Capitalism vs. SocialismFormal economies operate within limits of established and monitored policies and regulations. Capitalism and socialism are formal economies.The major differences between capitalism and socialism revolve around the role of the government and equality of economics. Capitalism affords economic freedom, consumer choice, and economic growth. Socialism, which is an economy controlled by the state and planned by a central planning authority, provides for a greater social welfare and decreases business fluctuations.

Capitalist Economy: Key CharacteristicsCapitalism is characterized in the following ways:• It is a market-based economy made up of buyers (people) and sellers (private or corporate-

owned companies).• The goods and services that are produced are intended to make a profit, and this profit is

reinvested into the economy.• The government should not interfere in the economies of the free market, meaning, the market

determines investments, production, distribution and decisions, and government interference is only allowed when making and enforcing rules or policies governing the conduct of business.

• There is a need for continual production and purchase for a capitalistic economy to operate efficiently.

• Capitalists believe that government does not use economic resources as efficiently as private enterprise.

The U.S. is considered to be a capitalist economy, along with most of the modern world; however, economists are quick to point out that almost every society has a socialist aspect or program within it.

Capitalism: Advantages and DisadvantagesThe advantages of capitalism include:• Consumer choice - Individuals choose what to consume, and this choice leads to more

competition and better products and services.• Efficiency of economics - Goods and services produced based on demand create incentives to

cut costs and avoid waste.• Economic growth and expansion (which is possible in the capitalist economy system) - This

increases the gross national product and leads to improved living standards.The disadvantages of capitalism include:• A chance of a monopoly of power - Firms with monopoly power (when a specific person or

enterprise is the only supplier of a particular commodity) can abuse their position by charging higher prices.

• Inequality - A capitalist society is based on the right to pass wealth down to future generations. If a small group of people hold all the wealth and that wealth continues to be passed down to the same groups of people, inequality and social division occur.

• Recession and unemployment - An economy based on the market of consumers and producers is invariably going to experience growth and decline.

Socialist Economy: Key CharacteristicsSocialism is characterized in the following ways:• The means of production are owned by public enterprises or cooperatives (the state), and

individuals are compensated based on the principle of individual contribution.• There is equal opportunity for all. Large-scale industries are cooperative efforts, and thus, the

returns from these industries must be returned to and benefit society as a whole.• Economic activity and production are planned by the central planning authority and based on

human consumption needs and economic demands.• Socialists believe economic inequality is bad for society, and the government is responsible

for reducing it via programs that benefit the poor.For example, in the U.S., we have Medicare, social security benefits, and social nutrition assistance programs that are considered socialist in nature.

Socialism: Advantages and DisadvantagesThe advantages of socialism include:• Great efficiency - Economic efficiency under socialism means that production decisions are

controlled and regulated by the central planning authority towards a particular goal.• Greater social welfare - In a socialist economy there is less inequality of income because of

the absence of private ownership of means of production.• Absence of monopolistic practices• Absence of business fluctuations - A socialist economy coordinates the action of various

producing units, prevents discrimination between saving and investment and makes full use of available resources.

The disadvantages of socialism include:• Elimination of individualism - When everything is controlled by a centralized body,

individuals are not allowed to own any assets; everything belongs to the state.• An artificial system - Demand and supply principles do not exist in an economy where the

state determines what is produced. In the long run, the economy becomes static rather than growing.

Consumers suffer - Individuals do not enjoy the status of being a consumer as in a capitalist economy. There is no competition in a socialist economy. Therefore, individuals are not afforded a choice, which usually leads to higher quality products and services.

Capitalism and the Free MarketMeet Tanya, the founder of a small tech company in the United States. She recently formed her company to design and build a smart watch, which is a miniature computer tablet that you can wear on your wrist. She dreams of making piles of money, which is one of the rewards of success in free market capitalism.Capitalism is an economic system that is organized around the principles of private property, freedom of exchange, competitive markets and limited government intervention. An economic system is simply a way that society structures how economic decisions will be made and resources will be allocated. Now, let's take a closer look at what a capitalistic system entails.Most property in a capitalistic economy is private. This means that individuals, instead of the government, own the factors of production. Factors of production are the things that we use to

