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The concept of the free market and its ability to regulate itself through the laws of supply and demand, competition, and self-interest is rooted in Adam Smith's theory of 'the invisible hand' described in his book "The Wealth of Nations". Capitalism itself, however, evolved with time from feudalism, mercantilism, and the Industrial Revolution. The Medieval European economy was governed by feudalism, where land and agriculture were the primary sources of wealth. In a feudal system, the economy is governed by the nobles who own land and offer protection, and the serfs, who benefit from this protection and work on those lands.
With time, different areas began to specialize in different goods and services based on the agricultural resources available to them. The goods and services that they were able to produce were traded for the goods and services they lacked. Because of this, cities became trade centers, and people moved to the cities to work for wages. Trade further expanded as countries colonized and gained access to more resources. As different countries began to produce similar goods and services, competition to produce and sell increased. The competition was further fueled by the Industrial Revolution, where people began to search for better and more efficient ways to produce goods and services.
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During the Industrial Revolution, large corporations (owned by one individual or small group of individuals) began to dominate the market since they employed the factory system and innovative technology to support mass production of goods at low costs. During this time, government regulation of these corporations and the market were subject to debate.
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A capitalist economy may seem to have plenty of positive characteristics and effects. After all, the quality of goods and services is high, and there is little to no government involvement. Those who regulate production and manufacture similar products are in direct competition with one another for consumers. Consumers will likely purchase the product with the highest quality at the lowest or most reasonable price. It motivates the owners to innovate and produce efficiently, leading to overall economic growth. Additionally, little to no government regulation allows the owners to act without limitation while working to produce efficiently.
Advantages of Capitalism
Capitalism benefits various groups of people, specifically those who own the factors of production, competitive skills, and consume or purchase goods and services. The owners of the corporation benefit financially. By producing goods and services efficiently, they can maximize their profits amassing great wealth. Although those who work for the owners do not profit as the owners do since they are paid a wage in exchange for their skills and work. This specifically compares to feudalism in which workers struggle for protection and access to land rather than wages. Lastly, consumers benefit from competition fueled by capitalism. Because of competition, consumers can select from a variety of similar goods and services of high quality at reasonable prices. With this variety and mass production of goods and services, the general standard of living also increases.
Disadvantages of Capitalism
However, there can also be a negative effect of capitalism. Without government regulation, owners can act without concern for the effects of their technology on the government or the general welfare and safety of their workers. In a capitalist economy, exploitation of workers is common since the goal is to mass-produce high-quality goods at low costs. It means that workers often work long hours for low wages to keep costs of production low. Furthermore, the division between these workers and the owners creates inequality and class division. Furthermore, a division exists between the owners and those who lack competitive skills and cannot work (the elderly, sick, unskilled).
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Capitalism is often compared to socialism because of their opposing beliefs regarding government regulation. In a pure capitalist economy, the government is not involved, and the factors of production are owned by individuals. Those who own these corporations or businesses aim to maximize their profit by keeping costs low and prices high. In a socialist economy, however, a governing authority owns the means of production while people work to produce goods and wealth. The profit is then distributed among the community. Each individual will receive a share of the profit based on how much they contributed after a portion is collected for the community.
What is Socialism?
Socialism is a system where people are inherently cooperative and entrusts the government for fair distribution of wealth and profit. Wealth and profit are allocated based on each individual's contribution that motivates people to work hard to receive a greater share. Before receiving their share, however, a portion is collected for the community. It is for those who are unable to work (the elderly, the young ones, the sick) to receive assistance from this fund. Additionally, the production focuses on what is necessary rather than what is profitable, ensuring that natural resources are not exploited for profit and are utilized to satisfy the needs of the community.
The United States is considered a mixed economy where individuals own the factors of production but are subject to limited regulation by the government. Additionally, the government employs some socialist programs in which it collects from an individual's share to benefit the community. Some examples of these programs include Social Security, Medicare, food assistance, education, and public housing.
Some benefits of socialism include shared profits among the community resulting in less inequality and class division. Additionally, those, who are unable to work, receive benefits from communal funds. Some disadvantages of socialism include slower economic wealth due to a lower drive to innovate or gain an edge in competition. There is also a risk of abuse of power by the central authority.
Comparison of Systems
| Factors | Capitalism | Socialism |
|---|---|---|
| Competition | Competition is high as the business owners work to gain consumers by creating quality products at a low cost while selling them at the highest possible price. | Competition is low as there the government owns the factors of production and regulates what and when is produced. |
| Government involvement | Government has little to no involvement in setting few (if any) limitations on business practices. | Government has high involvement and is trusted to distribute wealth evenly and fairly amongst the population. |
| Ownership | The factors of production are owned by individuals. | The factors of production are owned collectively. |
| Production | Production is focused on what is profitable. | Production is focused on what is necessary. |
| Technology and innovation | Use of technology and a drive to innovate are high as owners compete to create the highest quality good and the lowest possible price. | There is little motivation to develop new technology or innovate as there is no competition between producers. |
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In capitalism, a group of people has ownership of productive resources that have a monetary value. In this economic system, competition is high, and owners work to create the highest quality goods at the lowest possible cost. Here, the government has little to no involvement in enacting few (if any) regulations. Comparatively, the factors of production in a socialist economy are owned collectively, and the government is trusted to distribute the resulting wealth to the community. Although the United States employs programs like Medicare and Social Security, which exhibit socialist concepts, it is considered a mixed economy where the government enacts some limitations and regulations to control the market and independent businesses.
