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ECONOMY

ECONOMICS

Main Characteristics of Capitalist

Economies
By
BRIAN DOLAN
Updated February 08, 2023

Reviewed by
MICHAEL J BOYLE

Fact checked by
MELODY KAZEL

Nations around the world employ several different types of economic systems;
two such types are socialism and capitalism. Capitalism is often referred to as a
free market economy in its purest form, where the means of production are
owned by private interests.

Embedded in these economic systems are political and social elements that
influence the degree of purity of each system. In other words, many capitalist
nations have elements of socialism interwoven. So even though there are
different degrees or levels of commitment to the ideals of capitalism, there are
several traits that are common among all capitalist economies.

KEY TAKEAWAYS
Capitalism is an economic system that focuses on a free market to
determine the most efficient allocation of resources and sets prices
based on supply and demand.
TABLE OF CONTENTS

Socialism is often presented as the opposite of capitalism, whereby

there is no free market and the allocation of resources is determined by
a central body.
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Capitalism has many unique features, some of which include a two-
class system, private ownership, a profit motive, minimal government
i i d ii
 intervention, and competition.
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Understanding Capitalist Economy Traits

Two-Class System
TABLE OF CONTENTS
Historically, capitalist society was characterized by the split between two
classes of individuals: the capitalist class, which owns the means for producing
and distributing goods (the owners), and the working class, who sell their labor
to the capitalist class in exchange for wages (the workers). Ad
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The economy is run by individual corporations that own and operate

companies and make decisions as to the use of resources. But there exists a
“division of labor” that allows for specialization, typically occurring through
education and training, further breaking down the two-class system into
subclasses (e.g., the middle class). [1]  

Private Ownership
Private ownership, or private property, is the cornerstone of any capitalist-
based
TABLE OF economy. Without having private ownership enshrined in laws, the
CONTENTS

owners of capital have no incentive to take the risks associated with allocating
capital to the market. Private ownership is part of the "invisible hand" cited by
economist Adam Smith in his seminal book, "The Wealth of Nations." [2]
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With private property, owners of capital, or the means of production, are free to
employ their capital in the marketplace as they see fit with their own interests
employ their capital in the marketplace as they see fit, with their own interests
at the fore. Most businesses are incorporated as "for-profit" entities,TRADE
where the
means of capital allocation and production are put to use in pursuit of business

ventures that will yield them profits, while at the same time paying for labor to
make the products and services that the company uses.

While most corporations are for-profit entities, there exist numerous "not-for-
profit" corporations that typically provide a social good or service, but don't
seek to turn a profit. Charities, hospitals, and advocacy groups are typical
examples of not-for-profit corporations. They attempt to provide goods and
services on an at-cost basis, typically returning any profits to the companies for
further re-investment in the corporation and for ongoing operating expenses.

FAST FACT
Nationalization is the transfer of private ownership to state
ownership, which is what happened in Russia once it became the
Soviet Union. Conversely, when the Soviet Union collapsed,
privatization occurred, to some degree, which is the transfer of
business and industry from state ownership to private ownership.

Self-Interest
Another major force behind Adam Smith's invisible hand is the opportunity for
a company to deploy its capital to turn a profit for itself and its owners, e.g.,
shareholders, bondholders, and other capital providers. Commonly referred to
as the "profit motive," for-profit companies exist to make a profit, while not-for-
profit companies seek to balance out the costs of doing business, usually
covered by charitable contributions, with outlays for the services they provide.

Under the profit motive, companies seek to make and sell goods and services
only at a profit. These companies don't exist solely to satisfy people's needs.
Even though some goods or services may satisfy needs, they will only be
available if people have the resources to pay for them and if there is a profit for
the producer. Ad

The profit motive leads to the accumulation of wealth (creation of capital) and
 p ( p )
is the driving force behind capital allocation with for-profit corporations.
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profit motive also allows companies to use some portion of profits to undertake

research and development (R&D) for future products or services, or for general
corporate purposes, such as stock buyback plans. R&D may also be seen as a
crucial undertaking to remain competitive against others in the same industry.

