Economic Systems: Capitalism, Communism, and Socialism

An economic system consists of the institutions and the method by which resources are allocated and products and services are distributed. Economic systems differ primarily in who owns the factors of production, how the allocation of resources is directed and the method used to direct economic activity. The primary distinction between the different systems is the degree to which the government participates in the economy.

Communism

Communism, also known as a command system, is an economic system where the government owns most of the factors of production and decides the allocation of resources and what products and services will be provided.

The most important originators of communist doctrine were Karl Marx and Frederick Engels. Like the socialists before them, they wanted to end the exploitation of the masses by the few. The capitalist system at that time required workers to work under harsh and dangerous conditions for little pay. The end goal of communism was to eliminate class distinctions among people, where everyone shared equally in the proceeds of society, when government would no longer be needed.

Karl Marx agreed with Louis Blanc in how labor and income should be managed: "From each according to his abilities, to each according to his needs." However, it seems clear from history that Adam Smith had the correct principle, which is that people work in their own self-interest.

Marx and Engels believed there was a class struggle between the masses, which Marx called the proletariat, who could only offer their labor, and the owners of the means of production, which included land, raw materials, tools and machines, and especially money. Karl Marx called the ruling class the bourgeoisie. He believed that a political revolution was essential because the state was a central instrument of capitalist society, and since the bourgeoisie had a stranglehold on the government, it would, in many cases, be necessary to use force and violence to overthrow the capitalists.

Although Marx and Engels believed that property should belong to society, they did not really give much thought to how economic decisions would be made. Communist countries, particularly Russia and China, decided on a centrally planned economy (aka command economy). The centrally planned economy had the following major attributes:

Another major feature of communist economies was their emphasis on the country's self-reliance, discouraging international trade and investment.

Major decisions were made by the highest-ranking members of the Communist Party, which, in the Soviet Union, was the Politburo. The Politburo frequently met with the Central Committee that consisted of the heads of the local Communist Party factions and government ministries, the military, police, and other major participants in the economy.

Although the purpose of communism was to serve the needs of the proletariat, communist governments simply became repressive regimes that exploited their people to aggrandize their own power, exploiting the masses even more so than the capitalists.

Capitalism

As long ago as 1776, the Scottish philosopher Adam Smith set down many of the main principles of capitalism in his now classic book An Inquiry into the Nature and Causes of the Wealth of Nations.

Under capitalism (aka market system), each individual or business works in its own interest and maximizes its own profit based on its decisions. A market economy is one where the allocation of resources and the trading of goods and services are through the decentralized decisions of many firms and households. The equilibrium between supply and demand determines prices, which determines economic output, which, in turn, determines the allocation of resources.

The market system fosters competition that generally produces the most efficient allocation of resources. In pure capitalism, also known as laissez-faire capitalism, the government's role is restricted to providing and enforcing the rules of law by which the economy operates, but it does not interfere with the market. (Laissez-faire means "let it be.")

The essential characteristics of capitalism are that:

Because consumers are free to buy what they want, the competition for their funds will require businesses to satisfy their needs, or else they will cease to exist due to lack of sales. This consumer sovereignty is what effects the efficient allocation of resources.

The main purpose of the government in regard to the economy is to promote free markets, keep inflation low and steady, protect the rights of private property, and to guarantee contracts, which are necessary to conduct business.

The main benefit of capitalism is the promotion of competition. Although capitalism is usually described as a private ownership of resources, it is competition that provides the main benefit to society; the private ownership of resources is necessary, but not sufficient, for competition. In laissez-faire capitalism, businesses become free to form monopolies or oligopolies, which reduces competition, and thereby reduces the advantages of capitalism. Instead, a plutocracy is created, where the wealthy rule the economy for their own benefit.

Socialism

The definition of socialism varies widely, and many people use it synonymously for communism, but it is often distinguished as an economic system between communism and capitalism. Socialism is the social and economic doctrine that espouses public over private ownership and control of property and natural resources. Socialists argue that since everyone contributes to society in the form of work, therefore everyone should benefit from it. The degree of ownership or control differs among socialists. Some believe that the government should own most of the property and natural resources, while others believe that small businesses should be owned privately. Still others, mainly the rich, believe that simply taxing the rich more is a form of socialism.

