Updated on March 11, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Capitalism Definition

Capitalism refers to an economic system where businesses, resources, goods, and labor are owned by private entities. In such an economy, the role of the government is limited to regulation and monitoring. This system of economy prioritizes production and profits.

Capitalism is in stark contrast to socialism which prioritizes welfare and social equality. In a socialist economy, the government owns and controls production, investments, and price determination. With much less red tape, private ownership usually leads to efficient production. Capitalist theories advocate competition which brings down prices as a result of innovation.

Key Takeaways

  • Capitalism is an economic system where the means of production are owned by private entities.
  • Here, the government’s control is insignificant; price and production depend on the demand and supply.
  • In the present era, most world economies are mixed in nature, with a blend of capitalism with some degree of socialism.
  • Some nations have cronyism, where a capitalist economy is run by private entities but closely associated with government bodies.

Capitalism 1

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How does Capitalism Work?

In capitalism, the private sectorPrivate SectorThe private sector is a section of the national economy that the government does not own. The business conducted under this sector is carried out by companies or entrepreneurs who focus on profit maximization and customer satisfaction.read more faces very little governmental interference or control. Thus, there is a high degree of competition among the private players. Directly or indirectly, competition also expands the scope for development. The only potential concern is fair play. For smooth functioning, governments really need to ensure that the aggressive competition is also fair.

Capitalism is a theory. In practice, however, no country has a purely capitalist economy. Moreover, a purely production-oriented economy might come at the cost of citizen welfare or violate human rights. Therefore, most world economies combine capitalism with socialism to balance economic growthEconomic GrowthEconomic growth refers to an increase in the aggregated production and market value of economic commodities and services in an economy over a specific period.read more and public interest.

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Capitalism has seven fundamental pillars; each one is equally important for the privatization and growth of the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more. Following are the pillars:

Capitalism Pillars

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  1. Free-Market Economy: A capitalist economy represents an economic system where people can trade without governmental restrictions or control.
  2. Private Property: In a capitalist economy, individuals engaged in the production of goods or services can own capital goodsCapital GoodsCapital goods are man-made assets used in the manufacturing process of a product. They are used to produce the final goods that people consume daily. They are one of the four factors of production- the other three being natural resources, labor, and entrepreneurship.read more like land, building, and machinery.
  3. Supply-Demand Market: The capitalist economy works on supply and demand function. If the demand for a particular item increases, its price also increases. Similarly, if the supply of a product falls, the price escalates.
  4. Competition: Each firm in the capitalist economy tries to maximize its profit. So, there is no restriction on the entry and exit of new business entities in this kind of economy.
  5. Self-Interest: A capitalist economy prioritizes the maximization of profits. People work for themselves, i.e., for individual earnings and growth.
  6. Freedom of Choice: A free marketFree MarketA free market refers to an economic system free from government interventions and controlled by privately owned businesses.read more encourages the co-existence of many private firms. As a result, consumers have more options, be it for consumption or investment.
  7. Limited Government Role: In a capitalist economy, the government has little involvement in the functioning of private firms. They intervene only to prevent a monopoly. All the government has to do is ensure fair competition among business entities. However, this economic system gives the wealthy an unfair advantage. An economic inequalityEconomic InequalityEconomic inequality is the inequality in wealth distribution and opportunities among people belonging to different groups, communities or countries. Its increasing trend indicates more disparity, appropriately expressed with the cliché line “the rich get richer, while the poor get poorer.read more, therefore, is the biggest criticism against capitalist economies.

History of Capitalism

The evolution of capitalism can be traced back to the 16th century, when the British textile industry flourished. The intention was to utilize accumulated capital and produce goods generating profits. Simultaneously, Europe supplied precious metals, leading to price inflationPrice InflationPrice inflation is the rate of increase in the prices of a broad range of essential goods and services across a specific time period, generally a year.read more. The capitalists reaped maximum profits thanks to inflation. During the mercantileMercantileMercantilism refers to an economic policy or trade system wherein a country focuses on maintaining a favorable trade balance by maximizing exports and minimizing imports with other countries. Its purpose is to empower a nation via wealth and resource acquisition while improving its military and political might. read more era, between A.D. 1500 and 1750, the capitalists relished national power. It paved the way for economic development, legal standards, and monetary stability.

