Economic Systems: Capitalism

The theories of socialism and capitalism have been competing for more than a century. For Karl Marx, capitalism was a system that promoted class domination and oppression. The Marxist version of socialism as tested in the Soviet Union, Cuba, China, and other places has failed. Lack of individual freedom caused human suffering and economic ruin. The failure of this dramatic approach has not killed the approach itself. On the other hand, the basic principles of capitalism of voluntary exchange, free trade between nations, and the self-directed market via the "invisible hand" have been accepted by most as fundamental to a successful economy. However, unrestrained capitalism seems to have wrought evils of its own. The preponderance of the world engages some mixture of capitalist and socialist principles, and the debate continues as to the optimal mix. That is, markets should be free, but how free? In terms of global capitalism, most agree that free trade is ly preferable, and the debate usually turns to, how free?

Keywords Capitalism; Command Economy; Comparative Advantage; Division of Labor; Feudal System; Factors of Production; Laissez-Faire; Managed Economy; Market Economy; Mixed Economy; Mercantilism; Multilateral Treaty; Robber-Baron; Signatory; Socialism; State Socialism

Economic Systems: Capitalism

Overview

Capitalism is an economic system that consists of privately owned organizations competing in an open market for profit and ownership of the means of production. In contrast to socialist or communist systems, capitalism focuses on private business and investment. Investors in private companies (i.e., shareholders) are known as capitalists. Laissez-Faire economy, private enterprise system, and free-price system are synonyms for capitalism; socialism and communism are antonyms of capitalism. The production, pricing, and distribution of goods and services are determined by the market economy.

The essential feature of a market economy is the voluntary exchange of goods and services. The decisions about price and production are a product of the aggregate decisions of all the consumers and businesses in the economy. Market economies depend upon the theory that market forces (like supply and demand) will lead to the best course of action and as a result, a healthy market. The interaction of the market forces of supply, demand and price is sometimes called the market mechanism. A simple example of how the market mechanism works: Imagine competing manufacturers of similar products, for example, lemonade and iced tea. If tastes shift to iced tea, demand will increase for iced tea and decrease for lemonade. In response, the iced tea manufacturer will raise prices and lemonade manufacturers will lower prices. In response to the shifts in prices, consumers will buy less iced tea and more lemonade thereby equalizing demand for the two products. This voluntary exchange is the opposite of the planned economies of socialist and communist systems.

The Origins of Capitalism

Early capitalism can be traced to medieval Islamism civilizations of the ninth century. Stable currency, trading companies, contracts and concepts of credit contributed to the formation of a trader class that, in general, sold products at a price higher than their purchase price. Between 1600 and 1800, Europe went through an economic transformation that led to changes in agriculture, a mass movement to cities, the development of industry, commercial proliferation, and monetary sophistication. Capitalist practices, known as mercantilism, began to emerge as wealth became concentrated. This shift represented a fundamental change from the feudal system then in place.

Mercantilism

Mercantilism was based on the premise that a nation's route to prosperity lay in the accumulation of precious metals through a favorable balance of trade with other nations. To maximize exports and minimize imports, nations used heavy regulations. The mercantilist view of economics was zero-sum wherein every nation's gain represented some other nation's loss. The mercantilist prized saving and thrift as methods to accrue capital and engage in mining and export. Mercantilism lacked the fundamental feature of modern capitalism—the free market or lack of government intervention. Moreover, under current economic thought, barriers to trade retard economic development and do not encourage national prosperity. These main insights, the free trade among nations and the lack of government regulation (laissez-faire economics), form the foundation of modern economics and are attributed to the work of Adam Smith.

Adam Smith

Adam Smith (1723-1790) was a Scottish philosopher and founder of classical economics. Smith's book "An Inquiry into the Nature and Causes of the Wealth of Nations," published in 1776, insisted that the wealth of a nation was gauged by the variety and amount of the consumables the economy could command. Free trade was central to this measure because through trade, nations encountered a large variety of consumables. Smith directly countered the central idea of mercantilism by showing that trade could improve the conditions of all traders by creating wealth as opposed to the then prevalent assumption that regarded wealth as a fixed quantity. Underlying Smith's argument was the assumption that people act in their own best interest and to do so necessarily promotes general economic welfare. The capitalist, to maximize profit, will produce to satisfy the greatest needs of the people. Free market exchange occurs only if participants believe that they will be better off as a result, and the same general principle applies to society at large; thereby making everyone better off. Smith linked capitalism to the general welfare without specific consideration of any moral issues (Macleod, 2007).

