Economic Systems: Capitalism Research Paper Starter

Economic Systems: Capitalism

The theories of socialism and capitalism have been competing for more than a century. For Karl Marx, capitalism was a system that promoted class domination and oppression. The Marxist version of socialism as tested in the Soviet Union, Cuba, China and other places has failed. Lack of individual freedom caused human suffering and economic ruin. The failure of this dramatic approach has not killed the approach itself. On the other hand, the basic principles of capitalism of voluntary exchange, free trade between nations, and the self-directed market via the "invisible hand" have been accepted by most as fundamental to a successful economy. However, unrestrained capitalism seems to have wrought evils of its own. The preponderance of the world now engages some mixture of capitalist and socialist principles and the debate continues as to the optimal mix. That is, markets should be free, but how free? In terms of global capitalism, most agree that free trade is generally preferable and the debate usually turns to how free?

Keywords Capitalism; Command Economy; Comparative Advantage; Division of Labor; Feudal System; Factors of Production; Laissez-Faire; Managed Economy; Market Economy; Mixed Economy; Mercantilism; Multi-lateral Treaty; Robber-Barron; Signatory; Socialism; State Socialism

Economic Systems: Capitalism


Capitalism is an economic system that consists of private owned organizations competing in an open market for profit and ownership of the means of production. In contrast to socialist or communist systems, capitalism focuses on private business and investment. Investors in private companies (i.e. shareholders) are known as capitalists. Laissez-Faire economy, private enterprise system, and free-price system are synonyms for capitalism; socialism and communism are antonyms of capitalism. The production, pricing, and distribution of goods and services are determined by the market economy.

The essential feature of a market economy is the voluntary exchange of goods and services. The decisions about price and production are a product of the aggregate decisions of all the consumers and businesses in the economy. Market economies depend upon the theory that market forces (like supply and demand) will lead to the best course of action and as a result, a healthy market. The interaction of the market forces of supply, demand and price is sometimes called the market mechanism. A simple example of how the market mechanism works: Imagine competing manufacturers of similar products, for example, lemonade and iced tea. If tastes shift to iced tea, demand will increase for iced tea and decrease for lemonade. In response, the iced tea manufacturer will raise prices and lemonade manufacturer will lower prices. In response to the shifts in prices, consumers will buy less iced tea and more lemonade thereby equalizing demand for the two products. This voluntary exchange is the opposite of the planned economies of socialist and communist systems.

The Origins of Capitalism

Early capitalism can be traced to medieval Islamism civilizations of the ninth century. Stable currency, trading companies, contracts and concepts of credit contributed to the formation of a trader class that in general sold products a price higher than their purchase price. Between 1600 and 1800, Europe went through an economic transformation that led to changes in agriculture, a mass movement to cities, the development of industry, commercial proliferation and monetary sophistication. Capitalist practices, known as mercantilism, began to emerge as wealth became concentrated. This shift represented a fundamental change from the feudal system then in place.


Mercantilism was based on the premise that a nation's route to prosperity lay in the accumulation of precious metals through a favorable balance of trade with other nations. To maximize exports and minimize imports, nations used heavy regulations. The mercantilist view of economics was zero-sum wherein every nation's gain represented some other nation's loss. The mercantilist prized saving and thrift as methods to accrue capital and engage in mining and export. Mercantilism lacked the fundamental feature of modern capitalism; the free market or lack of government intervention. Moreover, under current economic thought, barriers to trade retard economic development and do not encourage national prosperity. These main insights, the free trade among nations and the lack of government regulation (laissez-faire economics), form the foundation of modern economics and are attributed to the work of Adam Smith.

Adam Smith

Adam Smith (1723-1790) was a Scottish philosopher and founder of classical economics. Smith's book "An Inquiry into the Nature and Causes of the Wealth of Nations," published in 1776, insisted that the wealth of a nation was gauged by the variety and amount of the consumables the economy could command. Free trade was central to this measure because through trade, nations encountered a large variety of consumables. Smith directly countered the central idea of mercantilism by showing that trade could improve the conditions of all traders by creating wealth as opposed to the then prevalent assumption that regarded wealth as a fixed quantity. Underlying Smith's argument was the assumption that people act in their own best interest and to do so necessarily promotes general economic welfare. The capitalist, to maximize profit, will produce to satisfy the greatest needs of the people. Free market exchange occurs only if participants believe that they will be better off as a result, and the same general principle applies to society at large; thereby making everyone better off. Smith linked capitalism to the general welfare without specific consideration of any moral issues (Macleod, 2007).

The Invisible Hand

A metaphor invoked by Adam Smith in "Wealth of Nations" and other writings to explain the concept of societal benefit through individual interest is that of an "invisible hand." Due to the natural competition for scarce resources within a free market, the market is effectively guided by an invisible hand. This invisible hand guides people to act in society's best interest, as a by-product of the pursuit of self-interest. According to Smith, these cumulative effects are more effective for the betterment of a nation than conscious and well-intentioned measures to the same end (Economics Dictionary).


The capitalist system as described in "Wealth of Nations" included concepts of value and production. The value of an item is determined by the cost of production. Therefore, items expensive to produce have a high value and vice versa. The key insight into production is the division of labor. Division of labor is the idea of specialization and rests on the premise that a person charged with only a portion of the process of production will find ever more efficient and effective ways to complete the task. This effectiveness increases the overall productiveness of the system. Factory assembly lines are an example of the division of labor concept at work.


A central idea of capitalism is the lack of government control, often called "Laissez-faire" which means literally "to leave alone." This policy of minimal government interference with the economy allows the voluntary exchange between market participants that is critical to the invisible hand idea mentioned above. John Stuart Mill (1806-1873), the English philosopher, economist and a leading proponent of utilitarianism strongly supported the policy of minimal government interference in the lives of citizens. Utilitarianism is the belief that the best course of action is that which brings the greatest happiness to the greatest number of people. John Stuart Mill's essay "On Liberty" set out to establish that the only valid justification for interfering with someone's actions was to protect someone else. This work had a significant influence in the United States and on the Supreme Court who generally adhered to the idea of economic activity free from the government interference for the beginning of the twentieth century (Utilitarianism, Oxford Dictionary of Politics).

The Limits of Free Market Capitalism in the United States

Capitalism, like most things, cannot be applied purely and totally; even the most aggressively capitalist economies must have regulation because a government must at least establish basic rules. For example, business would find it very difficult to function without the law of contracts. Moreover, governments also find it necessary to take corrective action when an unregulated market does not function well, that is, in instances of "market failure." In the United States, the ability of the federal government to legislate in a particular area is determined by the Constitution. The Constitution grants the federal government specific, or "enumerated," powers as opposed to a general authority to legislate. Therefore, every piece of legislation must be based on one of those powers. For example, Congress may legislate on matters affecting interstate commerce under the "Commerce Clause." The "Takings Clause" allows the Congress to exercise the power of eminent domain to take private property for the public good upon proper compensation. While it is easy to state the general type of power granted by the Constitution, the precise meaning of those powers in practice is neither self-evident nor universally agreed. The determination of whether the Constitution permits a particular Congressional act rests with the Supreme Court of the United States. The Court has the ultimate authority...

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