Like communism, socialism seeks to redistribute the wealth more equitably by the communal ownership of natural resources and major industries, such as banking and public utilities. Socialists also seek to nationalize monopolies, which greatly enrich their owners at the expense of the people. However, unlike communism, most small or nonessential enterprises would remain privately owned. Also unlike the Communists, most socialists do not advocate violence or force to achieve their economic system.

Early socialist ideas centered on common ownership or control, equality, and the simple life. Some socialists advocated violence as a means of achieving their ends, but later socialists developed policies that envisioned a nonviolent means of achieving socialism. They wanted to revise Marx's teachings, by advocating that socialist successes could be achieved through the ballot box gradually, without violent revolution, and this was often accomplished by using political parties, such as the Labor Party of Great Britain. Thus, various forms of socialist ideals have developed. Some sample subtypes of socialist systems include the following:

However, political strategies and unionization were not viable methods in countries like Russia, which was under authoritarian rule by the czars. Therefore, VI Lenin, who led the Bolshevik party of the Russian Social-Democratic Workers Party, realized that violence would probably be necessary to achieve socialism.

Lenin believed, as he argued in his book What is to be Done? (1902), that workers would only fight for better wages and working conditions, if they were led by a vanguard party of professional revolutionaries. The severe plight of the Russian people during World War I allowed the Bolsheviks to overcome the czarist regime and establish control. Thus, revolutionary Marxism was given a boost, which would be later used by other groups to gain control of their governments. Revolutionary Marxism eventually became known as Marxism-Leninism.

Some have advocated a market socialism: blending a free market economy with social ownership and control of property, where businesses would still compete for profit, but would be owned or at least be controlled by their laborers. The workers would choose their supervisors and managers, control the working conditions, set prices for the products and services, and decide how profits and losses will be shared.

Socialism in the modern world has yielded to the 3rd way, a center-left position committed to the socialists' objective of equality and welfare for the masses, but abandoning class-based politics and public ownership of production. Tony Blair of the British Labour Party promoted this 3rd way in 1995. Two years later, the Labour Party won a large victory, and Tony Blair served as prime minister for 2 terms.

Economic Systems of the Future

History has amply demonstrated that communism and socialism retard the growth of economies, because there is no competition between businesses, and the people who manage such businesses are often political appointees, chosen more for their social and political connections than for their understanding of the businesses that they manage. Furthermore, large industries are often under the control of many bureaucrats, who often issue conflicting demands. They care little about whether society wants their product or service, and do not care as much about costs, since these costs are paid by the government.

To illustrate how inefficient communism is compared to capitalism, consider the difference between the 2016 Gross Domestic Products of Germany and Russia:

2016 GDP

Germany

$3,477,796,000,000

Russia

$1,283,163,000,000

Russia is, by far, the largest country in the world, with a landmass slightly exceeding 6,600,000 mi.², and natural resources proportional to its landmass. It also has a population of 144,370,000. By contrast, Germany's land area is 137,879 mi.², with a population of 83,249,000. And despite Russia having a landmass almost 48 times that of Germany, with proportionally greater natural resources, and a much larger population, Germany's GDP in 2016 was 2.7 times that of Russia! Although Russia is a major military power, it is an economic midget: it achieves its military prowess by devoting a much larger percentage of its GDP to military spending, which is why most of the people in Russia live in relative poverty. Other small countries with a GDP larger than Russia include: Japan, United Kingdom, France, Italy, and even South Korea.

Or consider the difference between North and South Korea:

Source: NASA

The Stark Contrast Between the Lights of Civilization and the Darkness of Poverty

As can be easily seen from this 2014 nighttime photograph from the space station, the lights of civilization are conspicuous in South Korea and China, but virtually absent from North Korea. The contrast is especially stark along the border separating North and South Korea. Indeed, most of North Korea looks like the ocean at night.