The Invisible Hand

A metaphor invoked by Adam Smith in "Wealth of Nations" and other writings to explain the concept of societal benefit through individual interest is that of an "invisible hand." Due to the natural competition for scarce resources within a free market, the market is effectively guided by an invisible hand. This invisible hand guides people to act in society's best interest, as a by-product of the pursuit of self-interest. According to Smith, these cumulative effects are more effective for the betterment of a nation than conscious and well-intentioned measures to the same end (Economics Dictionary).

Value & Production

The capitalist system, as described in "Wealth of Nations," included concepts of value and production. The value of an item is determined by the cost of production. Therefore, items that are expensive to produce have a high value and vice versa. The key insight into production is the division of labor. Division of labor is the idea of specialization and rests on the premise that a person charged with only a portion of the process of production will find ever more efficient and effective ways to complete the task. This effectiveness increases the overall productiveness of the system. Factory assembly lines are an example of the division of labor concept at work.

Laissez-Faire

A central idea of capitalism is the lack of government control, often called laissez-faire, meaning "to leave alone." This policy of minimal government interference with the economy allows the voluntary exchange between market participants that is critical to the invisible hand idea mentioned above. John Stuart Mill (1806-1873), the English philosopher, economist and a leading proponent of utilitarianism strongly supported the policy of minimal government interference in the lives of citizens. Utilitarianism is the belief that the best course of action is that which brings the greatest happiness to the greatest number of people. John Stuart Mill's essay "On Liberty" set out to establish that the only valid justification for interfering with someone's actions was to protect someone else. This work had a significant influence in the United States and on the Supreme Court who generally adhered to the idea of economic activity free from government interference for the beginning of the twentieth century (Utilitarianism, Oxford Dictionary of Politics).

The Limits of Free Market Capitalism in the United States & the Mixed Economies

Capitalism, like most things, cannot be applied purely and totally; even the most aggressively capitalist economies must have regulation because a government must at least establish basic rules. For example, businesses would find it very difficult to function without the law of contracts. Moreover, governments also find it necessary to take corrective action when an unregulated market does not function well, that is, in instances of "market failure." In the United States, the ability of the federal government to legislate in a particular area is determined by the Constitution. The Constitution grants the federal government specific, or "enumerated," powers as opposed to a general authority to legislate. Therefore, every piece of legislation must be based on one of those powers. For example, Congress may legislate on matters affecting interstate commerce under the "Commerce Clause." The "Takings Clause" allows the Congress to exercise the power of eminent domain to take private property for the public good upon proper compensation. While it is easy to state the general type of power granted by the Constitution, the precise meaning of those powers in practice is neither self-evident nor universally agreed. The determination of whether the Constitution permits a particular Congressional act rests with the Supreme Court of the United States. The Court has the ultimate authority to declare what the law is. The Court is the guardian of the freedoms imagined by the framers of the Constitution and individual liberty in commerce fluctuates in lockstep with its decisions. The Court wields an enormous amount of power and occupies a central location in the operation of capitalism in the United States.

Until the 1930s, the prevailing philosophy on the Court favored "unregulated" markets in accord with classical economics of the type advocated by Adam Smith and John Stuart Mill. Here again, a bias for an unregulated market should not be taken to mean a lack of regulation as both federal and state governments regulated a great deal. However, the Supreme Court made decisions that facilitated the growth of the great capitalist institutions, including the multi-state corporation. The decisions prevented states from excluding corporations from other states, gave the corporation an individual identity, relaxed rules about the operations a corporation could undertake, and allowed corporate officers additional latitude in conducting corporate affairs.

