Useful Notes: Capitalism

Capitalism is an economic model designed to combat the problem that we don't live in a post scarcity society. Since many people consider a free market to be a core part of capitalism this article will cover market capitalism. Socialism is its biggest competitor.


Capitalism has actually been used to mean a couple different things:

The definition of Capitalism accepted by most is a system wherein certain individuals (the capitalist class) own the means of production and guide the economy. Various competing definitions have been created by supporters of capitalism and opposers of capitalism, but they are irrelevant here.

The Rational Consumer

First of all, we must note that all modern mainstream economic models assume a completely rational consumer. One that would always look for the best, lowest price before buying, provided that finding it out isn't too costly. This assumption is the basis for almost everything coming up.

Invisible Hand

The concept behind the invisible hand is if there is competition in an economy, each member of that economy can pursue their own self-interests and create general prosperity for all. An important concept early in the history of economic thought, this is a hotly contested idea today.

Supply and Demand

The price of something is determined by supply and demand. A higher quantity of a product means it is less likely a buyer will pay an outrageous amount of money for it because they can walk down the street and get it for a cheaper price. If the seller is the only one in possession of the product then that seller is the only way the buyer can get the product. If the buyer refuses to pay the seller's price the seller will just move onto a different customer who is willing to buy it.

If there is high demand for a product sellers can get more money out of the product because if desired badly enough buyers will pay whatever price. If there isn't high demand for a product sellers are forced to lower pricesnote  in order to raise demand.

Higher demand for a product causes the price to go up. Less demand for a product cause the price to go down. Higher supply of a product causes the price to go down. Lower supply of a product causes the price to go up.

The level of supply is determined by the sellers and the level of demand is determined by the buyers. If there are many sellers of the same product and many buyers of the same product then determining prices is a bit like determining the weather. Individual sellers of a product have no control over the price of a product because if seller A cuts back their supply Seller B will increase their supply. Seller B is losing money over the reduced prices but is gaining money from selling the extra inventory.

Market Failures

Market failures are instances when the market left alone does not produce the most efficient system to be put in place. It is almost entirely agreed that market failures do exist; the classical market failures are public goodsnote , externalitiesnote , and natural monopolynote . Left and right-wing economists have differing opinions on what constitutes a market failure. The general tendency among left-wing economists is to see more market failures, and to hold an optimistic view of government intervention, and the tendency among the right is to see fewer market failures, and to see more government failures when government chooses to intervene. Due to market failures, the existence of the invisible hand is debated by capitalists and anti-capitalists alike.

Law of Diminishing Returns and how it affects supply

The Law of Diminishing Returns states that the higher quantity of a product you make within a certain period of time the higher the cost of making an individual piece of that quantity. As an example if it costs two dollars to produce a single bottle in one day, and it will cost more than four dollars to make two bottles in one day. For the sake of this example lets say it costs five dollars to make two bottles and each additional bottle costs an extra dollar to produce in one day.

As mentioned above individual sellers have no control over prices and have to accept whatever the market price is. Going with the above example if the market price for bottles is seven dollars then sellers will make a profit off the first five bottles they produce, make even on the sixth one, and lose money on any consecutive bottles made within one day. If an individual seller wants to make a profit from any bottles after the fifth one either the price has to go up or production costs have to be lowered. Additionally, the producer can slow down the rate of production to produce only a profitable amount of bottles per day.

As for why each additional product costs more to produce than the last, imagine you are starving so you go to a fast food restaurant and order burgers. The first few burgers you buy taste delicious and are quenching your hunger. After a while it becomes less rational to spend money on burgers because if you eat enough you'll puke. (This is a related concept called marginal utility. Think of it this way: you are always asking "Do I want another burger?" and you keep eating until you want another burger less than it costs. For prices, it's this point where you stop buying burgers and the restaurant stops selling them that matters.)

Another analogy would be someone who owns an apple orchard. In a few hours her workers could go through and easily pick all the apples off of the bottom branches. The ones on the top branches however require more effort to get to. If a profit is to be made from those prices have to be increased. In a factory setting adding a few workers will increase productivity because they can specialize on specific tasks, but if you add enough workers, people will be bumping into each other. Some workers will also be standing around doing nothing because there aren't any tasks to do. Paying these workers their wages is a waste of the employer's money because no profit is coming from it. Whether all situations operate in this manner is debatable but it's a well-observed effect.