Of course, this stark contrast doesn't simply result from the difference between pure communism and pure capitalism, for such systems are nonexistent. The poverty in North Korea is created by their political leaders using the very limited resources of North Korea to help their leaders maintain political power. Kim Jong-un is diverting considerable resources to the production and testing of nuclear weapons and missiles to carry them, to develop the capability of destroying the United States that will serve as a deterrent to any attempt to topple his regime. That his people are suffering because of this massive diversion evidently does not faze him. Or, he may be seeking to use nuclear weapons to blackmail the rest the world, especially the United States. After all, after he develops hydrogen bombs and the missiles to carry them, what else can he do with them? His economy will still be in shambles, and since communist economies generally don't do well without, at least, some degree of freedom, it will probably be the only means of improving the lot of his people.

North Korea, Cuba, Russia, and China are really, more or less, dictatorships who promote the ideals of communism as propaganda, to convince the people that the government's exploitation of them is for their own good. However, the governing kleptocrats have no intention of ever relinquishing their power. In these dictatorships, it is the government exploiting the people rather than the capitalists. Here again, Adam Smith was right, people work for their own interest, including those in government. By allowing the government to own the means of production, they can also use that means to enrich themselves and their cronies at the people's expense. What Karl Marx did not realize is that government leaders are the same as capitalists, many of whom exploit who they can to enrich themselves. Even in the United States, lobbyists continually try to influence Congress and the president to pass laws in their favor, which is always at the expense of everyone else. (After all, if the laws were in the best interest of the people, then special interests wouldn't have to spend so much money to influence politicians to do otherwise, since, presumably, politicians would actually vote in the people's interest.)

Communism and socialism give great power to a few individuals who then become obsessed with retaining their power, even at the tremendous expense of society. For instance, Cuba and North Korea are almost completely communistic, and even though the Communist governments in both countries have controlled their countries for years, their people remain mired in abject poverty. Consequentially, the people of Cuba and North Korea are mere economic slaves, subjugated to enrich the communist dictators of these countries.

The other major problem with communism and socialism is that not only are the major leaders almost completely ignorant of economics and of the needs or wants of their people, but it is very difficult to remove them, in spite of their detriment to the economy. Even when a communist, such as Hugo Chávez in Venezuela, is elected in a democratic election, his primary goal is to retain his own power, even as the economy crumbles around him, because of gross mismanagement.

Capitalism works best because it promotes competition so that only the most efficient businesses survive. Survival requires that the business owners be knowledgeable about their business and able to manage it effectively, that they can minimize costs to produce their product or service, and that they know what people want. Otherwise, the business will fail, as most do.

Thus, capitalism provides the best means of achieving the efficient allocation of the factors of production and providing society with the goods and services that it most desires at the lowest possible cost. Capitalism maximizes the production possibility frontier, providing the greatest benefit to society with the available scarce resources.

An introductory textbook on Economics, lavishly illustrated with full-color illustrations and diagrams, and concisely written for fastest comprehension. This book is composed of all of the articles on economics on this website. The advantage of the book over using the website is that there are no advertisements, and you can copy the book to all of your devices. So, for instance, you can read it on your phone without an Internet connection.

Drawbacks of Capitalism

Although capitalism is the most effective means of allocating resources, it does have shortcomings, including the following:

A capitalist economy also requires a government to enact and enforce laws, to promote economic stability through monetary policy, to provide services that cannot be provided by a market system, such as a military to protect society against foreign invaders, and to redistribute some of the wealth to poorer people, especially by providing social security programs, such as health care, which is unaffordable for many people. Because the government plays a prominent role in all economies, all capitalistic economies are considered mixed economies, combining some features of a command economy with a market economy.

