Economic systems are highly complex methods of exchange that allow human societies to produce the goods and services needed by individuals within society to accomplish their day-to-day goals and pursue their desires. The simplest way to understand the function of an economic system is to borrow a term used by Karl Marx: mode of production. At their core, all economic systems, including capitalism, are modes of production designed to facilitate the exchange of goods and services across society, often by trading goods and services for currency. So, let's have a look on capitalism, it's history and compare it to socialism!

Capitalism Capitalism

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Table of contents

    Capitalism Definition

    Before jumping into a detailed explanation, a brief look at the dictionary definition will help to develop an initial understanding of the term.

    Capitalism- An economic system with private ownership of capital goods and where prices, production, and the distribution of goods are determined by competition in a free market.

    That definition has a lot to unpack in it; what are capital goods? What is a free market?

    Capital goods are goods which are used to produce other goods and are not typically purchased by an individual for private consumption. An example of a capital good would be raw cotton. Private ownership of these goods allows a single entity to produce and sell the capital good to multiple buyers who can then take the capital good and produce a finished product with it.

    Imagine walking into a clothing store and instead of having clothes they only sold raw cotton which you then had to make a T-shirt with yourself. It would be very burdensome! So we have private ownership which means that the cotton would be sold to a clothing company that would then make thousands of T-shirts with it. After the T-shirts have been made they are sent out to stores where individuals can purchase them if they choose to do so.

    The entire chain of events described above is made possible by individuals making private decisions in a free market of exchanges. The private decision being made takes place between the buyer and the seller. The seller has several options about what to do with their product, they could burn it, keep it, sell it, or do anything else they want with it. The buyer can do as they please with their money, they could save it, donate it, throw it from a roof, buy the product, or perform any other number of actions using it. Because both the buyer and seller are not forced to do any particular thing, they are making a private decision to buy and sell. This transaction takes place in what is known as the free market.

    Capitalism, New York Stock Exchange, traders on the floor, Study SmarterFig 1. New York Stock Exchange

    The free market refers to an area of competitive transactions where buyers and sellers trade using currency, goods, and services. Sometimes currencies are traded for other currencies, goods for other goods, and services for another service, but the most typical transaction is one where a currency is exchanged for a good or service.

    The free market is competitive because it offers a variety of options which buyers and sellers can select from. Because buyers want to spend the least amount possible for the best product they can get, sellers are forced to compete with each other. On the other hand, if a seller produces a superior product to the competition, it allows them to raise their prices and forces the competitors to innovate in an effort to attract more buyers.

    Laissez-faire Capitalism

    Laissez-faire, which is French for "let do" is a pure form of capitalism that advocates for an almost non-existent role for the government in the market. According to laissez-faire capitalism, when the state takes a role in the market its impact is always negative, not just for the market, but also for individual liberty and peace.

    Take a moment to think about the country you live in, does it tax businesses? Does it tax imported goods from other countries? Does it regulate multiple areas of the market making decisions in regards to what can and cannot be sold, who can sell what, and what prices they are allowed to charge? For Laissez-faire capitalism, all of these regulations and taxes infringe on people's freedom to make transactions as they see fit, which in turn places unnecessary obstacles upon the individual and restricts their ability to act in a manner which best benefits them.

    Imagine a small British business that sells quality flowers to a niche group of customers willing to spend more money on handmade bouquets and custom flower arrangements. The owner makes enough profit to provide herself with a monthly income of 3,000 pounds.

    The government, in a political dispute with the Netherlands, decides to impose a tariff on Dutch goods, including the flowers the shop owner needs to operate her business. As a result of the tariffs, the shop owner has to increase prices which drives away customers and now she only has a monthly income of 2,000 pounds. In this instance, the government's interference in the market negatively impacted the shop owner's life, forcing her to bear the economic cost of a political dispute.

    State Capitalism

    State capitalism is more or less the exact opposite of Laissez-faire and most capitalist systems in the world today fall somewhere between these two models. State capitalism differs from Laissez-faire in that the state takes a primary role in the market, it does this by owning companies and having controlling shares in established corporations. In state capitalism, the government acts similarly to a corporation and seeks to maximize profits to improve the overall economy of the state.

    The most obvious example of modern state capitalism would be the Chinese economic system, where the Chinese government has nationalized many of the country's largest companies.

    China is by no means the only state that engages in state capitalism. Norway is a modern example of less intrusive state capitalism in which the Norwegian state holds shares in several companies of national importance. Unlike the Chinese model, the Norwegian state is forbidden from owning controlling shares in private companies and is less capable of using private companies for political ends.

    Nationalisation is the takeover of a privately owned company by the state.

    History of Capitalism

    The history of capitalism and its exact origins is a highly debated topic to this day. With that said, most scholars would agree that the roots of capitalism developed as feudalism was slowly replaced by mercantilism which was spurred by the development of the modern nation-state.

