Capitalism

Capitalism

Investopedia / Zoe Hansen

What Is Capitalism?

Capitalism is an economic system in which private individuals or businesses own capital goods. At the same time, business owners (capitalists) employ workers (labor) who only receive wages; labor does not own the means of production but only uses them on behalf of the owners of capital.

The production of goods and services under capitalism is 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.

Key Takeaways

  • Capitalism is an economic system characterized by private ownership of the means of production, especially in the industrial sector, with labor paid only wages.
  • Capitalism depends on the enforcement of private property rights, which provide incentives for investment in and productive use of productive capital.
  • Capitalism developed historically out of previous systems of feudalism and mercantilism in Europe, and dramatically expanded industrialization and the large-scale availability of mass-market consumer goods.
  • Pure capitalism can be contrasted with pure socialism (where all means of production are collective or state-owned) and mixed economies (which lie on a continuum between pure capitalism and pure socialism).
  • The real-world practice of capitalism typically involves some degree of so-called “crony capitalism” due to demands from business for favorable government intervention and governments’ incentive to intervene in the economy.
2:05

Capitalism

Understanding Capitalism

Functionally, capitalism is one system of economic production and resource distribution. Instead of planning economic decisions through centralized political methods, as with socialism or feudalism, economic planning under capitalism occurs via decentralized, competitive, and voluntary decisions.

Capitalism is essentially an economic system whereby the means of production (i.e., factories, tools, machines, raw materials, etc.) are organized by one or more business owners (capitalists). Capitalists then hire workers to operate the means of production in return for wages. Workers, however, do not have any claim on the means of production nor on the profits generated from their labor - these belong to the capitalists.

As such, private property rights are fundamental to capitalism. Most modern concepts of private property stem from John Locke's theory of homesteading, in which human beings claim ownership through mixing their labor with unclaimed resources. Once owned, the only legitimate means of transferring property are through voluntary exchange, gifts, inheritance, or re-homesteading of abandoned property. Private property promotes efficiency by giving the owner of resources an incentive to maximize the value of their property. So the more valuable the resource is, the more trading power it provides the owner. In a capitalist system, the person who owns the property is entitled to any value associated with that property.

Why Private Property Rights Matter for Capitalism

For individuals or businesses to deploy their capital goods confidently, a system must exist that protects their legal right to own or transfer private property. A capitalist society will rely on the use of contracts, fair dealing, and tort law to facilitate and enforce these private property rights.

When property is not privately owned but shared by the public, a problem known as the tragedy of the commons can emerge. With a common pool resource, which all people can use, and none can limit access to, all individuals have an incentive to extract as much use-value as they can and no incentive to conserve or reinvest in the resource. Privatizing the resource is one possible solution to this problem, along with various voluntary or involuntary collective action approaches. 

Under capitalist production, the business owners (capitalists) retain ownership of the goods being produced. If a worker in a shoe factory were to take home a pair of shoes that they made, it would be theft. This concept is known as the alienation of workers from their labor.

Capitalism and the Profit Motive

Profits are closely associated with the concept of private property. By definition, an individual only enters into a voluntary exchange of private property when they believe the exchange benefits them in some psychic or material way. In such trades, each party gains extra subjective value, or profit, from the transaction. The profit motive, or the desire to earn profits from business activity, is the driving force of capitalism. It creates a competitive environment where businesses compete to be the low-cost producer of a certain good in order to gain market share. If it is more profitable to produce a different type of good, then a business is incentivized to switch.

Voluntary trade is another, related mechanism that drives activity in a capitalist system. The owners of resources compete with one another over consumers, who in turn, compete with other consumers over goods and services. All of this activity is built into the price system, which balances supply and demand to coordinate the distribution of resources.

A capitalist earns the highest profit by using capital goods (e.g., machinery, tools, etc.) most efficiently while producing the highest-value good or service. In this system, information about what is highest-valued is transmitted through those prices at which another individual voluntarily purchases the capitalist's good or service. Profits are an indication that less valuable inputs have been transformed into more valuable outputs. By contrast, the capitalist suffers losses when capital resources are not used efficiently and instead create less valuable outputs.

Capitalism vs. Markets

Capitalism is a system of economic production. Markets are systems of distribution and allocation of goods already produced. While they often go hand-in-hand, capitalism and free markets refer to two distinct systems.

