In the 18th century, Adam Smith, father of modern economics said: "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest." In a voluntary exchange transaction, both parties have their own interest in the outcome, but neither can obtain what he or she wants without addressing what the other wants. It is this rational self-interest that can lead to economic prosperity.
This line of thinking is the basic foundation for 'Capitalism'.
Learning Objectives
Capitalism is an economic system where individuals or businesses own the factors of production. What are these factors of production? There are 4 factors of production:
While businesses own capital goods, natural resources, and entrepreneurship, individuals own their labor.
The production of goods and services is determined by the market supply and demand. Free market or laissez-faire capitalism is the purest form of capitalism. Here private individuals are not restricted, instead, they decide what to produce or sell, where to invest, and at what price to sell goods and services. In short, there are no checks or controls in a laissez-faire marketplace.
Most countries practice a mixed capitalist system that includes some degree of government regulation of business and ownership of select industries.
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.
Most scholars believe that full-fledged capitalism emerged in Northwestern Europe, especially in Great Britain and the Netherlands in the 16th and 17th centuries. At first, the merchants (known as "buyer uppers") acted as a link between the producer and consumer. Gradually, merchants began to dominate the producers. Merchants did this by placing orders, paying in advance, supplying the raw materials, and paying wages for the work done in producing finished goods.
With the launch of the concept of a waged worker, the merchants (making money from trade) transitioned to capitalist (creating wealth from the ownership and control of the means of production). Thus, the first stage of capitalism came into being. This stage witnessed one new class, "primitive capitalists" exerting power over another new class "waged workers".
Early capitalism also gave rise to new methods of production like a cottage industry, which saw individual homes become mini-factories, with production directed by the capitalist. The cottage industry model became so widespread in the woolen textile industry that it became a method of mass production. In turn, the wool trade became Britain’s most important industry by the end of the 17th Century.
In the 18th century, Europe was dominated by a philosophical movement 'The Enlightenment' which was centered around the idea that reason is the primary source of authority and legitimacy and advocated such humanistic ideals as each human being is individually unique and valuable. Before the Enlightenment, governments never talked about human rights. However, this movement believed that a society is made up of unique individuals who pursue their individual interests - and this was 'healthy' and 'important' for the overall progress of the society.
People began to believe that self-interest is a good thing, and personal wealth is a self-interested goal, then widespread personal wealth is a good thing. Individual welfare leads to overall social welfare, and individual wealth leads to overall social wealth. Therefore, individuals must pursue self-interested goals. This shift in the social consciousness became the basis of capitalism.
In the late 1700s, Adam Smith, an 18th-century Scottish economist, philosopher, and author, who is considered the father of modern economics, in his book 'An Inquiry into the Nature and Causes of the Wealth of Nations' turned the social concept of individualism into the economic concept of capitalism. Before Smith, the economic self-interest of the individual was considered of no value to the economic welfare of society. Smith didn't agree with this belief. Instead, he suggested two concepts that eventually became the basis of capitalism:
Smith believes there is an "invisible hand" that guides the economy through a combination of self-interest, private ownership and competition. This creates a natural economic balance which results in general social wealth.
According to Adam Smith, there are five aspects of capitalism:
According to the laissez-faire economic theory, the government should take a hands-off approach to capitalism. Its role is to protect the free market and maintain a level playing field for producers, consumers and markets. It should prevent the unfair advantage obtained by monopolies and oligarchies. It should make sure information in distributed equitably, and there is no manipulation of information.
Its role is to maintain peace and order so that economy can work without interruption. The government should tax capital gains and income to achieve the goal of improving infrastructure.
There is the free operation of the capital markets. In a capitalist economy, there exist an interconnected and self-regulating network of producers, consumers, and markets operating on the principles of supply and demand. The laws of supply and demand set fair prices for stocks, bonds, derivatives, currency, and commodities.
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.
As the demand for a product/service goes up, supply goes down, and the price increases. On the other hand, as the demand for a product/service goes down, the supply goes up and prices decrease. In short, this is all about maximizing profit. This core value of capitalism comes from a political system called "mercantilism" which dominated Western European economic thought and policies from the 16th to 18th centuries. The major objective of mercantilism is building a wealthy and powerful state by encouraging exports and restraining imports. The basic idea was to bring gold and silver into the country to achieve a favorable balance of trade as well as to maintain domestic employment.
| Mercantilism (1500s-1700s) | Capitalism (mid 1700s-present) | |
| What is the main goal? | Profit | Profit |
| How should we attain wealth? |
Wealth accumulation: Mercantilists believe there is a fixed amount of wealth, therefore mercantilists will increase their overseas colonies and accumulate as much gold and silver as possible. |
Wealth Creation: Capitalist believe that wealth can grow, therefore capitalist competition and innovation will increase efficiency and grow wealth |
| How are prices set? | Monopoly: There is no competition. Instead, there is complete control of a product or business by one person or group who sets the prices. In mercantilism, industries are protected by the government. | Competition: Producers compete for consumer money by lowering their prices or introducing new products. |
| How are products traded? | Favorable Balance of Trade: Mercantilists export more than import and heavily tax the import of foreign goods | Free Trade: Capitalists support free trade with anyone and do not heavily tax the import of foreign goods. |
| How involved is the government in the economy? | Heavily involved | Not involved |
| What are the individual freedoms in this system? | Individuals do not have the freedom to make economic decisions. Instead, there is heavy regulation. | Individuals have freedom and opportunity to create wealth by making choices based on self-interest. |
Capitalism is founded on the following pillars:
The ways each of these pillars operate varies. For example, in laissez-free economies, there is little or no market regulation; in mixed economies, governments regulate markets to avoid market failures (e.g. pollution) and promote social welfare (e.g. public safety). Predominately we have mixed capitalist economies around the world.
