(From Grolier Multimedia Encyclopedia)


Capitalism is an economic system in which the means of production are privately owned. Business organizations produce goods for a market guided by the forces of supply and demand. Capitalism requires a financial system that enables business firms to borrow large sums of money, or capital, to maintain and expand production. Underlying capitalism is the presumption that private enterprise is the most efficient way to organize economic activity. The 18th-century economist and philosopher Adam Smith expressed this idea in his Wealth of Nations (1776), extolling the free market in which the businessman is "led by an invisible hand to promote an end which was no part of his intention."

The marketplace is the center of the capitalist system. It determines what will be produced, who will produce it, and how the rewards of the economic process will be distributed. From a political standpoint, the market system has two distinct advantages over other ways of organizing the economy: (a) no person or combination of persons can control the marketplace, which means that power is diffuse and cannot be monopolized by a party or a clique; (b) the market system tends to reward efficiency with profits and to punish inefficiency with losses. Economists often speak of capitalism as a free-market system ruled by competition. But capitalism in this ideal sense cannot be found anywhere in the world. The economic systems operating in Western countries today are mixtures of free competition and governmental control.

Historical Development

Many of the institutions of capitalism existed in ancient times. Trade, moneylending, and insurance were well known to the Greeks and Romans. But the growth of state power under the Roman Empire prevented any further development of a private business class. Modern capitalism evolved in the late Middle Ages out of the social order of medieval Europe. The medieval economy was based on manorialism, a system in which peasants cultivated large estates and had rights to what they produced, in return for services and dues paid to their lords. The land remained under the lord's ownership, but the tillers inherited the right to cultivate it.

With the rise of centralized monarchies, kings competed with the local autonomy of the manor lords. In the towns a merchant class grew, and the development of commerce began to create a regional and international economy. Through the joint-stock company, forerunner of the modern corporation, these merchants could finance large ventures for exploring and developing distant lands, activities controlled by rising national governments that sought to make commerce serve the state through policies known as mercantilism.

From the 16th to the 18th century, great rural-to-urban migrations created an abundance of capitalist labor. The Reformation encouraged a view of life more favorable to commerce than the medieval Roman Catholic outlook had been. The advancement of science, with its emphasis on observation and inductive reasoning, tended to undermine the authority of the old order. The rising commercial and industrial classes, called by the French the bourgeoisie, sought a new political order corresponding to their economic interests.

Indeed, the concept of interest became a new political idea. The 17th-century English political theorists Thomas Hobbes and John Locke thought of society as created by a compact among people, in which the state's primary obligation was to protect the interests of its citizens. A central interest was the right of property. This current in political thought culminated in the work of Adam Smith, who argued that the commercial classes, if allowed enough freedom, could best achieve prosperity for the country. The crux of Smith's argument was that the economic order should be as independent as possible from the political order. Smith's Wealth of Nations was a critique of the existing system of state controls that he called mercantilism. He argued that state intervention not only diminished freedom but also was economically inefficient. The state's proper role should be to protect private property and enforce contracts; production and distribution should be regulated by the market.

The 19th century was an era of unprecedented economic growth, especially in Britain and the United States. It was the age of laissez-faire economic liberalism and free trade, when politics and economics were thought of as separate spheres of human endeavor. The Industrial Revolution transformed society, first in Britain, then in France and Germany, and later in the United States. By the end of the century most people worked in the factory and the office. Large industrial cities developed, and with them labor unions and working-class political parties that regarded employers and capitalists as their enemies and the capitalist system itself as something to be modified or even eliminated. The most far-reaching attack on capitalism was that of Karl Marx and Friedrich Engels, whose writings became the intellectual basis of European socialism and communism.

The early theorists of capitalism had not foreseen the tendency of the business enterprise to grow ever larger. This occurred in several ways: the industrial plant expanded in order to gain the advantage of lower unit costs from mass production; the business firm evolved from the artisan's small shop to a corporation operating a number of mills, factories, and transportation lines; and corporations in turn merged with one another to form combines or trusts. Thus a large segment of industry came to be controlled by a relatively few firms.

The modern firm was characterized by several innovations. The sale of stocks and bonds gave it access to the savings of the public. The corporate form of organization gave it independence from its owner—in the eyes of the law, the corporation was a "person" and could sue as a legal entity, independently of its stockholders. The stockholders, concerned primarily with the return on their investment, tended to cede their powers to salaried managers.