Precursors to Capitalism

Capitalism is a relatively new type of social arrangement for producing goods in an economy. It arose largely along with the advent of the industrial revolution, some time in the late 17th century. Before capitalism, other systems of production and social organization were prevalent, out of which capitalism emerged.

Feudalism and the Roots of Capitalism

Capitalism grew out of European feudalism. Up until the 12th century, a very small percentage of the population of Europe lived in towns. Skilled workers lived in the city but received their keep from feudal lords rather than a real wage, and most workers were serfs for landed nobles. However, by the late Middle Ages rising urbanism, with cities as centers of industry and trade, become more and more economically important.

Under feudalism, society was segmented into social classes based on birth or family lineage. Lords (nobility) were the land owners, while serfs (peasants and laborers) did not own land but were under the employ of the landed nobility.

The advent of industrialization revolutionized the trades and encouraged more people to move into towns where they could earn more money working in a factory rather than subsistence in exchange for labor. Families’ extra sons and daughters who needed to be put to work, could find new sources of income in the trade towns. Child labor was as much a part of the town's economic development as serfdom was part of the rural life.

Mercantilism

Mercantilism gradually replaced the feudal economic system in Western Europe and became the primary economic system of commerce during the 16th to 18th centuries. Mercantilism started as trade between towns, but it was not necessarily competitive trade. Initially, each town had vastly different products and services that were slowly homogenized by demand over time.

After the homogenization of goods, trade was carried out in broader and broader circles: town to town, county to county, province to province, and, finally, nation to nation. When too many nations were offering similar goods for trade, the trade took on a competitive edge that was sharpened by strong feelings of nationalism in a continent that was constantly embroiled in wars.

Colonialism flourished alongside mercantilism, but the nations seeding the world with settlements were not trying to increase trade. Most colonies were set up with an economic system that smacked of feudalism, with their raw goods going back to the motherland and, in the case of the British colonies in North America, being forced to repurchase the finished product with a pseudo-currency that prevented them from trading with other nations.

It was Adam Smith who noticed that mercantilism was not a force of development and change, but a regressive system that was creating trade imbalances between nations and keeping them from advancing. His ideas for a free market opened the world to capitalism.

The Growth of Industry

Adam Smith's ideas were well-timed, as the Industrial Revolution was starting to cause tremors that would soon shake the Western world. The (often literal) gold mine of colonialism had brought new wealth and new demand for the products of domestic industries, which drove the expansion and mechanization of production. As technology leaped ahead and factories no longer had to be built near waterways or windmills to function, industrialists began building in the cities where there were now thousands of people to supply ready labor.

Industrial tycoons were the first people to amass their wealth in their lifetimes, often outstripping both the landed nobles and many of the money lending/banking families. For the first time in history, common people could have hopes of becoming wealthy. The new money crowd built more factories that required more labor, while also producing more goods for people to purchase.

During this period, the term "capitalism"—originating from the Latin word "capitalis," which means "head of cattle"—was first used by French socialist Louis Blanc in 1850, to signify a system of exclusive ownership of industrial means of production by private individuals rather than shared ownership.

Capitalism involved reorganizing society into social classes based not on ownership of land, but ownership of capital (i.e., businesses). Capitalists were able to earn profits from the surplus labor of the working class, who earned only wages. Thus, the two social classes defined by capitalism are the capitalists and the laboring classes.

Pros and Cons of Capitalism

Pros

Industrial capitalism tended to benefit more levels of society rather than just the aristocratic class. Wages increased, helped greatly by the formation of unions. The standard of living also increased with the glut of affordable products being mass-produced. This growth led to the formation of a middle class and began to lift more and more people from the lower classes to swell its ranks.

The economic freedoms of capitalism matured alongside democratic political freedoms, liberal individualism, and the theory of natural rights. This unified maturity is not to say, however, that all capitalist systems are politically free or encourage individual liberty. Economist Milton Friedman, an advocate of capitalism and individual liberty, wrote in Capitalism and Freedom (1962) that "capitalism is a necessary condition for political freedom...it is not a sufficient condition."

A dramatic expansion of the financial sector accompanied the rise of industrial capitalism. Banks had previously served as warehouses for valuables, clearinghouses for long-distance trade, or lenders to nobles and governments. Now they came to serve the needs of everyday commerce and the intermediation of credit for large, long-term investment projects. By the 20th century, as stock exchanges became increasingly public and investment vehicles opened up to more individuals, some economists identified a variation on the system: financial capitalism.