make goods and services and include land, labor and capital. You also get to keep the profits from your economic activities. Since you get to keep what you earn, this tends to encourage risk-taking and innovation. If Tanya didn't have the right to the profits generated from sales of her smart watches, she may not bother to invest time, energy or money to take the risk and innovate.A second important feature of capitalism is freedom of exchange. An exchange is simply trading one resource for another. Nobody can force Tanya to sell her company. Moreover, nobody can be forced to buy Tanya's smart watches. And Tanya cannot force anyone to work for her.Instead, everybody in a capitalistic economy has the right to engage in exchanges or not engage in exchanges. People make exchanges according to their self-interest. If the deal isn't worth it to one of the parties, then the deal won't go through. In other words, if a potential customer doesn't think Tanya's smart watch is worth the price, he will not exchange money for it.The third primary feature of capitalism is competitive markets. A market is a place where buyers and sellers come together to engage in economic exchanges. A perfectly competitive market is characterized by a large number of sellers that offer identical products for sale and everybody has information that they need to make a rational decision regarding a potential exchange. If all products are the same, businesses must compete on price.Perfectly competitive markets seldom exist. Most markets are competitive markets and are characterized by a large number of businesses selling similar products with all participants having pretty good information. For example, Tanya isn't the only, or the largest, company coming up with smart watches.Limited government intervention in the economy is also a major characteristic of capitalism. This type of competitive market is often referred to as a free market. The government generally does not set the prices of goods or services - the market sets the price. And the government's regulatory role is pretty much limited to ensuring that there is a level and fair playing field. In other words, the government sets up the rules, so that no one has an unfair advantage in the market.

Market PriceWhile Tanya isn't subject to the government telling her the price at which she must sell her smart watch, she must bow to the law of supply and demand:• If all other things remain the same, as the quantity of a good or service supplied increases, the

price of it will decline.• If all other things remain the same, as the demand of a good or service increases, the price of

it will increase.• If all other things remain the same, the market price for a good or service is the price at which

the supply of it equals the demand for it. This price is often referred to as the 'equilibrium price' because it is the price where demand equals supply.

If the market price for Tanya's smart watch is lower than the costs for Tanya to produce it, she will lose money. That's the risk businesses take in a capitalistic economy. Tanya has a right to her profits but is also accountable for her losses.

Limits to CapitalismCapitalism isn't perfect. Markets are not perfectly competitive in the real world. Sometimes,

monopolies are created without government intervention. A monopoly exists where one firm controls the quantity of a good or service and can set the price as high as people are willing to pay.People can usually get what they want in free market capitalism - if they have the money. If they don't have money, they don't get to buy. This can include such things as food and shelter. A related criticism is the unequal distribution of wealth created by capitalism.Some disparity of wealth is not a bad thing necessarily because it provides an incentive for people to work hard, take risks and innovate. However, if there is too much disparity, it tends to make for an unequal playing field, as wealth tends to generate more wealth. In other words, in capitalism, it often takes money to make money.Unfettered self-interest advocated by pure capitalism can also be destructive. If the concern is only for maximizing a person's self-interest, poor labor conditions, environmental degradation and risks to consumer health and safety can occur.In reality, all economies are mixed economies. In the United States, for example, state and federal governments regulate the market to protect consumers, employees, investors and the environment. Taxes are imposed to pay for regulation, government goods and services and to redistribute some wealth so the poorest segments of society have a minimal level of resources to survive in a market economy.

Economists use two basic models to describe economic growth. In this lesson, you'll find out more about each one of these models using real-world examples. So buckle up your seatbelts!

The Keynesian Model and the Classical Model of the EconomyWe're talking about two models that economists use to describe the economy. Let's take a look at each one and the important assumptions behind them. Then we can look at them visually, using the laws of supply and demand.

