What Is Capitalism?

FINANCE & DEVELOPMENT, June 2015, Vol. 52, No. 2

Sarwat Jahan and Ahmed Saber Mahmud

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Free markets may not be perfect but they are probably the best way to organize an economy

Capitalism is often thought of as an economic system in which private actors own and control property
in accord with their interests, and demand and supply freely set prices in markets in a way that can
serve the best interests of society.

The essential feature of capitalism is the motive to make a profit. As Adam Smith, the 18th century
philosopher and 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.” Both
parties to a voluntary exchange transaction 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.

In a capitalist economy, capital assets—such as factories, mines, and railroads—can be privately owned
and controlled, labor is purchased for money wages, capital gains accrue to private owners, and prices
allocate capital and labor between competing uses (see “Supply and Demand” in the June 2010 F&D).

Although some form of capitalism is the basis for nearly all economies today, for much of the last
century it was but one of two major approaches to economic organization. In the other, socialism, the
state owns the means of production, and state-owned enterprises seek to maximize social good rather
than profits.

Pillars of capitalism

Capitalism is founded on the following pillars:

private property, which allows people to own tangible assets such as land and houses and intangible
assets such as stocks and bonds;

self-interest, through which people act in pursuit of their own good, without regard for sociopolitical
pressure. Nonetheless, these uncoordinated individuals end up benefiting society as if, in the words of
Smith’s 1776 Wealth of Nations, they were guided by an invisible hand;

competition, through firms’ freedom to enter and exit markets, maximizes social welfare, that is, the
joint welfare of both producers and consumers;

a market mechanism that determines prices in a decentralized manner through interactions between
buyers and sellers—prices, in return, allocate resources, which naturally seek the highest reward, not
only for goods and services but for wages as well;

freedom to choose with respect to consumption, production, and investment—dissatisfied customers

can buy different products, investors can pursue more lucrative ventures, workers can leave their jobs
for better pay; and

limited role of government, to protect the rights of private citizens and maintain an orderly environment
that facilitates proper functioning of markets.

The extent to which these pillars operate distinguishes various forms of capitalism. In free markets, also
called laissez-faire economies, markets operate with little or no regulation. In mixed economies, so
called because of the blend of markets and government, markets play a dominant role, but are
regulated to a greater extent by government to correct market failures, such as pollution and traffic
congestion; promote social welfare; and for other reasons, such as defense and public safety. Mixed
capitalist economies predominate today.

The many shades of capitalism

Economists classify capitalism into different groups using various criteria. Capitalism, for example, can
be simply sliced into two types, based on how production is organized. In liberal market economies, the
competitive market is prevalent and the bulk of the production process takes place in a decentralized
manner akin to the free-market capitalism seen in the United States and the United Kingdom.
Coordinated market economies, on the other hand, exchange private information through non–market
institutions such as unions and business associations—as in Germany and Japan (Hall and Soskice, 2001).

More recently, economists have identified four types of capitalism distinguished according to the role of
entrepreneurship (the process of starting businesses) in driving innovation and the institutional setting
in which new ideas are put into place to spur economic growth (Baumol, Litan, and Schramm, 2007).

In state-guided capitalism, the government decides which sectors will grow. Initially motivated by a
desire to foster growth, this type of capitalism has several pitfalls: excessive investment, picking the
wrong winners, susceptibility to corruption, and difficulty withdrawing support when it is no longer
appropriate. Oligarchic capitalism is oriented toward protecting and enriching a very narrow fraction of
the population. Economic growth is not a central objective, and countries with this variety have a great
deal of inequality and corruption.

Big-firm capitalism takes advantage of economies of scale. This type is important for mass production of
products. Entrepreneurial capitalism produces breakthroughs like the automobile, telephone, and
computer. These innovations are usually the product of individuals and new firms. However, it takes big
firms to mass-produce and market new products, so a mix of big-firm and entrepreneurial capitalism
seems best. This is the kind that characterizes the United States more than any other country.