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Video Transcript
Formal and Informal Economies
'Economy' is defined in this lesson as the wealth and resources of a region in terms of the production and consumption of goods and services. There are two types of economies: formal and informal. Formal economies consist of those driven by the market or government, while informal economies exist without formalized policies or regulations.
This lesson will discuss formal economy systems in terms of capitalism and socialism and the underground economy, which is considered an informal economy. We will cover the key characteristics, advantages, and disadvantages of these types of economies.
Capitalism vs. Socialism
Formal economies operate within limits of established and monitored policies and regulations. Capitalism and socialism are formal economies.
The major differences between capitalism and socialism revolve around the role of the government and equality of economics. Capitalism affords economic freedom, consumer choice, and economic growth. Socialism, which is an economy controlled by the state and planned by a central planning authority, provides for a greater social welfare and decreases business fluctuations.
Capitalist Economy: Key Characteristics
Capitalism is characterized in the following ways:
- It is a market-based economy made up of buyers (people) and sellers (private or corporate-owned companies).
- The goods and services that are produced are intended to make a profit, and this profit is reinvested into the economy.
- The government should not interfere in the economies of the free market, meaning, the market determines investments, production, distribution and decisions, and government interference is only allowed when making and enforcing rules or policies governing the conduct of business.
- There is a need for continual production and purchase for a capitalistic economy to operate efficiently.
- Capitalists believe that government does not use economic resources as efficiently as private enterprise.
The U.S. is considered to be a capitalist economy, along with most of the modern world; however, economists are quick to point out that almost every society has a socialist aspect or program within it.
Capitalism: Advantages and Disadvantages
The advantages of capitalism include:
- Consumer choice - Individuals choose what to consume, and this choice leads to more competition and better products and services.
- Efficiency of economics - Goods and services produced based on demand create incentives to cut costs and avoid waste.
- Economic growth and expansion (which is possible in the capitalist economy system) - This increases the gross national product and leads to improved living standards.
The disadvantages of capitalism include:
- A chance of a monopoly of power - Firms with monopoly power (when a specific person or enterprise is the only supplier of a particular commodity) can abuse their position by charging higher prices.
- Inequality - A capitalist society is based on the right to pass wealth down to future generations. If a small group of people hold all the wealth and that wealth continues to be passed down to the same groups of people, inequality and social division occur.
- Recession and unemployment - An economy based on the market of consumers and producers is invariably going to experience growth and decline.
Socialist Economy: Key Characteristics
Socialism is characterized in the following ways:
- The means of production are owned by public enterprises or cooperatives (the state), and individuals are compensated based on the principle of individual contribution.
- There is equal opportunity for all. Large-scale industries are cooperative efforts, and thus, the returns from these industries must be returned to and benefit society as a whole.
- Economic activity and production are planned by the central planning authority and based on human consumption needs and economic demands.
- Socialists believe economic inequality is bad for society, and the government is responsible for reducing it via programs that benefit the poor.
For example, in the U.S., we have Medicare, social security benefits, and social nutrition assistance programs that are considered socialist in nature.
Socialism: Advantages and Disadvantages
The advantages of socialism include:
- Great efficiency - Economic efficiency under socialism means that production decisions are controlled and regulated by the central planning authority towards a particular goal.
- Greater social welfare - In a socialist economy there is less inequality of income because of the absence of private ownership of means of production.
- Absence of monopolistic practices
- Absence of business fluctuations - A socialist economy coordinates the action of various producing units, prevents discrimination between saving and investment and makes full use of available resources.
The disadvantages of socialism include:
- Elimination of individualism - When everything is controlled by a centralized body, individuals are not allowed to own any assets; everything belongs to the state.
- An artificial system - Demand and supply principles do not exist in an economy where the state determines what is produced. In the long run, the economy becomes static rather than growing.
- Consumers suffer - Individuals do not enjoy the status of being a consumer as in a capitalist economy. There is no competition in a socialist economy. Therefore, individuals are not afforded a choice, which usually leads to higher quality products and services.
Underground Economy
The Informal or Underground Economy refers to an economy that is unmonitored by any form of government, not taxed, and not included in any gross national product calculations.
The underground economy is characterized by:
- Economic activity is unmonitored.
- Changing social or economic environments that may result in a lack of other options, leaving people no choice.
The underground economy accounts for ~15% of employment in countries such as the United States.
Lesson Summary
Economy, which is defined as the wealth and resources of a region, can be grouped into two types: formal and informal.
Capitalism and socialism are formal economies that differ based on the role of the government and equality of economics. Capitalism affords economic freedom, consumer choice, and economic growth. This type of economy, however, may promote monopolies and inequality and lead to an economic recession. Socialism, which is an economy controlled by the state and planned by a central planning authority, provides for a greater social welfare and decreases business fluctuations. Socialism, however, eliminates individualism and consumer choice and may lead to a stagnant economy.
The informal or underground economy refers to an economy that is unmonitored by any form of government, not taxed, and not included in any gross national product calculations.
Learning Outcomes
When this lesson is completed, you should be able to:
- Define and identify the characteristics of a capitalist economy
- Describe and recognize how a socialist economy works
- Recall what makes up an underground economy
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