Understanding capitalism

The term “capitalism” emerged in the mid 19th century. It can be described as an economic system with private ownership of assets and the means of production, profit-driven production with capital accumulation and wage labour, with resource allocation that is coordinated primarily by competitive markets and prices. This all happens under a legal framework that enforces property and contracts rights.

There are a number of different parts that are relevant and associated with capitalism as an economic system. For this resource we will focus only on two key areas. Free markets and companies limited by shares.

Free markets

A free market is an economic system in which the allocation of goods, services, and resources is coordinated primarily through voluntary exchange. Prices are set by supply and demand, with minimal central planning and intervention.

With free markets, you’d generally expect to see multiple buyers and sellers that compete against one another. This competition helps to encourage innovation and quality improvements in an attempt to capture more of the market.

Decisions around what gets produced is decentralised across individuals and companies, these individuals and companies will decide themselves what they will produce, how they will produce it and who they are producing it for.

Advantages of free markets

Free markets are often effective for encouraging innovation and entrepreneurship.A competitive market can help with increasing variety, quality and enabling more consumer choice.

Free markets can also create an environment that is capable of handling rapid changes and that could be due to things like changing consumer preferences or technology.

Decentralised decision making can also be a great way to solve problems, as with a free market a number of people can solve a problem in their own different way and then the market will decide which solution is the best.

Problems with free markets

Without any regulation, free markets don’t handle the problem of externalities. A company could keep creating products that pollute the environment and this growing cost to society would keep happening, potentially at an industrial scale if there weren't any interventions. A tax might be necessary to reduce and remove these negative externalities where possible.

Free markets are also not very effective for providing public goods, like national defence or funding for public spaces, parks, research or creating open standards.

And free markets can also easily lead to the overuse of natural resources, like from fisheries, woodlands or groundwater as some examples.

Both natural monopolies and network effect based monopolies can also emerge in a free market, things like utilities and digital platforms such as social media networks or marketplaces.

In practice, markets are rarely perfectly “free”. In reality, you need to prevent and correct these different issues that can happen using regulations, intervention and public provision.

Companies limited by shares

One of the early and more famous joint-stock companies you may have heard of is the Dutch East India Company, which was established in 1602. A shared based company structure helps with enabling people to invest into companies and receive a return on investment in the future if the company succeeded. Investors receive shares of ownership, and these shares last in perpetuity. The following factors represent some of the most defining features of a company that is limited by shares.

Capital share based ownership

Shares represent a form of capital that is used to determine ownership in a capitalist organisation. Shares are commonly received for capital investments or labour contributions. Owners and investors assume any financial risks with the potential for personal gain.

Class distinction

Capitalism commonly leads to a two class structure where there are owners (capitalists) and workers (employees). Employees are not entitled to receive any shares of ownership in a capitalist organisation. It is up to the goodwill of the owners if they are to receive any shares for their contributions. If employees do receive shares, the amount of shares given does not need to reflect the full value of the contributions being made by each employee.

Shareholder rights

Shares often give owners perpetual governance and incentive rights. For governance this means they are entitled to participate in decisions about appointing directors for the board. For incentives this means that whilst they are still holding the shares they will benefit from share value appreciation and any dividend payments. Not every share has governance rights and some shares can be capped in terms of the return on investment they are able to make.

Shareholder governance

Shareholders determine who sits on the board or directors. The board then determines who will fill any executive positions. Executives will then govern the organisation and how it is operated.

Shareholder incentives

Capitalist organisations commonly have the primary goal of maximising shareholder value. Shareholders benefit from the organisation due to any share value appreciation or through dividend payments that are made by the business.

Employee incentives

Employees are paid in salaries and wages. Sometimes employees receive share options or bonuses. Employee labour can be commonly treated as a commodity that is bought and sold in the labour market based on skills, market demand and negotiation.