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Capitalism

An economic system that encourages the private ownership of businesses that operate to generate profit

What is Capitalism?

Capitalism is an economic system that allows for and encourages the private ownership of businesses that operate to generate profit. Also known as the market system, capitalism is characterized by private land ownership rights, competitive markets, the stable rule of law, freely operating capital markets, low corruption, a price discovery process, and competitive markets. In other words, it is the opposite of communism, in which the means of production are owned by and controlled by the government.

 

Capitalism - 3 Principles of Capitalism

 

Summary of capitalism

Want to understand the concept quickly? Below is a bullet point let of the key characteristics of capitalistic systems:

  • Means of production are privately owned
  • Companies are incentivized to earn profits
  • Supply and demand drive markets
  • Capital markets operate freely
  • Reliable legal system
  • Property can be privately owned
  • Inequality levels are high
  • Government involvement is low

 

Benefits of capitalism

The main benefit of capital is that it provides a strong incentive and motivation to produce, grow, innovate, improve and move forward in a positive way. Those who believe in a free market system argue that free markets and competition result in superior businesses and thus better products and services. These motivators for business operations and benefits for consumers combine to form a positive feedback loop or virtuous cycle where consumers spend more money and companies innovate more.

In addition to the above, the capitalist system lets the market decide how to allocate resources. This means capital, labor, and natural resources are distributed where they can make the biggest impact (profit) and thus, the economy becomes self-organizing.

 

Drawbacks of capitalism

One of the main challenges of a capitalist system is that it doesn’t help take care of those who don’t possess skills that are in high demand and thus may not be able to earn a living.  Also, the system may naturally result in large disparities of wealth and inequality as those with capital are able to generate more capital more easily.

Some argue that there is an opportunity for corruption in the system and it unfairly tilts the scales. For example, donations and lobbying to politicians can influence laws in favor of specific business owners and provides them with a competitive advantage over others with capital but without political influence.

One final criticism is that places priority on profit instead of social benefits, the environment, and community.

 

Alternative economic systems

While capitalism isn’t perfect, there are not many other shining examples of other economic systems. The most common alternative systems are:

 

Types of Economic Systems

 

1. Socialism

Socialism is the closest alternative to capitalism. It provides a system where both individuals and governments own the means of production, and they may compete. For example, in the oil industry, there may be a combination of state-owned oil producers and privately-owned ones. It gives the government more control over strategic assets and may provide more revenues than just collecting taxes.

The downside of socialism is the government may not be as efficient of an operator, and thus will not be as profitable as the private competitors. It may also mean the state-owned companies get favorable terms and treatment.

 

2. Communism

The communist economic system is one step further than socialism where the government owns the entire means of production (i.e., all businesses are state-owned) and the government provides all citizens with a fixed standard of living. Communism is the opposite of capitalism in that all business are state-owned, the economy is centrally planned, and the allocation of capital is not a free market.

 

3. Fascism

Fascism is a nationalistic type of economic system where the government forces business to place the interest of the nation above their company’s. In fascism, the ruling party and central planners of the country dictate what business owners need to do. The primary focus of this system is on nation-building, and it may be coupled with strong military force.

 

Capitalism in business modeling

At CFI, we focus on delivering world-class corporate finance training where students learn to build financial models on a wide range of businesses. While most of the classes and case studies focus on businesses that operate in a capitalistic market, it doesn’t mean that the same types of analysis don’t transfer to business in other systems such as socialism, communism, or fascism.

 

Capitalism in Financial Analysis

 

As you can see in the above image from CFI’s strategy course, the focus on strategic analysis is to identify the forces impacting an industry, and these forces may work under any type of system.

 

Additional resources

Thank you for reading this guide understanding how the various economic systems function, and the pros and cons of each.

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