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What Is Capitalism?

July 1, 2003

In July 2003, The Heartland Institute will release Let's Put Parents Back in Charge! a 96-page paperback book that presents the need for parental choice in education and explains how to join the school choice movement.

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In July 2003, The Heartland Institute will release Let's Put Parents Back in Charge! a 96-page paperback book that presents the need for parental choice in education and explains how to join the school choice movement. Chapter 4 of the book, "What Is Capitalism?" is excerpted below.

Many criticisms of school vouchers are actually thinly veiled criticisms of capitalism, the way the economy in the U.S. (and most of the rest of the world) is organized. This is not merely a verbal trick by voucher opponents: Vouchers, after all, would rely on the institutions and processes of capitalism to educate most of the nation's roughly 45 million school-aged children.

This chapter reminds the reader of (or introduces the reader to) some basic truths about capitalism.

Not a Philosophy but an Economy

The word "capitalism" sounds like the label of a philosophy, rather than a system of producing, distributing, and consuming goods and services. But capitalism is, in fact, just a type of economy. What distinguishes it from other economies, as economist Thomas Sowell has written, is that it is "not run by political authorities."

Unlike the economy of the household, the economies of our neighborhood, community, and nation are characterized by specialization and the division of labor. People acquire different skills, enabling them to work in groups to produce a relatively narrow range of goods in abundance. Goods can be exchanged on a regular basis, increasingly with people who are not members of the producer's household or community.

Exchange creates the problem of coordination: How much should be produced, and on what terms should it be exchanged for the products of other producers? Traditional societies give that authority to individuals or groups by virtue of their birth into a caste or ascension in a tradition-defined hierarchy. Militaristic or totalitarian societies give authority to dictators or elites, who enforce their will through the exercise of force or terror.

Three Institutions of Capitalism

Capitalist societies use freedom to solve the coordination problem. Three institutions stand at the center of a capitalist economy: private property, markets, and the Rule of Law.

Private property. In a capitalist economy, people have rights to the fruit of their labor and whatever other property they acquire through legal means. Property includes a person's life (we own our own bodies) and liberty as well as physical possessions. Alienable property--possessions--can be sold or leased to others. Inalienable property--life and liberty--cannot be sold at any price.

Markets. Markets are where goods and services are exchanged. Producers (sellers) and consumers (buyers) meet in markets to negotiate mutually agreeable prices for the goods and services that are exchanged. In a free market, no outside authority determines or fixes those prices.

Rule of Law. Capitalism requires that rules defining property rights and the duties and rights of citizens be established, made widely known, and enforced. A key aspect of this legal system is "equality of laws to all manner of persons," or what we call the Rule of Law. Capitalism depends on the Rule of Law to prohibit coercion and fraud. Without the Rule of Law, long-term agreements and contracts would be risky or impossible, because people could not be prevented from dealing dishonestly with each other.

How Capitalism Works

To see how capitalism works, picture two people meeting in a market, one with something to sell and the other looking to buy the same item. The buyer and seller will engage in trade voluntarily only if both expect to benefit from the exchange. An object worth relatively little to one person may be worth more to another, because their wants, opportunities, and perspectives are different. The stage is set for a mutually beneficial and voluntary trade.

When many buyers and sellers meet in markets to exchange goods and services, their offers and bids create prices that can be posted, advertised, and otherwise made known. This feature distinguishes capitalist economies from all other economic systems. Prices reflect each individual buyer's and seller's knowledge of particular circumstances of time and place, a huge body of information that cannot be known to any one person. Prices act as signals telling producers what consumers are willing to buy, and consumers what producers are willing to sell.

In a capitalist system, assets such as land are privately owned and can be bought and sold freely. Those who think they can put a particular piece of property to better use than its current owner can bid to own it. The owner of the under-performing property has an incentive to sell it to the highest bidder, who is able to pay more than what the property is worth to its current owner. The result is that property tends to find its way into the hands of those who can put it to its best and highest use, thereby minimizing waste and reducing costs.

Entrepreneurs are people alert to opportunities to make profits by putting resources to better use. They anticipate what consumers want, how much they are willing to pay for it, and how much it will cost in the future to provide it. Entrepreneurs whose forecasts are most accurate, and businesses that produce most efficiently the products consumers want, are rewarded by being able to sell the most product. Entrepreneurs who guess wrong and businesses that are inefficient producers will sell less, and possibly stop producing products altogether. As a result of this competition, those businesses that remain in the market are the ones that most accurately anticipate and most efficiently meet consumer wants, and the prices they charge tend to be the average or typical market price.

Profits are necessary to the entrepreneurial process. The prospect of profits determines how much a business invests in producing a product. At any given time countless opportunities are being created and disappearing in a large and complex economy. The profit motive harnesses the knowledge and self-interest of many competing producers and potential producers of goods and services to determine which opportunities should be acted on and which passed over.

Competition among producers (sellers) and consumers (buyers) ensures the profits earned by entrepreneurs and the prices paid by consumers tend to be driven down toward the lowest level a producer is able to accept and still have enough money to produce the product. If one producer tries to keep his prices too much higher than his cost of production, the profit motive causes other producers to try taking orders away by offering a lower price. In this way, competition and choice ensure better goods and services are available at lower cost to consumers who most value them.

Competition works to limit the profits that entrepreneurs and businesses are able to earn. In a typical year in the U.S., profits amount to less than 6 percent of national income, and from 1968 to 1998 they did not exceed 9 percent. This would seem to be a reasonable price to pay for the important role profits play in directing resources to where they are most needed.

Markets versus Government Intervention

The discovery that private property, markets, and the Rule of Law together create an economy that works best without government management is generally attributed to Adam Smith (1723-1790). In The Wealth of Nations, published in 1776, Smith wrote that each of us, though we aim at only our own gain, is "led by an invisible hand to promote an end which was no part" of our intention, which is the public or common good. Self-interest guides consumers to the most efficient producers (who can offer the best value for money), and competition among producers ensures innovation and efficiency are rewarded.

Many efforts have been made by many countries to make capitalism "more efficient" by interfering in one of the three key institutions of capitalism. Surely human planning can produce better results than the spontaneous outcome of unplanned and unthinking markets! But such efforts have rarely, if ever, succeeded.

This does not mean there is no role at all for government to play. Adam Smith and many leading defenders of capitalism found room in their theories for a substantial role for government. For example, Milton Friedman says "the need for government ... arises because absolute freedom is impossible. However attractive anarchy may be as a philosophy, it is not feasible in a world of imperfect men."

Government has an important role to play, but it must not undermine the key institutions of private property, markets, and the Rule of Law if economic growth and prosperity are to occur.

Briefly Put

Capitalism is a system that relies on freedom, rather than tradition or military force, to organize the production, distribution, and consumption of wealth. Its key institutions are private property, markets, and the Rule of Law. Two key elements of capitalism are prices and profits, which make it possible for producers and consumers to make the best choices.

Although much planning takes place in a capitalist economy, there is no central plan or planner. Instead, capitalism's institutions and the profits, prices, and other instruments it creates form a spontaneous order, continuously adjusting to new information, fulfilling needs, and discovering new opportunities. Efforts to "improve capitalism" by planning have usually failed.

Joseph Bast is a Senior Fellow at The Heartland Institute. He cofounded Heartland in 1984, serving as executive director then as president & CEO until January 2018. His research and writing focuses on climate change and energy policy. @JosephLBast
Dr. Herbert Walberg is a senior fellow with The Heartland Institute and a former member of its Board of Directors.