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Capitalism Explained

Dennis Hammer is a writer and finance nerd with six years of investing experience. He writes about personal finance for Wealthsimple. Dennis also manages his own investment portfolio and has funded several businesses in the past. Dennis holds a Bachelor's degree from the University of Connecticut.

Almost everyone in the world practices some form of capitalism. That includes you. As an investor, your goal is to take advantage of capitalism’s biggest benefit: the ability to create wealth. In this article, we’ll explain capitalism and how this concept benefits you.

What is capitalism?

Capitalism is a popular economic system that relies on private ownership and competition to drive economic advancement. It’s responsible for many of the incredible products and technologies we enjoy every day.

You’re participating in capitalism when you purchase goods and services or trade your labor for a wage. You’re also participating every time you invest, which is all the time if you have an investment portfolio or high interest savings account.

Capitalism definition

Capitalism is an economic system where private individuals and businesses own the means of production. The production levels and prices of goods and services are based on free market competition, not a central government or regulating body. Investments are determined by private decisions.

The word capitalism comes from capital, which refers to resources (goods, money, property, etc.) that are used to produce more wealth. A capitalist is someone who practices capitalism by using his or her resources to make more resources.

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How capitalism works

Under capitalism, prices of products and wages for workers are determined by the forces of supply and demand. Capitalists are driven to create the most value (profit) at the least cost. Consumers want high quality goods and services at the lowest prices. Competition forces producers to cater to consumer demands. The government’s role, therefore, is to protect the legal rights of all participants (producers and consumers), not regulate the free market.

This means that under capitalism, successful companies are the ones that create the greatest value at the least cost. Companies who fail to create value efficiently will be forced out of the market once consumers realize they can purchase the same value for less elsewhere.

Profit is what drives people and companies to develop new products and services that customers want to buy. Company A and Company B strive to make the best product in order to make the most sales. The real winner here is the customer who gets quality products at the lowest prices. If the means of production were state-owned, it’s argued, people would lack the motivation to create and improve products.

Unlike other economic systems like socialism and communism, capitalism isn’t concerned with equitable arrangements. It does not seek to make everyone equal. In fact, capitalism seeks inequality. The logic works like this: Capitalists seek to have more wealth. That drive forces innovation and expansion, which spurs economic development.

Feudalism to capitalism

Capitalism was born out of European feudalism. In feudal societies, most workers were serfs for feudal lords (who were just wealthy property owners with protection from the state—their monarch). Even skilled workers who lived in cities received wages from their benefactor, rather than from the production of goods and services.

Over time urbanism rose, which created more opportunities for industry and trade. People moved toward cities and towns where they could work for a wage rather than subsistence from their feudal lord. They began to trade between towns, then counties, then across nations. As more sellers entered the market, they grew competitive.

Eventually, large-scale trade and colonization of new lands created demand for new products and services. Demand drove the expansion of production. Producers invested in mechanization and automation. Advancements in energy meant factories didn’t have to be built near water. They could be built near working people. This was the Industrial Revolution.

This period is when private citizens (industry tycoons, you could call them) began to amass more wealth in their own lifetimes than the nobility. This was the first time in history that common people could become wealthy. It was also the first time scholars and philosophers began using the term capitalism to refer to this system of ownership of industrial means by private individuals.

Mixed capitalist systems

Truthfully, most capitalist systems throughout history have been mixed capitalism. A mixed system is one where the public (often by way of the government) replaces, limits, or regulates private interests. In the United States, Canada, and United Kingdom, for example, governments own some of the means of production, but most is owned by private parties.

In mixed capitalist systems, government regulation limits how people can trade. There are also rules that place limits on private property and how it can be exchanged. Here are some examples of government intervention that limit capitalism:

  • Minimum wage laws

  • Anti-trust legislation

  • Licenses and permits

  • Prohibited products/sales

  • Worker safety regulations

Furthermore, many governments own or partially own certain industries they feel shouldn’t be subject to capitalist forces. This includes industries like railroads, public utilities (water, electricity, phone service, etc.), or some medical facilities.

Private property rights

Capitalism depends on private property rights and a system to enforce them. Private property creates efficiency by giving the owners of capital goods a reason to maximize the value of their property.

Think of it like this: A restaurant provides quality food and excellent service because the owners want to build a strong reputation and earn money for a long time. But if the restaurant could be taken away at any time, and all work and investment were lost, the owners would be less willing to pour their time, effort, and money into it.

Private property rights also mean the owners of property are entitled to the value it creates through its activities (like business operations) or its sale. That restaurant owner gets to keep the profit from his day-to-day operations. He also gets to sell the business one day and keep that money.

When private property isn’t recognized, but instead shared by the public, a problem called the tragedy of commons may emerge. If everyone owns a resource, everyone will have incentive to extract value from it and no one will have incentive to conserve it or reinvest it.

Types of capitalism

Capitalism is one process by which we solve our problems of resource production and distribution, but like all economic systems, there are several variations of capitalism.

1. Anarcho-capitalism

Anarcho-capitalism is an economic system that advocates for the elimination of the state entirely. Proponents of this system believe people would self-regulate if they weren’t forced to by a government. Anarcho-capitalists believe everything should be left to the free market and private property. In an anarcho-capitalist society, law enforcement and courts would be operated by privately funded parties selected by consumers rather than a central public authority.

