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Capitalism and the Free Market: Definition & Limitations

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  • 0:04 Capitalism and the Free Market
  • 2:58 Market Price
  • 3:52 Limits to Capitalism
  • 5:18 Lesson Summary
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Lesson Transcript
Instructor: Shawn Grimsley
Capitalism is an economic system that has played a dominant part in building the world in which we currently live. In this lesson, you'll learn about some key concepts of capitalism, as well as its limitations.

Capitalism and the Free Market

Meet Tanya, the founder of a small tech company in the United States. She recently formed her company to design and build a smart watch, which is a miniature computer tablet that you can wear on your wrist. She dreams of making piles of money, which is one of the rewards of success in free market capitalism.

Capitalism is an economic system that is organized around the principles of private property, freedom of exchange, competitive markets and limited government intervention. An economic system is simply a way that society structures how economic decisions will be made and resources will be allocated. Now, let's take a closer look at what a capitalistic system entails.

Most property in a capitalistic economy is private. This means that individuals, instead of the government, own the factors of production. Factors of production are the things that we use to make goods and services and include land, labor and capital. You also get to keep the profits from your economic activities. Since you get to keep what you earn, this tends to encourage risk-taking and innovation. If Tanya didn't have the right to the profits generated from sales of her smart watches, she may not bother to invest time, energy or money to take the risk and innovate.

A second important feature of capitalism is freedom of exchange. An exchange is simply trading one resource for another. Nobody can force Tanya to sell her company. Moreover, nobody can be forced to buy Tanya's smart watches. And Tanya cannot force anyone to work for her.

Instead, everybody in a capitalistic economy has the right to engage in exchanges or not engage in exchanges. People make exchanges according to their self-interest. If the deal isn't worth it to one of the parties, then the deal won't go through. In other words, if a potential customer doesn't think Tanya's smart watch is worth the price, he will not exchange money for it.

The third primary feature of capitalism is competitive markets. A market is a place where buyers and sellers come together to engage in economic exchanges. A perfectly competitive market is characterized by a large number of sellers that offer identical products for sale and everybody has information that they need to make a rational decision regarding a potential exchange. If all products are the same, businesses must compete on price.

Perfectly competitive markets seldom exist. Most markets are competitive markets and are characterized by a large number of businesses selling similar products with all participants having pretty good information. For example, Tanya isn't the only, or the largest, company coming up with smart watches.

Limited government intervention in the economy is also a major characteristic of capitalism. This type of competitive market is often referred to as a free market. The government generally does not set the prices of goods or services - the market sets the price. And the government's regulatory role is pretty much limited to ensuring that there is a level and fair playing field. In other words, the government sets up the rules, so that no one has an unfair advantage in the market.

Market Price

While Tanya isn't subject to the government telling her the price at which she must sell her smart watch, she must bow to the law of supply and demand:

  • If all other things remain the same, as the quantity of a good or service supplied increases, the price of it will decline.
  • If all other things remain the same, as the demand of a good or service increases, the price of it will increase.
  • If all other things remain the same, the market price for a good or service is the price at which the supply of it equals the demand for it. This price is often referred to as the 'equilibrium price' because it is the price where demand equals supply.

If the market price for Tanya's smart watch is lower than the costs for Tanya to produce it, she will lose money. That's the risk businesses take in a capitalistic economy. Tanya has a right to her profits but is also accountable for her losses.

Limits to Capitalism

Capitalism isn't perfect. Markets are not perfectly competitive in the real world. Sometimes, monopolies are created without government intervention. A monopoly exists where one firm controls the quantity of a good or service and can set the price as high as people are willing to pay.

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