Beginning in the early 1930s, the laissez-faire capitalism in the United States began to lose the protection of the Supreme Court. A series of cases related to the extent of the federal government's control over commercial affairs began to open the doors for increased control over capitalism. Notably, the Court significantly increased the scope of the commerce clause by allowing Congress to legislate on matters that had a cumulative effect on commerce in addition to matters directly related to commerce such as roads and cars. As a result, Congress had the power to implement nationwide programs and laws that directly impacted the function of the economy. This broad power remains in the twenty-first century, but in 1995, the Supreme Court set limits on Congressional authority for the first time since the Great Depression. Some have dubbed the decisions an "anti-federalist revival" signaling an era of reduced federal regulation, however, the actual effect on regulation remains to be seen.

The New Deal Program

The push of legislation before the Court that began to erode the laissez-faire policy was part of President Roosevelt's "New Deal" program designed to lift the country out of the Great Depression. The New Deal was a comprehensive, centrally planned economic policy. Some of the New Deal programs were:

• The Federal Depositors Insurance Corporation (FDIC) which provides government insurance against loss for bank deposits;

• The Civilian Conservation Corps (CCC) which put youth to work on natural conservation projects, and;

• The Federal Emergency Relief Administration (FERA) which distributed cash payments to those unable to work.

In addition, the familiar Social Security Administration was formed on the model of an insurance company to provide pension and other benefits and the National Labor Relations Act (NLRA), or Wagner Act, guaranteed workers the right to collective bargaining. This switch from laissez-faire to increased regulation was marked by bitter disagreement between the judiciary and executive. The Court decided several cases that declared certain portions of the New Deal legislation unconstitutional. In 1937, President Roosevelt proposed a plan to alter the composition of the federal judiciary by increasing the number of judges on the Supreme Court. However, the following year the Court decided a couple of cases favorable to the New Deal and a conservative justice announced his retirement, dubbed by the media as "the switch in time that saved nine." Public support for the "court packing" subsided and the legislation was never passed (Court Packing Plan, Oxford Companion to the Supreme Court).

Mixed Economies

As mentioned, unrestrained capitalism has never existed and to describe an economy as capitalist is to say that it is predominantly capitalist. The same is generally true of socialism. The New Deal and other controls on the free market can be understood to dilute the concentration of capitalism with elements of socialism to create a mixed economy. In a mixed economy, the central government intervenes in the production, distribution, and exchange of goods and services but participants have more economic freedom than in a command economy. Different countries strike different balances between capitalism and socialism.

Capitalism Compared

Capitalism, like socialism, has many variants. Relatively unbridled laissez-faire capitalism in the United States in the early twentieth century gave rise to the industrial revolution, the roaring 1920s, and fabulously wealthy industrialists like Rockefeller, Carnegie, and Vanderbilt. This period ended in the Great Depression and gave rise to the social policies of the New Deal. This ebb and flow of capitalist policies is evident in other countries as well, with differences in degree and timing.

State Capitalism

One variant of capitalism is called state capitalism. The term generally describes market economies with heavy regulation or government control as opposed to stateless capitalism, market capitalism, or "free enterprise." To some extent or another, France and Germany are associated with a form of state capitalist system. In a more modern usage, the term is also used to describe a system whereby state-owned businesses are operated according to capitalist principles. As a general matter, the state acts as an agent of the people and interferes with the economy on the people's behalf. Managed economy is another term that denotes considerable government control of markets.

Market Capitalism

As a general matter, American capitalism is more of a market capitalism characterized by lower taxes and less government regulation, e.g., on labor, than European economies. A general difference between American capitalism and European capitalism can be drawn from the interests companies serve. European capitalism tends to view companies and institutions as serving stakeholder interests while American companies serve shareholder interests. Stakeholders in a company are clients, suppliers, employees, and the surrounding community in that order. Serving stakeholder interests incorporates a significant social responsibility component to the corporate culture and generally results in higher overall wages and stability for employees and long-term investment. A shareholder focus tends to value short-term gains with relatively little concern about employee cutbacks.

