The Essential Role of Private Enterprise in a Modern Economy

A Worker Cooperative in New York City

Geoffrey M. Hodgson

‘The question we ask today is not whether our government is too big or too small, but whether it works … Nor is the question before us whether the market is a force for good or ill. Its power to generate wealth and expand freedom is unmatched.’

Barack Obama, 2009.

Politicians engage in slogans and sound-bites, but sometimes they reveal their true aims.

The Labour Party is now immersed in a battle for its leadership, and possibly for its survival as a viable political party. Jeremy Corbyn, overwhelmingly elected as leader in 2015 by about sixty per cent of the party membership, has lost the confidence of about eighty per cent of the party’s MPs.

Owen Smith

Owen Smith, Corbyn’s challenger for the Labour leadership, once worked for the private, research-based, pharmaceutical company Pfizer. In response, Corbyn and his allies have been quick to condemn Smith’s association with private enterprise.

Corbyn has always been a supporter of the original version of Labour’s Clause Four, with its aim of ‘common ownership of the means of production, distribution and exchange’. But since he became Labour Leader, he has kept this long-term aim mostly under wraps, highlighting his opposition to austerity economics instead.

However, on 21 July 2016, we had a brief peep under the tarpaulin, showing us Corbyn’s real aims.

Corbyn’s opposition to privately-funded pharmaceutical research

At his campaign launch on that day, in response to a question about Smith, Corbyn declared that ‘medical research shouldn’t be farmed out to big pharmaceutical companies like Pfizer and others but should be funded through the Medical Research Council as a way of developing those drugs’.¹

The Association of the British Pharmaceutical Industry (ABPI) – the trade association for over 120 UK companies producing prescription medicines – quickly responded with a statement questioning Corbyn’s judgement in this area.

The ABPI pointed out that the pharmaceutical industry invests more than £88bn a year into research and development for new medicines and vaccines to help fight disease. In the UK this equates to £4.1bn per year of investment in R&D, with the Medical Research Council contributing £770m and research charities £1.3bn.

The pharmaceutical industry is global, and it is difficult to see how the taxpayer-funded UK Medical Research Council could take over the roles of the large private players in this sphere, unless this research was dramatically diminished. As the ABPI pointed out, research in this area has to be a collaboration between industry researchers, academics and clinicians, involving both public and private institutions.

Many successes in the development of drug treatments – including for breast cancer and HIV – have involved collaborations between research-oriented universities, risk-taking companies, concerned charities, government agencies, and so on. Typically these collaborations involve complex synergies and are international in scope.

Corbyn’s proposal that modern levels of pharmaceutical research should be publicly rather than privately funded – within one country – is feasible in neither budgetary nor practical terms.²

But further, in his zeal for the public takeover of research and development, Corbyn has failed to learn one of the crucial economic lessons of the twentieth century, concerning the limitations of largely publicly-owned R&D and need more broadly for a healthy, innovative, private sector.

This lesson is sketched out later below.  It concerns the vital role of different forms of private enterprise – from corporations to worker cooperatives, which all have legal autonomy and they sell their products on a market. But first we emphasise that the essential role of the state and the public sector.

The state and the public sector are vital

We should also understand the vital role of the public sector in modern capitalist economists, including in the sphere of research. Numerous authors, including Richard Nelson, Ha-Joon Chang, Erik Reinert, Mariana Mazzucato and myself, have argued that – for several reasons – the state plays an essential, supportive role within modern capitalism.

In practical terms, evidence shows that the most successful economies are those that involve a collaboration of public and private institutions, including for research, development and innovation.

For example, the modern patent system is backed up by legal and state powers that protect innovations from plagiarism and provide incentives for private research and creativity. It is an example of the way in which the state can maintain institutions that encourage private research.

There are areas where private enterprise works best, and there are areas where the public sector can be usefully involved. Determining these best areas in each case, is a practical question, involving detailed, complex, ongoing, empirical examination and experimentation.

