Nations around the world employ several different types of economic systems; two such types are socialism and capitalism. Capitalism is often referred to as a free market economy in its purest form, where the means of production are owned by private interests.
Embedded in these economic systems are political and social elements that influence the degree of purity of each system. In other words, many capitalist nations have elements of socialism interwoven. So even though there are different degrees or levels of commitment to the ideals of capitalism, there are several traits that are common among all capitalist economies.
- Capitalism is an economic system that focuses on a free market to determine the most efficient allocation of resources and sets prices based on supply and demand.
- Socialism is often presented as the opposite of capitalism, whereby there is no free market and the allocation of resources is determined by a central body.
- Capitalism has many unique features, some of which include a two-class system, private ownership, a profit motive, minimal government intervention, and competition.
Understanding Capitalist Economy Traits
Historically, capitalist society was characterized by the split between two classes of individuals: the capitalist class, which owns the means for producing and distributing goods (the owners), and the working class, who sell their labor to the capitalist class in exchange for wages (the workers).
The economy is run by individual corporations that own and operate companies and make decisions as to the use of resources. But there exists a “division of labor” that allows for specialization, typically occurring through education and training, further breaking down the two-class system into subclasses (e.g., the middle class).
Private ownership, or private property, is the cornerstone of any capitalist-based economy. Without having private ownership enshrined in laws, the owners of capital have no incentive to take the risks associated with allocating capital to the market. Private ownership is part of the "invisible hand" cited by economist Adam Smith in his seminal book, "The Wealth of Nations."
With private property, owners of capital, or the means of production, are free to employ their capital in the marketplace as they see fit, with their own interests at the fore. Most businesses are incorporated as "for-profit" entities, where the means of capital allocation and production are put to use in pursuit of business ventures that will yield them profits, while at the same time paying for labor to make the products and services that the company uses.
While most corporations are for-profit entities, there exist numerous "not-for-profit" corporations that typically provide a social good or service, but don't seek to turn a profit. Charities, hospitals, and advocacy groups are typical examples of not-for-profit corporations. They attempt to provide goods and services on an at-cost basis, typically returning any profits to the companies for further re-investment in the corporation and for ongoing operating expenses.
Nationalization is the transfer of private ownership to state ownership, which is what happened in Russia once it became the Soviet Union. Conversely, when the Soviet Union collapsed, privatization occurred, to some degree, which is the transfer of business and industry from state ownership to private ownership.
Another major force behind Adam Smith's invisible hand is the opportunity for a company to deploy its capital to turn a profit for itself and its owners, e.g., shareholders, bondholders, and other capital providers. Commonly referred to as the "profit motive," for-profit companies exist to make a profit, while not-for-profit companies seek to balance out the costs of doing business, usually covered by charitable contributions, with outlays for the services they provide.
Under the profit motive, companies seek to make and sell goods and services only at a profit. These companies don't exist solely to satisfy people's needs. Even though some goods or services may satisfy needs, they will only be available if people have the resources to pay for them and if there is a profit for the producer.
The profit motive leads to the accumulation of wealth (creation of capital) and is the driving force behind capital allocation with for-profit corporations. The profit motive also allows companies to use some portion of profits to undertake research and development (R&D) for future products or services, or for general corporate purposes, such as stock buyback plans. R&D may also be seen as a crucial undertaking to remain competitive against others in the same industry.
True capitalism needs a competitive market, one with multiple players offering similar goods and services at competitive prices. Without competition, monopolies will develop, and instead of the market setting the prices for goods and services, the seller is the price setter, which is against the tenets of capitalism.
To combat anti-competitive tendencies, which are in line with the profit motive, many governments employ anti-monopoly laws to maintain a competitive landscape. As such, the government seeks to avoid industry consolidation, i.e., the road to monopolization, so a free marketplace can be sustained. For example, in the U.S., the Federal Trade Commission's (FTC's) Bureau of Competition is charged with reviewing potential mergers and acquisitions in an attempt to avoid a monopolistic consolidation in a particular industry.
Competition leads companies to strive to be better than their competitors, so that they may gain a larger portion of the market share for their given product or service, increasing their profits, which often leads to innovation to edge out the competition. As discussed, this innovation furthers society in terms of technology and thought. Competition is also beneficial to consumers as it results in lower prices as businesses seek to make themselves more attractive when compared with their competitors.
Following closely with competition between industry peers, capitalist economies rely on an open market to determine what goods are produced and what they should cost. Consumers, whether businesses or individuals, mostly have the final say in how much a product or service is worth and what it should cost, based on a competitive marketplace. Consumers will pursue their own profit motive in seeking to find the best product at the best price, serving as another incarnation of the invisible hand.
The market mechanism also relies on the concepts of supply and demand as the overriding economic principle. Put simply, the greater the demand and the lower the supply, the higher the prices are that are likely to be obtained by the producers of that good or service, and vice versa.
