Capitalism: Characteristics, Examples, Pros, Cons

What It Is, How It Works, and Comparisons to Socialism and Communism

capitalist
Tony Stark, as portrayed by Robert Downey Jr., is an example of an innovative capitalist. Photo: Kevin Winter/Getty Images

Definition: Capitalism is an economic system where private entities own the factors of production. The four factors are entrepreneurship, capital goodsnatural resources, and labor. The owners of capital goods, natural resources, and entrepreneurship exercise control through companies. The individual owns his or her labor. The only exception is slavery. But slavery is illegal throughout the entire world.

(Source: Bruce Scott, "The Political Economy of Capitalism," Harvard Business Review," 2006.)

Characteristics of Capitalism

In theory, ownership means two things to the private entities. First, they control the factors of production. Second, they derive their income from their ownership. That gives them the ability to operate their companies effectively. It also gives them the incentive to maximize profit.

In corporations, the shareholders are the owners. Since there so many, each one has little control. They elect a board of directors that manages the company through chief executives. (Source: "Theory of Capitalism," The Center on Capitalism and Society, Columbia University.)

Capitalism requires a free market economy to succeed. The market sets the prices of the components of supply. It also distributes them according to the laws of supply and demand. The owners of supply compete against each other for the highest profit.

They sell their goods at the highest possible price while keeping their costs as low as possible.  

Here's how the forces of competitive pressure work to keep prices moderate and production efficient. When demand increases for a particular good, prices rise thanks to the law of demand. When competitors realize they can make a higher profit, they increase production.

This adds to supply, which lowers prices back down to a level where only the best competitors remain. 

Another component of capitalism is the free operation of the capital markets. This sets the fair prices for stocks, bonds, derivatives, currency and commodities through the laws of supply and demand. Capital markets allow companies to raise funds to expand. Companies distribute profits among the owners. They include investors, stockholders and private owners.

The government's role in capitalism is to maintain a level playing field. It prevents the unfair advantages obtained by monopolies or oligarchies. It keeps order with national defense. It adjudicates international law. It also maintains infrastructure. It taxes capital gains and income to accomplish these goals. The government also creates legislation to protect the free market. They ensure that no one manipulates the free market or prevents all information from being distributed equitably. (Source: "The Role of Self-Interest and Competition in a Market Economy," The Federal Reserve Bank of St. Louis.)

Capitalism Advantages

Capitalism ensures that an economy will produce the most desired products at an acceptable price. That's because consumers will pay more for what they want the most.

Businesses then provide what customers want to obtain the most profit. At the same time, they make their production as efficient as possible. This is because the companies that keep their costs low will receive more profit.  

Most important for economic growth is capitalism's intrinsic reward for innovation. This includes innovation in more efficient production methods. It also means innovation of new products. As Steve Jobs said, "You can't just ask customers what they want and then try to give that to them. By the time you get it built, they'll want something new."  (Source: " Pure Capitalism, and the Market System," Harper College.)

Capitalism Disadvantages

Capitalism doesn't provide for those who lack competitive skills. This includes the elderly, children, the developmentally challenged and their caretakers. To keep society functioning, capitalism requires government policies that value the family unit.

Capitalism does not promote equality of opportunity. Those without the proper nutrition, support and education may never make it to the playing field. Society will never benefit from their valuable skills. (Source: "Markets Versus Controls," Brown University.)

In the short term, this is in the best interest of those who succeed in capitalism. They have fewer competitive threats. They may also start to use their power to "rig the system" by creating more barriers to entry. This includes laws, educational attainment, and even money itself. In the long term, this can limit diversity and the innovation it creates

Capitalism ignores external costs, such as pollution. This makes goods cheaper and more accessible. But over time, it depletes natural resources and lowers the quality of life in the affected areas. (Source: "Pros and Cons of Capitalism," EconomicsHelp.)

Difference Between Capitalism, Socialism and Communism

AttributeCommunismSocialismCapitalism
Factors of production are owned byEveryoneEveryoneIndividuals
Factors of production are valued forUsefulness to peopleUsefulness to peopleProfit
Allocation decided byCentral planCentral planLaw of supply and demand 
From each according to hisAbilityAbilityMarket decides
To each according to hisNeedContributionIncome, wealth and borrowing ability

Capitalism versus Socialism

Economic theorists say that socialism evolves from capitalism. It improves upon it by providing a direct route between citizens and goods and services. The people own the factors of production instead of the capitalist.

Many socialistic countries own the companies in oil, gas and other energy-related resources. It’s strategic for the government to control these profitable industries. The government collects the profit instead of corporate taxes. It also distributes these profits in government spending programs. These state-owned companies still compete with private ones in the global economy. 

Capitalism Versus Communism

Communism evolves beyond both socialism and capitalism, according to theorists. The government provides everyone a minimum standard of living. That's guaranteed, regardless of their economic contribution. 

Most societies in the modern world have elements of all three systems. This blend of systems is called a mixed economy. Elements of capitalism are also in some traditional and command economies. 

Capitalism and Democracy

Economist Milton Friedman suggested that democracy can only exist in a capitalistic society. But many countries have socialist economic components and a democratically-elected government. Others are communist, but have thriving economies thanks to capitalistic components. Examples include China and Vietnam. Still others are capitalist and governed by monarchs, oligarchs or despots.

The United States is mostly capitalistic. The federal government does not own very many corporations. One important reason is that the U.S. Constitution protects the free market. For example:

  • Article I, Section 8 establishes the protection of innovation through copyright.
  • Article I, Sections 9 and 10 protects free enterprise and freedom of choice. It prohibits states from taxing each others' production.
  • Amendment IV prohibits unreasonable government searches and seizures, thereby protecting private property.
  • Amendment V protects the ownership of private property.
  • Amendment XIV prohibits the government from taking property without due process of law.
  • Amendments IX and X limits the government's power to those specifically outlined in Constitution. All other powers not mentioned are conferred to the people.

The Preamble of the Constitution sets forth a goal to "promote the general welfare." It requires the government to take a larger role than that prescribed by a pure market economy. This led to many social safety programs, such as Social Security, food stamps and Medicare. (Source: James Dick, Jeffrey Blais, Peter Moore, "Chapter 1, How Has the Constitution Shaped the Economic System in the United States?" Civics and Government.)