Capitalism is an economic system based on free markets and limited government intervention. Proponents argue that capitalism is the most efficient economic system, enabling improved living standards. Advocates of capitalism such as Milton Friedman argue capitalism and the economic freedoms it embodies is also essential for the promotion of political freedoms.
However, despite its ubiquity, many economists criticise aspects of capitalism and point out is many flaws and problems. In short, capitalism can cause inequality, market failure, and boom and bust economic cycles.
Problems of Capitalism
The benefits of Capitalism are rarely equitably distributed. Wealth tends to accrue to a small % of the population. This means that demand for luxury goods is often limited to a small % of the workforce. The nature of capitalism can cause this inequality to keep increasing. This occurs for a few reasons
Inherited wealth. Capitalists can pass on their assets to their children. Therefore, capitalism doesn’t cause equality of opportunity, but those born in privilege are much more likely to do well because of better education, upbringing and inherited wealth.
Interest from assets. If capitalists are able to purchase assets – bonds, house prices, shares, they gain interest, rent and dividends. They can use these proceeds to buy more assets and wealth – creating a wealth multiplier effect. Those without wealth get left behind and may see house prices rise faster than inflation.
The economist Thomas Piketty wrote an influential book Capital in the Twenty-First Century, which emphasised this element of capitalism to increase inequality. As a general rule, Picketty argues wealth grows faster than economic output. He uses expression r > g (where r is the rate of return to wealth and g is the economic growth rate.)
2. Financial instability/economic cycle
Capitalism relies on financial markets – shares, bonds and money markets but financial markets have a tendency to cause booms and busts. In a boom period, lending and confidence rise, but frequently markets get carried away by ‘irrational exuberance’ causing assets to the spike in value. But, this boom can quickly turn to a crash when market sentiment changes. These market crashes can cause economic downturns, recession and unemployment. At various times, capitalism has suffered prolonged recessions (the 1930s), periods of mass unemployment and decline in living standards.
3. Monopoly Power
In a free market, successful firms can gain monopoly power. This enables them to charge higher prices to consumers. Supporters of capitalism argue only capitalism enables economic freedom. But, the freedom of a monopoly can be abused and consumers lose out because they have no choice. For example, in industries like tap water or electricity supply, which are a natural monopoly, consumers have no alternative but to pay the prices charged by consumers. In the Nineteenth Century, monopolies like Standard Oil bought our rivals (often with unfair competitive practices) and then became very profitable.
Monopsony is market power in employing factors of production. For example, firms can have monopsony power in employing workers and paying lower wages. This enables firms to be more profitable but can mean workers don’t share from the same level of proceeds as the owners of capital. It explains why with increasing monopsony power we have seen periods of stagnant real wage growth while firms profitability has increased (2007-17 in UK and US)
In a free market, factors of production are supposed to be able to easily move from an unprofitable sector to a new profitable industry. However, in practice, this is much more difficult. E.g. a farm worker who is made unemployed cannot just fly off to a big city and find a new job. He has geographical ties to his birthplace; he may not have the right skills for the job. Therefore, in capitalist societies, we often see long periods of structural unemployment.
6. Environmental costs and externalities
In capitalist economies, there is limited government intervention and reliance on free markets. However, market forces ignore external costs and external benefits. Therefore, we may get over-production and over-consumption of goods that cause harmful effects to third parties. This can lead to serious economic costs – pollution, global warming, acid rain, loss of rare species; external costs that damage future generations.
7. Encourages greed. The nature of capitalism is to reward profit. The capitalist system can create incentives for managers to pursue profit over decisions which would maximise social welfare. For example, firms are using theories of price discrimination to charge higher prices to consumers who want to jump the queue. This makes sense from the perspective of maximising profit. However, if we have a society, where the rich can pay to jump a queue at a Fairground – or pay to see Congressman quicker – it erodes social norms and a sense of ‘fair-play’
The pursuit of the profit motive has encouraged some law firms to aggressively pursue litigation claims. This has created a society where we devote resources to protecting ourselves from being sued. Further reading – “Moral Limits of Markets” by Michael Sanders