What Is Capitalism?

Capitalism is an economic system in which individuals and private parties control the means of production and profits are the key driver of economic activity.

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Capitalism is an economic system in which individuals and private parties control the means of production, and profits are the key driver of economic activity. You’ll find some form of capitalism in virtually every modern economy. Understanding how capitalism works is key to understanding business, markets, and the economy in general.

How capitalism works

Capitalism is an economic system in which profit-driven private actors, rather than the government, control economic activity. The laws of supply and demand drive the production, pricing, and distribution of goods and services. Although you’ll find elements of capitalism in most economies around the world today, no purely capitalistic society has ever existed. Free-market activity exists, but the government intervenes to various degrees.

Adam Smith, the 18th-century Scottish philosopher who penned An Inquiry into the Nature and Causes of the Wealth of Nations, is widely considered the forefather of capitalism. However, Smith never used the word capitalism in his writings, using the phrase commercial enterprise instead. Capitalism didn’t become a widely used term until the late 19th century.

Defining features of capitalism

Capitalism is an economic system based on private property ownership, competition, and limited government; socialism is a system in which government plays a central role in controlling the means of production and resources, along with providing for the basic well-being of its citizens.

Some defining characteristics of capitalism include:

  • Competition: Businesses compete for consumer money and aim to maximise profits. Workers also compete against one another, seeking to maximise their wages in the labour market.
  • Private property ownership: Private ownership is a cornerstone of capitalism because owners have an incentive to maximise value and earn profits. Although limited government is a key feature of capitalism, protecting property rights is a generally accepted function.
  • Self-interest: People are motivated by self-interest rather than overall societal welfare. However, due to competition within free markets, society benefits from the pursuit of self-interest.
  • Freedom of choice: Customers can choose different products or businesses, while investors can pursue better opportunities. Workers can choose among employers and seek jobs that offer better wages.
  • Markets dictate pricing: Supply and demand determine the prices of goods, services, and labour.

Pros and cons of capitalism

Your perspective on the merits of capitalism and whether the advantages outweigh the disadvantages are likely tied to your political leanings. Here are a few of the commonly cited pros and cons of capitalism.

Pros:

  • Innovation and efficiency: Proponents argue that competition among profit-motivated actors spurs the creation of new goods and services. Competition causes businesses to maximise efficiency, which should lead to better prices for consumers.
  • Equality of opportunity but not outcome: Theoretically, capitalism is supposed to offer everyone the freedom to compete and succeed, although, of course, not everyone will succeed. People often have wildly different opportunities based on circumstances that are beyond their control.
  • Freedom of choice: Because freedom is a hallmark of capitalism, customers can choose to spend their money elsewhere if they believe a business creates inferior products or disapprove of its practices. Competition among businesses to attract labour is supposed to create better wages and conditions for workers.

Cons:

  • Competition for profits may have adverse outcomes: When companies relentlessly pursue profit, it can lead to negative outcomes. For example, companies may be motivated to cut corners at the cost of the environment or public health. Critics also worry that maximising efficiency could lead to widespread loss of jobs as businesses replace workers with robots and artificial intelligence.
  • Inequality: Capitalism is often cited as a driver of inequality. People who have less ability to compete or who don’t succeed are often left behind with little social safety net.
  • Workers often lose out: Although proponents argue that capitalism forces employers to compete for workers, critics argue that competition can create a race to the bottom for workers. Someone will typically be willing to do a job for less money, which can lead to lower wages and worse working conditions.

An example of capitalism

Capitalism and socialism are often presented as opposing schools of thought. In reality, however, many modern economies feature elements of both.

For instance, the United Kingdom is widely seen as a capitalist country. The ability to earn profits, seek better opportunities, and own private property are defining features of the British economy. However, the UK is actually a mixed market economy, meaning it has characteristics of both capitalism and socialism. For example, the government builds roads and other infrastructure, provides universal education for students, and, of course, directs funds to the National Health Service as well as the state pension.

This article contains general educational content only and does not take into account your personal financial situation. Before investing, your individual circumstances should be considered, and you may need to seek independent financial advice.  

To the best of our knowledge, all information in this article is accurate as of time of posting. In our educational articles, a "top share" is always defined by the largest market cap at the time of last update. On this page, neither the author nor The Motley Fool have chosen a "top share" by personal opinion.

As always, remember that when investing, the value of your investment may rise or fall, and your capital is at risk.