Economic Output: The Long and Short of ItI want you to imagine that you're in the town of Ceelo, where Bob the business owner is taking the day off. He's decided to drive to Green Meadows, which is the next town over. To get there, Bob takes the expressway. It has three lanes on each side, and it's a very busy expressway. So just imagine that Bob enters the expressway.Now imagine you're inside of a helicopter far above the expressway, looking at it from a bird's-eye view. You can see the progress of every car on it, and you can see the movement on the expressway, like it's a big machine with moving parts. As you watch the traffic from above, you notice that the cars are going an average of 55 miles per hour. Why 55? Because there's a speed limit sign posted that says 55. If you're on this expressway, 55 is your potential speed. From time to time, however, the cars slow down. Let's look at two scenarios that would cause a slowdown.Imagine that traffic is slowing down on the expressway right now. Why is it slowing down? Because there are too many cars trying to get on at the same time. There's an influx of cars trying to merge on to the expressway ahead. What happens next? The average speed of the cars goes below 55 miles per hour as all of the cars behind slow down for a few minutes. This machine made up of individual cars goes below its potential. Eventually, though, this situation resolves itself when the extra cars get on to the expressway. The cars begin moving faster again,

and traffic returns to its potential of 55 miles per hour. Nothing is required to help the cars, they simply slow down for a little bit.Now let's look at another scenario. Imagine there's an accident between Ceelo and Green Meadows. A big business truck carrying products and services flips on its side and blocks the road. Fortunately, the driver is okay, and he gets out of the truck. However, the truck is blocking everyone from moving through. When this happens, it takes a long time before traffic is traveling at its potential speed again. In fact, traffic stops completely until the police arrive on the scene and tow trucks come and clear the accident from the road. Finally, even after a bad accident like this, traffic will start up again and it will reach its potential speed of 55 miles per hour. But there's no telling how long it would have taken to clear the accident without the help of the police and the tow trucks.Over the years, economists came up with two basic models of the economy. There are other variations of this, but these are the basic concepts. The first one's called the Classical Model.Guess when that started? A long time ago, in a galaxy far, far away. When you hear the words 'Classical Model' you can also think of Beethoven wearing that really weird wig. It's an old model, very old. The other model is called the Keynesian Model, named after the famous economist John Maynard Keynes. This is a newer model. When you hear the word 'Keynesian' just think of the Great Depression, because this model came about as a result of the Great Depression.Economist John Maynard Keynes

The Classical ModelThe Classical Model was popular before the Great Depression. It says that the economy is very free-flowing, and prices and wages freely adjust to the ups and downs of demand over time. In other words, when times are good, wages and prices quickly go up, and when times are bad, wages and prices freely adjust downward.The major assumption of this model is that the economy is always at full employment, meaning that everyone who wants to work is working and all resources are being fully used to their capacity. The thinking goes something like this: if competition is allowed to work, the economy will automatically gravitate toward full employment, or what economists call potential output - just like the expressway at an average speed of 55 miles per hour. Remember what happened when traffic slowed down because there were too many cars? After a few minutes, everything went back to normal. Classical economists believe that the economy is self-correcting, which means that when a recession occurs, it needs no help from anyone. So that's the Classical Model.

The Keynesian ModelA second model is called the Keynesian Model. As I said before, this model came about as a result of the Great Depression. Economist John Maynard Keynes observed that the economy is not always at full employment. In other words, the economy can be below or above its potential. During the Great Depression, unemployment was widespread, many businesses failed and the economy was operating at much less than its potential.Think back to the expressway that Bob was driving on. Picture Bob behind the wheel, when the business truck fell on to its side and traffic came to a complete standstill for a long time. It was stuck until the police and the tow truck came. When economist John Maynard Keynes was observing the Great Depression, he realized that the economy could be well below its potential for a long time, and that something was causing it to get stuck. It may be self-correcting like the classical economists were saying, but it was taking way too long. In the meantime, people were losing jobs and were suffering. Keynes believed that the government and monetary leaders should do something to help the economy along in the short run, or the long run may never come. In fact, he is quoted as saying 'In the long run, we are all dead.'Most of us can identify with this idea when we think about the economy. Sometimes the economy is strong and sometimes it's weak. This is exactly what Keynes' model recognizes. The economy may start out in a state of balance in which everyone is fully employed, but strong demand for products and services temporarily pulls the economy above the full employment level. This is what economists call an expansion. When weaker demand temporarily pulls the economy below the full employment level, economists call that a recession.When the economy falls below its full employment potential, the situation is known as a recession

Classical vs. Keynesian Model: Which is Correct?So, we have two models of economic growth. The Classical Model says that the economy is at full employment all the time and that wages and prices are flexible. The Keynesian Model says that the economy can be above or below its full employment level and that wages and prices can get stuck. So, which model is the correct model?Just think about the expressway again for a moment. If you watch the expressway for a long time, you'll notice that from time to time, too many cars try to enter the expressway at once, and traffic slows down. This happens more frequently, but when it does, traffic returns to its potential speed of 55 miles per hour without any help. Once in a long while, there's a major accident though. It doesn't happen very often, but when it does, chances are, if the police and the tow trucks don't show up, it could take a really long time before traffic returns to its potential speed of 55 miles per hour.