Modern Conceptions of Capitalism

The rise of the corporation and the domination of many industries by a few firms led to new ideas about capitalism. Many liberals and populists favored breaking up large corporations and requiring them to refrain from practices that were monopolistic or injurious to competition. For this they turned to the state, pressing for antitrust laws to guarantee a competitive economy. Others held that large firms were not necessarily less competitive than small ones and that it was wrong to conclude that modern capitalism was less dynamic and progressive than that of Adam Smith's day. The Austrian-American economist Joseph Schumpeter, arguing in defense of large firms, held that the prime mover in capitalist progress was not the small businessperson but the entrepreneur who introduced and developed new technologies.

Schumpeter evolved his ideas during the Depression of the 1930s, at a time when laissez-faire capitalism seemed to many people to have outlived its day. The British economist John Maynard Keynes held that the capitalist slump might continue indefinitely unless the state took measures to raise aggregate demand for goods and services (see economy, national). Keynes and his followers argued that an unregulated economy was not necessarily progressive and that intelligent fiscal policy and monetary policy were required to stabilize the economy and keep it growing. The government should spend more money in times of slump and also reduce taxes in order to increase aggregate demand. In boom times, according to Keynes, the policies should be reversed in order to hold down inflation. In the decades after World War II the Western industrial countries gradually adopted Keynesian policies of managing demand.

Modern capitalism thus differs from the capitalism of the 19th century in its dependence on the state. The government is expected to take measures to combat both mass unemployment and inflation. The government is also charged with other economic responsibilities, from regulating business practices and defending the environment to enforcing minimum wages and ensuring equal opportunity. Modern capitalism may be thought of as a hybrid, combining private enterprise and state control.

Ongoing Problems

Pessimism characterized capitalism in the 1970s, a decade confronted with the simultaneous existence of high rates of inflation and high unemployment. Economists had previously thought them to be incompatible; unemployment occurred during slumps and inflation during times of prosperity. In the 1970s, however, high rates of inflation coincided with high rates of unemployment in the United States and some other industrialized countries. This so-called stagflation presented a dilemma: efforts to combat inflation tended to make unemployment worse, and vice versa.

The pessimism of the 1970s gave way to the optimism of the "Reagan revolution" of the 1980s, which signaled the return of capitalism as the dominant ideological and moral force in the United States. Central to the Reagan philosophy were two precepts: that the size of government had to be reduced and that the economy had to be deregulated. As a precondition for the resurgence of capitalism, the president obtained substantial income tax cuts and, ultimately, tax reform. The negative side of this policy, however, was seen in ballooning federal deficits. Free markets in the 1980s were no longer seen as throwbacks to a more primitive era but rather as the engine of prosperity.

A key element in this transformation was the gradual reduction of inflation rates, spurred on, in part, by a precipitous decline in the price of oil. This led to a dramatic decline in interest rates with a resulting expansion of the U.S. economy—marked by continuous creation of new jobs.

The decade of the 1980s was marked by a tremendous expansion of the Western economies and the emergence of a global economy, in which the prosperity promised by capitalism seemed assured. More important than the apparent success of free-market economies was the continuing economic and ultimate political dissolution of the Communist world. In simple economic terms Communist nations were unable to meet the consumer demands of their citizens. Comparedwith o the seemingly limitless abundance of the West, Eastern-bloc nations were poor: standing in line for scarce commodities became the emblem for life under communism.

The triumph of the capitalist system was seen as primarily owing to the superiority of free markets over the "command and control" economies of the Communist nations. Yet the euphoria that followed the demise of communism was tempered by the problems engendered by the expansion that occurred during the 1980s through the early '90s. A sharp decline in the Japanese stock market, real estate, and banking sectors as well as economic uncertainty in the European Union (EU) and a recession in the United States raised questions about the long-term economic stability of the system. Renewed expansion and growth, however, somewhat allayed concern by the mid-1990s.

The rise of the global economy has brought sweeping changes in the "rules of the economic game." Businesses must now compete worldwide with industries that have different costs for capital, labor, and materials, in addition to different traditions of public-private cooperation and labor-management relations. The perceived "unevenness" of the economic playing field among nations led to renewed calls in the United States for trade protection, particularly against Japan and China. A policy of sweeping downsizing of corporations is seen as an effort to contain costs and to maintain a competitive trading advantage in the global economy.

