Capitalism is a term that has been subject to much debate and controversy over the past century and beyond. Commentators have disagreed fiercely over not only the merits of capitalism but also the meaning of the term itself. Nonetheless, a brief and uncontroversial way to define capitalism is as an economic system that emphasizes private ownership and the creation of goods and services for the purpose of profit.

Capitalism can be viewed as an economic system that has been a driving force in many advanced economies, fostered growth and innovation, enabled people to lift themselves out of poverty, and greatly improved living standards. But it also has many staunch critics, who will argue that, regardless of outcomes or track records, it is a deeply harmful and exploitative system. So, to clear up any confusion, what really is capitalism, and what isn’t it?

What capitalism is, and what capitalism isn’t

One of the key features of capitalism is the private ownership of the means of production and the ability for individuals to accumulate capital through investment and trade. It enabled the emergence of entrepreneurs, merchants, and manufacturers, who invested in new technologies and business ventures.

In turn, this led to the creation of jobs, higher wages, and improved living standards at large. The market forces of supply and demand also led to the efficient allocation of resources and the creation of new industries.

Contrary to what it is often labeled as, capitalism is not “pro-business.” At least not in the sense of being an enforcement of the interests of existing businesses. Instead, capitalism is pro-competition

A genuine free market is one in which established businesses must continue to innovate and offer more value to consumers in order to compete with unobstructed new challengers. In a free market, businesses cannot rely on regulations or bailouts to maintain their advantage.

Unlike with socialism, or communism, at the other end of the spectrum of economic systems, capitalism did not stem from a single ideology or theory, nor was it implemented through violent revolution.

Furthermore, capitalism did not originate from a conscious, top-down drive to bring about a new society based on a particular economic system. 

Indeed, while “capitalist” is a term dating back to the mid-17th century, the term “capitalism” was only later coined by critics rather than proponents of the economic system that emerged and developed in Europe during the Enlightenment, succeeding the feudalism of the Middle Ages. So how did this system gradually come about?

How did capitalism start?

The story of capitalism is deeply intertwined with that of liberty. 

What we would now call capitalism can be traced back to the Renaissance as individuals across Europe could trade more freely as they became emancipated from feudalism. The ideas of the Enlightenment, such as individual liberty and the pursuit of happiness, laid the foundation for a new economic system based on private property and free markets

Subsequently, starting in the 18th century in Western Europe, the Industrial Revolution, a truly transformative period of human history, brought about a dramatic increase in productivity and economic growth. The development of new technologies, such as the steam engine and the power loom, revolutionized manufacturing and transportation, making it possible to produce goods on a large scale and at a much lower cost.

Capitalism enabled the emergence of a middle class, composed of small business owners, professionals, and skilled workers. The rise of capitalism also led to significant changes in the relationship between individuals and the state. It challenged the supreme authority of rulers, heralding the rise of democracy and spreading political rights and freedoms. 
Industrialization and globalization saw increasingly capitalist economic systems spread across Europe and the world.

What are the pros and cons of capitalism?

Free-market capitalism has a number of obvious advantages over other economic systems. For one, it encourages innovation and competition, which leads to economic growth and increased prosperity for individuals. It also allows for individual freedom and choice in terms of economic decision making.

When dividing countries into four different tiers, data shows a clear correlation between economic freedom and per-capita income. Indeed, economies that are more capitalist see significantly higher per-capita incomes than countries with less economic freedom.

According to the Economic Freedom of the World report for 2022, here are the average per-capita incomes for each quartile:

  • Most free: $48,251
  • Second quartile: $23,234
  • Third quartile: $14,122
  • Least free: $6,542

Nonetheless, capitalism has had many fierce critics, who will point to a number of perceived problems. Chief among the issues capitalism is criticized for is that of the unequal distribution of wealth — or in other words, inequality of outcome. 

From a collectivist, egalitarian viewpoint, such an issue would appear intolerable. To such a critic, equality of outcome matters more than different individuals becoming more prosperous but to different extents.

Yet, the economy is not like a pie whereby everyone must fight to claim their share of a finite substance. Instead, the economy is something that can grow infinitely. As such, the idea that there is a fixed amount of resources and wealth to be distributed among the population is a flawed one. 

The economy has the potential to expand and create new opportunities for growth and prosperity. It is not a zero-sum game where one person’s gain is another person’s loss. Instead, a growing economy can benefit everyone, by creating jobs, increasing productivity and raising living standards.

However, Karl Marx, the most prominent anti-capitalist, saw things differently.

Why did Karl Marx attack capitalism?

Karl Marx criticized capitalism for several reasons. First, he believed that capitalism was inherently exploitative, as it allowed a small class of capitalists to control the means of production and extract surplus value from the labor of the working class. As such, workers would need to sell their labor in order to make a living.

Second, Marx argued that capitalism was inherently unstable and prone to economic crises. He believed that the drive for profit would lead entrepreneurs to invest in new technologies and methods of production, which would increase productivity and reduce the cost of goods.