When it comes to these two economic models, both of them are correct, because they're describing the economy at two different points in time. The Classical Model does a great job of describing the economy in the long run - where resources are fully employed and everyone is working. The Keynesian Model does a great job of describing what happens when there's a recession and people are out of work or when the economy is temporarily overheating and a shortage of workers takes place.

Lesson SummarySo let's review the key points from this lesson:These are the two basic models of the economy: the Classical Model and the Keynesian Model.The Classical Model was popular before the Great Depression. It says that the economy is very free-flowing, and wages and prices freely adjust to the ups and downs of demand over time. In other words, wages and prices are flexible. It also says the economy is always at full employment, what economists call potential output. Classical economists believe that the economy is self-correcting, which means that when a recession occurs, it needs no help from anyone.The Keynesian Model came about when economist John Maynard Keynes observed that the economy is not always at full employment. In other words, the economy can be below or above its potential. Keynes believed that governments and monetary leaders should do something to help the economy in the short run, or the long run may never come. In fact, he is quoted as saying, 'In the long run, we are all dead.'Which one of these models is the correct model of the economy?Both of them are correct, because they are describing the economy at two different points in time. The Classical Model describes the economy in the long run - where resources are fully employed and everyone is working. The Keynesian Model describes what happens during expansions and recessions, in the short run, when the economy is above or below its potential.

Short BiographyJohn Maynard Keynes was a British economist who lived from 1883 - 1946. Keynes' economic theories had a significant influence on policy in Europe and America during and after the Great Depression. Professionally, Keynes spent time as an economics lecturer at Cambridge and as an employee of the British government working in India. While both experiences played an important role in Keynes' career, it was his writings while at Cambridge that gave him the exposure that would allow him to ultimately influence government policies around the world.

Economic TheoryPrior to Keynes, most European economies - and certainly the United States' - had relied on Adam Smith's theory of free markets and the invisible hand. For the most part, the growth of capitalism was good to the countries that used it; just as it was supposed to, it provided the incentive for innovation and hard work. But, it also created a boom and bust cycle that meant every few years the economy would shrink, costing people their jobs and wealth. Keynes thought there might be a better way for governments to be involved in the economy that could help smooth out the economic cycle that led the busts.Keynes suggested that governments should take an active role in managing the economy. He believed that by being involved in the bond market, both as a seller and a buyer, governments

could influence interest rates. By influencing interest rates, governments could encourage or discourage consumers from saving money. If the economy was struggling, the government could buy bonds, making interest rates drop. Since people wouldn't be able to make much money on their savings, and because they could borrow money so cheap, there would be more spending, and thus, economic growth.On the other hand, if the economy started to grow too fast and inflation became a concern, the government could sell bonds, taking money out of the system and forcing rates higher, encouraging people to save rather than spend. Keynes' idea required constant monitoring and action by a centralized bank, but he strongly believed that involvement could eliminate, or at least seriously minimize, the severity and frequency of economic busts.

During World War I Britain and the United States suspended the gold standard - a monetary policy aimed at controlling inflation that set a limit on the amount of currency a country could print to the value of the gold they held. After World War I both countries went back to the gold standard, but Keynes argued that was a bad idea. Again, Keynes was pro-government intervention in the economy, and having currency tied to a standard limited what governments could do. The impact of Keynes' theories are clear today as the gold standard is no longer used anywhere in the world, and central banks play a huge role in domestic and international economies.