Instead, Corbyn resorts to ideology, with this prescription: public ownership works best, and even when in doubt, nationalize. This is the mirror image of free-market ideologists, who stipulate: markets work best, and even when in doubt, privatize.

A simplistic ideological debate between private and public ownership dominated the twentieth century. The ‘common ownership’ version of Labour’s Clause Four, which lasted from 1918 to 1995, expressed one side in the debate. Margaret Thatcher and Ronald Reagan, among many others, took the other side.

A key lesson of the twentieth century is that the dichotomy between public and private provision is misleading. The key question is how they can be usefully combined. Within any useful combination, both private and public enterprise have a crucial role to play. This essay explains why a private sector is vital.

My recent book entitled Conceptualizing Capitalism explains why the role of the state is also crucial, even to sustain the institutions that make private enterprise work. But here I concentrate on the case for private enterprise.

The failure of centrally-planned innovation

Any vision of a large-scale planned economy involves assembling information in local or national agencies, and then making decisions based on this information. Proposed innovations and other changes must be appraised, and decisions on their viability must be made.

In their schemes to bring all knowledge together into the hands of planners, advocates of comprehensive planning overlook the time and other difficulties involved in gathering and dealing with available information. Also they give inadequate consideration to how innovations are to be incentivized, tested and promoted.

Innovation depends on hunches about the future. Successful innovation takes into account local, tacit and other knowledge concerning circumstances and possibilities. Much of this knowledge involves complex details and contexts, and cannot all be brought together and utilized by a central committee or planning authority.

Because of diminished competitive pressures, nationalized industries in centrally planned economies, such as the Soviet Union and Mao’s China, have been unimpressive in terms of innovation and flexibility. Why should a committee back innovation or change, especially when it carries risks of failure? Why should they risk their jobs when they have no secure right of additional reward in the case of success?

The economist Peter Murrell showed empirically that the former Communist countries were apparently no less efficient in allocating resources than capitalist economies. Where they lagged was in terms of dynamic efficiency: the ability to innovate. This shortfall is endemic to any system that works on the basis of hierarchical planning, rather than independent enterprise with legal rights to reap and retain rewards.

Whatever the limitations of a market system, it has the advantage that it does not require majority agreement before a decision can be made to produce or distribute a good or service. Private property and contracts permit zones of autonomy within an interrelated system; agents may reach decisions through negotiated contracts with others. The costs and benefits are devolved to individuals or firms.

Through private enterprise it is possible for many technological or institutional innovations to be pioneered without the prior agreement of (democratic) committees or (undemocratic) bureaucrats. This analysis is borne out by experience. The former Soviet-type economies in Russia and China lacked devolved autonomy, secured by private ownership.

Eventually they learned that lesson. The change in China was most dramatic. After the Communist Revolution of 1949, agriculture in China was organized into large collective farms. Other than by threats and bureaucratic bullying, farmers had little incentive to improve productivity. Risky innovation was unwise. Productivity remained low and often there were shortages of food. But Mao Zedong died in 1976, opening up the possibility of reform.

In 1978 some Chinese peasant farmers decided to withdraw from collective farms and take responsibility for production at the household level, where the household (instead of the collective) received the revenue from its sold output. Individual households had much greater incentives to work harder and to innovate. After decades of slow growth under Mao, China’s explosive economic growth began with those changes in rural areas. As a result, unprecedented millions were lifted out of poverty.

China’s spectacular economic growth began when agriculture began to pass into the private control of the peasants after 1978. The Chinese Communist Party endorsed these changes in the rights to use and manage land (while keeping legal title to the land in the hands of the collectives), and also promoted private businesses in rural areas.

China also retained many state-owned enterprises. The state continued to play a major strategic role in economic development. China has demonstrated how viable public and private sectors are essential for growth and innovation in a modern large-scale economy.

The failure of classic socialism

Some version of socialism might work on a small scale. Cooperation can work in this context, based on close, inter-personal interactions. Humans have co-operated in this way, in families and tribal groups, for many thousands of years.

Elinor Ostrom

Nobel Laureate Elinor Ostrom studied the management of common-pool resources – such as medieval common land, fisheries or agricultural irrigation schemes – and showed how they can be effectively managed by relatively small local communities.

