Karl Marx was a German philosopher who wants to prove that capitalism didn't work. And he wanted to prove this in a mathematical way. One of his arguments is this. Let's say you have a firm in the market. And that firm has a very profitable product. What that's going to do is other firms are going to notice there's profit in the market.
So they're going to enter the market. As they enter the market, there's going to be more competition. How do you deal with competition? Well, you lower your price. As you lower your price, you become more competitive, but you also cause your own profits default. So this is going to keep continuing more firms are going to keep entering the market and then that's going to cause you to lower your price more and more, and your profit is going to go down and down until they get to zero.
At a certain point. That means that if your profit is zero, then investors no longer have a reason to invest in your company. Because they're not going to get any additional returns, they're going to get a breakeven return. So, if investment has no incentive, they're not going to invest, investment falls, if investment falls, employment falls, and essentially, you've killed your own financial market just by having competition. So that is what Karl Marx's ideas. Now it's we can see there is a flaw with this.
And that flaw is that profits don't actually go to zero. And it turns out, he's missing one important factor. And that factor is technology and innovation. If you have technology and innovation, you can keep increasing profits. So this innovation and technology needs to be supported in the financial system to keep profits high. How do you do that?
Well, it turns out you need to have The development of a legal system that can support innovation and support the financial system. In 1776, Adam Smith came along and he's given credit for essentially inventing economics because he put a lot of different ideas about economics together for the first time. One of his ideas is this. If people are allowed to trade freely, then self interested traders in the market will compete with one another. By competing, they lead markets towards a positive output. As though there were some kind of invisible hand guiding.
You can have an example let's say you have a vendor selling ice cream and another vendor selling ice cream. If you're going to buy from one or the other, they're going to compete on price and they're going to keep lowering their price just to stay competitive. So you're going to get a product for the best price just by being in a market with competition. Now, this idea of Adam Smith was accepted for a little while. Yeah, okay, there's an invisible hand guiding prices and making products better in the market. But there was a few examples where they seem to be exceptions.
JOHN Nash came around with his ideas on Game Theory and started to point out some of the flaws in this. For example, in the Middle Ages, you had the tragedy of the commons, where publicly owned lands would always be over grazed by farmers compared to private land. reasons because a farmer would know that if I don't let my cattle graze on this public land, another firm is going to grace so I may as well do it. So that land always got overgrazed. There was a bunch of other examples that john Nash came about with as well. But the most important takeaway is this, we need to have something to deal with the case where people acting in their own self interest causes a negative repercussion in the market.
So this comes down to innovation. Now, if you want to have innovation and technology in the market, you need to have some kind of legal system to protect this. But there's a fine line. If too weak, then you've discouraged innovation, because there isn't enough incentive to do research and development. But if it's too strong, then companies may not innovate anymore, and products may remain expensive, too long. Let's give an example here.
Let's say you invent a pharmaceutical drug. And this drug is really good, but it's really hard to get it to market. You find it really difficult to get it onto the shelves and stores and it's going to take a long time to do that. But you've already patented this product, but you aren't able to get it to market in time that the patent expires. So what happens now? Well, a large pharmaceutical drug company will be looking to the patents patent picking.
And they will now come across your patent and see all the instructions of how to make this drug. So they'll be able to take it to market, and they'll get all the profit from it, even though you invented it, but you weren't able to profit off in time. Now, there are some solutions to this, for example, venture capitalists can come along and help remove the problems that real estate companies might have needing cash. And this is where you see Silicon Valley and route 128 in the Research Triangle, which is just a bunch of tech universities in that area. And one of the questions that were asked for a while is why is areas like Silicon Valley successful? Is it just socializing of bright people in that area?
That doesn't seem to be a good enough explanation. Why is it not helping elsewhere? Well, there's a few things well, there's easily transferable job skills. People are experts in that area. There's a dense concentration of research universities in that area. But that wasn't enough to stop some countries from trying, for example, Canada to try to incentivize venture capital funds, they said, we're gonna have lots of money for entrepreneurs, we're just gonna give them money.
Now there was an issue, a lot more projects got money. But a lot more of these projects failed. And venture capitalists didn't trust the projects that got funded. Now. The reason is because it was hard to distinguish good innovations from bad ones. Whereas in Silicon Valley, only good projects got funded.
But in Canada, bad projects got funded, as well. So it was hard to know where you should stick your money. And if you were an entrepreneur and you had in product that was really good. Were you better off investing in Canada, where you would get easy money or going to Silicon Valley where money was maybe chainable? And maybe not? Well, you If you went to Silicon Valley, they likely had experts who understood your idea and will give you even more venture capital money than if you went to Canada and took the easy money.
So, these are one of the reasons why Silicon Valley was able to stay as the lead for such a long time. economist and Kluger also points out, that if the net present value of bribing a politician is higher than the net present value of competing and innovating and coming up with new technology, then the firm will probably bribe the politician rather than compete if they can succeed in bribing politicians, and probably means there's a weak rule of law. And that's why in rich countries, you might have a lot of technology and innovation, because that's a lot more profitable than bribing politicians. Whereas in some third world countries, it's a lot more profitable to describe the politician rather than to try to come up with some kind of tech knology so we can see that having legal regulation is important in a financial market. But there's a fine line because if you have too much regulation, then you might have a big corporation that will survive forever and prevent entrepreneurs from getting past legal hurdles and regulations.
So the role that government plays in the financial system is extremely important. And that's what we'll get into more in the next section.