What Is Capitalism?

FINANCE & DEVELOPMENT, June 2015, Vol. 52, No. 2

Sarwat Jahan and Ahmed Saber Mahmud
PDF version
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 assetssuch 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.
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 Smiths 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 sellersprices, 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.
The many shades of capitalism
Economists classify capitalism into different groups using various criteria.
Capitalism, for example, can be simply sliced into two types, based on how
production is organized. In liberal market economies, the competitive market is
prevalent and the bulk of the production process takes place in a decentralized
manner akin to the free-market capitalism seen in the United States and the
United Kingdom. Coordinated market economies, on the other hand, exchange
private information through nonmarket institutions such as unions and business
associationsas in Germany and Japan (Hall and Soskice, 2001).
More recently, economists have identified four types of capitalism distinguished
according to the role of entrepreneurship (the process of starting businesses) in
driving innovation and the institutional setting in which new ideas are put into
place to spur economic growth (Baumol, Litan, and Schramm, 2007).
In state-guided capitalism, the government decides which sectors will grow.
Initially motivated by a desire to foster growth, this type of capitalism has several
pitfalls: excessive investment, picking the wrong winners, susceptibility to
corruption, and difficulty withdrawing support when it is no longer
appropriate. Oligarchic capitalismis oriented toward protecting and enriching a
very narrow fraction of the population. Economic growth is not a central
objective, and countries with this variety have a great deal of inequality and
corruption.
Big-firm capitalism takes advantage of economies of scale. This type is important
for mass production of products. Entrepreneurial capitalism produces
breakthroughs like the automobile, telephone, and computer. These innovations
are usually the product of individuals and new firms. However, it takes big firms
to mass-produce and market new products, so a mix of big-firm and
entrepreneurial capitalism seems best. This is the kind that characterizes the
United States more than any other country.
The Keynesian critique
During the Great Depression of the 1930s, the advanced capitalist economies
suffered widespread unemployment. In his 1936 General Theory of Employment,
Interest, and Money, British economist John Maynard Keynes argued that
capitalism struggles to recover from slowdowns in investment because a capitalist
economy can remain indefinitely in equilibrium with high unemployment and no
growth. Keynesian economics challenged the notion that laissez-faire capitalist
economies could operate well on their own without state intervention to promote
aggregate demand and fight high unemployment and deflation of the sort seen
during the 1930s. He postulated that government intervention (by cutting taxes
and increasing government spending) was needed to pull the economy out of the
recession (see What Is Keynesian Economics? in the September 2014 F&D).
These actions sought to temper the boom and bust of the business cycle and to
help capitalism recover following the Great Depression. Keynes never intended to
replace the market-based economy with a different one; he asserted only that
periodic government intervention was necessary.
The forces that generally lead to the success of capitalism can also usher in its
failure. Free markets can flourish only when governments set the rules that
govern themsuch as laws that ensure property rightsand support markets
with proper infrastructure, such as roads and highways to move goods and
people. Governments, however, may be influenced by organized private interests
that try to leverage the power of regulations to protect their economic position at
the expense of the public interestfor example, by repressing the same free
market that bred their success.
Thus, according to Rajan and Zingales (2003), society must save capitalism from
the capitaliststhat is, take appropriate steps to protect the free market from
powerful private interests that seek to impede its efficient functioning. The
concentration of ownership of productive assets must be limited to ensure
competition. And, because competition begets winners and losers, losers must be
compensated. Free trade and strong competitive pressure on incumbent firms will
also keep powerful interests at bay. The public needs to see the virtues of free
markets and oppose government intervention in the market to protect powerful
incumbents at the expense of overall economic prosperity.
Economic growth under capitalism may have far surpassed that of other economic
systems, but inequality remains one of its most controversial attributes. Do the
dynamics of private capital accumulation inevitably lead to the concentration of
wealth in fewer hands, or do the balancing forces of growth, competition, and
technological progress reduce inequality? Economists have taken various
approaches to finding the driver of economic inequality. The most recent study
 analyzes a unique collection of data going back to the 18th century to uncover
key economic and social patterns (Piketty, 2014). It finds that in contemporary
market economies, the rate of return on investment frequently outstrips overall
growth. With compounding, if that discrepancy persists, the wealth held by
owners of capital will increase far more rapidly than other kinds of earnings
(wages, for example), eventually outstripping them by a wide margin. Although
this study has as many critics as admirers, it has added to the debate on wealth
distribution in capitalism and reinforced the belief among many that a capitalist
economy must be steered in the right direction by government policies and the
general public to ensure that Smiths invisible hand continues to work in societys
favor.
Sarwat Jahan is an Economist in the IMFs Strategy, Policy, and Review Department,
and Ahmed Saber Mahmud is Associate Director in the Applied Economics Program at
Johns Hopkins University.

References

Baumol, William J., Robert E. Litan, and Carl J. Schramm, 2007, Good Capitalism, Bad
Capitalism, and the Economics of Growth and Prosperity (New Haven, Connecticut: Yale
University Press).
Hall, Peter A., and David Soskice, eds., 2001, Varieties of Capitalism: The Institutional
Foundations of Comparative Advantage (New York: Oxford University Press).
Piketty, Thomas, 2014, Capital in the Twenty-First Century (Cambridge, Massachusetts:
Belknap Press).
Rajan, Raghuram, and Luigi Zingales, 2003, Saving Capitalism from the Capitalists:
Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity(New
York: Crown Publishing Group).

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