The redistribution of some wealth is necessary, because even in a capitalist economy, some people gain tremendous wealth, then use it to influence governments to make them even wealthier, usually at the expense of poor people. For instance, in the United States, working income is taxed at a higher rate than either investment income or inherited income, income that accrues mostly to the wealthy. Although there is a progressive, marginal income tax rate in the United States, the tax is almost a flat tax when payroll taxes are added, and since payroll taxes do not apply to either investment income or inherited income, most wealthy people pay a lower percentage of their income in taxes than either the middle class, or even many of the poor, which is one reason why the top 1% are accumulating an ever greater portion of the world's wealth.

No doubt that the science of economics will guide the development of future economies, fine tuning them by promoting what works and eliminating what doesn't work. But only if the influence of special interests and power grabs by megalomaniacs can be limited or eliminated. And by understanding economics, the electorate can avoid bamboozlement by specious advertising and talking points, and vote for politicians that would better serve the people instead of themselves.

Is the Redistribution of Wealth Socialism?

During the 20th century, the word socialism often meant a system of government akin to communism. Nowadays, people use the word mostly to mean a redistribution of wealth, viewed by many as unfair. However, it is a common tacit assumption that the initial distribution of newly created wealth was fair. But an inquiry into capitalism shows that this is probably not the case. As Adam Smith noted long ago, people act in their own interest. This simple observation lays at the foundation of capitalism. It is the invisible hand. But if people act in their own interest, then is it not reasonable to suppose that the people who distribute the wealth will try to keep more of it for themselves, by sharing it less? The growth of inequality is firm evidence for this.

Inequality is growing because most of the economies of the world are creating more and more wealth, but the people who decide how that wealth is distributed have decided to keep more of it themselves. This is easier to see by looking at businesses. CEOs are paying themselves more and more money, sometimes, more than 300 times what their average workers make. And yet, are they 300 times better? We know from statistics that the abilities of most people lie within 2 standard deviations of the mean. While the ability of some people may be more than twice the ability of average people in some regards, abilities do not deviate much more than that. While a professional baseball pitcher may be able to pitch a baseball more than twice as fast as most people, no baseball pitcher can pitch more than 3 times faster than most people. Certainly, no one is 300 times better than the average person. That CEOs are paying themselves much more than what they are worth can easily be seen in companies going bankrupt, because even those CEOs still receive millions of dollars in compensation. Even when the board of directors decides to get rid of a bad CEO, many of those CEOs walk away with millions of dollars of severance pay. How do CEOs accomplish this? Simple. They decide or significantly influence how the business revenue is distributed. And when they distribute more to themselves, that leaves less for everyone else in the company. When a company is going bankrupt, the CEO chooses the bankruptcy firm, so naturally they will choose a firm that will allow them to walk away, in many cases, with millions of dollars, even when they were largely responsible for bankrupting the firm. Moreover, CEOs are often compensated with employee stock options, which further saves them taxes, because the money earned from these options are exempt from employment taxes and are subject to the lower long-term capital gains rate rather than the hefty marginal rate that applies to most income earned from work.

The unfair distribution of wealth can also be seen in some countries with rich natural resources, such as Iran, Nigeria, and Venezuela. These countries have natural-resource wealth great enough to make everyone there rich, and even though no person was responsible for those resources, political leaders keep most of the money and wealth to themselves, which is why many political leaders and their cronies are willing to kill so many people or commit other atrocities to maximize their wealth. Greed has been the main cause of wars and slavery throughout the ages and across all cultures sophisticated enough to have a hierarchy.

The wealthy also benefit from the tax code. The tax code in most countries favors the wealthy by taxing income earned from work the most, while taxing investment income and gratuitous transfers less, money that accrues mostly to the wealthy. The wealthy have significant influence over the writing of the tax code, so it is no surprise why so many parts of the tax code favor the wealthy.