Competition
True capitalism needs a competitive market, one with multiple players offering
similar goods and services at competitive prices. Without competition,
monopolies will develop, and instead of the market setting the prices for goods
and services, the seller is the price setter, which is against the tenets of
capitalism.

To combat anti-competitive tendencies, which are in line with the profit motive,
many governments employ anti-monopoly laws to maintain a competitive
landscape. As such, the government seeks to avoid industry consolidation, i.e.,
the road to monopolization, so a free marketplace can be sustained. For
example, in the U.S., the Federal Trade Commission's (FTC's) Bureau of
Competition is charged with reviewing potential mergers and acquisitions in an
attempt to avoid a monopolistic consolidation in a particular industry.

Competition leads companies to strive to be better than their competitors, so Ad

that they may gain a larger portion of the market share for their given product
or service, increasing their profits, which often leads to innovation to edge out
 g g
the competition. As discussed, this innovation furthers society in terms of
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technology and thought. Competition is also beneficial to consumers as it

results in lower prices as businesses seek to make themselves more attractive

when compared with their competitors.

Market Mechanism
Following closely with competition between industry peers, capitalist
economies rely on an open market to determine what goods are produced and
what they should cost. Consumers, whether businesses or individuals, mostly
have the final say in how much a product or service is worth and what it should
cost, based on a competitive marketplace. Consumers will pursue their own
profit motive in seeking to find the best product at the best price, serving as
another incarnation of the invisible hand.

The market mechanism also relies on the concepts of supply and demand as
the overriding economic principle. Put simply, the greater the demand and the
lower the supply, the higher the prices are that are likely to be obtained by the
producers of that good or service, and vice versa.

Important: The so-called invisible hand guides the levels of supply
and demand until a price equilibrium point is reached: a price that
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consumers are willing to pay and where the producer are willing to
sell. This concept is also known as market equilibrium, typically
reached when there are numerous producers and consumers of a
 reached when there are numerous producers and consumers of a
certain good or service. TRADE

Adam Smith and John Maynard Keynes

Adam Smith was an economist who is best known for his 1776 publication of
"The Wealth of Nations." In the book, Smith comes out as an advocate of free
markets, guided by the invisible hand of self-interest. Translated into modern
terminology, Smith's book is often cited as the basis of modern capitalism,
where markets should be free to produce supply and set prices. Most notably,
Smith saw no need for government involvement in an economy, leaving him as
the most notable of the laissez-faire economists. [2]

In contrast, John Maynard Keynes, in his 1936 "The General Theory of

Employment, Interest and Money," believed the government had a role to play
in the economy, particularly when demand faltered. Keynes' view was that the
government should stimulate the demand side of the economy through
increased fiscal spending (in other words, government spending). His belief was
that government spending could support the economy until consumer demand
rebounded and could support the economy on its own. [3]

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Both economists and their works remain highly visible in academic circles and
frequently frame the debate about contemporary economic developments,
even today.

As one example of Keynesian theory in practice, the massive U.S. government

spending on infrastructure projects during the Great Depression arguably
sustained the economy until World War II came along and offered full
employment. As well, there are several more recent downturns (the Global
Financial Crisis of 2008-09 and Coronavirus in 2019-20) in which increased
government spending laid the foundations for the sharp recoveries in demand
that followed each episode.

Freedom To Choose
Central to the concept of a capitalist economy is the freedom to choose a
product from among various competitors' offerings. Using the principles of
competition and the invisible hand of supply and demand, consumers in
Ad
capitalist economies should have the greatest freedom of choice available.
Consumers act as the final arbiter of demand, while corporations are free to
pursue their own profit motives as they offer the right amount of supply
pursue their own profit motives as they offer the right amount of supply.
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Freedom of choice is one of the hallmarks of a capitalist economy, combining

multiple facets of competition, self-interest, and supply and demand. Capital
will be drawn to those products for which demand is high enough to make it a
profitable trade, meaning consumer demand is the linchpin of a capitalist
economy. In the U.S., consumer demand accounts for roughly 70% of economic
activity, leaving consumer spending as the driving force behind the functioning
of the world's largest economy. [4]