2. Laissez-faire capitalism

Laissez-faire capitalism comes from the underlying belief that economic competition is a natural order and government intervention can only reduce its effectiveness. It comes from a French term that translates to “leave alone.”

Laissez-faire capitalism advocates for the government’s complete withdrawal from the economy. They believe private individuals should be allowed to buy, sell, and invest in anything, any way they like. They oppose any sort of legislation that regulates the market, such as corporate taxes, licensing, duties, and minimum wages.

3. Free market capitalism

Free market capitalism is another form of unregulated capitalism like anarcho-capitalism and laissez-faire capitalism. In free market capitalism, the market is based entirely on the rules of supply and demand with very little or no government intervention. All transactions are voluntary exchanges between private buyers and sellers. The term “free market” is often used to refer to an economy unencumbered by government regulation.

4. Late-stage capitalism

Late-stage capitalism refers to a) the period of global capitalism after the 1940s and b) the injustices, inequality, and absurdities that can arise in a capitalist system. It refers to an economic climate where the majority of wealth is owned by a tiny minority of people, monopolies, and de-facto oligarchs have rigged the system in their favor, and corporations have the same rights as people. The phrase has become more popular over the last few years because it expresses people’s frustration with a system that appears to grow less fair.

5. Surveillance capitalism

Surveillance capitalism is the name for an economic system where human experience and behavior data are considered raw materials that can be monetized to boost their competitive advantage. Companies first extract data from online and offline experiences and then feed it into a machine intelligence that predicts or influences human behavior.

Targeted marketing is the most common example of surveillance capitalism. Companies monitor and track people’s online behavior to learn about them, then focus marketing efforts on consumers who are most likely to buy. Many companies also sell customer data to third parties.

How capitalism affects people and the world

Capitalism’s impact depends on whether you’re a worker or an owner. If you own a business and employ other people, capitalism probably makes sense. When you bring in more profit, you can pay workers more or hire new ones, which raises everyone’s standard of living.

But if you’re a worker, it may seem like all of your labor just makes someone else richer, which is why inequality is one of the major criticisms of capitalism. Anti-capitalists argue that capitalism is an inhuman, unsustainable, and exploitable system that’s at odds with democracy due to how capital resources attract political power.

Capitalism vs socialism

Socialism is an economic system that assumes people are naturally cooperative. The goal is to create an egalitarian society for the benefit of all. The workers own the means of production. Individuals can still own property, but the means of generating wealth belong to the community. Workers are compensated in proportion to their contribution, but necessarily equal to one another.

Communism vs capitalism

Under communism, there is no such thing as private property. All property is owned by the state. People are considered to be economically equal, no matter their ability to produce goods and services. The state (a strong government) controls all aspects of the economy, including food, housing, education, and medical care. Under capitalism, all of these functions are managed by private parties.

Examples of capitalism

The Index of Economic Freedom is a database that measures economic freedom based on a number of qualitative and quantitative factors. It considers the following countries to be capitalist, listed in order of those with the most economic freedom.

  1. Hong Kong

  2. Singapore

  3. New Zealand

  4. Switzerland

  5. Australia

  6. Ireland

  7. United Kingdom

  8. Canada

  9. United Arab Emirates

  10. Taiwan

  11. Iceland

  12. United States

  13. Netherlands

  14. Denmark

  15. Estonia

  16. Georgia

  17. Luxembourg

  18. Chile

  19. Sweden

  20. Finland

  21. Lithuania

  22. United States

  23. Malaysia

  24. Czech Republic

  25. Germany

  26. Mauritius

  27. Norway

  28. Israel

  29. Qatar

  30. South Korea

Pros and cons of capitalism

Is capitalism a perfect system? Just like any economic system, there are advantages and disadvantages to capitalism.

Pros of capitalism

“Capitalism has brought with it progress, not merely in production but also in knowledge.” - Albert Einstein

  • Economic freedom helps political freedom by giving people power outside of their government. If the state owns the means of production, it may grow too powerful.

  • People tend to feel like capitalism is a fair system, even if they aren’t wealthy.

  • Entrepreneurs have incentive to develop, improve, and invest in new products.

  • Capitalist companies have incentive to be efficient with resources.

  • A climate of efficiency and innovation drives economic expansion.

  • Capitalism is responsible for (or at least has contributed to) the greatest increase in people’s standard of living. It may not be perfect, but there aren’t any better alternatives.

Cons of capitalism

“Capitalism has defeated communism. It is now well on its way to defeating democracy.” - David Korten

  • Private ownership means companies can become monopolies that control entire markets and ultimately charge high prices.

  • Businesses with monopsony power (monopsony is a business with only one buyer) can pay lower wages because workers don’t have any other choice.

  • Capitalist companies tend to not consider social benefits like education, healthcare, or environmental protection unless there’s profit to be made with those activities.

  • Capitalist economies tend to cycle between periods of high and low economic activity.

  • Inequality creates social division and resentment among groups of people.

  • There is a diminishing return on the utility of wealth. A billionaire who earns an extra million doesn’t see as much economic value as a poorer person would.

  • Wealth can become concentrated in families as each generation passes it down to the next, creating de facto dynasties.

If you’re an investor, you are a capitalist, at least to some degree. You’re using your capital to create more capital. You participate in a capitalist economy every time you make a trade, deposit funds in your investment account, or show up to work for your employer. It isn’t a perfect system, but allows businesses and people to build wealth.

Last Updated October 10, 2018

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