Economies of Scale

Economies of Scale refers to a situation where it is cheaper for a business to produce more of an item than less. Think of it as like buying in bulk, but for producers.

It costs a great deal to make one hand-built automobile, as it takes a few skilled workers a fairly long period of time to make it using hand tools and whatnot. Since this manufacture of only one unit of product takes a long period of time and uses skilled laborers (who earn more money than unskilled), the end product (a hand-built car) ends up costing a lot of money.

It costs far less to make one machine-manufactured automobile because of the economy of scale. This states that an efficient production process that makes the product faster with unskilled laborers can in turn make more product in a far shorter period of time and therefore cost less to make and sells for a lower price. The entire industrial revolution is built upon this concept.

For a good real-life example: look at a Ford Model T or a Volkswagen Beetle. Making either car by hand would result in a far slower turnout and a more expensive product, but the entire point of both vehicles was a cheaper product for the masses. They were cheaper because the more of them were made, the cheaper they became to manufacture: the beginning capital (factory construction, machinery purchase, etc.) was far greater than making a hand-built car, but the volume of the sales made up for it.

In some cases, economies of scale make it cheaper to waste some materials than to make what is necessary because there are costs at each price point (the number of items being made) where going to a larger quantity may be cheaper even if a lot of the material is simply wasted or recycled. A university newspaper on the US West Coast has a daily newspaper, which, to serve the campus community and visitors, needs about 30,000 copies each day. The newspaper has 50,000 copies printed each issue and recycles 20,000, because at 50,000 they can use much less expensive (and more automated) offset printers, but a lower quantity would use a less efficient system and be more expensive, even though almost half of the printing order is pure waste.