Keynesian EconomicsKeynes' theories focused on the role government could, and should, play in managing fiscal policy to help foster sustainable economic growth. Keynes was supportive of government intervention, so the name of economic theories that encouraged government involvement in the economy became known as Keynesian Economics.Reception of Keynesian economics has varied over the past century. During his lifetime, Keynes was very involved in helping Britain establish economic policy and other European countries and the United States applied many of his theories. Especially after the Great Depression, the idea that the government could help eliminate, or at least minimize the impact of, economic busts was very popular. It remained a popular idea until the late-1970s, when the

ideas of Milton Friedman, the ideologies of world leaders like Margaret Thatcher and Ronald Reagan, and the fear of big government that came from the post-Cold War USSR all emerged to cast a cynical shadow over government involvement in any aspect of the economy.As you might expect, after the 'Great Recession' and financial crisis of 2007-2008, there was a resurgence of interest in Keynesian thought. Movements like the 'Occupy Wall Street' became a voice for a growing group of citizens that were trying to take care of themselves but couldn't find a job to do it, all while CEOs and Wall Street traders made millions on millions in bonuses. Once again, many saw the invisible hand holding down the masses and lifting up a select few. The extent to which the popularity of Keynesian thought makes its way into policy is yet to be seen.

Final ThoughtsDepending on the economic environment at any given time, popular opinion may follow Keynesian thought or may take on a more laissez-faire flavor (no government involvement). To find the best solution, managers, citizens, and policymakers need to understand the principles behind each approach to a capitalist economy. In this lesson you learned about one side of that - the side based on the thoughts and theories of John Maynard Keynes.

In this lesson, you'll learn how the government uses stabilization policy to smooth out the ups and downs of the business cycles. In stark opposition to the classical approach, this Keynesian approach favors taking immediate action to stabilize a troubled economy.

A President Reacts to a Faltering EconomyOn February 17, 2009, President Barack Obama signed into law the American Recovery and Reinvestment Act. Enacted by the 111th Congress of the United States, it was designed to address one of the biggest crises since the Great Depression. With great intentions to create jobs quickly, the act called for $787 billion of additional government spending and tax benefits for consumers and businesses.Although this was a predictable government response to crisis at hand, economist and Nobel laureate Paul Krugman criticized the act for being too weak of a response. And although the recession, which started in 2007, officially ended in June of 2009, the unemployment rate was still high for some time after the President pursued this fiscal policy - something that happens quite frequently.

What Is Fiscal Policy?The word 'fiscal' means 'budget' and refers to the government's budget. Fiscal policy is the use of government spending, taxation or transfer payments to influence economic output, which economists measure using real GDP, or gross domestic product. You can listen to one of the lessons on gross domestic product to learn more about that. Fiscal authorities attempt to stabilize the economy during its ups and downs, and in the process, they face challenges.For the rest of this lesson, we'll learn what stabilization policy is, how it works and what some of these challenges are. Aggregate demand is the total of goods and services produced during the year. When the government uses fiscal policy to stimulate aggregate demand, economists call it expansionary fiscal policy. On the other hand, when the government uses fiscal policy to reduce aggregate demand, this is called contractionary fiscal policy.Now, I want you to imagine something with me. Let's say that an old man by the name of Sam

