Modern economies in much of Western society today are organized under the banner of capitalism. Some of the most important aspects of a capitalist system are private property, private control of the factors of production, accumulation of capital, and competition.

Put simply, a capitalist system is controlled by market forces, while a communist system is controlled by the government. Here we go over some of the main factors that describe a capitalist economy.

Key Takeaways

  • Capitalism is a system of economic production whereby business owners (capitalists) acquire the means of production (capital) and hire workers who get paid for their labor.
  • Capitalism is defined by private property rights, capital accumulation and re-investment, free markets, and competition.
  • While capitalism has certainly helped propel innovation and prosperity in modern society, it can also create inequalities and contribute to market failures.

What is Capitalism?

Capitalism is an economic system in which private individuals or corporations own capital goods - i.e. factories, raw materials, the means (tools) of production. The production of goods and services is then based on supply and demand in the general market—known as a market economy—rather than through central planning—known as a planned economy or command economy.

The purest form of capitalism is free market or laissez-faire capitalism. Here, private individuals are unrestrained. They may determine where to invest, what to produce or sell, and at which prices to exchange goods and services. The laissez-faire marketplace operates without checks or controls.

Today, most countries practice a mixed capitalist system that includes some degree of government regulation of business and ownership of select industries.

Private Property

The right to private property is a central tenet of capitalism. Citizens cannot accumulate capital if they are not allowed to own anything, if they fear the stuff they own can be easily stolen or confiscated, or if they cannot freely buy or sell the things the own and transfer that ownership to others. As long as the owner stays within the parameters of the law, which generally are broad in capitalist systems, the individual may do what they want with the property they own.

A private citizen may purchase property from another private citizen at a price that is mutually agreed upon and not dictated by a government. In a capitalist system, the free market forces of supply and demand, rather than a central governing body, set the prices at which property is bought and sold. Private property rights are an important foundation of capitalist production. These rights clearly separate the ownership of the means of production from the workers who use them. For instance, an entrepreneur will own the factory and the machines used in it, as well as the finished product. A worker located inside of that factor and using those machines has no ownership of them, and cannot take home with the them the finished product for personal use or sale - that would be considered theft. The worker is only entitled to their wages in return for their labor.

Factors of Production

In capitalism, private enterprise controls the factors of production, which include land, labor, and capital. Private companies control deploy a mix of these factors at levels that seek to maximize profit and efficiency.

A common indicator of whether the factors of production are privately or publicly controlled is what happens to surplus product. In a communist system, surplus product is distributed to society at large, while in a capitalist system, it is held by the producer and used to achieve additional profit.

Accumulation of Capital

The centerpiece of a capitalist system is the accumulation of capital. In a capitalist system, the driving force behind economic activity is to make a profit. Capitalists see amassing profits as a way to provide a powerful incentive to work harder, innovate more and produce things more efficiently than if the government had sole control over citizens' net worth. This financial incentive is the reason capitalist economies see innovation as going hand-in-hand with their market system.

Indeed, Karl Marx, observing how capitalism was emerging in the wake of the industrial revolution, understood the accumulation and re-deployment of capital, re-investing back into the company to expand production and efficiency, was a defining feature of capitalism.

Markets & Competition

Competition is the other vital attribute of a capitalist system. Private businesses compete to provide consumers with goods and services that are better, faster and cheaper. The principle of competition forces businesses to maximize efficiency and offer their products at the lowest prices the market will bear, lest they get put out of business by more efficient and better-priced competitors.

While doing business with a particular company in a capitalist system is voluntary, in contrast, the central government in a communist system has effective monopolies in all industries. This means it has no incentive to operate efficiently or provide low prices because its customers do not have the option of looking elsewhere.

