Capitalism and Socialism

For over a century, we have been debating the merits of capitalism versus socialism. Although the debate rages on, economies around the world have been converging on a hybrid system, which I will call the modern economic system. The modern economic system uses both the state and the market to organize production and distribution. The market solves problems that the state cannot solve, and vice versa.

In the modern economic system, capitalism directly produces most of the wealth (the goods and services that we use). The state expropriates a significant percentage of that wealth and uses it to do a lot of things. Some is distributed to the poorer members of society through welfare programs. Some is used to provide services, such as roads and education. Some is used to maintain state power internally and externally. A considerable amount finds its way into the hands of elites, where it funds both extravagant lifestyles and the pursuit of political power. The system tolerates an unequal distribution of wealth, but it has a social safety net that protects people from falling into abject poverty (in most cases). It isn’t perfect, but it generates a reasonable standard of living for most people.

I won’t try to describe the modern economy in all its details. In particular, I’ll leave out the debt-based financial system, although that is a key component. I just want to make the point that it is a hybrid of capitalism and socialism, and that it works reasonably well. Although they are often viewed in opposition to each other, capitalism and socialism are complementary parts of a functional whole.

Before going further, I should define the two key terms I am using: capitalism and socialism. My definitions might not be exactly what is in the dictionary, but I think they capture the ordinary usage of the terms and are useful for analysis. Here are my definitions:

  • Capitalism: Market-organized production and distribution of goods and services.
  • Socialism: State-organized production and distribution of goods and services.

Now I’ll expand on those basic definitions.

In capitalism, production and distribution are organized by agents seeking to maximize profits within a market. The state creates the market by defining and enforcing laws. Violence and theft are prohibited. There are laws governing exchange, such as contract law and labor law. A currency is established. Within this framework, a system of economic order emerges: a network of exchange relationships.

Market prices coordinate economic activity between strangers. Markets generate an emergent system of production and distribution that is efficient, in the sense that it produces the things that people value the highest at the lowest cost in resources and labor. The most important feature of capitalism is its efficiency.

Socialism is sometimes defined as state ownership of the means of production, but I think that definition is vague and doesn’t fit the ordinary usage of the term. As I define it, socialism is state-organized production and distribution. By that definition, every society is socialist to some extent, because every society must fund the operation of the state. Societies differ in what they socialize, but all societies have some socialized components, such as the military and law enforcement.

The political debate over socialism versus capitalism is over what should be socialized. Should food production and distribution be socialized so that no one goes hungry? Should education be socialized so that all children have the same opportunities in life? How big should the military be? Should there be user fees on roads? Socialism is more than a social safety net, although that is usually part of it.

Capitalism and socialism depend on each other.

Socialism is necessary for capitalism, because the state must create the conditions for the market by defining and enforcing laws. Law is a service that must be provided by the state. So is military defense. The state typically provides other services that contribute to making capitalism work, such as money and basic infrastructure.

Capitalism is necessary for socialism, because capitalism generates wealth efficiently, and thus it generates a surplus of wealth that can fund the operation of a powerful state. The state also relies on the market to organize most production tasks. For example, the state will typically hire a construction company to build a road.

Both capitalism and socialism can solve problems of poverty.

Capitalism produces wealth efficiently, and so it solves the collective problem of poverty by making a society richer. Capitalism also allows individuals to solve their personal problems of poverty by seeking employment in the labor market.

Socialism solves individual problems of poverty by redistributing wealth to those in need. This prevents individuals from falling into abject poverty if they are unable to work.

Inefficiency and corruption are the great weaknesses of socialism. The state does not have the information or the incentives necessary to organize a complex economy. State power must be wielded by people, and people may use that power to enrich themselves. Democracy is a very crude mechanism (much less efficient than the market) for translating individual judgments into social judgments. Bureaucracy (aka “management”) is also a very crude mechanism for coordinating action. Taken too far, socialism destroys the productivity of a society.

Capitalism has weaknesses too. The great weakness of capitalism is that profits tend toward zero in an open market.

Profit is revenue minus the cost of production. For producers to make a profit, prices must be above the cost of production. Whenever prices exceed the cost of production, there is an opportunity for a new producer to enter the market and offer the same product at a lower price and still make a profit. Thus, market incentives tend to drive prices down to the cost of production. They also incentivize producers to find ways to lower the cost of production, which is one of the reasons why capitalism is efficient. But in the long run, prices get dragged toward the cost of production. Competition makes capital investment risky.

Also, capitalism allows individuals and companies to accumulate a lot of wealth, which can then be used to capture the political system. Of course, the potential for corruption exists in any society, regardless of the economic system. The big owners of capital often use their wealth to advocate for monopoly or oligopoly positions, to protect their profits from erosion. The open market is a useful abstraction, but it never exists in a pure form.

So, capitalism and socialism both have weaknesses, and those weaknesses are present in the modern economic system. The weaknesses are often used to argue for one versus the other, but that is a false dichotomy. It is impossible to have pure capitalism or pure socialism. Both are necessary to modern society. Replacing one with the other would not produce a utopia. It would destroy society.

It is impossible to fully eliminate the problems of capitalism and socialism, but we can minimize them by understanding them.

We need to stop viewing capitalism and socialism as conflicting ideologies. Instead, we should view them as complementary forms of social organization. Each solves different problems. There is no point debating which is better. Instead, we should be discussing how we can use capitalism and socialism to improve our societies.