What is Capitalism?

Because society's resources are scarce, every economy faces three fundamental questions:

  • What goods and services are going to be produced?
  • How are the goods and services going to be produced?
  • Who is going to get the goods and services produced?

Capitalism is an economic system in which individual consumers and producers ultimately decide the answers to these questions. Consumers "vote" for the goods they want to purchase (by their behavior at the grocery store, the mall, at restaurants, etc.) and firms decide how best to produce these goods by relying on existing technology or by developing new methods of production. A direct contrast to capitalism is communism, a system in which government bureaucrats decide the answers to the three fundamental questions (often with limited information about the wants and desires of its citizens and the capabilities of its producers).

How Does Capitalism Work?

Every transaction between a consumer and a business involves a price that serves as market information. For example, goods that are highly sought after will have high prices, and high prices are a signal to businesses that resources should be used to produce more of these goods. On the other hand, resources will not be wasted to produce goods with little demand. As Adam Smith put it, scarce resources are moved to their most productive ends through an "invisible hand" (the price system) without the government having to decide how to allocate the scarce resources.

Another benefit of the capitalist system is that resources are used efficiently. A free market will allow any number of producers to vie for the affections of the consumers. This competition leads to the adoption of production processes that yield the lowest costs and, thus, the lowest prices. Firms that cannot compete are pushed from the market.

Crony Capitalism

Capitalism, as a market system, is not to be confused with crony capitalism. With cronyism, businesses (often those that can't compete in the marketplace) vie for competitive favors from governmental power brokers. Government contracts are granted to businesses that are the largest campaign contributors and not those that offer the lowest prices.

Does the Government have a Role?

Capitalism doesn't completely rule out government intervention. Capitalism's foundation is the protection of property rights (and intellectual property rights); if these rights aren't maintained businesses have no incentive to be creative. Thus, governments must protect their citizens from thieves from within and without. Government intervention might also be needed in the event of a market failure. For example, businesses might produce too much of a good because they don't internalize the cost of polluting the environment.