Capitalism is an economic model that calls for individual households and privately owned businesses to control the economy. It is one of two main economic models. The other is central planning, which calls for government control of the economy.
No purely capitalist or completely centrally planned economy has ever existed. The economic systems of all nations use some government control and some private choice. But economies that rely mostly on private decisions are usually described as capitalist. Such economies include those of the United States and Canada. The former Soviet Union and many nations of Eastern Europe once relied heavily on central planning. Such economies are sometimes called socialist or Communist. Many other nations rely less on capitalism than the United States does but more than the Soviet Union did.
How capitalism differs from central planning
In basically capitalist systems, private decision-makers determine how resources will be used. They decide what mix of goods and services will be produced. They also choose how goods and services will be distributed among the members of society. Capitalism is frequently known as free enterprise or modified free enterprise because it permits people to engage in economic activities largely free from government control. Other names sometimes applied to basically capitalist systems are free market systems, laissez faire systems, and entrepreneurial systems. In systems based on central planning, the government makes most major economic decisions. Government planners tell managers what to produce, whom to sell it to, and what price to charge. Centrally planned economies are often called command economies.
The root of the word capitalism is capital. Capital has several meanings in economics and business. In business, it refers to the money needed to hire workers, buy materials, and pay bills. In economics, capital includes buildings, equipment, and other assets used to produce things. In basically capitalist systems, most land, factories, and other capital is privately owned. In systems based on central planning, the government owns most of the capital used in production.
Capitalism in its ideal form
The Scottish economist Adam Smith laid out the basic argument for capitalism. He presented his ideas in a landmark book called The Wealth of Nations (1776). Smith maintained that a government should not interfere with a nation’s economy. Instead, a government should let individuals act as “free agents” who pursue their own self-interest. Such free agents, he argued, would naturally act in ways that would bring about the greatest good for society. They would seem to act “as if guided by an invisible hand.”
Private choices.
An example of how an ideal capitalist economy would work is an arrangement called perfect competition. Such competition is also known as pure competition. In perfect competition, privately owned businesses decide what goods or services to produce. They also choose how much to produce and what methods to employ in production. These choices determine how much labor and capital a business will need. In other words, private firms “supply” goods and services. They “demand” labor and capital. A desire for profits drives the choices a business makes.
Each household chooses what products and services to buy. The choices are based on prices, household income, and individual preferences. Each household also decides how much to work—in other words, how much labor to supply. Workers take jobs only when employers offer them wages that adequately compensate them for their time and effort.
In addition, each household chooses how much to save out of its income. These savings provide capital for businesses. When a household deposits money in a savings account, for example, the bank may loan the funds to businesses. Besides borrowing from banks, most corporations issue stocks and bonds. They sell the stocks and bonds to investors to raise needed capital. Thus, households “demand” goods and services and “supply” labor and capital.
Markets.
Businesses and households exchange labor, capital, and goods and services in markets. A market is a place or situation in which people buy and sell things. In a capitalist economy, the prices of labor, capital, and goods and services are determined mainly by market forces. There are two main market forces, supply and demand. Supply is the amount of a good or service that is offered for sale. Demand is the amount of a good or service that users can and would like to buy at alternative prices. Generally, the market will force prices to fall when supply exceeds demand. The market will force prices to rise when demand exceeds supply.
Another important feature of markets is competition. Competition exists when many suppliers try to sell the same kinds of things to the same buyers. A supplier who charges lower prices or improves the quality of his or her products can take buyers away from competitors.
Competition among employers for workers and among workers for jobs helps set wage rates. Businesses need to pay wages high enough to attract the workers they need. When jobs are scarce, however, workers may accept lower wages than they would when jobs are plentiful. Similar competition helps determine interest rates—that is, the cost of borrowing money.
In theory, pure competition would produce exactly the right combination of goods and services to match the tastes and buying power of the consumers. No government involvement would be required. In addition, perfect competition would lead firms to adopt the most economical methods and technologies. Prices would drop to the lowest levels permitted by the cost of production. Inefficient firms would lose money and be driven out of business by better-managed firms.
Capitalism as it exists
Capitalism as it exists today differs from the ideal of pure competition. All societies have governments. All governments make economic decisions. For example, governments tax households and businesses. Governments use those taxes to purchase goods and services and to transfer income to the needy. The chief areas of government involvement in a capitalist economy include ensuring competition, protecting the public interest, stabilizing the economy, and equalizing the distribution of wealth.
Ensuring competition.
For vigorous competition to exist, an industry must consist of numerous producers. None of the producers must control much of the market. In many industries, however, a few big firms have market power. Market power is the influence that results from their large share of sales. Market power enables them to limit competition and to raise prices above competitive levels. Firms with market power often erect obstacles called entry barriers that prevent new firms from getting started in an industry. For example, a firm may control the supply of raw materials needed to make a product. Or it may own patents covering the manufacturing process.
The most extreme market power occurs in a monopoly. In a monopoly, a single firm or a cooperating group of firms controls the supply of a product or service for which no close substitute exists.
In the United States, huge monopolies dominated many industries in the late 1800’s. In response, the government passed the Sherman Antitrust Act of 1890. The Sherman Act outlawed “combinations … in restraint of trade.” In 1914, the Clayton Antitrust Act outlawed a number of specific business practices that large firms had used to eliminate smaller rivals. Today, the Antitrust Division of the United States Department of Justice and the Federal Trade Commission oversee American business to curb unfair methods of competition.