Role of government

Capitalist economists are divided on the exact role the government should play in the economy. Some of those roles include:
  • Enforcing Property Rights: Stealing is wrong. Not only is theft generally agreed upon to morally damaging to the individual who steals, and causes suffering to those who are stolen from, but widespread theft (such as the looting that occurs in riots) creates massive market inefficiencies, and thus widespread theft would be a market failure. According to capitalists, if someone desires a product they should pay the agreed-upon price. Fraud is considered a form of stealing (as theft by trick) so it would fall under this.
    • There is much debate on what counts as stealing. Supporters of capitalism believe that using or taking the private property and personal possessions of someone else is stealing, whereas socialists only believe that using or taking the personal possessions of someone else is stealing. Finally, anarcho-capitalists would not only agree with the former, but also go further and add that enforcing the collection of taxes is stealing too.
      • There is even some debate as to what someone can actually own, such as intellectual property. Supporters say that as it was made by someone, the idea belongs to the creator. If creators did not own their own ideas other people could steal them and use someone else's ideas to make a lot of money at the expense of the creator. For example, if Alice were a small businesswoman who discovered a way to manufacture cars more efficiently, Bob, who already has a big business and thus all of the infrastructure in place, could take Alice's idea and apply it to his own plants. Now Alice has payed the R&D costs for the research but Bob is the one making the money on her idea. Opponents say that the reason we have property in the first place is to manage finite resources and define property as "something one person owns to the exclusion of other people owning it." For example, if Alice owned a pencil Bob could not use that pencil without first taking it from Alice. Ideas, on the other hand, are infinite, that is one person can have it and someone else can use it without diminishing the first person's 'ownership' of it. For example, if Alice owned a book and Bob copied the it onto his own paper, both of them can still enjoy the book.
  • Providing Public Services: Some things, such as lighthouses, well-maintained roads, and clean air are considered impossible for an individual person or organization to make a profit from because property rights are near impossible to enforce on these things. The government however can pay for these things with tax money, which they can force everyone to pay. Whether they should do this is the subject of debate among the many different schools of economic thought. See below.
    • Included in this could be considered the funding of unprofitable markets until the kinks can be worked out enough for the private sector to make a profit in these markets. Various examples that are pointed to are the funding of the earlier voyages in the age of exploration that spanned the fifteenth to seventeenth centuries, the space race, cancer research, and non-fossil fuel energy sources.
  • Helping Out In Recessions: Recessions are viewed as a natural consequence of capitalism. The free market naturally goes through ups and downs. What you can do without abolishing capitalism outright, which isn't an option for the overwhelming majority of economists, is make the ups last as long as possible while making the downs last as little as possible. If the economy is bad enough, the government can either print more money or increase spending to boost the economy. It is an agreed principle of economics that these government actions can and will cause economic expansion, but whether they should is debated by the left and right. (See different schools below.)
  • Regulating Monopolies and Oligopolies: The problem with monopolies is that due to the law of diminishing returns, it's impossible for them to make a profit making huge quantities of a product, so prices naturally stay high. The government can intervene in these situations and either force the company to break up, put a minimum limit on how much they have to produce, put a maximum limit on how much they can charge, and/or use tax money to reimburse the company for any lost profits if they increase supply. The problem with oligopolies is it reduces the likelihood that individual suppliers will renege on a deal to keep total supply in the economy as low as possible. The government can regulate these in a similar manner. Again, whether the government should regulate mono/oligopolies is debated. Though a moderate consensus is that governments should break up mono/oligopolies as well prevent them from forming, what constitutes a mono/oligopoly is not agreed upon. Further to the left, economists believe that the state should assume control of a mono/oligopoly if it is naturally occurring, such as in the generally agreed-upon case of water or energy suppliers (it is extremely hard to foster competition when actual land control is involved). Further to the right, it is argued that the side effects of the government trying to combat the mono/oligopoly will lead to far worse results than if just left alone.
  • Regulating The Money Supply: Money is the lifeblood of a capitalist/market economy. If the amount of money circulating in the economy is higher than the demand for money it will cause inflation. If the amount of money circulating in the economy is lower than the demand it will cause deflation. Modern-day Austriansnote  like Ron Paul do not believe the government should do this, but even among right-wing economists the need for the government to have a monetary regime is widely supported. (To wit, the person who has used the central bank in the US to increase the money supply most is Ben Bernanke, a Repubican.)
  • Banning Products: Markets will produce whatever people are willing to pay for even if the product isn't good for society (think fast food, or cigarettes). In these cases, government intervention is the only way to stop production and consumption of them. This creates the black market problem however, such as in the case of illegal drugs. Thus, whether banning the creation of certain products should happen is, again, hotly debated.
  • Bailing Out Companies: Some companies are considered "too big to fail" . If they go under, their suppliers may have to lay people off or go under as well because of the lost business. The unemployed workers now have less money coming in and this could affect demand in other markets. In situations like this the government can preventively step in but this is very controversial. Opponents saying doing this prevents companies from learning from their mistakes and enforces the behavior that required the bailout in the first place, however, the people most often proposing a bailout are also the people most likely to support regulations that would prevent further occurences of that "bad behavior". Bailouts are actually a wide variety of fiscal practices, ranging from a simple loan from the government to short-term nationlization of the firm. (IE, the government owns the company for a certain period of time.)