Their small size allows participants to monitor each other, to ensure that necessary tasks are carried out and that the interests of the community are served.

Enforcement mechanisms range from praise to punishment. Within these relatively small and cohesive groups, trust and targeted sanctions are mechanisms for encouraging cooperation, reciprocity and compliance with customary rules.

But socialism on a small scale would lack the economies of large-scale production and the technological dynamism of today’s competitive capitalism. Modern medicines and technologically-advanced treatments, requiring extensive funding, risk-taking and research collaboration, could not be developed. With inferior drugs and healthcare, human longevity would be lower than it is today.

In larger socialist societies, individual incentives for effort and innovation are diminished, and compensatory, face-to-face, trust-based mechanisms to sustain cooperation are relatively less effective. When we move from communities of a hundred or so, where it is possible for everyone to know everyone else, to communities of thousands or more, then interpersonal trust and reputation are much less effective at the overall level, and they have to be supplement both other incentives and constraints.

When thousands of people are brought together, and rewards are shared, then there is less incentive to make the extra effort, because the rewards from that additional work would be hugely diluted.

Large private corporations face this problem too. But competitive pressure on the private corporation obliges it to incentivise its workforce in some way, so that most employees pull their weight.

Market competition is absent or much diminished in a centrally planned economy. Instead, the pressure to perform comes from the state. Consequently, strong discipline is necessary to sustain production, and larger-scale socialism engenders authoritarianism and bureaucracy. Twentieth-century evidence strongly supports this analysis.

Those that propose ‘democratic socialism’ in large-scale societies fail to address some key practical questions. How is all the important information to be gathered and transmitted? How are resources to be produced and distributed? How is everyone to be incentivized to work well and to innovate? And if the system is to be ‘democratic’, how would it be possible for everyone involved to vote on every important decision?

Robert Owen

Such practical considerations show that democratic socialism (at least in the classic sense of Robert Owen and Karl Marx, who proposed common ownership and the abolition of private enterprise) is unfeasible in any large-scale complex economy.

While interpersonal interactions can engender cooperation on a small scale, in large-scale societies other mechanisms and incentives are necessary. For dynamism and efficiency, there have to be competition, markets and a large private sector, as well as a state.

Private ownership is also important for political reasons, to create zones of politico-economic power that can countervail state autocracy.

Contrary to the twin, all-or-nothing, ideologies of classical socialism and free-market purism, this leaves open a huge area for economic reform and development. A private sector can be made up of many different kinds of enterprise, including worker cooperatives and social enterprises, as well as more conventional corporations. The state can intervene in a myriad of ways, including the adoption of redistributive taxation and the development of a strong welfare state.

Once all this is understood, then the game changes – irrevocably. Once it is realized that classical socialism cannot work (at least in a humane way) then you have to look for alternatives. Once it is acknowledged that private property and markets are indispensable in large-scale modern economies, then you have to accept them, warts and all. The best that can be done is to minimize their deleterious effects, and to explore viable avenues of institutional reform.

Much of the Labour Party learned this lesson in the era from 1945 to 2015. It adjusted to the mixed economy and began to understand the virtues and indispensability of private enterprise. That lesson seems to be forgotten by a large number of Labour Party members, who continue to support Corbyn and his naïve, outdated ideology. Unless that lesson is learned again, and quickly, then Labour has no future as an electable political party.

23 July 2016

Edited 24 July 2016

1. Corbyn added that he was in favour of a National Health Service that is ‘totally public’ with ‘publicly employed people running it’. Is he aware that GPs are not NHS employees but self-employed contractors? If so, is it his intention to make all GPs employees?

2. In an interview on 24 July 2016, Corbyn’s ally John McDonnell backtracked on his leader’s statement, re-admitting a role for private sector pharmaceutical research under some vague notion of ‘democratic control’. He said that Corbyn’s statement had been ‘misinterpreted’. But this dishonest manoeuvring under pressure fails to mask their true aims.

Bibliography

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