Capitalism is an economic model that calls for control of the economy by individual households and privately owned businesses. It is one of two main economic models. The other is central planning, which calls for government control of the economy.
No purely capitalist or completely centrally planned economy has ever existed. The economic systems of all nations use some government control and some private choice. But economies that rely mostly on private decisions are usually described as capitalist. Such economies include those of the United States and Canada. The former Soviet Union and many nations of Eastern Europe once relied heavily on central planning. Such economies are sometimes called socialist or Communist. Many other nations rely less on capitalism than the United States does but more than the Soviet Union did.
How capitalism differs from central planning
In basically capitalist systems, private decision-makers determine how resources will be used, what mix of goods and services will be produced, and how goods and services will be distributed among the members of society. Capitalism is frequently known as free enterprise or modified free enterprise because it permits people to engage in economic activities largely free from government control. Other names sometimes applied to basically capitalist systems are free market systems, laissez faire systems, and entrepreneurial systems. In systems based on central planning, the government makes most major economic decisions. Government planners tell managers what to produce, whom to sell it to, and what price to charge. Centrally planned economies are often called command economies.
The root of the word capitalism is capital. Capital has several meanings in economics and business. In business, it refers to the money needed to hire workers, buy materials, and pay bills. In economics, capital includes buildings, equipment, machinery, roads, and other assets used to produce things. In basically capitalist systems, most land, factories, and other capital is privately owned. In systems based on central planning, the government owns most of the capital used in production.
Capitalism in its ideal form
The Scottish economist Adam Smith, in a landmark book called The Wealth of Nations (1776), laid out the basic argument for capitalism. Smith maintained that a government should not interfere with a nation’s economy but instead should let individuals act as “free agents” who pursue their own self-interest. Such free agents, he argued, would naturally act in ways that would bring about the greatest good for society “as if guided by an invisible hand.”
Private choices. An example of how an ideal capitalist economy would work is an arrangement called perfect competition, also known as pure competition. In perfect competition, privately owned businesses, driven by a desire for profits, decide what goods or services to produce, how much to produce, and what methods to employ in production. These choices determine how much labor and capital a business will need. In other words, private firms “supply” goods and services and “demand” labor and capital.