The main venue for this competition is in the free market. A market is an abstract notion that broadly describe how the forces of supply and demand manifest through prices. If demand for some good rises and the supply remains the same, the price will go up. The price going up, however, will send a signal to producers that they should make more of that good because it is suddenly more profitable. This will increase the supply to meet the new larger demand, sending the price back downward a bit. This process creates what economists call an equilibrium state that adjusts to fluctuations in supply and demand.

Problems With Capitalism

Capitalism, undoubtedly, is a major driver of innovation, wealth, and prosperity in the modern era. Competition and capital accumulation incentivize businesses to maximize efficiency, which allows investors to capitalize on that growth and consumers to enjoy lower prices on a wider range of goods. However, sometimes this doesn't work out as planned. Here, we will just consider just three problems of capitalism: asymmetric information; wealth inequality; and crony capitalism.

Asymmetric Information

For free markets to work the way they are intended as a hallmark of capitalist production, a major assumption must hold: information must be "perfect" (i.e. all knowledge available is freely knowable), and symmetric (i.e. everybody knows everything about everything). In reality this assumption does not hold, and this causes problems.

Asymmetric information, also known as "information failure," occurs when one party to an economic transaction possesses greater material knowledge than the other party. This typically manifests when the seller of a good or service possesses greater knowledge than the buyer; however, the reverse dynamic is also possible. Almost all economic transactions involve information asymmetries.

In some circumstances, asymmetric information may have near fraudulent consequences, such as adverse selection, which describes a phenomenon where an insurance company encounters the probability of extreme loss due to a risk that was not divulged at the time of a policy's sale.

For example, if the insured hides the fact that he's a heavy smoker and frequently engages in dangerous recreational activities, this asymmetrical flow of information constitutes adverse selection and could raise insurance premiums for all customers, forcing the healthy to withdraw. The solution is for life insurance providers is to perform thorough actuarial work and conduct detailed health screenings, and then charge different premiums to customers based on their honestly-disclosed risk profiles.

Wealth Inequality

One recurrent issue with the capitalist system of production is that its competitive markets and private corporations produce a winner-takes-all paradigm that leaves losers in the dust. If two companies both make chairs, and one can do it cheaper or more efficiently, either the laggard will go out of business and lay off its employees, or the successful company can acquire the laggard and lay off many of the employees in that company.

More pressing is the fact that workers only receive wages, while business owners and investors enjoy the full share of all profits. As a result, as a company grows the business owners get wealthier as they employ more workers - workers who work hard for meager wages in comparison with what top executive and owners receive. Over time, these disparities grow and grow. Compounding the problem is that workers often need to work to earn the money necessary to survive and support themselves and their families. They have little choice but to work for relatively low wages just to make ends meet.

Crony Capitalism

Crony capitalism refers to a capitalist society that is based on the close relationships between business people and the state. Instead of success being determined by a free market and the rule of law, the success of a business is dependent on the favoritism that is shown to it by the government in the form of tax breaks, government grants, and other incentives.

In practice, this is the dominant form of capitalism worldwide due to the powerful incentives both faced by governments to extract resources by taxing, regulating, and fostering rent-seeking activity, and those faced by capitalist businesses to increase profits by obtaining subsidies, limiting competition, and erecting barriers to entry. In effect, these forces represent a kind of supply and demand for government intervention in the economy, which arises from the economic system itself. 

Crony capitalism is widely blamed for a range of social and economic woes. Both socialists and capitalists blame each other for the rise of crony capitalism. Socialists believe that crony capitalism is the inevitable result of pure capitalism. On the other hand, capitalists believe that crony capitalism arises from the need of socialist governments to control the economy.

The Bottom Line

In reality, most countries and their economies fall in between capitalism and something akin to socialism/communism. Some countries incorporate both the private sector system of capitalism and the public sector enterprise of socialism to overcome the disadvantages of both systems. These countries are referred to as having mixed economies. In these economies, the government intervenes to prevent any individual or company from having a monopolistic stance and undue concentration of economic power. Resources in these systems may be owned by both state and individuals.