Capitalism and Economic Growth

By creating incentives for entrepreneurs to reallocate away resources from unprofitable channels and into areas where consumers value them more highly, capitalism has proven a highly effective vehicle for economic growth.

Before the rise of capitalism in the 18th and 19th centuries, rapid economic growth occurred primarily through conquest and extraction of resources from conquered peoples. In general, this was a localized, zero-sum process. Research suggests average global per-capita income was unchanged between the rise of agricultural societies through approximately 1750 when the roots of the first Industrial Revolution took hold.

In subsequent centuries, capitalist production processes have greatly enhanced productive capacity. More and better goods became cheaply accessible to wide populations, raising standards of living in previously unthinkable ways. As a result, most political theorists and nearly all economists argue that capitalism is the most efficient and productive system of exchange.

Cons

At the same time, capitalism has also generated immense wealth disparities and social inequalities. While capitalists enjoy the potential for high profits, workers are exploited for their labor, with wages always kept lower than the true value of the work being done. Unemployment is another symptom of capitalism, where unproductive workers are left out of the labor force or replaced by technological advancements or inventions. This creates a struggle between the working class and the capitalist class, where workers fight for better conditions, fairer wages, and greater dignity. Meanwhile, business owners and investors favor higher profit margins, often by means of reducing wages and cutting down on the workforce.

Another drawback of capitalism is that it often leads to a host of negative externalities, such as air and noise pollution. Negative externalities are costs paid for by society and not the producer of the externality. A factory dumping waste into a river or emitting smoke into the air is a problem shouldered by the communities that the factory is in, and not the business itself.

Crony Capitalism

One downside of capitalism is its incentives to corrupt. 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 desire of governments to control the economy.

Pros and Cons of Capitalism

Pros
  • More efficient allocation of capital resources

  • Competition leads to lower consumer prices

  • Wages and general standards of living have risen overall

  • Spurs innovation and invention

Cons
  • Creates inherent class conflict between capital and labor

  • Generates enormous wealth disparities and social inequalities

  • Unequal conditions lead to poverty and unemployment for some

  • Can incentivize corruption and crony capitalism in the pursuit of profit

  • Produces negative externalities such as pollution

Capitalism vs. Socialism

In terms of political economy, capitalism is often contrasted with socialism. The fundamental difference between capitalism and socialism is the ownership and control of the means of production. In a capitalist economy, property and businesses are owned and controlled by individuals. In a socialist economy, the state owns and manages the vital means of production. However, other differences also exist in the form of equity, efficiency, and employment.

Equity

The capitalist economy is unconcerned about equitable arrangements. The argument is that inequality is the driving force that encourages innovation, which then pushes economic development. The primary concern of the socialist model is the redistribution of wealth and resources from the rich to the poor, out of fairness, and to ensure equality in opportunity and equality of outcome. Equality is valued above high achievement, and the collective good is viewed above the opportunity for individuals to advance.

Efficiency

The capitalist argument is that the profit incentive drives corporations to develop innovative new products that are desired by the consumer and have demand in the marketplace. It is argued that the state ownership of the means of production leads to inefficiency because, without the motivation to earn more money, management, workers, and developers are less likely to put forth the extra effort to push new ideas or products.

Employment

In a capitalist economy, the state does not directly employ the workforce. This lack of government-run employment can lead to unemployment during economic recessions and depressions. In a socialist economy, the state is the primary employer. During times of economic hardship, the socialist state can order hiring, so there is full employment. Also, there tends to be a stronger "safety net" in socialist systems for workers who are injured or permanently disabled. Those who can no longer work have fewer options available to help them in capitalist societies.

Karl Marx, Capitalism, and Socialism

Karl Marx was famously critical of the capitalist system of production because he saw it as an engine for creating social ills, massive inequalities, and self-destructive tendencies. Marx argued that, over time, capitalist businesses would drive one another out of business through fierce competition, while at the same time the laboring class would swell and begin to resent their unfair conditions. His solution was socialism, whereby the means of production would be handed over to the laboring class in an egalitarian fashion, In this system, production would take place via organizations like worker cooperatives, with profits shared equitably among all employed.

Varieties of Capitalism

Today, many countries operate with capitalist production, but this also exists along a spectrum. In reality, there are elements of pure capitalism that operate alongside otherwise socialist institutions.

