What Is Capitalism?

Capitalism Explained

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Capitalism is an economic system where private entities own the factors of production. The four factors are entrepreneurship, capital goods, natural resources, and labor. The owners of capital goods, natural resources, and entrepreneurship exercise control through companies. Individuals own their labor.  

In theory, the system may sound simple. But in practice, it’s much more complicated—and can have both positive and negative effects. Here’s how capitalism works and the advantages and disadvantages of this economic system.

What Is Capitalism?  

Capitalistic ownership means owners control the factors of production and derive their income from their ownership. That gives them the ability to operate their companies efficiently. It also provides them with the incentive to maximize profit.

In corporations, the shareholders are the owners. Their level of control depends on how many shares they own. The shareholders elect a board of directors and hire chief executives to manage the company.

Capitalism requires a free market economy to succeed. It distributes goods and services according to the laws of supply and demand. The law of demand says that when demand increases for a particular product, its price rises. When competitors realize they can make a higher profit, they increase production. The greater supply reduces prices to a level where only the best competitors remain.

Capitalism’s priorities of growth, profits, and the discovery of new markets often come at the expense of other factors, such as equity, worker quality of life, and the environment. 

Capitalism emerged during the 16th century and accelerated during the Industrial Revolution, propelled by colonialism, the nascent factory system, and the Atlantic Slave Trade. While the system generated wealth and prestige for owners, it often did so by exploiting those with little to no power, such as factory workers and people indigenous to Africa and the Americas. Capitalism’s expansion in 19th-century America relied on economic growth generated through the labor of enslaved people on land forcefully taken from Native Americans.

How Capitalism Works

The owners of supply compete against each other to earn the highest profit. They sell their goods at the highest possible price while keeping their costs as low as possible. Competition keeps prices moderate and production efficient, although it can also lead to worker exploitation and poor labor conditions, especially in countries without strict labor laws.

Another component of capitalism is the free operation of the capital markets. The laws of supply and demand set fair prices for stocks, bonds, derivatives, currency, and commodities. Capital markets allow companies to raise funds to expand.

Laissez-faire economic theory argues that government should take a hands-off approach to capitalism and should intervene only to maintain a level playing field. The government's role is to protect the free market. It should prevent the unfair advantages obtained by monopolies or oligarchies. It ought to prevent the manipulation of information, making sure it is distributed equitably.

Part of protecting the market is keeping order with national defense. The government should also maintain infrastructure, and it taxes capital gains and income to pay for these goals. Global governmental bodies adjudicate international trade.

Text reads: "The pros and cons of capitalism: the best products for the best price, innovation is often rewarded; lacks equality of opportunity, external costs are ignored"
Evan Polenghi © The Balance 2019

Advantages of Capitalism

Capitalism results in the best products for the best prices because consumers will pay more for what they want the most. Businesses provide what customers want at the highest prices they’ll pay, but prices are limited by competition among businesses, which make their products as efficiently as possible to maximize profit.

Most important for economic growth is capitalism's intrinsic reward for innovation, including new products and more efficient production methods. Steve Jobs, a co-founder of Apple Computer Inc., tried to stay ahead of consumer demands, once stating, "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."

The people who benefit most from capitalism tend to be those who already hold wealth and economic power.

Disadvantages of Capitalism

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

Despite the idea of a level playing field, capitalism does not promote equality of opportunity. Those without good nutrition, support, and education may never even make it to the playing field, and society will never benefit from their valuable skills.People who are able to find work may face low wages, limited possibilities for advancement, and potentially unsafe working conditions.

In the short term, this inequality may seem to be in the best interest of capitalism's winners. They have fewer competitive threats and may use their power to rig the system by creating barriers to entry. For example, they may donate to elected officials who support laws that benefit their industries. They could send their children to private schools while supporting lower taxes and less funding for public schools.

Inequality limits diversity and the innovation it creates. For example, a diverse business team is more able to identify market niches, understand the various needs of a diverse population, and target products to meet those needs.

Capitalism also ignores external costs, such as pollution and climate change, in its pursuit of increasing levels of consumption and growth. The system makes goods cheaper and more accessible in the short run, but over time, it depletes natural resources, lowers the quality of life in the affected areas, and increases costs for everyone.

Capitalism and Democracy

Monetarist economist Milton Friedman suggested that democracy can exist only in a capitalistic society. However, many countries have socialist economic components and democratically elected governments. Other countries, such as China and Vietnam, are communist but have thriving economies thanks to capitalistic elements. Still others are capitalist and governed by monarchs, oligarchs, or despots.

The Preamble of the Constitution sets forth a goal to "promote the general welfare." It requires the government to take a more significant role than that prescribed by a pure market economy. That's why the U.S. has many social safety programs, such as Social Security, food stamps, and Medicare.

However, capitalism may also compromise democracy. For example, the Supreme Court case Citizens United v. FEC (2010) gave corporations the same rights as people in terms of their ability to contribute unlimited funds to election campaigns. The controversial decision has increased the influence that wealthy people and companies are able to have on the outcomes of federal, state, and local elections, reinforcing the effects of structural inequality such as the racial wealth gap.

Examples of Capitalism

The United States is one example of capitalism, but it doesn't rank among the 10 countries with the freest markets, according to the Index of Economic Freedom for 2021. It bases its ranking on nine variables, including​ a lack of corruption, low debt levels, and protection of property rights. 

The top 10 most capitalistic countries are:

  1. Singapore
  2. New Zealand
  3. Australia
  4. Switzerland
  5. Ireland
  6. Taiwan
  7. United Kingdom
  8. Estonia
  9. Canada
  10. Denmark

The United States has hit its lowest global rating with a rank of 20th. Its weakest points are its massive government spending and poor fiscal health. It's also weak in its tax burden that restricts taxpayer freedom. Its strongest points are labor freedom, business freedom, and trade freedom.

The phrase “late stage capitalism” has grown in popularity, used both sincerely and tongue in cheek, as a way to describe various capitalist economies.

Differences: Capitalism, Socialism, Communism, and Fascism
Attribute Capitalism Socialism Communism Fascism
Factors of production are owned by: Individuals Everyone Everyone Everyone
Factors of production provide: Profit Usefulness to people Usefulness to people Nation-building
Allocation decided by: Supply and demand Central plan Central plan Central plan
Each gives according to: Market Ability Ability Value to the nation
Each receives according to: Wealth Contribution Need Value to the nation

Capitalism vs. Socialism

Proponents of socialism say their system evolves from capitalism. It improves upon it by providing a direct route between citizens and the goods and services they want. The people as a whole own the factors of production instead of individual business owners.

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

Capitalism vs. Communism

Communism evolves beyond both socialism and capitalism, according to theorists. The government provides everyone with a minimum standard of living., which is 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 also occur in some traditional and command economies. 

Capitalism vs. Fascism

Capitalism and fascism both allow private ownership of businesses. Capitalism gives those owners free rein to produce goods and services demanded by consumers. Fascism follows nationalism, requiring business owners to put national interests first. Companies must follow the orders of the central planners.

Key Takeaways

  • In capitalism, owners control the factors of production and derive their income from it.
  • Capitalism incentivizes people and businesses to maximize the amount of money they earn through competition. 
  • Competition drives innovation as individuals create ways to accomplish tasks more efficiently.
  • Capitalism can reinforce and increase systemic inequality, incentivize worker exploitation, and contribute to pollution and climate change.