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Capitalism(free market economy) is an economic system, dominant in the Western world since the breakup of feudalism, in which most means of production are privately owned and production is guided and income distributed largely through the operation of markets.

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 .

Although some form of capitalism is the basis for nearly all economies today, for much of the past 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 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 the 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:

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 non–market institutions such as unions and business associations—as 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 .

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 capitalism is 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.

Criticisms of capitalism:

Advocates and critics of capitalism agree that its distinctive contribution to history has been the encouragement of economic growth. Capitalist growth is not, however, regarded as an unalloyed benefit by its critics. Its negative side derives from three dysfunctions that reflect its market origins.

1. The unreliability of growth

Many critics have alleged that capitalism suffers from an inherent  instability that has characterized and plagued the system since the advent of industrialisation. Because capitalist growth is driven by profit expectations, it fluctuates with the changes in technological or social opportunities for capital accumulation. As opportunities appear, capital rushes in to take advantage of them, bringing as a consequence the familiar attributes of an economic boom. Sooner or later, however, the rush subsides as the demand for the new products or services becomes saturated, bringing a halt to investment, a shakeout in the main industries caught up in the previous boom, and the advent of recession. Hence, economic growth comes at the price of a succession of market gluts as booms meet their inevitable end.

This criticism did not receive its full exposition until the publication of the first volume of Marx’s Das Kapital in 1867. For Marx, the path of growth is not only unstable for the reasons just mentioned—Marx called such uncoordinated movements the “anarchy” of the market—but increasingly unstable. Marx believed that the reason for this is also familiar. It is the result of the industrialization process, which leads to large-scale enterprises. As each saturation brings growth to a halt, a process of winnowing takes place in which the more successful firms are able to acquire the assets of the less successful. Thus, the very dynamics of growth tend to concentrate capital into ever larger firms. This leads to still more massive disruptions when the next boom ends, a process that terminates, according to Marx, only when the temper of the working class snaps and capitalism is replaced by Socialism.

Beginning in the 1930s, Marx’s apocalyptic expectations were largely replaced by the less violent but equally disquieting views of the English economist John Maynard Keynes, first set forth in his influential The General Theory of Employment, Interest, and Money (1936). Keynes believed that the basic problem of capitalism is not its vulnerability to periodic saturations of investment but rather its likely failure to recover from them. He raised the possibility that a capitalist system could remain indefinitely in a condition of equilibrium despite high unemployment, a possibility not only entirely novel (even Marx believed that the system would recover its momentum after each crisis) but also made plausible by the persistent unemployment of the 1930s. Keynes therefore raised the prospect that growth would end in stagnation, a condition for which the only remedy he saw was “a somewhat comprehensive socialization of investment.”

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 . 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 them—such as laws that ensure property rights—and 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 interest—for example, by repressing the same free market that bred their success.

Thus, according to Rajan and Zingales (2003), society must “save capitalism from the capitalists”—that is, take appropriate steps to protect the free market from powerful private interests that seek to impede its efficient functioning. When political interest and the capitalist class combine, “crony capitalism” may emerge, and nepotism will be more rewarding than efficiency. 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.

2. The quality of growth

A second criticism with respect to market-driven growth focuses on the adverse side effects generated by a system of production that is held accountable only to the test of profitability. It is in the nature of a complex industrial society that the production processes of many commodities generate outcomes (called “externalities”) that are bad as well as those that are good—e.g., toxic waste, Pollution or unhealthy working conditions as well as useful products.

The catalog of such market-generated ills is very long.

• Smith himself warned that the division of labour, by routinizing work, would render workers “as stupid and ignorant as it is possible for a human creature to become,”
• Marx raised the spectre of alienation as the social price paid for subordinating production to the imperatives of profit making.
• Other economists warned that the introduction of technology designed to cut labour costs would create permanent unemployment.

In modern times much attention has focused on the power of physical and chemical processes to surpass the carrying capacity of the environment, a concern made cogent by various types of environmental damage arising from excessive discharges of industrial effluents and pollutants—most importantly, global warming and climate change. Because these social and ecological challenges spring from the extraordinary powers of technology, they can be viewed as side effects of socialist as well as capitalist growth. But the argument can be made that market growth, by virtue of its overriding obedience to profit, is congenitally blind to such externalities.

3. Equity

A third criticism of capitalist growth concerns the fairness with which capitalism distributes its expanding wealth or with which it shares its recurrent hardships. This criticism assumes both specific and general forms.

The specific form focuses on disparities in income among layers of the population. In the early 21st century in the United States, for example, the lowest quintile (fifth) of all households received only 3.1 percent of total income, whereas the topmost fifth received 51.9 percent. Significantly, this disparity results from the concentration of assets in the upper brackets. Also, the disparity is the consequence of highly skewed patterns of corporate rewards that give, say, chief executive officers of large U.S. companies an average of more than 300 times the annual compensation earned by ordinary office or factory employees.

Moving from specific examples of distribution to a more general level, the criticism may be broadened to an indictment of the market principle itself as the regulator of incomes. An advocate of market-determined distribution will declare that in a market-based society, with certain exceptions, people tend to be paid what they are worth; that is, their incomes will reflect the value of their contribution to production. Thus, market-based rewards lead to the efficiency of the productive system and thereby maximize the total income available for distribution.

This argument is countered at two levels. Marxist critics contend that labourers in a capitalist economy are systematically paid less than the value of their work by virtue of the superior bargaining power of employers, so that the claim of efficiency masks an underlying condition of exploitation. Other critics question the criterion of efficiency itself, which counts every dollar of input and output but pays no heed to the moral or social qualities of either and which excludes workers from expressing their own preferences as to the most appropriate decisions for their firms.

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 . 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 Smith’s invisible hand continues to work in society’s favor.