The capitalists were inclined towards the Industrial Revolution of the 18th century. They invested both capital and expertise. It was a free-market economy that promoted liberalism in the 19th century. Various policies like balanced budgets, free trade, gold standards, and limits for poverty relief were formulated. At that point, the MarxismMarxismMarxism is a social, economic, and political doctrine developed by German philosophers Karl Marx and Friedrich Engels in 1848 to describe the class struggle between capitalists and laborers.read more theory of economy relented capitalist influence. The new socialist theory highlighted the poor working conditions of industrial labor.

After World War I, international markets narrowed down. Consequently, the national currenciesNational CurrenciesA national currency (NC) is any form of money used by the people of a nation as a medium of exchange to engage in economic transactions.read more took over gold standards across Europe and the U.S. By the onset of the 1930s’ Great DepressionGreat DepressionThe Great Depression refers to the long-standing financial crisis in the history of the modern world. It began in the United States on October 29, 1929, with the Wall Street Crash and lasted till 1939.read more, the capitalist economy lost its relevance. As a result, many countries started leaning towards socialism. After World War II, though, the capitalist economy made a comeback. In the 21st century, the capitalist economy grew steadily. But at some point, it had to recede. The Great Recession of 2007-2009 made people consider socialism once again. It was partially adopted in the U.S. Most countries feature a mixed economyMixed EconomyA mixed economic system is one that combines capitalist and socialist ideals. It allows for the protection of private assets while also allowing for liberty in use of capital and federal intervention in economic decisions.read more.  

Capitalism Examples

There are many capitalist economies and countries in the world, some of its examples are as follows:

  1. Singapore
  2. New Zealand
  3. Australia
  4. Switzerland
  5. Ireland
  6. Taiwan
  7. United Kingdom
  8. Estonia
  9. Canada
  10. Denmark

In the real world, there is no absolute capitalism. Instead, most economies are mixed to some extent. For example, Singapore has the highest freedom score of 89.7%.

Capitalism Pros and Cons

The capitalist mindset encouraged people to work hard and gain maximum profit from their privately owned businesses. Since profit is the main motive, the level of innovation and technological development rose. As a result, consumers could buy but the best products at competitive prices.

Such an economic system improves production efficiency, resource allocation, and trade practices. Moreover, it enhances the standard of living and eliminates discrimination in society. In addition, there is low government intervention, which makes business registration and licensing convenient. Bureaucratic red-tapism is minimal.

The capitalist economy has a considerable drawback. Capitalism causes a massive divide between the wealthy and the poor. The business owners more or less rig the system. People belonging to lower economic strata are unhappy. When a capitalist economy goes into recession, unemployment is high. Though the capitalist economy provides rapid development, it also results in a quick downturn. Also, existing businesses use their power to create barriers against new entrants. Also, the natural resource depletion rate is higher; all thanks to minimal government interventions. Finally, excessive competition leads to a price-dominant market. That is, there is one price leader or price setter; other firms are forced to match their strategies to survive the competition.

Socialism vs Capitalism

In socialism, the government owns the means of production – capital goods and resources. Whereas, in capitalism, the means of production are owned by private entities. In the former, governments ascertain the price and production level. With the latter, price and production are dictated by demand-supply.

The socialist economy focuses on distributing wealthWealthWealth refers to the overall value of assets, including tangible, intangible, and financial, accumulated by an individual, business, organization, or nation.read more equally among the rich and the poor. Its main aim is the welfare of the citizens. Moreover, it safeguards citizens’ human rights. This is achieved by ensuring easy access to public amenities. In contrast, the capitalist economy leads to unequal distribution of wealth. 

Frequently Asked Questions (FAQs)

Why is capitalism bad?

The prominent drawback of a capitalist economy is economic inequality. It encourages people to chase monetary and materialistic benefits. Social welfare and human rights take a back seat. In addition to rapid development associated with capitalist economies, there is also equally rapid unemployment during a recession. But often, this aspect is overlooked.

Is the United States a capitalist?

The economy of the United States is a mix of capitalism and socialism. The government is highly involved in the public sector services like education, medical care, courts, telecom, and roads.

What are the five main characteristics of capitalism?

A capitalist economy possesses the following traits:
1. Capitalist economies ensure free markets.
2. The means of production are owned by individuals or private companies.
3. The demand and supply for goods and services control price and production levels.
4. The role of the government is minimal.
5. The market is driven by self-interest, i.e., yielding profits.

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