Capitalism in the United Kingdom

The United Kingdom in the late twentieth century is a good example of the fluctuating approaches to capitalism. In the 1980s, conservative Prime Minister Margaret Thatcher reduced the size of the central government and welfare state, lowered income tax, and encouraged small business development. Thatcherism became a part of the British vocabulary. While the approach helped the British economy improve, economic inequality increased, and social services declined. Toward the end of the decade, unemployment and inflation trended upward. A more socialist approach followed. The "Third Way" political movement included a form of capitalism with more government intervention. It is often associated with former British Prime Minister Tony Blair. The "Third Way" refers to the movement of the Socialist British Labour into a more capitalist direction as the "New Labour Party" under Prime Minister Blair. This new direction abandoned the policy of state intervention in favor of commitment to social justice. Thus, the "Third Way" moved away from the extreme left but represented a significant shift in policy from Thatcher's conservative policies.

Capitalism in Japan

Japan, a highly collectivist society, was once held as the ideal model for capitalist growth. During the 1980s, Japan experienced tremendous growth with their model of capitalism marked by an organization-centered, or stakeholder approach to corporate governance. The Japanese model included such features as lifetime employment and a cooperative role of central banking in business. The Japanese Model placed emphasis on cooperation and arrangements based on long-term relationships. This contrasts with the individualist American focus on production, self-interest, individual creativity, and competition in free markets. Japan's success with their capitalist model was short-lived (Konzelmann, 2005), while the more market-based approach of the United States experienced relative success through the early-twenty-first century.

Globalization

Part of the fundamental theory expounded by Adam Smith involved the importance of trade. Through trade, nations can increase their specialization in the effort to maximize their comparative advantage in production and trade to maximize variety and give rise to global wealth creation. These principles are based, to a varying degree, on the notion of a flexible workforce, capitalist accumulation, deployment of resources, and self-interest. The world has accepted the value of trade, although different countries, at times, disagree as to the degree of freedom that should be involved.

To encourage free trade, 164 countries had joined the World Trade Organization as of 2022. The countries include major traders, the United States and China. The World Trade Organization is essentially a set of multilateral treaties designed to reduce trade barriers among signatories and provide a common set of rules for trade and trade related matters.

The move toward world trade based largely on capitalist principles increases the interconnectedness between countries and the cultural exchange. The benefits of global capitalism as practiced reveal advantages and disadvantages. Critics of global trade argue that poor nations may be exploited, in terms of labor, civil rights, and environmental damage, and inequality among nations will increase. The relationship has been compared to the type of relationship that existed in the United States in the early twentieth century by the so-called robber-barons. Proponents of globalization argue that world trade is a key element of worldwide economic development that allows all countries access to foreign capital and benefits from comparative advantage.

Conclusion

Terms & Concepts

Command Economy: An economy in which supply and price are regulated or imposed by a central nonmarket authority. Prime examples are genuine communist economies.

Comparative Advantage: “A situation in which a country, individual, company or region can produce a good at a lower opportunity cost than that of a competitor” (Dictionary.com).

Division of Labor: The division of a body of workers according to tasks performed to produce a product in different stages and thus, more effectively and efficiently.

Feudal System: The political and economic system in Europe between the ninth and fifteenth centuries; characterized by a holding of land by lords who utilized contracted workers. The workers were in a way indebted to the landowners and were required to serve the lord in numerous ways.

Factors of Production: The resources required to produce a product; capital, labor, and land.

Laissez-Faire: The economic practice which desires to limit government regulation of commerce in favor of allowing an economic system to operate freely.

Managed Economy: Economy in which considerable government intervention takes place to direct economic activity. Socialist and communist economies are managed much more than capitalist economies, which rely more upon market forces to direct economic activity.

Mixed Economy: An economy that exhibits elements of both a capitalist and socialist system.

Mercantilism: Practice that took hold in Europe after feudalism which focused on the collection of monies, colonies, and a merchant marine along with the development of industry and mining. Mercantilism was concerned with creating a favorable balance of trade.

Multilateral Treaty: A international agreement between more than two counties, as compared to bi-lateral treaty involving two countries.

Robber-Baron: A derogatory term which originated from twelfth-century Europe in reference to feudal lords who became wealthy through unethical business practices. Also used to refer to wealthy American Industrials such as Andrew Carnegie and John D. Rockefeller.

Signatory: Refers to a country who has agreed to be bound by treaty.