Many people consider government handouts to be a form of socialism, but tax breaks and tax loopholes are, likewise, government handouts. If the government fails to collect $100 of revenue because of a tax break that it granted or a tax loophole that the taxpayer took advantage of, that is $100 that the government does not receive, and since its revenue requirements remain unchanged, then it must collect revenue from someone else or borrow the money, creating a debt eventually to be paid by someone else. This has the same effect as simply giving someone $100. The government has $100 less in revenue either because it gave $100 as a handout or granted someone a $100 tax break. Because the wealthy receive most of the tax breaks, it could be said that the wealthy receive most of the socialism. For instance, in the United States, the wealthy receive a unified tax credit worth more than 4.5 million dollars, much more than what most Americans will make in their entire lifetimes! But because the government is not collecting this money from the wealthy, then it must collect the money from someone else, usually from the lower classes, for which money has a much higher utility, since they need the money to live. Or the government borrows the money, to be paid later, with interest.

But if the wealthy have so little need for more money, then why do they want more money? Because wealth is how the wealthy measure themselves among themselves. Thus, the wealthy want more money to increase their status, the middle class want more money so that they can live better, and the poor want more money simply to live.

So, not only do the wealthy benefit by keeping more of the created wealth to themselves while sharing it less, but they also benefit from an unfair tax code that places the heaviest tax burden on income earned from work, taking money from people who need it the most so that more can be given, or less taken away, from those who need it the least. Some of the wealthy have so much money that they are willing to pay more than $100,000,000 for a painting, because the marginal utility of money is so low for them, that they simply do not know what else to do with it.

When the wealthy award themselves most of the wealth and do not pay their fair share of taxes, then the lower classes will have less money. Conservatives want to keep wages low, worker benefits few or nonexistent, and they want to reduce regulations so that they do not have to spend money protecting the environment or public health. As Karl Marx noted, capitalists want to exploit workers by transferring as much of the wealth created by those workers to themselves as possible while sharing as little as possible with their workers. This is why slave owners became rich. They reaped the wealth created by their slaves by keeping most of the wealth while paying the slaves as little as possible, barely enough for most of them to survive.

Another way to show that the wealthy are receiving most of the socialism is to see how the wealth is distributed in communist countries, supposedly the ultimate socialist societies, if socialism is considered the unfair distribution of wealth. In communist countries, it is the poor who should be benefiting from the system, but instead, they are toiling to enrich communist leaders. It has been reported periodically that Vladimir Putin is the richest man in the world, so, in Russia at least, it is Putin and his cronies who are benefiting from communism while it is the poor who are creating the wealth that the leaders transfer to themselves. Serfdom disguised! Communist leaders are benefiting so much from this arrangement that they suppress free speech and threaten the world with nuclear destruction to maintain their status quo. Karl Marx said that capitalists exploit their workers for their own benefit; in communist countries, it is the communist leaders who exploit the people.

Karl Marx was correct when he said that capitalists exploit their workers for their own benefit, but what Marx did not understand, I think, is that the capitalists were exploiting their workers, not because they were capitalists, but because they were people, and people have been doing this since the beginning of history, when writing and records were starting to be used by the elites to organize society. That the elite has always exploited the people has been prevalent throughout history and across all cultures, whether the economic system was serfdom, feudalism, slaveholding societies, communism, socialism, and yes, even capitalism. Greed is simply a biological characteristic of human beings. It is the reason why people work in their own interest. Greed is the invisible hand! It has been the reason for wars throughout history and it will be the reason, should it happen, that we self-destruct in a nuclear holocaust.

While people continually proclaim that they want a fair society, the people who are benefiting from the unfairness work behind the scenes to make it unfair, so that they can continue to benefit from the unfairness. The reason why conservatives are called conservatives is because they want to keep things the same, because they are benefiting from the status quo, which is understandable, since they created the status quo! The reason why liberals want to change society is partly because they feel they are not benefiting enough from the economic wealth that they helped to create, at least not to the extent of their contribution.

In this article, I have discussed the different economic systems. However, in the end, all government systems, past and present, are truly plutocracies, governments ruled by the wealthy for their own benefit, running the government either directly, as in Communist countries or dictatorships, or indirectly, by using their money to influence politicians or even by becoming politicians, as in most democracies. So if socialism is defined as the unfair distribution or redistribution of wealth, then it is clear that it is the wealthy who receive most of the socialism, just as they have throughout history!

The Pauper's Money Book shows how you can manage your money to greatly increase your standard of living.