In the post-cold war capitalist era of the late 1990s, significant differences developed among the economies of the world's leading industrialized nations. The U.S. economy, having absorbed the costs of the earlier savings and loan debacle, leveraged buyouts, and an inflated real-estate market, entered a prolonged period of flourishing stock markets, low unemployment, and low inflation. France, Germany, and other Western European nations, on the other hand, faced severe challenges from high unemployment, high taxation, and high labor costs that made their exports less competitive in the world markets. EU member nations also wrestled with the problem of meeting the stringent requirements of entry into economic and monetary union in 1999, while still paying the generous social benefits to which their citizens had become accustomed.

The 21st century began with new problems for the capitalist systems of the developed countries in the West as well as continued affirmation of capitalism itself by its voters. A short recession in the United States accompanied by a sharp decline in its financial markets took place in 2000, while high unemployment and stagnant economies continued to characterize the financial climate in many European nations. Communist China, in contrast, although having remained Marxist in theory, saw its economy grow manyfold as a result of its having begun to employ capitalist free-market practices in the 1990s. In addition to recession, the United States experienced further economic strains at the beginning of the century. A series of corporate scandals and major bankruptcies, as well as the terrorist attacks of September 11, 2001, negatively affected businesses of all sizes. Whereas significant tax cuts did benefit the corporate economy, they failed to stimulate enough jobs to make up for those lost in the recession or to replace the many blue-collar jobs that had been moved overseas to take advantage of significantly lower wages and benefits, one of the results of globalization. In addition, a new phenomenon, overseas outsourcing, which likewise takes advantage of lower wages and benefits elsewhere, sent a number of U.S. skilled technical jobs to places such as India and Pakistan. Furthermore, the gap between the world's richest and poorest nations became more evident and further publicized during the early years of the new century. The dire poverty in Africa, the Caribbean, Latin America, and Asia was being acknowledged more and more to be due, in part at least, to the kind of capitalism practiced by the Western democracies.

Henry Plotkin

Further Reading:

Amin, Samir, Capitalism in the Age of Globalization: The Management of Contemporary Society (1997).

Bell, Daniel, The Cultural Contradictions of Capitalism (1978).

Braudel, Fernand, The Structures of Everyday Life: Civilization and Capitalism, 15th-18th Centuries, 3 vols., trans. by Siân Reynolds (1982-84; repr. 1992).

Chandler, Alfred D., Jr., Scale and Scope: The Dynamics of Industrial Capitalism (1990).

Cornwall, John, Economic Breakdown and Recovery: Theory and Policy (1994).

Drucker, Peter F., Post-Capitalist Society (1993).

Friedman, Milton, Economic Freedom, Human Freedom, Political Freedom (1992).

Galbraith, John Kenneth, American Capitalism: The Concept of Countervailing Power (1993).

Gordon, John Steele, An Empire of Wealth: The Epic History of American Economic Power (2004).

Greenfield, Liah, The Spirit of Capitalism: Nationalism and Economic Growth (2001).

Haslett, David W., Capitalism with Morality (1994).

Heilbroner, Robert L., 21st Century Capitalism (1994).

Safarian, A. E., et al., eds., East Asian Capitalism: Diversity and Dynamism (1996).

Schumpeter, Joseph A., History of Economic Analysis, rev. ed. (1996).

Silk, Leonard, et al., Making Capitalism Work (1996).

Silverman, Bertram, and Yanowitch, Murray, New Rich, New Poor, New Russia: Winners and Losers on the Russian Road to Capitalism (1997).

Tawney, Richard H., Religion and the Rise of Capitalism (1947; repr. 1998).

Thurow, Lester C., The Future of Capitalism: How Today's Economic Forces Shape Tomorrow's World (1997).

Weber, Max, The Protestant Ethic and the Spirit of Capitalism (1950; repr. 1996).

Williamson, Oliver E., The Economic Institutions of Capitalism: Firms, Markets, Relational Contracting (1987).

Zwass, Adam, From Failed Communism to Underdeveloped Capitalism: Transformation of Eastern Europe, the Post-Soviet Union, and China (1995).