However, despite plentiful evidence of the power of innovation to improve living standards overall, Marx viewed such a phenomenon as distinctly negative. He argued on the grounds that it would lead to a surplus of unemployed workers and ultimately a falling rate of profit that would, in turn, lead to economic crises and recessions.

Most importantly of all, Marx argued that capitalism was inherently unjust because it leads to the unequal distribution of wealth and power. There will inevitably be inequality in a capitalist economic system, this much is true. But where Marx goes wrong is in his idea that a capitalist system leads to the extreme concentration of wealth among the few while the vast majority of people are left in abject poverty. 

On this note, capitalism’s track record — freer economies enabling billions of people to lift themselves out of poverty — and socialism’s track record – with a huge amount of power and wealth concentrated in a few hands of top government bureaucrats – speaks for itself.

Does capitalism work?

Economies based on the capitalist principles of private property, trade, profit, and innovation have proven to be a powerful engine of economic growth, innovation, and prosperity, lifting millions of people out of poverty and improving living standards for people around the world.

The ability for individuals and businesses to own private property and make trade and profit decisions based on market signals drives innovation and investment. This leads to an increase in productivity and economic output, resulting in more goods and services available to consumers at lower prices. Furthermore, capitalism encourages competition, which leads to increased efficiency and better products and services.

There are numerous examples of countries where capitalism has enabled millions to lift themselves out of poverty. These include Botswana, Estonia, Hong Kong, Singapore, Taiwan, and many others.

When considering the economic history of many countries in the post-Soviet world, particularly in the Baltic region, it is clear that embracing capitalism and implementing reforms has led to improvements across a wide range of metrics related to prosperity and liberty. In contrast, countries that have failed to make meaningful reforms have experienced stagnation in both economic development and personal freedom.

Is capitalism better than socialism?

Capitalism, with its emphasis on individual initiative and the profit motive, has consistently been shown to be the best way to create wealth and improve living standards for most people. On the other hand, socialism has been demonstrated to lead to economic stagnation, poverty, and tyranny.

History has presented us with several opportunities to make direct comparisons through countries that have been divided into capitalist and socialist halves.

From the aftermath of World War II until its eventual reunification in 1990, Germany was divided into a socialist East and a more capitalist West. Likewise, Korea has been divided into capitalist and socialist halves for some 70 years since the Korean War.

In both these cases, the more capitalist entities, West Germany and South Korea, saw remarkable economic growth and development, higher living standards, and greater political and personal freedom than their socialist counterparts.

Indeed, South Korea is now an advanced economy and stable democracy, while neighboring North Korea is a totalitarian dictatorship where citizens experience severe repression and regular famines.

Furthermore, in 1991, immediately after reunification, decades of diverging economic policies meant that West Germany had a GDP per capita of €22,767, while this figure in former East Germany stood at just €7,395 — the highest in the entire Eastern Bloc nonetheless. Although an east-west economic divide does remain in Germany, the gap has closed significantly over the past three decades.

The Soviet Union was real socialism

The Soviet Union is the best-known example of a failed experiment in socialism. Despite the promises of prosperity and equality by socialist ideologues, the Soviet economy performed poorly and was characterized by shortages, inefficiencies, and a lack of incentives

In the Soviet Union, the central government controlled nearly all aspects of the economy, and the lack of market-based pricing led to widespread shortages of goods and services. The government also set production quotas, which often resulted in the production of goods that were not in line with consumer demand. 

The Soviet economy was driven by bureaucracy rather than by consumers. Such a scenario where consumers could not obtain the goods and services they wished to purchase inevitably led to black markets. Despite severe punishments at stake for participants, the Soviet Union’s “parallel economy” became mainstream. Services that would normally involve months of waiting could be procured immediately in exchange for highly coveted foreign currency.  

Ultimately, the absence of private ownership and competition led to a lack of innovation and progress. The Soviet Union’s highly-centralized planned economy led to the lack of proper allocation of resources and overproduction of certain goods.

Additionally, the Soviet government’s attempts to redistribute wealth and eliminate class distinctions were largely unsuccessful, and the country remained highly unequal. Entrepreneurship was prohibited and punished, as was any form of dissent against the ruling party.

Why socialism failed in the Soviet Union

By the time of the Soviet Union’s collapse in 1991, its economy had been stagnating for many years. The attempt to revitalize the Soviet economy by implementing some limited economic reforms under Gorbachev came too late. By this stage, the Soviet Union was increasingly lagging behind the West economically and technologically, as the rapidly modernizing global economy presented ever more challenges to the maladaptive Soviet model, beset by burdensome central planning and corruption.

The harsh and repressive nature of the Soviet government led to widespread human rights abuses and a total lack of political and civil liberties. As such, a combination of social and economic factors tied to centralization and competitive disadvantage caused the collapse of the Soviet Union and showcased the failure of socialism as a viable economic system.

Are pro-capitalism reforms successful?

(Read more about this subject in the article “The post-Soviet world, 30 years on“)

Following the fall of the Soviet Union, the post-communist countries of Eastern Europe have, for the most part, undergone a significant transformation. During the past three decades, the region has integrated the global economy and seen a remarkable increase in living standards.

