1.4 – Basic Features of Capitalism
Learning Objectives
By the end of this section, you will be able to:
- Identify the basic components of a capitalist economy
- Define essential concepts in economics, including market and theory
- Construct a model of the economy in terms of the interaction of households and businesses through market exchange
Economics is not limited to studying only capitalist economies, but odds are the economies you’ll be studying as you work through this text will be principally capitalist in composition. Capitalism is sometimes called the free-market or private-enterprise system. A market is an institution that brings together buyers and sellers of goods or services. These buyers and sellers may be individuals, businesses, governments, or other types of organization.
Market economies are based on private enterprise: the means of production (resources, technologies, and businesses) are acquired through investment, and owned and operated by private individuals or groups of private individuals with a basic goal of earning profits. Governments, then, protect these property rights, help to settle disputes between different parties (for example, two competing businesses), and to varying degrees regulate all sorts of economic activity.
In a capitalist economy, profit is one way to garner an income and, if we’re sticking to just the basics, wages are the other (of course there are plenty of other ways to make money as well). While it’s possible to have a free-market economy in which everyone is a business owner, in actual modern capitalist economies, the private ownership of the means of production is always accompanied by a working class who must earn their living by working for the business owners. And, as you’ll learn in various chapters throughout this text, economists have very different theories about how these different types of income fit together in capitalist economies.
A Simple Model of Capitalism
A theory is a simplified representation of how two or more variables interact with each other. The purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. If done well, this enables the analyst to understand the issue and any problems around it. A good theory is simple enough to be understood, while complex enough to capture the key features of the object or situation being studied.
Sometimes economists use the term model instead of theory. Strictly speaking, a theory is a more abstract representation, while a model is more applied or empirical representation. Models are used to test theories, but for this course we will use the terms interchangeably.
A very basic model to start with in economics is the circular flow diagram, which is shown in Figure 2. It pictures the economy as consisting of two groups—households and businesses (or ‘firms’)—that interact in two markets: the goods and services market in which firms sell and households buy and the labor market in which households sell