Protecting the public interest.
Business leaders in unregulated industries often do not consider costs to society in making their decisions. For example, a factory may dispose of toxic waste cheaply by pouring it into a river. But the resulting pollution may harm people downriver, kill fish, and destroy other valuable natural resources. In most capitalist economies, the government tries to ensure that social costs and environmental impacts are considered in business decisions. The U.S. Environmental Protection Agency, for example, helps enforce clean water and clean air legislation.
Governments also protect the public interest by providing or preserving goods and services called public goods. Public goods include law enforcement, national defense, and clean air. Anyone can benefit from whatever public goods are provided, even someone who does not pay for them. Public goods thus differ from most goods and services sold under capitalism. Those goods and services can be withheld for nonpayment. Private firms seldom find it profitable to preserve or produce public goods. For this and other reasons, such goods are often protected or provided by governments through the use of tax dollars.
Stabilizing the economy.
Market economies are naturally unstable. Economic output alternately rises and falls in a pattern called the business cycle. Most economists consider a nation’s economy to be in a recession if the output of goods and services has fallen for six consecutive months. During recessions, firms are less profitable. Unemployment rises. Poverty increases. Recessions hurt many people, especially the workers who lose jobs. Periods of economic growth, on the other hand, often bring a general increase in prices, called inflation. Inflation hurts people whose income does not keep pace with prices.
Some economists believe the government should work to stabilize the economy and ease the natural fluctuations of the business cycle. To end a recession, a government may boost its own spending or reduce taxes. It may also lower interest rates so loans will be cheaper and easier to get. These measures tend to increase the demand for goods and services and to create more jobs.
Other economists believe that the government should not intervene to try to stabilize the economy. They believe that economic cycles are self-correcting. According to this view, government intervention is ineffective or even may make the fluctuations worse.
Equalizing the distribution of wealth.
Some people in capitalist nations are rich and can afford many luxuries. Others lack basic food, clothing, and shelter. This inequality results in part from capitalism’s emphasis on economic freedom. To a great extent, people in a capitalist economy are free to profit from—or suffer from—their own economic decisions. People will likely prosper if they have ambition and a willingness to work and take risks. But some people are handicapped by factors beyond their control. These factors include racial, ethnic, and sex discrimination. Differences in education and variations in inherited ability or wealth also affect people’s prosperity.
Many government programs exist to correct some of the inequality in capitalist countries. For example, households with higher incomes are required to pay taxes at higher rates. Some needy families get cash benefits.
History of capitalism
From the 1500’s to the 1700’s, the major European trading nations used an economic system known as mercantilism. Under this system, governments regulated their economic affairs to ensure that exports exceeded imports. They placed high tariffs on imported goods to make them cost more at home. Governments also gave financial aid to local farms and industries so they could lower the prices of their exports. Nations enriched their treasuries by selling more goods than they bought.
The development of capitalism.
During the mid-1700’s, a group of French economists known as physiocrats urged governments to stop interfering in foreign trade. Their policy, called laissez faire, demanded an end to tariffs and other trade restrictions. Laissez faire is a French phrase meaning allow to do.
Adam Smith also argued that a nation could increase its wealth most rapidly by allowing free trade. He believed that people who followed their economic best interests would automatically act in the economic best interest of society. In The Wealth of Nations, Smith described how laissez faire should work. His ideas first became influential during the early 1800’s. During that period, the British government began to remove its mercantilist controls. The United Kingdom thus developed the first capitalist economy. Capitalism soon spread to other major trading nations.
Changing attitudes toward capitalism
began to develop in the 1800’s. New technology in industrialized nations helped create many new products. The increased production brought prosperity to many businesses. But problems also developed. Several depressions occurred. In addition, many workers earned low wages and labored under bad conditions.
As a result of these developments, the German social philosopher Karl Marx claimed that laissez-faire capitalism would be destroyed. He predicted that owners of businesses would become wealthier while their workers grew poorer. Finally, the workers would overthrow the capitalist system. Marx was wrong in predicting that workers in capitalist economies would not share in rising standards of living. However, his ideas influenced the revolutions that led to the introduction of Communism in Russia in 1917 and in China in 1949.
Capitalism faced its most serious challenge during the Great Depression. The Depression was a worldwide business slump that began in 1929. During the 1930’s, many banks, factories, and stores closed. Millions of people lost their jobs, homes, and savings. Many also lost faith in capitalism. Political leaders sought new economic theories. As a result, the British economist John Maynard Keynes gained notice. Keynes, though neither a socialist nor a Communist, rejected the traditional capitalists’ belief that government should keep out of economic affairs. He explained his ideas in his book The General Theory of Employment, Interest and Money (1936). Keynes said a nation’s level of economic activity depends on the total spending of consumers, business, and government. Keynes urged increased government spending to fight the Depression. The Great Depression lasted until the early 1940’s. At that time, huge amounts of government military spending for World War II (1939-1945) finally stimulated the world economy.
Capitalism in former Communist nations.
Communist governments were established in much of Eastern Europe after World War II. But in the 1980’s, the centrally planned economies of Eastern Europe and the Soviet Union began to crumble. In 1989, non-Communist governments came to power in several Eastern European lands. In 1991, the Soviet Union broke apart into Russia and 14 other independent nations.
During the 1990’s, Russia and the other formerly Communist lands struggled to build capitalist institutions. They worked to lift government price controls and to increase private ownership of business. They also tried to shift economic decision-making from the government to households and private companies.
