Capitalism is an economic system with three key features. First, the enterprises that produce goods and services are privately owned. Second, economic activity is coordinated by markets, which means that firms buy inputs and sell their products at prices determined by supply and demand, with the aim of making a profit. Third, the labor of producing goods and services is performed by free individuals who sell their labor time to business firms in exchange for a wage.
Capitalism arose in the fourteenth century in northern Italy, but it did not become well established until the sixteenth century in England and some parts of continental Western Europe. At the time of the founding of the United States at the end of the eighteenth century, capitalism had not yet developed significantly in America. Capitalism developed rapidly in the northern United States after 1800, and after the Civil War it spread to the South as well. Today, capitalism is the dominant economic system in the world.
Capitalism can be contrasted with four other economic systems that have played important roles in human society over the past thousand years: slave systems, feudal systems, independent producer systems, and socialist systems. In a slave system, the producers are owned by a class of “masters” who thereby own the goods produced by the slaves. A slave system based on African labor, centered around production of staple crops such as cotton and rice, arose in the American South early in the colonial period. It became the mainstay of the southern economy as well as influenced the form of governance in the South. The Civil War ( 1961–1965 ) finally ended the southern slave system.
In a feudal system, the producers are tied to the land and are required to produce for the landowner as well as to satisfy their own needs. The United States differs from many other parts of the world in its absence of a significant feudal past. In early American history there were some attempts to establish feudal economic relations, such as in Maryland, but they did not take hold in a context where escape from a feudal manor was not difficult.
An economy of independent producers is one in which families own small farms or small businesses but, unlike in capitalism, the owners also perform all or most of the labor. This type of economy prevailed in the colonial period in the northern section of what became the United States and in the western United States for much of the nineteenth century. Today, independent producers (the self-employed) still make up about 11 percent of the economically active population in the United States and a much larger share in some other countries.
The fourth type of economic system is a socialist system. The traditional definition of a socialist system is one in which enterprises are publicly owned and economic decision making is coordinated by means of central planning rather than the price mechanism. Goods and services are produced not to gain a profit from sale but to fulfill the economic plan, which is supposed to be designed to meet the wants and needs of the population. The only feature similar to capitalism is that labor is performed in return for a wage, but workers are employed by public enterprises rather than privately owned firms.
In other parts of the world, socialist systems arose in a number of countries in the twentieth century, such as the Soviet Union after 1917, China after 1949, and Cuba after 1959. In some countries with socialist systems, such as Yugoslavia in the 1960s and China after 1978, central planning was replaced by a system of market exchange. Scholars disagree about whether the resulting market socialism is a form of socialism or a return to capitalism.
Although the number of socialist economies declined sharply after 1989, socialist political parties remain influential in many parts of the world. New efforts to build a socialist economy have arisen in the 2000s in Venezuela and some other countries in South America. China, which has achieved the fastest economic growth in the world since 1978 and surpassed Japan to become the second largest economy in 2010, claims to have a socialist economy, although China also has significant capitalist features. Capitalism and socialism are seen as the two economic alternatives in the world today, although capitalism has dominated since 1989.
Adam Smith ( 1723–1790 ), a Scottish philosopher, was the first thinker to provide a systematic analysis of how capitalism worked. His famous book, An Inquiry into the Causes of the Wealth of Nations ( 1776 ), explained how business owners, pursuing their own profit, introduce division of labor in their workshops. Smith used the example of a pin factory to show how production of a whole product by a single craftsperson was replaced by many wage workers cooperating through division of the production process into many simple steps. Smith extolled the greatly increased productivity possible through division of labor. He also introduced the metaphor of the “invisible hand” to suggest that a competitive market economy channels self-interested individual behavior toward contributing to the social good. However, he also believed there were problems in the capitalist system, such as harmful effects on workers who spent their workday doing simple, repetitive tasks, and a tendency for business owners to collude to raise their prices.
Karl Marx ( 1818–1883 ), a German scholar and revolutionary, was one of the first to use the term capitalist production in his major work, Capital: A Critique of Political Economy ( 1867 ), which provided a comprehensive and controversial analysis of capitalism. Marx was both an admirer and critic of capitalism. He argued that capitalism's virtue is that the owners of enterprises—the capitalists—are driven by competition to reinvest their profits in new technologies that rapidly increase output and labor productivity over time. Marx viewed capitalism as a revolutionary system that radically transforms society by harnessing science to production.
