The Definition of Capitalism

by Cynthia Gaffney ; Updated September 28, 2018
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Capitalism is a system of free trade, where the people of a society operate businesses to produce and sell or supply various goods to meet a demand driven by buyers. It's a society that focuses on individuals rather than the collective society, with a "pull yourself up by your bootstraps" type of thinking.

Two other main economic systems exist; socialism and communism. Although there is some evidence that capitalism existed in some areas during Europe's middle ages, the three systems started to take shape during the 16th–to-18th centuries.

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The British had a prosperous and growing cloth industry, and businesses started to reinvest and save their profits. Traditional thoughts about acquiring wealth relaxed during the 16th century's Protestant Reformation, and in 18th-century England, development started to shift to industry, and capital accumulated from previous businesses became the investment funds that drove the Industrial Revolution.

Capitalism Definition

A capitalism definition can be summed up as describing a country's industry and trade, which is controlled by for-profit, private or corporate-owned businesses. You might have heard this concept called free enterprise, or the free market. Companies in a capitalist environment operate in competition with each other, and they're free, for the most part, of any state control. Some say that capitalists feel greed is good because it drives profits. Profits drive innovation and the development of new products, creating more choices for people who can afford to buy them.

However, the term capitalism also has a deeper meaning to many and has inspired passionate conversations about its meaning as an economic freedom that goes hand-in-hand with a democratic society, such as described in Nobel laureate Milton Friedman's "Capitalism and Freedom" (1962).

In a capitalist society, the supply and demand for various goods drive the type and amount of goods and services produced by businesses. Many people support the idea of capitalism because they feel economic freedom opens the door to political freedom while allowing for state-owned production would cause federal authoritarianism and overreach.

In contrast, a communist society would engage in some type of central planning at the state or government level, to determine which goods and services it wanted to provide, in what quantities and what price, to its population.

A socialist society, the third type of economic market, aims to eliminate the financial gap between the rich and the poor. In its pure form, socialism relies on the government to redistribute wealth so that all members of society are on an equal financial footing.

Economic Significance

Capitalism is significant in our economic history in part because of how it developed. As commerce developed in the 16th through 18th centuries, business owners accumulated capital and used it to expand their operations instead of the usual investing in cathedrals or pyramids as was done before the 16th century. During the Industrial Revolution, this accumulated capital allowed for new business growth and set the stage for capitalism.

Adam Smith, an economist, and philosopher considered by many to be the father of capitalism published a book in 1776 titled "An Inquiry Into the Nature and Causes of The Wealth of Nations." Smith recommended in his book that economic decisions should be determined by the free play of self-regulating forces in the market. Nineteenth century politics integrated his theories and ideas, with policies on free trade, balanced budgets, stabilized currency using the gold standard and minimum levels of financial relief for the poor in society.

Fast-forward to the decades after World War II, and after many ups and downs, the economies of major capitalist countries had started performing fairly well, renewing confidence in capitalism, which had waned in the 1930s. By the 1970s, however, economic inequality had risen dramatically, which revived questions about capitalism's long-term viability, which was magnified even more by the Great Recession of 2007-to-2009.

What Are the Main Features of Capitalism?

The main features of capitalism can be described as follows:

  • Private property: Allowed in a capitalist society. This includes all items that enable production, such as factories, machines, tools, land for mining and more.
  • Price mechanism: A capitalist economy is driven by prices that are determined solely by the interaction of supply and demand, without any interference from the government or other outside forces.
  • Freedom of enterprise: Every individual has the right to his own means of production, and can produce any type of goods or services that he chooses.
  • Consumer sovereignty: Consumers play the most important role in a capitalist society. The entire pattern of production is guided by the wants, wishes and demands of consumers.
  • Profit motive: Maximizing profit guides production levels and is the main motive of producers.
  • No government interference: Under capitalism, the government does not interfere in the activities of the economy. Producers of goods and services for consumers have the freedom to make their own decisions.
  • Self-interest: In a capitalist system, individuals are driven by their self-interest, which leads to hard work to maximize their income by keeping their customers happy.

Pros and Cons of Capitalism

Capitalism, like other market models, has its strengths and weaknesses. Because people in a capitalist society are free to produce whatever they'd like and sell it at whatever price the market will bring, this environment encourages innovation because of business owners who want to become wealthy. Due to the competitive environment of the market, companies have good reason to operate efficiently.

Consumers reap the benefits of choosing whatever products they desire and speaking up when they require something that doesn't yet exist so that some enterprising company can supply it. Additionally, a capitalist economy prevents a large, bureaucratic government from forming or intervening, and many consider capitalism better than the alternatives, such as socialism or communism.

