Capitalism ☑️ Explained for Dummies

What is capitalism?

Capitalism refers to an economic system in which private entities such as individuals or businesses are the owners of capital goods, entrepreneurship, and natural resources. Simultaneously, the owners (called capitalists) employ workers (labourers) who only receive salaries or wages as remuneration, while the prices of goods are determined by supply and demand in a free market.

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Fundamentals of capitalism

There are various fundamentals that define capitalism as an economic system. In this regard, some economists also call them components, features, or characteristics, while the International Monetary Fund (IMF) refers to ‘the pillars of capitalism.’ This article will focus on the following six fundamentals: private property, profit motive, market competition, wage labour, freedom to choose, and the limited role of government.

Private property

Private property implies that people and entities are allowed to own tangible assets - such as land, houses, and equipment - and intangible assets like stocks (shares of companies), bonds, and derivatives. The right to own private property enables the free exchange of goods, products, and labour. Furthermore, property rights inspire individuals and businesses to make improvements to their property and to maximise the use of their resources, which in turn enhances competition in the marketplace.

Profit motive

In an issue (dated June 2015) of Finance & Development, published by the International Monetary Fund (IFM), the writers stated the following: ‘The essential feature of capitalism is the motive to make a profit,’ quoting Adam Smith (known as the ‘father of modern economics’): ‘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.’ It is a central idea in capitalism that businesses or individuals act primarily in self-interest, pursuing their own good, making money and generating profits that increase the wealth of the owners. They achieve this by minimising capital and production costs while selling their goods at the highest price possible. However, keeping costs as low as possible can lead to the exploitation of labourers, poor working conditions, and environmental damage. Proponents of the free-market concept are of the opinion that the profit motive makes the best allocation of resources possible.

Market competition

In an economic system such as capitalism, private businesses are in competition with each other to increase their market share by producing innovative products and rendering outstanding services at competitive prices. Market competition keeps prices moderate and improves production efficiency. This principle also applies to individuals. Put in the words of the IMF: one of the pillars of capitalism, ‘market mechanism’ is described as a pillar ‘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.’ This is in contrast with two other types of economies, namely:

A command economy, also referred to as a planned economy, is where a central government or authority regulates, organises, and controls all economic activities, aiming to maximise social welfare.
A planned economy prevents market forces (like supply and demand) from determining the production and prices of goods.
A mixed economy system refers to an economic system that combines some of the components of capitalism and some of the elements of a command economy.

In addition, in capitalism, capital markets and commodity markets operate freely where the laws of supply and demand determine fair prices for stocks (shares), derivatives, and commodities, to name a few. Capital markets enable companies to raise funds to expand and improve their products.

Wage labour

In a capitalist economy, the means of production (such as capital, raw materials, tools, equipment, and technology) are owned and controlled by a relatively small group of people, the capitalist owners, according to Karl Marx. These means are used to produce goods and to render services. Contrarily, the people (called the proletarians by Karl Marx) without these resources have only their time and labour to sell, earning wages or salaries. Typically, capitalist societies have a significantly higher percentage of wage labourers compared to capitalist owners.

Freedom to choose

In a free market economy like capitalism, participants have the freedom to choose regarding items such as consumption, employment, production, and investments.

Limited role of government

Almost every advocate of capitalism is in favour of some government involvement in the economy, although, only to a certain extent. The general view is that a government should only create a level playing field. In a working paper, ‘The Political Economy of Capitalism’ (dated 2006) of the Harvard Business School, Bruce R. Scott mentioned that ‘government’s mode of intervention in a capitalist system is primarily indirect,‘ raising, the following important responsibility: ‘It creates legitimates, administers and periodically modernizes the various market frameworks that spell out the conditions in which the economic actors may acquire and employ capital and labor to produce, distribute, and sell goods and services.’ Scott continued, saying that as a result, ‘economic actors receive the right to use their power in competition with other, subject to prevailing laws and regulations.’ Furthermore, the market frameworks can establish various ‘policy priorities’ such as:

protecting the status quo to promoting growth and development,
protecting consumers as well as producers, and
protection from labour to the protection of capital.

Scott observed that the indirect system of governance unavoidably represents a strategy which is to a great extent implicit rather than explicit. One of the important conclusions in the Harvard working paper reads as follows: ‘While successful capitalism depends on the granting of power to private actors to enter, compete in, and exit from markets, it also depends upon the state’s power to restrain the private actors so that they do not abuse these powers.’ (All the accentuations in the quotations from the working paper of the Harvard Business School are by the article writer.) Put in other words, in a capitalist economy the government’s responsibility is to protect the free market, and to curb and even prevent the control exercised by monopolies. Capitalism Explained

Capitalism versus socialism and communism

Socialism

Contrary to capitalism, socialism is an economic system in which the means of production are owned and controlled by the people as a whole, commonly called the community. Proponents of socialism argue that this economic system of cooperative ownership allows a more equitable distribution of resources and wealth. In practice, the means of production are controlled by a central authority or government institution while individuals rely on the state to provide for their needs such as healthcare and education.

Communism

Simply put, communism is a philosophy and economic system that promotes the equitable distribution of wealth among the people as well as the ‘common ownership of production.’ In practice, communism calls for the control of the means of production by the working class, referred to as the proletariat. Furthermore, the government provides every citizen with a guaranteed minimum standard of living, notwithstanding their economic contribution.

Advantages of capitalism

Capitalism is considered a highly effective economic system for economic growth.
Capitalist production processes have significantly strengthened and improved productive capacity, making more and better products more available to consumers, and raising living standards in unprecedented ways.

This is because producers provide the best products for the best prices because people are willing to pay more for what they want most. However, prices are limited because of competition between producers.

The rise of industrial capitalism enhanced the expansion of the financial sector. For instance, stock exchanges have become progressively public and investment opportunities have become available for individuals.
Capitalism rewards innovation regarding new products and effective production methods. This implies that producers have to stay ahead of consumer demands.

Disadvantages of capitalism

Capitalism has also negative effects such as air and noise pollution, as well as the pollution of rivers and other water resources. In addition, it depletes natural resources, affecting the quality of life in many areas.

These negative effects also increase the costs of societies which are negatively affected. In these instances, the costs incurred by societies are referred to as negative externalities.

Capitalism causes enormous wealth disparities and social inequalities. One of the reasons for this is that capitalism does not advance equality of opportunity. People lacking good nutrition, support, and education may never have the chance to play on the so-called ‘level playing field.’

Furthermore, people who are eventually employed may receive low wages, have limited possibilities for promotion, and potentially unsafe working conditions.

Unemployment is another negative effect of capitalism, where unskilled and unproductive labourers are excluded from the labour force or are replaced by technological inventions. Typically, this creates a struggle between labour unions and workers on the one side, and capitalists on the other side.