is sick. Sam oversees a vast economy of small businesses, corporations and non-profit organizations. When Sam does well, they do well and vice versa. Right now, Sam is lying in the bed at his residence, which happens to be in the Rocky Mountains.Sam has several assistants, who work for him, to try to keep him safe and healthy and allow him to do as much work as possible, even though he's getting old. After a brief argument, Sam's assistant calls for medical help. However, she calls two doctors, because she wants two opinions about Sam's condition. She wants to know what, if anything, should be done to help Sam.Now I want you to fast forward with me. There are two doctors standing on each side of Sam's bed. One doctor was educated at the highly theoretical free market college of inner healing in Austria, while the other doctor was educated at the college of interventional internal medicine of the United Kingdom. They both examine Sam, they take his vitals and evaluate his physical condition by assessing the symptoms he's presenting at the moment - but, as usual, it's always more enjoyable to hear an explanation from an expert with a British accent.So, what's going on with Sam? He's losing weight, he may have a fever and he is definitely coughing incessantly throughout the day and night and having trouble breathing clearly. Oh my word. The first doctor looks at Sam, and then at the other doctor, and says 'Sam has a virus. This is the common cold and there's nothing we can do for him. This cold just has to run its course. His body will take care of itself, because that's the way it was created. Let Sam go, tell him to rest and eventually, he'll get strong again.'Now, the second doctor looks at Sam, and then looks at the first doctor, and with an exquisite British accent, he says, 'The patient is very sick. He has a major infection, and if something isn't done to help him, some of his organs may stop working.' At this point, in the back of Sam's mind, he's thinking about all the businesses and organizations that could be affected by such a scenario, and the hundreds of thousands of people who could lose their jobs because he's not doing well.So here we have one patient and two doctors. One set of symptoms and two experts with two opinions - opinions that don't agree on what should be done. These two doctors don't agree because each of them has a different perspective, probably based on where they were educated. Doctor #1 believes Sam's body will take care of itself and recommends that everyone else leave the room and stay out of Sam's way. Doctor #1 prescribes absolutely nothing.On the other hand, doctor #2 believes that Sam needs immediate intervention, and prescribes the strongest antibiotic on the market, in addition to a heavy dose of corticosteroids to open up his lungs and give him more strength and help him breathe better. Doctor #2 prescribes taking immediate action to speed up Sam's metabolism and defeat this infection.So, which doctor has the correct diagnosis and prescription? Perhaps it's hard to tell. Let's suppose in this lesson that doctor #2, who believes in taking immediate action, wins the battle of the minds and influences Uncle Sam's assistants long enough to start treatment right away.Now you have a mental image of how economists view the government's role, and what the government should do during two extremes: on the one hand, recession, and on the other hand, high inflation. Some economists believe in the free market, and tend to prescribe doing nothing to fix the economy, while other Keynesian economists believe in taking immediate action.

The Keynesian Revolution: How Fiscal Policy Began

The Keynesian approach is based on the work of John Maynard Keynes

In 1936, the Keynesian Revolution began with John Maynard Keynes' book The General Theory of Employment, Interest and Money. Much of what you're learning in macroeconomics, as a matter of fact, is based on his thinking and ideas. Since that time, many presidents have followed the advice of their council of economic advisors and used fiscal policy to address recessions and inflation.In economics, there are basically two major approaches to how the government should deal with recessions - the Keynesian approach and the Classical approach. Fiscal policy is a Keynesian thing - not a Classical thing. Classical economists believe the government should do nothing to help the economy during a downturn or an inflationary gap, because the self-correcting forces, they believe, of the free market, will adjust and restore employment without any help. This classical mindset was the prevailing economic view before the Great Depression. These days, the opposite perspective is most commonly held.Keynesian economists believe that recessions occur because economic output is too low, and inflation occurs because economic output is too high. They believe the government, like a doctor, should use its toolkit to treat the economy by deliberately influencing aggregate demand. Their view is one of having the opportunity, and perhaps even the duty, to try to help people when they are out of work, and also to try to keep inflation from getting out of control and stealing the value of our dollar. So when President Obama used fiscal policy in 2009, he was obviously following the advice of his economic advisors, who believe in the Keynesian approach.

Stabilization PolicySo far, we've talked about what fiscal policy is, and we've looked at the two opposing viewpoints, or approaches to the economy. We saw that President Obama used expansionary fiscal policy to fight a recession in 2009, and that one of his economic advisors pleaded with him to even increase the size of the additional government spending. Everything we've talked about so far goes under the umbrella of what economists call 'stabilization policy.'The economy doesn't always grow every year. It experiences recessions and expansions in a pattern of ups and downs that economists call the business cycle. Like doctor #2 in the earlier illustration, the government must accurately forecast interest rates before it can influence them to smooth out the business cycle - this is what economists often refer to as stabilization policy. If you'd like to learn more about that, you can check out my lesson on stabilization policy.

Lesson SummaryOkay, it's time to review. The government uses a fiscal policy toolkit, like a doctor, to administer policies, such as increased government spending, lower taxes or higher unemployment benefits that help strengthen aggregate demand when it's weak. When the economy is overheating with inflation, fiscal policy does the opposite and slows down economic growth to address the problem of inflation.When the government uses fiscal policy to stimulate aggregate demand, which is the total goods and services produced during the year, economists call this expansionary fiscal policy. On the other hand, when the government uses fiscal policy to reduce aggregate demand, they call this contractionary fiscal policy.