entry, the more democratic the system. An industry that allows market participants easy entry tends to attract bright, hard-working entrepreneurs. The more rules and regulations, or the higher the capital requirements of entry, the less efficient an industry becomes as there is no way to disrupt the established players.

4. Externality Pricing. If you don't price externalities into a market system, you are going to end up looking like the bottom of the Hudson River - it's cheap to pollute when there is no cost. While some externalities are worth accepting, others are not.

When you combine the forces above, among others, you create a wildly dynamic system that moves society forward through all kinds of innovative ideas, products, and services. What you do *not* necessarily do is make the capitalist wealthy, particularly in the case of the innovators who do not survive long-term. Partly due to competition, much of the value gets passed from the business to the customer, creating a better society but not a particularly good investment.

What is a hard-driving capitalist to do if society keeps ending up with the benefit and she has a shareholders meeting to run next Tuesday and needs to show profits? A modern (well, maybe not so modern) trend is to try to interfere with the principles above. If you can create barriers either through the market or through government, you protect your castle with a bigger moat. Let's look at some examples.

Wal-Mart
Retail is not a particularly profitable business on a percentage margin basis, but if you build it to enough scale, you can establish a barrier that competitors cannot overcome, driving other choices away. The buying volume becomes the protective moat. Wal-Mart became a no-commitment buying agent for rural Americans, and passed almost all of the benefit to the customer. It was all working well until this laugh-y guy named Bezos showed up.

Costco
Determined to undermine Walmart in price, Costco restructured the retail model to focus on few items, forklifts moving products, and critically, quietly assigning the last, most expensive leg of the transportation chain to the customer. This is why people from central Vermont drive halfway across the state to shop at our one statewide Costco location. This is a form of time externality transferred to the customer. In fairness to Costco, it is the customer's choice.

Microsoft
Software has low barriers to entry, making it a prime target for hard-working immigrants and ambitious smart people. Existing ambitious smart software people like Bill Gates knew this, so the competitive moat was built by using the network effects of operating systems. This is the same principle that keeps Facebook in power. The competitive advantage is the fact that there is little choice - you have to join the platform everyone else is on.

Pretty Much Any Large Financial Firm
The regulatory and compliance structures established by Dodd-Frank are difficult for a small but rising firm, as the costs are high, and large firms can spread the overhead over a larger client base. Many lawmakers have little understanding of the operational differences between small and large firms, so this is easy for a lobbyist to exploit. The disruptive up-and-comers are eliminated.

The list above is by no means exhaustive. The important point: in a fair capitalist system you create value by giving customers better choices. Capital flows freely to support those innovators. But that is not always the reality of today's landscape.

Dan Cunningham