State Socialism: Term used to describe a market economy with heavy regulation.

Bibliography

Hostility, of sorts. (2007). Economist, 385(8560), 108. Retrieved July 14, 2008, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=28033553&site=ehost-live

Jahan, S. (2018, May 10). What is capitalism? IMF. Retrieved May 28, 2023, from https://www.imf.org/en/Publications/fandd/issues/Series/Back-to-Basics/Capitalism

Kalinowski, T. (2013). Regulating international finance and the diversity of capitalism. Socio-Economic Review, 11, 471-496. Retrieved October 25, 2013, from EBSCO online database SocINDEX with Full Text http://search.ebscohost.com/login.aspx?direct=true&db=sih&AN=88429757&site=ehost-live

Kauppinen, I. (2013). Academic capitalism and the informational fraction of the transnational capitalist class. Globalisation, Societies & Education, 11, 1-22. http://doi.org/10.1080/14767724.2012.678763

Konzelmann, S. (2005). Varieties of capitalism: Production and market relations in the USA and Japan. British Journal of Industrial Relations, 43, 593-603. Retrieved August 5, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=18893300&site=ehost-live

Levitt, T. (1956). The changing character of capitalism. Harvard Business Review, 34, 37-47. Retrieved July 14, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=6774094&site=ehost-live

Macleod, A. (2007). Invisible hand arguments: Milton Friedman and Adam Smith. Journal of Scottish Philosophy, 5, 103-117. Retrieved July 20, 2008, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=28100031&site=ehost-live

Mencinger, J. (2013). From the collapse of socialism to the crisis of capitalism: Experiences of Central and Eastern European countries. Ljetopis Socijalnog Rada/Annual of Social Work, 20, 11-34. Retrieved October 25, 2013, from EBSCO online database SocINDEX with Full Text: http://search.ebscohost.com/login.aspx?direct=true&db=sih&AN=88982819&site=ehost-live

Moore, P. (2006). Global knowledge capitalism, self-woven safety nets, and the crisis of employability. Global Society: Journal of Interdisciplinary International Relations, 20, 453-473. Retrieved July 14, 2008, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=22908967&site=ehost-live

Vanolo, A. (2013). Alternative Capitalism and Creative Economy: The Case of Christiania. International Journal Of Urban & Regional Research, 37, 1785-1798. doi:10.1111/j.1468-2427.2012.01167.x. Retrieved October 25, 2013, from EBSCO online database SocINDEX with Full Text:http://search.ebscohost.com/login.aspx?direct=true&db=sih&AN=89769281&site=ehost-live

What is capitalism: Varieties, history, pros & cons, socialism. Investopedia. (2023, March 9). Retrieved May 25, 2023, from https://www.investopedia.com/terms/c/capitalism.asp

Suggested Reading

Litonjua, M. D. (2013). State vs. market: What kind of capitalism? International Review Of Modern Sociology, 39, 53-87. Retrieved October 25, 2013, from EBSCO online database SocINDEX with Full Text: http://search.ebscohost.com/login.aspx?direct=true&db=sih&AN=88004736&site=ehost-live

Ivanova, M. N. (2013). The Great Recession and the State of American Capitalism. Science & Society, 77, 294-314. doi:10.1521/siso.2013.77.3.294 Retrieved October 25, 2013, from EBSCO online database SocINDEX with Full Text: http://search.ebscohost.com/login.aspx?direct=true&db=sih&AN=87972956&site=ehost-live

Konzelmann, S. (2005). Varieties of capitalism: Production and market relations in the USA and Japan. British Journal of Industrial Relations, 43, 593-603. Retrieved August 5, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=18893300&site=ehost-live

Levitt, T. (1956). The changing character of capitalism. Harvard Business Review, 34, 37-47. Retrieved July 14, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=6774094&site=ehost-live

Macleod, A. (2007). Invisible hand arguments: Milton Friedman and Adam Smith. Journal of Scottish Philosophy, 5, 103-117. Retrieved July 20, 2008, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=28100031&site=ehost-live

The state of denial we're in. (2005, January 15). Economist, 374(8409), 63. Retrieved August 5, 2008, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=15682576&site=ehost-live