Nonetheless, building a full market economy has been a challenging and lengthy process. While trade and prices were quickly liberalized, institutional reforms such as changing governance, competition policies, labor market changes, privatization, and business restructuring faced resistance from those with vested interests. 

The results of these changes varied, with initial high inflation and economic downturns as prices were freed. However, the severity of these issues and the time it took to recover and experience economic growth varied greatly depending on the conditions in each country. 

Living standards were observed to have dropped in the immediate aftermath of market reforms, leading to some observers claiming that the reforms were too radical and should instead be more gradual. 

However, the earlier and more ambitious adopters of market reforms, particularly countries such as Estonia, Poland, and the Czech Republic, would be vindicated, as their economic development has far surpassed those post-communist nations whose governments were more hesitant in embracing capitalism.

Let’s consider the example of Poland where, since 1992, GDP has increased in every single year with the exception of 2020, and GDP per capita has increased from $1,731 in 1990 to $17,841 in 2021. 

Compare that to neighboring Belarus, where GDP per capita only rose from $2,125 to $7,304 during the same period.

Chart showing GDP per capita in Poland and Belarus from 1990 to 2021

Indeed, where bold and early reforms were implemented, economies experienced faster recovery and income growth. Conversely, countries that were slower to implement changes were more affected by enduring crises.

The 2000s saw strong growth and stability throughout much of the former Eastern Bloc, with large capital inflows and a positive global environment. This was especially true for countries that saw rapid convergence with Western Europe.

Capitalism and freedom

Free-market reforms are not only beneficial in economic terms. Moving towards a more capitalist economic system is also conducive to greater respect for individual rights and a freer society overall. 

A genuine free market means that individuals are free to engage in economic activities without interference from state institutions. They can make their own economic decisions, such as what to produce, what services to offer, what to sell, and what prices to charge. 

Capitalism allows for entrepreneurship. This gives individuals the opportunity to create businesses that offer them the means to be self-sufficient and independent by providing a useful service or producing a valuable product.

By allowing people to engage in mutually beneficial trade, capitalism drastically reduces the likelihood of armed conflict. Where economies are intertwined through trade, disputes are more likely to be solved through peaceful means.

In his book, Capitalism and Freedom, Nobel prize winning economist Milton Friedman discusses the relationship between economic freedom and political freedom, arguing that they are mutually reinforcing. He argues that a free market economy, in which individuals have the freedom to make economic choices and pursue their own self-interest, is necessary for political freedom.

The Prague Spring of 1968 offers a poignant example of the link between economic freedom and political liberties. In this instance, reforms and liberalization driven by a popular movement against authoritarianism began to present a threat to the survival of communism in Czechoslovakia. The situation angered Soviet leaders who sought to maintain a tight grip over the entire Eastern Bloc, and Soviet tanks subsequently rolled into Czechoslovakia to force the reversal of reforms.

A free market economy allows for individual economic and political power to be dispersed, making it difficult for any one group or individual to gain too much power and potentially become a threat to individual freedom. On the other hand, political freedom is necessary for economic freedom, as a government that enforces contracts, property rights, and the rule of law is necessary for a functioning market economy.

Is capitalism bad?

Regardless of the overwhelmingly positive outcome under more capitalist economic systems, could it be that capitalism is still just fundamentally bad? Even though freer markets lead to economic growth and greater respect for individual rights, is it not a problem if some individuals enjoy enormous wealth while others struggle to get by?

Consider this: capitalism is the most effective economic system for raising living standards, it rewards people for productivity and innovation, lowers costs for consumers, and is more conducive to freedom. But there is still a more compelling case for the morality of capitalism.

Ayn Rand (1905-1982), a Russian-American philosopher and novelist, believed that capitalism is fundamentally good because it is the only system that fully respects and protects individual rights and freedom, and allows for the full expression of human potential.

Ayn Rand explained why capitalism is the only moral economic system

Within her philosophy of Objectivism, Ayn Rand explained that not only is capitalism the most effective economic system for prosperity, but more importantly it is the only moral economic system. Indeed, the moral foundation of capitalism is the principle of individual rights, which include the right to life, liberty, property, and the pursuit of happiness.

The faculty of reason, our means of acquiring knowledge, is at the core of Rand’s unique and compelling theory of rights. Furthermore, an individual’s rights should be understood as their property — not as something that can be granted or revoked by the state.

In order to pursue their rational self-interest, the only proper guide for human action, each individual must be free from coercion and free to judge their own needs. 

As such, Rand established that capitalism is morally good precisely because it is the only economic system that allows individuals to act fully according to their own rational self-interest. It is the only economic system that does not involve coercion.

Be sure to click on the button below to get your free copy of the e-book “The Morality of Capitalism,” where you can find a strong moral defense of capitalism through a collection of articles written by experts, including Nobel Prize winner Vernon Smith.

This piece solely expresses the opinion of the author and not necessarily the organization as a whole. Students For Liberty is committed to facilitating a broad dialogue for liberty, representing a variety of opinions.