We can classify capitalism into various groups based on different criteria.
1. Based on how production is organized, capitalism can be classified as liberal market economy and coordinated market economy.
2. Based on the role of entrepreneurship in driving innovation for economic growth, capitalism can be classified into four types: state-guided, oligarchic, big-firm, and entrepreneurial.
| Type of capitalism | Characteristics |
| State-guided capitalism |
The government decides which sectors will grow. This is done by government investment/ownership of banks to guide investment, regulation like exclusive licenses, tax breaks, and government contracts, limiting foreign investment, and trade protection. The initial motivation is to foster growth, but there are several pitfalls like selecting the wrong winners, susceptibility to corruption, and difficulty to redirect. |
| Oligarchic capitalism | This is oriented toward protecting and enriching a very narrow fraction of the population, mostly rich and influential. Economic growth is not a central objective, and countries with this variety have a great deal of inequality and corruption. |
| Big-firm capitalism | This takes advantage of economies of scale which is important for the mass production of products. |
| Entrepreneurial capitalism | It produces breakthroughs like the automobile, telephone, and computer. These innovations are usually the product of individuals and new firms. |
It takes big firms to mass-produce and market new products, so a mix of big-firm and entrepreneurial capitalism seems best.
3. Some other forms of capitalism.
This refers to an unregulated form of capitalism with financial deregulation, privatisation and lower tax on high earners. It could also be referred to as Unrestrained capitalism or free market capitalism.
A term used to refer to the situation where business success is related to strategic influences with civil servants, politicians and those in authority.
It occurs when state owned industries play a key role within the market economy. Under state capitalism, the government also plays a key role in planning, for example deciding to invest in transport and communication. To some extent, China has become a model of state capitalism. Private firms play a key role, but the government also plays a key role in planning energy, transport and the Chinese government influences monetary policy and exchange rate policy. The difference between state capitalism and state socialism is that under state socialism there is no room for private enterprise and competition.
It is essentially a free market economy, but with a degree of government regulation to avoid the excesses and inequalities of capitalism.
A term used to refer to societies where capitalism is firmly established. There is widespread acceptance of status quo, and little political activism over fundamental political issues. In advanced capitalism, consumerism is important.
No. Capitalist system and free-market system are economic environments where supply and demand are the main factors of price and production of goods and services. While the two economic systems, the Free Market and Capitalism, are based on the law of supply and demand, both systems have different characteristics.
| Free market | Capitalism |
| It is an economic system in which prices are determined by unrestricted competition between privately owned businesses. | It is an economic system in which a country's trade and industry are controlled by private owners for profit rather than by the state. |
| Focused on the exchange of wealth, or goods and services. | Focused on the creation of wealth, and ownership of capital and factors of production. |
| Can have a monopoly on the market and prevent free competition. | Leads to free competition in the economy. |
The main difference between capitalism and socialism is the extent to which the government controls the economy.
Socialist governments strive to eliminate economic inequality by tightly controlling businesses and distributing wealth through programs that benefit the poor, such as free education and healthcare. The mantra of socialism is, “From each according to his ability, to each according to his contribution.” This means that each person in society gets a share of the economy’s collective production—goods and wealth—based on how much they have contributed to generating it. Workers are paid their share of production after a percentage has been deducted to help pay for social programs that serve “the common good.” Socialism sounds more compassionate, but it does have its shortcomings. One disadvantage is that people have less to strive for and feel less connected to the fruits of their efforts. With their basic needs already provided for, they have fewer incentives to innovate and increase efficiency. As a result, the engines of economic growth are weaker. Socialism is most often criticized for its provision of social services programs requiring high taxes that may decelerate economic growth.
Capitalism, on the other hand, holds that private enterprise utilizes economic resources more efficiently than the government and that society benefits when the distribution of wealth is determined by a freely-operating market. It is intended to drive business owners to find more efficient ways of producing quality goods. This emphasis on efficiency takes priority over equality. For consumers, this dynamic is intended to create a system wherein they have the freedom to choose the best and cheapest products. In capitalist economies, people have strong incentives to work hard, increase efficiency, and produce superior products. By rewarding ingenuity and innovation, the market maximizes economic growth and individual prosperity while providing a variety of goods and services for consumers.
Capitalism is most often criticized for its tendency to allow income inequality and stratification of socio-economic classes.
Pros: There are many positives of capitalism. Capitalism ensures efficiency because it is self-regulated through competition. It promotes innovation, freedom and opportunity. Capitalism meets the needs of the people and is beneficial to societies as a whole.
Cons: Capitalism ignores people's needs, results in wealth inequality, and does not promote equal opportunity. Capitalism also encourages mass consumption, is unsustainable, and provides an incentive for business owners to harm the environment for monetary gains. Some argue that it is ineffective and unstable.