The standard spectrum of economic systems places laissez-faire capitalism at one extreme and a complete planned economy—such as communism—at the other. Everything in the middle could be said to be a mixed economy. The mixed economy has elements of both central planning and unplanned private business.

By this definition, nearly every country in the world has a mixed economy, but contemporary mixed economies range in their levels of government intervention. The U.S. and the U.K. have a relatively pure type of capitalism with a minimum of federal regulation in financial and labor markets—sometimes known as Anglo-Saxon capitalism—while Canada and the Nordic countries have created a balance between socialism and capitalism.

Mixed Capitalism

When the government owns some but not all of the means of production, but government interests may legally circumvent, replace, limit, or otherwise regulate private economic interests, that is said to be a mixed economy or mixed economic system. A mixed economy respects property rights, but places limits on them.

Property owners are restricted with regard to how they exchange with one another. These restrictions come in many forms, such as minimum wage laws, tariffs, quotas, windfall taxes, license restrictions, prohibited products or contracts, direct public expropriation, anti-trust legislation, legal tender laws, subsidies, and eminent domain. Governments in mixed economies also fully or partly own and operate certain industries, especially those considered public goods, often enforcing legally binding monopolies in those industries to prohibit competition by private entities.

Anarcho-Capitalism

In contrast, pure capitalism, also known as laissez-faire capitalism or anarcho-capitalism, (such as professed by Murray N. Rothbard) all industries are left up to private ownership and operation, including public goods, and no central government authority provides regulation or supervision of economic activity in general.

Welfare Capitalism


Many European nations practice welfare capitalism, a system that is concerned with the social welfare of the worker, and includes such policies as state pensions, universal healthcare, collective bargaining, and industrial safety codes.

What Is an Example of Capitalism?

An example of capitalist production would be if an entrepreneur starts a new widget company and opens a factory. This individual uses available capital that they own (or from outside investors) and buys the land, builds the factory, orders the machinery, and sources the raw materials. Workers are then hired by the entrepreneur to operate the machines and produce widgets. Note that the workers do not own the machines they use nor the widgets that the produce. Instead, they receive only wages in exchange for their labor.

Who Benefits From Capitalism?

Capitalism tends to benefit capitalists the most. These include business owners, investors, and other owners of capital. While capitalism has been evaluated as improving the standard of living for many people across the board, it has by far benefited those at the top. Just witness the rise of the 1% (and the 0.1% and 0.01%), and how much of the overall wealth these relatively small groups of individuals own and control.

Why Is Capitalism Harmful?

Because of how it is structured, capitalism will always pit business owners and investors (i.e., capitalists) against the working class. Capitalists are in competition against one another, and so will seek to increase their profits by cutting costs, including labor costs. At the same time, workers want to see higher wages, fairer treatment, and better working conditions. These two incentives are fundamentally at odds with one another. This creates class conflict, inequalities, and misery among the working class. Capitalism also produces negative externalities that can harm the environment and peoples' health and incentivizes cronyism and other bad behavior.

Is Capitalism the Same as Free Enterprise?

Capitalism and free enterprise are often seen as synonymous. In truth, they are closely related yet distinct terms with overlapping features. It is possible to have a capitalist economy without complete free enterprise, and possible to have a free market without capitalism. Any economy is capitalist as long as private individuals control the factors of production. However, a capitalist system can still be regulated by government laws, and the profits of capitalist endeavors can still be taxed heavily.

"Free enterprise" can roughly be understood to mean economic exchanges free of coercive government influence. Although unlikely, it is possible to conceive of a system where individuals choose to hold all property rights in common. Private property rights still exist in a free enterprise system, although the private property may be voluntarily treated as communal without a government mandate.

As an example, many Native American tribes existed with elements of these arrangements, and within a broader capitalist economic family, clubs, co-ops, and joint-stock business firms like partnerships or corporations are all examples of common property institutions.

If accumulation, ownership, and profiting from capital is the central principle of capitalism, then freedom from state coercion is the central principle of free enterprise.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. Trinity University. "Adam Smith on Money, Mercantilism, and the System of Natural Liberty."

  2. Cambridge University Press. "Cries of Pain: The Word 'Capitalism'."

  3. Milton Friedman. "Capitalism and Freedom," Page 17.

  4. New World Encyclopedia. "Anarcho-Capitalism."