The Keynesian critique

During the Great Depression of the 1930s, the advanced capitalist economies suffered widespread
unemployment. In his 1936 General Theory of Employment, Interest, and Money, British economist John
Maynard Keynes argued that capitalism struggles to recover from slowdowns in investment because a
capitalist economy can remain indefinitely in equilibrium with high unemployment and no growth.
Keynesian economics challenged the notion that laissez-faire capitalist economies could operate well on
their own without state intervention to promote aggregate demand and fight high unemployment and
deflation of the sort seen during the 1930s. He postulated that government intervention (by cutting
taxes and increasing government spending) was needed to pull the economy out of the recession (see
“What Is Keynesian Economics?” in the September 2014 F&D). These actions sought to temper the
boom and bust of the business cycle and to help capitalism recover following the Great Depression.
Keynes never intended to replace the market-based economy with a different one; he asserted only that
periodic government intervention was necessary.

The forces that generally lead to the success of capitalism can also usher in its failure. Free markets can
flourish only when governments set the rules that govern them—such as laws that ensure property
rights—and support markets with proper infrastructure, such as roads and highways to move goods and
people. Governments, however, may be influenced by organized private interests that try to leverage
the power of regulations to protect their economic position at the expense of the public interest—for
example, by repressing the same free market that bred their success.

Thus, according to Rajan and Zingales (2003), society must “save capitalism from the capitalists”—that
is, take appropriate steps to protect the free market from powerful private interests that seek to impede
its efficient functioning. The concentration of ownership of productive assets must be limited to ensure
competition. And, because competition begets winners and losers, losers must be compensated. Free
trade and strong competitive pressure on incumbent firms will also keep powerful interests at bay. The
public needs to see the virtues of free markets and oppose government intervention in the market to
protect powerful incumbents at the expense of overall economic prosperity.
Economic growth under capitalism may have far surpassed that of other economic systems, but
inequality remains one of its most controversial attributes. Do the dynamics of private capital
accumulation inevitably lead to the concentration of wealth in fewer hands, or do the balancing forces
of growth, competition, and technological progress reduce inequality? Economists have taken various
approaches to finding the driver of economic inequality. The most recent study analyzes a unique
collection of data going back to the 18th century to uncover key economic and social patterns (Piketty,
2014). It finds that in contemporary market economies, the rate of return on investment frequently
outstrips overall growth. With compounding, if that discrepancy persists, the wealth held by owners of
capital will increase far more rapidly than other kinds of earnings (wages, for example), eventually
outstripping them by a wide margin. Although this study has as many critics as admirers, it has added to
the debate on wealth distribution in capitalism and reinforced the belief among many that a capitalist
economy must be steered in the right direction by government policies and the general public to ensure
that Smith’s invisible hand continues to work in society’s favor.

Industrialization
R. Biernacki, in International Encyclopedia of the Social & Behavioral Sciences, 2001
Industrialization is the process of applying mechanical, chemical, and electrical sciences to
reorganize production with inanimate sources of energy. A technological criterion of
industrialization by no means entails technological determinism. On the contrary, comparative
studies of industrialization have served as a key field for social investigators to highlight the
influence of culture, political contingency, and the timing of local development in relation to
world history. Cross-national comparisons of industrialization have undermined unilinear models
that had predicted that the international sharing of technology would lead to convergence in the
social institutions of manufacture.

Processes of industrialization across capitalist societies as well as across state-dominated

societies with central planning, such as the former Soviet Union, have shared essential
similarities. Initially industrialization is marked by massive transfers of labor out of agriculture
and into factories that have concentrations of capital equipment. Increases in the productivity of
the labor devoted to manufacture come to balance increases in demand for goods, however, and
employment in the service sector increases more rapidly than in manufacture after initial
industrialization. In the leading industrial societies of Europe, Asia, and North America,
employment growth has increasingly concentrated in services, expert professions, and finance.
Even in industrialized countries that are net exporters of manufactures, such as Germany, the
absolute number of workers in manufacturing has usually declined since the 1970s. Indeed, some
national economies, including that of the UK, have become net importers of manufactured goods
and net exporters of design know-how and of financial services that put technology to work
elsewhere.