On the downside, capitalism can give rise to large, powerful firms that form monopolies and exploit the desires and needs of consumers by continually driving up prices and limiting supply. Firms can also exploit workers if they're in a monopsony position. This means that there's only one buyer for the company's goods, and certain workers can't find employment elsewhere, so the firm uses its monopsony power to pay lower wages.

In a profit-driven economy, firms are likely to ignore externalities, such as factory-generated pollution or exploitation of natural resources. In a free market, there is little motivation from profit-makers to fund public services and goods, meaning that public health, transport and education suffer.

Although in a capitalist society people can work hard and be rewarded financially for it, this ignores inherited wealth passed on from previous generations. In this sense, capitalism fails to offer fair opportunities and equal outcomes for all, and the gap between the rich and poor continues to widen. Inequality then leads to divisions in society, which drives resentment due to the unequal opportunities. Finally, a feature of capitalism is the boom and bust cycle, which drives mass unemployment and puts consumers through painful recessions.

Is All Capitalism The Same?

The basic idea of capitalism is the same for different societies, but varying degrees of government intervention can create something that looks more like a mixed economy. For example, "turbo-capitalism," which implies no government regulation at all, would have more issues with inequality, monopolies and lack of services for public welfare. A society that is primarily capitalist, but which allows for some degree of government intervention, can lead to a quite different, and more beneficial outcome.

The U.S. is considered a capitalist society, but the government, which accounts for about 35 percent of the U.S. GDP, has substantial intervention in areas such as health care, education and transportation. France, with a government GDP of 50 percent, is still considered essentially a free market economy. No specific dividing line has been established to delineate where capitalism ends, and a mixed economy begins.

What Are Examples of Capitalism?

Suppose you own a leading retail company. Your business employs 1,100 people at all levels, and you want to maximize profits by catering to your customers and providing the best products at the lowest prices. Since competition is pretty steep in your industry, your company tries to keep its prices low to acquire more customers. In a capitalist economy, your business goal is to achieve the maximum utility of your business assets for the lowest cost to make a profit. In this scenario, the only part government plays is to protect your legal rights and attempt to regulate the free market.

This works because of a key hypothesis of capitalism, which is that the markets are always efficient. This means that, for example, company stock prices on the stock market are all determined by supply and demand, and they always reflect a fair, correct price, and those prices help investors make more informed decisions about how to invest. On the flip side, people who oppose capitalism and don't believe in the efficient market hypothesis speculate that market prices are the result of mispricing and mistakes that result in lowering the market price of company stocks, allowing more room for growth.

Capitalism Versus Socialism Versus Communism

Each of the three economic systems, in its pure form, has strengths and weaknesses. However, in reality, no society has an economy that represents a pure form; they typically have features of more than one economic system. For example, the capitalist U.S. society has a government-owned and operated postal service, and a government-mandated Social Security system. Many opinions abound about which economic model is better; U.S. President Richard Nixon expressed this when he said, "Capitalism works better than it sounds, while socialism sounds better than it works."

Socialism differs from capitalism in that the goal is to have wealth and income shared equally among all members of the society. Unlike communists, socialists don't fear that workers would violently overthrow capitalists, and they don't believe that people should be completely restricted from having private property. Socialists believe that people naturally want to cooperate with each other, rather than to compete, and the goal is to narrow, although not totally eliminate, the expanse between the rich and poor. In a socialist society, the government would be responsible for redistributing wealth so that everyone has the same, fair outcome and opportunities.

One of the hallmarks of communism is that no one is allowed to own any private property. Karl Marx, a 19th-century economist, known as the Father of Communism, felt that the widening gap between the rich and poor needed to be resolved. He saw capitalism as a system that would exploit the poor over time, and that they would eventually rise up in protest. The basic principles of communism attempt to correct this exploitation. Marx believed that in a capitalist society, people were encouraged to be greedy and would knock out their competition no matter the cost. Instead of letting people own private property, he felt it should be shared, and that the government should control the society in the name of the people.

About the Author

Cynthia Gaffney has spent over 20 years in finance with experience in valuation, corporate financial planning, mergers & acquisitions consulting and small business ownership. She has worked as a financial writer and editor for several online finance and small business publications since 2011, including AZCentral.com's Small Business section, The Balance.com, Chron.com's Small Business section, and LegalBeagle.com. A Southern California native, Cynthia received her Bachelor of Science degree in finance and business economics from USC.

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