Minimal Government Intervention

Capitalist societies believe markets should be left alone to operate without
government intervention, an idea known as laissez-faire. True capitalists
believe that a free market always will create the right amount of supply to meet
demand and all prices will adjust accordingly. This is the basic thesis of Adam
Smith's free-market treatise. [2]

While corporations may be highly skilled in capital allocation and profit

maximization, there are numerous areas where government regulation is
necessary to proscribe actions that hurt the common good. Depending on the
industry, corporations may undertake actions that may hurt the common good,
such as the unregulated disposal of toxic waste or consumer financial scams. Ad
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In many cases, there is very little profit incentive for companies to avoid actions
that harm the common good. As such, governments regularly seek to
promulgate rules and regulations that limit or prescribe the manner in which
businesses conduct themselves.

A completely government-free, capitalist society exists in theory only. Even in

the U.S., the poster child for capitalism, the government regulates certain
industries, such as the Dodd-Frank Act for financial institutions or the Clean Air
and Clean Water Acts for industrial polluters, and the Consumer Financial
Protection Bureau (CFPB) to protect consumers from financial chicanery. [5]

If such regulations are applied uniformly to every company in a particular

industry, then they all face the same cost-burden of compliance with Ad

government regulations, so there should be no impact on the competitive

landscape.
 p
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Why Do Companies Seek To Control a Particular Market?
The short answer is pricing power. The fewer competitors in a given industry,
the more the company can charge for its goods or services. The more
competitors there are, the more competition will force prices lower.

What Is the Most Important Pillar to a Capitalist Economy?

Private property is the linchpin to capitalist economies. Without laws
guaranteeing private ownership, capital owners have little incentive to deploy
their capital into the economy, as their profits and property could conceivably
be seized by the government, for example.

Why Do Governments in Capitalist Economies Impose Laws

and Regulations on Companies?
Typically, the answer is to promote the public good and protect it from the
worst impulses of capitalism (see the Self-Interest section, above). This is most
evident in environmental and consumer protection laws, where the regulations
help to protect the environment we all share and to protect citizens from
predatory financial practices, among many others.

The Bottom Line

Capitalism in its purest form is a society in which the market sets prices for the
sole purpose of profits. Theoretically, any inefficiency or intervention that
reduces profit-making will be eliminated by the market. In a capitalist economy,
individuals have the right to choose any occupation they wish and to own
property, plant, and equipment to start businesses. They are allowed to
conduct the business as they see fit while competition with other businesses
leads to lower prices and innovation. [1]

Pure capitalists will say that any government regulation distorts the market and
consequently means higher prices for consumers. However, sometimes
government regulation is needed to protect consumers and the common good,
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two areas where the profit motives of capitalism might be in conflict with
crucial elements of society such as the environment and banking regulation.
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ARTICLE SOURCES

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Related Terms
Related Terms
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What Is the Invisible Hand in Economics?
The invisible hand is a metaphor for how, in a free market economy, self-interested
individuals can promote the general benefit of society at large.
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Marxism: What It Is and Comparison to Communism,

Socialism, and Capitalism
Marxism is a set of social, political, and economic theories developed by Karl Marx that
formed the basis of socialist principles.
more

Free Enterprise: Definition, How It Works, Origins, and

Example
Free enterprise is an economic system where few restrictions are placed on business
activities and ownership in terms of trade and government intervention.
more

Self-Interest: What It Means in Economics, With Examples

Self-interest refers to actions that elicit personal benefit. Economist Adam Smith studied
self-interest and its positive influence on the economy.
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What Is Capitalism: Varieties, History, Pros & Cons,

Socialism
Capitalism is an economic system whereby monetary goods are owned by individuals or
companies, and where workers earn only wages. more

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Political economy is a branch of the social sciences that focuses on the interrelationships
among individuals, governments, and public policy.
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