Key Capitalist Thinkers and Their Ideas (In Chronological Order of Appearance)
  • Adam Smith: Wrote The Wealth of Nations, laying the philosophical foundations of the capitalist system. You probably remember in high school reading about how he argued against regulations and for the free market, and that his main contribution was that an "invisible hand" would correct market failures and guide all resources as efficiently as possible as long as everyone acts in their self-interest. Contrary to how history books tell it, however, Smith actually was in favor of government regulations, but only if they benefited the worker rather than the wealthy. Additionally, what Smith actually referred to with his "invisible hand" metaphor is not the same as how the metaphor is used today. Instead of saying that an "invisible hand" will correct market failures and that regulations are thus unneeded, he was saying that international trade would not harm domestic production because the "invisible hand" of home bias would lead people to invest in their own country. That one time he used the metaphor was stretched well beyond his original meaning. He was also more suspicious of the wealthy and corporations than is often mentioned, even giving his support to a progressive taxation system that lessens the burden on the poor.
  • David Ricardo: Came shortly after and formulated the basis of trade theory by noticing the difference between comparative and absolute advantage. Absolute means a nation can simply produce more in a given time period, but comparative means that a nation can produce at less of a cost. Very few nations have an absolute advantage in trade, but having a comparative advantage in something is very useful (imagine that Brazil grows pineapples, Iceland catches cod and they trade with each other. Both parties benefit because of their specializations).
  • Alfred Marshall: Discovered the concept of Supply and Demand and lent more credos to the invisible hand. His methods of quantifying the benefits of production and consumption are the basis of welfare economics. His most important work, Principles of Economics (mercifully, that's the full title) was the leading economic textbook for a very long time.
  • Henry George: Could be seen as among the first left-leaning capitalists. He believed in general that people had property rights, but that nature was sacred and belonged to all people equally, and thus advocated public ownership of land. Without getting too technical, he also saw common ownership of land as a way to decrease poverty. His philosophy, which came to be known as Georgeism, is popular among environmentalists and green-politics activists. His most important work is Progress and Poverty: An Inquiry into the Cause of Industrial Depressions and of Increase of Want with Increase of Wealth: The Remedy (shortened: Progress and Poverty). His works paved the way for the ides of a graduated income tax (the more you make, the higher you pay in income taxes; the lower, the less).
  • Thorsten Veblen: Veblen's work focuses mostly on studying the relationship between individuals and social institutions in terms of economics. His most famous work is The Theory of the Leisure Class: An Economic Study of Institutions (shortened as The Theory of the Leisure Class).
  • John Maynard Keynes: Keynes is by far the most important economist of the 20th century - all others, even those who disagree with him more than the agree, are forever left in his shadow and have been profoundly influenced by the man. The first capitalist thinker to seriously propose extensive government intervention in the economy, or at least, the first with a serious following (see the Keynesian schools below). Nearly all major world leaders of capitalist countries, whether on the right or the left, use macroeconomic policies that are, to varying degrees, influenced by Keynes' books. Despite his reputation in some circles as a leftist, he was definitely not a socialist. Whereas economists before Keynes were more focused on keeping inflation low, Keynes was obviously more focused on economic downturns. He proposed that deficit spending by government could be used as direct economic stimulus to help get economies out of recessions, and believed that regulation should be used to surgically remove the economic behaviors that caused the last recession. What Smith is to the basic free-market model, and microeconomics, Keynes is to the basic mixed-market model, and macroeconomics. His most important work is The General Theory of Employment, Interest, and Money (shortened: The General Theory) in 1936.
  • Milton Friedman: Probably the second most important economist of the 20th century. Friedman broke the Keynesian domination of economic thinking that had been in place since the 1930's, and brought back the free-market principles of Adam Smith. He was an economic adviser to Ronald Reagan, and he also highly influenced Margaret Thatcher and other right-leaning leaders. Basically, he is to the right what Keynes is to the left. Among his most important contributions to economics are his theory of a "natural rate of unemployment" and what would eventually be called stagflation (an economic period of high inflation and rising unemployment, leading to lower growth), saying that trying to prevent one of them will eventually cause both of them to rise. Most importantly, he argued that the only area of the economy that governments should regulate is the monetary supply, which should be controlled aggressively. Often called the leading opponent to Keynes; this isn't really true, and Friedman, though he disagreed with Keynes' "initial" conclusions, openly said he was influenced by Keynesian economics and called Keynes' The General Theory "a great book." He argued that increased government influence in the economy would undermine basic liberties, so he's really popular with Libertarians. He also led to the US having a solely volunteer military, by the way.
  • Robert Solow: Found that economic growth comes not from adding more input (labor and capital) but through advances in technology. Another notable contribution is the introduction of the Neo-Classical growth model, also known as the Solan-Swan growth model. He is a Neo-Keynesian (see below).
  • Paul Krugman: The face of modern Keynesian economics. Predicted the 2007-8 financial collapse in his most popular work The Return of Depression Economics. That said, his most important contributions have been in trade theory. (He is among the few leftists who are in full support of free trade.) His work fathered both new trade theory, and new economic geography, both of which are way to complex to begin to explain here. Depression Economics may be his most popular work, but his most important works are the papers in Journal of International Economics and Journal of Political Economy which introduced those two theories, which won him his Nobel prize. For the life of us, we can't find the names of those papers but rest assured they're overly long and filled with overly complex vocabulary. He is identified as a Neo-Keynesian, but says he's leaning Post-Keynesian these days. Krugman is self-proclaimed to be One of Us and even (on a lark) wrote an essay in 1978 called The Theory of Interstellar Trade in an attempt "to cheer himself up when he was an oppressed assistant professor" in which he hypothesized about how the time distortion associated with traveling at relativistic speeds should affect billing rates for shipping and transportation across interstellar distances.