    Feudalism was an economic system in which rich nobility would offer peasants a place to live on their land in exchange for working on the same land. The nobility in turn got their land from the crown for military service.

    Mercantilism only became possible with the rise of the nation-state, a concept that came about after the Thirty Years War and the Treaty of Westphalia in 1648, which ended the war. With the birth of the state came an increased need for states to acquire wealth and resources to better compete with one another and this led to the development of mercantilism.

    The system of mercantilism is relatively straightforward; states would attempt to increase their exports and decrease their imports in an effort to reduce their dependency on other states while increasing the dependency of other states on them. This arrangement meant that states wanted large workforces to produce goods and sought raw materials from states or territories they could easily exploit, this would eventually turn into colonialism and act as a catalyst for the industrial revolution.

    Capitalism, Port Scene with Villa Medici, Traders at a port in Italy, Study Smarter Fig. 2: Port Scene with the Villa Medici

    As European states started to accumulate large amounts of wealth they began investing it inside the state and improving production methods and technologies. These improvements brought on changes in the way states, scholars, and merchants thought about money and commerce, leading to the development of capitalism as it is understood today. The defining moment in the development of capitalism came through the book "The Wealth of Nations" a text written by Scottish economist Adam Smith that laid the foundation for capitalism as we understand it today.

    Capitalism vs Socialism

    Capitalism and socialism are two economic systems that are often placed in juxtaposition with one another and for good reason. Both of these systems are aiming at very different goals, capitalism attempts to maximise profit and production while socialism's main goal is to create an economic system that places the labourer in the best possible position.

    Where capitalism and socialism begin their split is in how both systems view the ownership of the means of production. For capitalism, the means of production are privately owned and used to generate a profit for those who own them. In socialism, the means of production are owned by no one particular person but are instead held by social ownership. So what exactly does this mean? To better understand let's start with a definition of the "means of production".

    The means of production is anything that can be used to produce goods or services, this can include land, labour, and social connections.

    Under a capitalist system, the means of production are owned by the individual who has the capital, that is, the money, to purchase the land, materials, machines, and labour necessary to produce something. In capitalism, the individual who organises and pays for all of this is responsible for creating the means of production and as a result receives all of the profits that are made after paying for everything necessary to produce the product, including human labour.

    Because the individual did all of this using their own economic resources, they own the means of production and can dictate who gets paid what and how many hours are worked. The labourer makes a deal with the owner of the means of production in this system; the labourer will trade their labour in exchange for a wage and the owner will dictate everything else.

    Socialism looks at this arrangement and raises an objection. The labourer, having no real choice but to work or become homeless and starve is essentially forced into taking whatever deal the private owner of the means of production offers them. Of course, the labourer could offer their labour elsewhere, but the nature of the free market dictates that all of the owners of the means of production will offer roughly the same deals to labourers as they are in competition with one another.

    As a result, the labourer is constantly forced into the worst position that company owners can place them in. The owner is trying to extract the most amount of labour at the lowest possible wage to produce more profit from their production process. Socialism argues that the first step in eliminating this problem is to remove private ownership of the means of production and place the ownership instead in the hands of the individuals who are conducting the labour, as to remove the incentive to exploit the labourers.

    Capitalism - Key takeaways

    • Capitalism is an economic system that places the means of production in the hands of individuals and facilitates transactions on a free market made up of buyers and sellers.
    • Laissez-faire capitalism is a pure form of capitalism that attempts to severely restrict the role of the state in the market.
    • State capitalism is a form of capitalism that demands the state take an active role in the market, including owning controlling shares of companies and nationalizing companies.
    • Capitalism has its origins in mercantilism, a system of exchange that replaced feudalism and emphasized producing exports and reducing imports.
    • Adam Smith wrote the definitive text on capitalism, Wealth of Nations.
    • Capitalism and socialism differ in many respects, but the primary divide rests on who should be the owner of the means of production.
    Frequently Asked Questions about Capitalism

    What is Capitalism?

    An economic system that places the means of production into private ownership and encourages exchanges on a free market. 

    What is the difference between capitalism and socialism?

    Capitalism advocates for the means of production to be privately held while socialism argues that they should be publicly owned.

    What is laisses-faire capitalism?

    Laisses-faire is French for "let do" and advocates for a market that is free from state intervention. 

    What is the history of capitalism?

    Capitalism rose out of mercantilism which rose out of feudalism. It has its roots in Enlightenment thought and evolved heavily throughout the industrial revolution. 

    What is state capitalism? 

    State Capitalism is a form of Capitalism in which the state plays a heavy role in the market and owns the majority of major companies operating within its territory.

    Test your knowledge with multiple choice flashcards

    Who wrote Wealth of Nations

    What is the English meaning of Laissez-faire

    What are capital goods?


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