However, Marx also believed capitalism had a dark side. He argued that capitalists exploit workers in their drive for profit, extending the workweek and creating unsafe and unhealthy working conditions. He claimed that the periodic economic downturns that had occurred since the early nineteenth century, bringing business failures and high unemployment, are an inevitable product of the unplanned nature of capitalist production. He predicted that eventually the problems of capitalism would lead the workers to rise up against it, replacing it with a socialist system. Marx viewed socialism or communism (he used both terms) as a superior economic system that would eliminate classes in society and share the growing wealth that can be produced using advanced technology among the whole population.
In the late nineteenth century, Alfred Marshall ( 1842–1924 ) and others developed what is known today as neoclassical economic theory, which extended Adam Smith's “invisible hand” metaphor. Neoclassical theory claims that a competitive market economy is optimally efficient at satisfying consumer wants, as firms respond to the price signals generated by supply and demand. However, neoclassical theory allows for a possible need for government intervention in markets in cases of market failure, which occurs when market transactions impose costs or benefits on third parties or when a buyer cannot know the features of the product being purchased.
John Maynard Keynes ( 1883–1946 ), writing during the Great Depression of the 1930s, argued that capitalism has a serious flaw—it lacks any mechanism to assure full employment of labor. He proposed that the government correct this flaw by using its spending power to bring full employment when private spending is too low. A combination of the neoclassical theory of competitive markets and the Keynesian theory of employment and output dominated the economics textbooks after World War II, starting with Paul A. Samuelson's famous textbook Economics: An Introductory Analysis, first published in 1948.
The debate about government and economy continues today. Some support capitalism with a limited role for the government. Others believe capitalism requires an activist role for government in the economy. Some argue that the relation between government and economy represented by socialism would be the best system.
Frederick A. Hayek ( 1899–1992 ), an Austrian economist, made the case for capitalism with limited government based on the role of information in economic decision making. Hayek argued that the main strength of capitalism is its effective use of economic information. He reasoned that much of the essential information for economic decision making concerns local economic conditions at a moment in time. Such information cannot be effectively communicated to any centralized decision maker, such as a government official. Hence, he argued, the most effective economic system allows individuals to make the economic decisions, utilizing their local knowledge supplemented by information about the world outside their local sphere that is communicated to them by market prices.
Milton Friedman ( 1912–2006 ), a longtime professor at the University of Chicago, took a different tack in supporting a limited government role in the capitalist economy. Friedman argued that competitive markets guarantee individual freedom. He reasoned that economic decisions can be made only in two ways, by the free choice of an individual or the coercive action of government. Competitive markets are based on free choice by individuals, which, Friedman argues, means that the coercive hand of government should rarely intervene in the market. According to this view, advocates of socialism, as well as those who favor active government under capitalism, are misguidedly supporting the limitation of human freedom by encouraging an expansion of state power that will make individuals subordinate to state officials.
Advocates of an active government role in a capitalist economy cite the views of Keynes, as well as the neoclassical concept of market failure. Some emphasize that active government is the only way to prevent periodic high unemployment. Others support government regulation of business behavior to prevent the environmental degradation that can result from pursuit of profit. Still others argue that capitalism gives rise to a very unequal and unjust distribution of income that only government action can modify through progressive income taxes, social welfare programs, minimum-wage laws, and guarantees of workers' right to form unions to bargain with their employers.
Advocates of socialism cite Marx and other critics of capitalism to argue that capitalism cannot meet the economic needs of the whole population. They make a case that a socialist economy can bring full employment, a relatively equal distribution of income, elimination of poverty, and a sustainable relation to the natural environment. They argue that the first attempts to build a socialist system in the twentieth century were highly flawed by undemocratic political institutions and excessively centralized economic planning. They suggest that a socialist system, having no wealthy class able to exercise outsized political power, could be more democratic than capitalism.
The evolution of capitalism in the United States over time has had a big impact on American governance. The American constitutional system, with its separation of powers and checks and balances, was designed in a new country with a precapitalist economy of independent small farmers and artisans, wealthy merchants and landowners in the North, and even wealthier planters in the South living off the labor of slaves. As capitalism arose and changed over time, it transformed the economy in many ways including turning the majority into wage and salary workers in an interdependent national and even international economy of large corporations. American governance has been pressed to adjust to these momentous economic changes by accommodating a growing role for government in the economy. When capitalism gives rise to economic difficulties, the American constitutional system inevitably experiences strains. Contending groups agree only that decisive action is needed to solve the economic problems, which runs up against a constitutional system that was not intended to facilitate quick and decisive action by government.
SEE ALSO Capitalism and Democracy ; Free-Market Economics, Theory of ; Keynesianism ; Regulation Smith, Adam .
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David M. Kotz
University of Massachusetts Amherst Shanghai University of Finance and Economics