Capitalist vs. Socialist Economies: What's The Difference?

Capitalism and socialism are economic systems that countries use to manage their economic resources and regulate their means of production.

In the United States, capitalism has always been the prevailing system. It is defined as an economic system where private individuals or businesses, rather than the government, own and control the factors of production: entrepreneurship, capital goods, natural resources and labor. Capitalism's success is dependent on a free market economy, driven by supply and demand.

With socialism, all legal production and distribution decisions are made by the government, with individuals dependent on the state for food, employment, healthcare and everything else. The government, rather than the free market, determines the amount of output, or supply and the pricing levels of these goods and services.

Communist countries, like China, North Korea, and Cuba, tend toward socialism, while Western European countries favor capitalist economies and try to chart a middle course. But, even at their extremes, both systems have their pros and cons.

In capitalist economies, governments play a minimal role in deciding what to produce, how much to produce, and when to produce it, leaving the cost of goods and services to market forces. When entrepreneurs spot openings in the marketplace, they rush in to fill the vacuum.

Capitalism is based around a free market economy, meaning an economy that distributes goods and services according to the laws of supply and demand. The law of demand says that increased demand for a product means an increase in prices for that product. Signs of higher demand typically lead to increased production. The greater supply helps level prices out to the point that only the strongest competitors remain. Competitors try to earn the most profit by selling their goods for as much as they can while keeping costs low.

Also part of capitalism is the free operation of the capital markets. Supply and demand determine the fair prices for stocks, bonds, derivatives, currencies and commodities.

In his seminal work, “An Inquiry into the Nature and Causes of the Wealth of Nations,” economist Adam Smith described the ways in which people are motivated to act in their own self-interest. This tendency serves as the basis for capitalism, with the invisible hand of the market serving as the balance between competing tendencies. Because markets distribute the factors of production in accord with supply and demand, the government can limit itself to enacting and enforcing rules of fair play.

In socialist economies, important economic decisions are not left to the markets or decided by self-interested individuals. Instead, the government—which owns or controls much of the economy’s resources—decides the whats, whens, and hows of production. This approach is also called “centralized planning.”

Advocates of socialism argue that the shared ownership of resources and the impact of social planning allow for a more equal distribution of goods and services and a more fair society.

Both communism and socialism refer to left-wing schools of economic thought that oppose capitalism. However, socialism was around several decades before the release of the "Communist Manifesto," an influential 1848 pamphlet by Karl Marx and Friedrich Engels. Socialism is more permissive than pure Communism, which makes no allowances for private property.

In capitalist economies, people have strong incentives to work hard, increase efficiency, and produce superior products. By rewarding ingenuity and innovation, the market maximizes economic growth and individual prosperity while providing a variety of goods for consumers. By encouraging the production of desirable goods and discouraging the production of unwanted or unnecessary ones, the marketplace self-regulates, leaving less room for government interference and mismanagement.

But under capitalism, because market mechanisms are mechanical, rather than normative, and agnostic in regard to social effects, there are no guarantees that each person's basic needs will be met. Markets also create cycles of boom and bust and, in an imperfect world, allow for “crony capitalism,” monopolies and other means of cheating or manipulating the system. 

[Important: In socialist societies, basic needs are met; a socialist system’s primary benefit is that the people living under it are given a social safety net.]

In theory, economic inequity is reduced, along with economic insecurity. Basic necessities are provided for. The government itself can produce the goods people require to meet their needs, even if the production of those goods does not result in a profit. Under socialism, there’s more room for value judgments, with less attention paid to calculations involving profit and nothing but profit. 

Socialist economies can also be also more efficient, in the sense that there’s less of a need to sell goods to consumers who might not need them, resulting in less money spent on product promotion and marketing efforts.

Socialism sounds more compassionate, but it does have its shortcomings. One disadvantage is that people have less to strive for and feel less connected to the fruits of their efforts. With their basic needs already provided for, they have fewer incentives to innovate and increase efficiency. As a result, the engines of economic growth are weaker.

Another strike against socialism? Government planners and planning mechanisms are not infallible, or incorruptible. In some socialist economies, there are shortfalls of even the most essential goods. Because there’s no free market to ease adjustments, the system may not regulate itself as quickly, or as well.

Equality is another concern. In theory, everyone is equal under socialism. In practice, hierarchies do emerge and party officials and well-connected individuals find themselves in better positions to receive favored goods.

• Capitalism and socialism are so different that they’re often seen as diametrically opposed.
• Capitalism is based on individual initiative and favors market mechanisms over government intervention, while socialism is based on government planning and limitations on private control of resources.
• Left to themselves, economies tend to combine elements of both systems: capitalism has developed its safety nets, while countries like China and Vietnam may be edging toward full-fledged market economies.