Schools Of Thought
  • Austrian School: Key thinkers include Ludwig von Mises, and Friedrich Hayek. Since we're trying to avoid massive technical details, imagine these guys as the free-market faithful to the core. Modern supporters include Ron Paul and his followers. This school is considered heterodox, which is a nice way of saying that most economists consider them completely wrong. Known for their dislike of central banking (ie. the Federal Reserve) and fiat currency ("it's money because we say so" - essentially allows printing money), backing of the gold standard (ie. money is gold and government messing with it would be impossible), and different views of recessions (during the booms people are making bad investments because cheap credit makes them look good, recessions are the inevitable hangover period). The usual complain about this school is that, since they are more or less completely against the use of statistical methods and empirical observations to study how capitalism works, they're more of a political ideology or philosophy than an actual study of economics. As such, while some of their ideas have had a lasting influence on the field, most of it has been widely dismissed as borderline pseudoscientific.
  • Chicago School: Central thinker is Milton Friedman. The Chicago school has been noted for being very supportive of free-market fundamentals, but Friedman's more important contributions were to monetary theory, where he, in essence, supported massive government intervention. In short, monetarists are called so because they believe that the primary way the government should intervene in the economy is through controlling the money supply, and should otherwise be rather laissez-faire.
  • Georgeists: Based on the thinking of Henry George. As noted, those mostly likely to be Georgeists in the modern age are environmentalists and green-politicians. Milton Friedman held the opinion that their land value tax proposal would be the least damaging method of taxation to the economy.
  • Institutional Economics: Developed out of Thorsten Veblen's work. Studies the interactions between institutions and how that produces an economy. The earlier strain of this is considered Heterodox.
    • New Institutional Economics: Much like Neo-Keynesians (see below), institutionalists were able to regain a lot of respect within the greater establishment by incorporating neoclassical analysis (to make that simple, "incorporating neoclassical analysis" generally just means taking a macroeconomic school and rooting it in the microeconomic basics).
  • Keynesians or New Keynesians (sometimes called Old-Keynesians): First emerged as followers of Keynes during The Great Depression and post-war period. The influence of the Keynesian school and the success of Keynesian policies in practice led the post-war period until the early '70s to be referred to as, alternately, the "Golden Age of Capitalism" and "The Golden Age of Keynesianism". The original school lost support after Keynesian ideas played a key role in the "stagflation" of the '70s as predicted by Milton Friedman (see Chicago School) and after the "Lucas Critique" emerged noting that Keynesianism, as among the first macroeconomic schools of thought, had never bothered to root itself in microeconomic basics. Sub-schools emerged afterwards, including...
    • Post-Keynesians: According to Keynes biographer Lord Skidlesky, this school is the closest to Keynes' thinking.
    • Neo-Keynesians: Not to be confused with New Keynesians. Emerged in the '90s as a response to the Lucas critique by finding basis for Keynesian macroeconomics in microeconomics, though unlike other microeconomic-centric thinkers, they assume a number of market failures.

      Although out of fashion for much of the 80s and 90s, when monetarism was in full swing, these days Keynesianism is arguably making something of a comeback thanks to the ongoing financial crisis which began in 2008. More economists have been making the argument that the recession was caused by a lack of government oversight and deregulation (their opponents vehemently deny this and claim government intervention was the root of the problem) and have supported strong regulation and deficit spending as a response. Ben Bernanke, head of the US Federal Reserve, was a prominent supporter of this view, as is Paul Krugman today.
  • Social Democrats advocate use of the free market where it seems to work and use of government intervention where the free market seems to fail (see role of government above). Whether Social Democrats are considered capitalists, socialists, both, or neither varies from person to person, even among Social Democrats themselves. Capitalism does allow for government intervention but social democrats are among the people mentioned above who see many market failures to correct.

Alternative Title(s):

Useful Notes Capitalism