What Is Capitalism?

Free markets may not be perfect but they are probably the best way to organize an economy

CAPITALISM is often thought of as an economic system in which private actors own and control property in accord with their interests, and demand and supply freely set prices in markets in a way that can serve the best interests of society. The essential feature of capitalism is the motive to make a profit. As Adam Smith, the 18th century philosopher and father of modern economics, said: “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.” Both parties to a voluntary exchange transaction have their own interest in the outcome, but neither can obtain what he or she wants without addressing what the other wants. It is this rational self-interest that can lead to economic prosperity. In a capitalist economy, capital assets—such as factories, mines, and railroads—can be privately owned and controlled, labor is purchased for money wages, capital gains accrue to private owners, and prices allocate capital and labor between competing uses (see “Supply and Demand” in the June 2010 F&D). Although some form of capitalism is the basis for nearly all economies today, for much of the last century it was but one of two major approaches to economic organization. In the other, socialism, the state owns the means of production, and state-owned enterprises seek to maximize social good rather than profits

The Political Economy of Capitalism

Microeconomics is the study of how markets—the usual defining institution of capitalism—coordinate decentralized decision making through a price mechanism to bring supply and demand into equilibrium. In this time-tested perspective, capitalism is a largely self-regulating economic system in which the proper role of government is limited to providing certain basic public goods and services at low cost. Harvard Professor Gregory Mankiw, the author of a leading economics textbook and former Chairman of the President’s Council of Economic Advisors, recently reminded readers of the Wall Street Journal of this point of view, claiming: “Adam Smith was right when he said that ’Little else is required to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes and a tolerable administration of justice.’”(1) Smith’s explanation for this minimalist role for government was derived from his seminal insight that the pricing mechanism would coordinate the actions of private actors so as to achieve socially optimal outcomes. Or, in Smith’s words: “As every individual…endeavours…to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of greatest value; every individual labours to render the annual revenue of society as great as he can. [While] he intends only his own gain, …he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.”(2)

Pillars of Capitalism 

Capitalism is founded on the following pillars: • private property, which allows people to own tangible assets such as land and houses and intangible assets such as stocks and bonds; • self-interest, through which people act in pursuit of their own good, without regard for sociopolitical pressure. Nonetheless, these uncoordinated individuals end up benefiting society as if, in the words of Smith’s 1776 Wealth of Nations, they were guided by an invisible hand; • competition, through firms’ freedom to enter and exit markets, maximizes social welfare, that is, the joint welfare of both producers and consumers; • a market mechanism 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; • freedom to choose with respect to consumption, production, and investment—dissatisfied customers can buy different products, investors can pursue more lucrative ventures, workers can leave their jobs for better pay; and • limited role of government, to protect the rights of private citizens and maintain an orderly environment that facilitates proper functioning of markets. The extent to which these pillars operate distinguishes various forms of capitalism. In free markets, also called laissez-faire economies, markets operate with little or no regulation. In mixed economies, so called because of the blend of markets and government, markets play a dominant role, but are regulated to a greater extent by government to correct market failures, such as pollution and traffic congestion; promote social welfare; and for other reasons, such as defense and public safety. Mixed capitalist economies predominate today

Reference :

(1) Adam Smith, as favorably cited by Gregory Mankiw, The Wall Street Journal, January 3, 2006. 

(2) Adam Smith, Wealth of Nations, Oxford World Classics, pages 291-292.

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