The so-called invisible hand guides the levels of supply and demand until a price equilibrium point is reached: a price that consumers are willing to pay and where the producer are willing to sell. This concept is also known as market equilibrium, typically reached when there are numerous producers and consumers of a certain good or service.
Adam Smith and John Maynard Keynes
Adam Smith was an economist who is best known for his 1776 publication of "The Wealth of Nations." In the book, Smith comes out as an advocate of free markets, guided by the invisible hand of self-interest. Translated into modern terminology, Smith's book is often cited as the basis of modern capitalism, where markets should be free to produce supply and set prices. Most notably, Smith saw no need for government involvement in an economy, leaving him as the most notable of the laissez-faire economists.
In contrast, John Maynard Keynes, in his 1936 "The General Theory of Employment, Interest and Money," believed the government had a role to play in the economy, particularly when demand faltered. Keynes' view was that the government should stimulate the demand side of the economy through increased fiscal spending (in other words, government spending). His belief was that government spending could support the economy until consumer demand rebounded and could support the economy on its own.
Both economists and their works remain highly visible in academic circles and frequently frame the debate about contemporary economic developments, even today.
As one example of Keynesian theory in practice, the massive U.S. government spending on infrastructure projects during the Great Depression arguably sustained the economy until World War II came along and offered full employment. As well, there are several more recent downturns (the Global Financial Crisis of 2008-09 and Coronavirus in 2019-20) in which increased government spending laid the foundations for the sharp recoveries in demand that followed each episode.
Freedom To Choose
Central to the concept of a capitalist economy is the freedom to choose a product from among various competitors' offerings. Using the principles of competition and the invisible hand of supply and demand, consumers in capitalist economies should have the greatest freedom of choice available. Consumers act as the final arbiter of demand, while corporations are free to pursue their own profit motives as they offer the right amount of supply.
Freedom of choice is one of the hallmarks of a capitalist economy, combining multiple facets of competition, self-interest, and supply and demand. Capital will be drawn to those products for which demand is high enough to make it a profitable trade, meaning consumer demand is the linchpin of a capitalist economy. In the U.S., consumer demand accounts for roughly 70% of economic activity, leaving consumer spending as the driving force behind the functioning of the world's largest economy.
Minimal Government Intervention
Capitalist societies believe markets should be left alone to operate without government intervention, an idea known as laissez-faire. True capitalists believe that a free market always will create the right amount of supply to meet demand and all prices will adjust accordingly. This is the basic thesis of Adam Smith's free-market treatise.
While corporations may be highly skilled in capital allocation and profit maximization, there are numerous areas where government regulation is necessary to proscribe actions that hurt the common good. Depending on the industry, corporations may undertake actions that may hurt the common good, such as the unregulated disposal of toxic waste or consumer financial scams.
In many cases, there is very little profit incentive for companies to avoid actions that harm the common good. As such, governments regularly seek to promulgate rules and regulations that limit or prescribe the manner in which businesses conduct themselves.
A completely government-free, capitalist society exists in theory only. Even in the U.S., the poster child for capitalism, the government regulates certain industries, such as the Dodd-Frank Act for financial institutions or the Clean Air and Clean Water Acts for industrial polluters, and the Consumer Financial Protection Bureau (CFPB) to protect consumers from financial chicanery.
If such regulations are applied uniformly to every company in a particular industry, then they all face the same cost-burden of compliance with government regulations, so there should be no impact on the competitive landscape.
Why Do Companies Seek To Control a Particular Market?
The short answer is pricing power. The fewer competitors in a given industry, the more the company can charge for its goods or services. The more competitors there are, the more competition will force prices lower.
What Is the Most Important Pillar to a Capitalist Economy?
Private property is the linchpin to capitalist economies. Without laws guaranteeing private ownership, capital owners have little incentive to deploy their capital into the economy, as their profits and property could conceivably be seized by the government, for example.
Why Do Governments in Capitalist Economies Impose Laws and Regulations on Companies?
Typically, the answer is to promote the public good and protect it from the worst impulses of capitalism (see the Self-Interest section, above). This is most evident in environmental and consumer protection laws, where the regulations help to protect the environment we all share and to protect citizens from predatory financial practices, among many others.
The Bottom Line
Capitalism in its purest form is a society in which the market sets prices for the sole purpose of profits. Theoretically, any inefficiency or intervention that reduces profit-making will be eliminated by the market. In a capitalist economy, individuals have the right to choose any occupation they wish and to own property, plant, and equipment to start businesses. They are allowed to conduct the business as they see fit while competition with other businesses leads to lower prices and innovation.
Pure capitalists will say that any government regulation distorts the market and consequently means higher prices for consumers. However, sometimes government regulation is needed to protect consumers and the common good, two areas where the profit motives of capitalism might be in conflict with crucial elements of society such as the environment and banking regulation.