Capitalism, a term of disparagement coined by socialists in the midnineteenth century, is a misnomer for "economic individualism," which Adam Smith earlier called "the obvious and simple system of natural liberty." Economic individualism's basic premise is that the pursuit of self-interest and the right to own private property are morally defensible and legally legitimate. Its major corollary is that the state exists to protect individual rights. Subject to certain restrictions, individuals (alone or with others) are free to decide where to invest, what to produce or sell, and what prices to charge, and there is no natural limit to the range of their efforts in terms of assets, sales and profits, or the number of customers, employees, and investors, or whether they operate in local, regional, national, or international markets.

The emergence of capitalism is often mistakenly linked to a Puritan work ethic. German sociologist Max Weber, writing in 1903, located the catalyst for capitalism in seventeenth-century England, where members of a religious sect, the Puritans, under the sway of John Calvin's doctrine of predestination, channeled their energies into hard work, reinvestment, and modest living, and then carried these attitudes to New England. Weber's thesis breaks down, however. The same attitudes toward work and savings are exhibited by Jews and Japanese, whose value systems contain no Calvinist component. Moreover, Scotland in the seventeenth century was simultaneously orthodox Calvinist and economically stagnant.

A better explanation of the Puritans' diligence is that by refusing to swear allegiance to the established Church of England, they were barred from activities and professions to which they otherwise might have been drawn—land ownership, law, the military, civil service, universities—so they focused on trade and commerce. A similar pattern of exclusion or ostracism explains why Jews and other racial and religious minorities in other countries and later centuries tended to concentrate on retail businesses and money lending.

In early nineteenth-century England the most visible face of capitalism was the textile factories that hired women and children. Critics (Richard Oastler and Robert Southey, among others) denounced the mill owners as heartless exploiters. They described the working conditions—long hours, low pay, monotonous routine—as if they were unprecedented. Believing that poverty was new, not merely more visible in crowded towns and villages, critics compared contemporary times unfavorably with earlier centuries. Their claims of increasing misery, however, were based on ignorance of how squalid life actually had been earlier. Before children began earning money working in factories, they had been sent to live in parish poorhouses, apprenticed as unpaid household servants, rented out for backbreaking agricultural labor, or became beggars, vagrants, thieves, and prostitutes. The precapitalist "good old days" simply never existed (see Industrial Revolution and the Standard of Living).

Nonetheless, by the 1820s and 1830s the growing specter of child labor and "dark satanic mills" generated vocal opposition to these unbridled examples of self-interest and the pursuit of profit. Some critics urged legislative regulation of wages and hours, compulsory education, and minimum-age limits for laborers. Others offered more radical attacks and alternatives. The most vociferous were the socialists, who aimed to eradicate individualism, the name that preceded capitalism.

Socialist theorists repudiated individualism's leading tenets: that individuals possess inalienable rights, that society should not restrain individuals from pursuing their own happiness, and that economic activity should not be regulated by government. Instead, they proclaimed an organic conception of society. They stressed ideals such as brotherhood, community, and social solidarity and set forth detailed blueprints for model utopian colonies in which collectivist values would be institutionalized.

The short life span of these utopian societies acted as a brake on the appeal of socialism. But its ranks swelled once Karl Marx offered a new "scientific" version, proclaiming that he had discovered the laws of history and that socialism inevitably would replace capitalism. Beyond offering sweeping promises that socialism would create economic equality, eradicate poverty, end specialization, and abolish money, Marx supplied no details at all about how a future socialist society would be structured or operate.

Even nineteenth-century economists—in England, America, and Western Europe—who were supposedly capitalism's defenders, did not defend capitalism effectively because they did not understand it. They came to believe that the most defensible economic system was one of "perfect" or "pure" competition. Under perfect competition all firms are small scale, products in each industry are homogeneous, consumers are perfectly informed about what is for sale and at what price, and all sellers are what economists call price takers (that is, they have to "take" the market price and cannot charge a higher one for their goods).

Clearly, these assumptions were at odds with both common sense and the reality of market conditions. Under real competition, which is what capitalism delivered, companies are rivals for sales and profits. This rivalry leads them to innovate in product design and performance, to introduce cost-cutting technology, and to use packaging to make products more attractive or convenient for customers. Unbridled rivalry encourages companies to offer assurances of security to imperfectly informed consumers, by means such as money-back guarantees or product warranties and by building customer loyalty through investing in their brand names and reputations (see Advertising and Brand Names).

Companies that successfully adopted these techniques of rivalry were the ones that grew, and some came to dominate their industries, though usually only for a few years until other firms found superior methods of satisfying consumer demands. Neither rivalry nor product differentiation occurs under perfect competition, but they happen constantly under real flesh-and-blood capitalism.

The leading American industrialists of the late nineteenth century were aggressive competitors and innovators. To cut costs and thereby reduce prices and win a larger market share, Andrew Carnegie eagerly scrapped his huge investment in Bessemer furnaces and adopted the open hearth system for making steel rails. In the oil-refining industry John D. Rockefeller embraced cost cutting by building his own pipeline network, manufacturing his own barrels, and hiring chemists to remove the vile odor from abundant, low-cost crude oil. Gustavus Swift challenged the existing network of local butchers when he created assembly-line meat-packing facilities in Chicago and built his own fleet of refrigerated railroad cars to deliver low-price beef to distant markets. Local merchants also were challenged by Chicago-based Sears Roebuck and Montgomery Ward, which pioneered mail-order sales on a money-back, satisfaction-guaranteed basis.

Small-scale producers denounced these innovators as "robber barons," accused them of monopolistic practices, and appealed to Congress for relief from relentless competition. Beginning with the Sherman Act (1890), Congress enacted antitrust laws that were often used to suppress cost cutting and price slashing, based on acceptance of the idea that an economy of numerous small-scale firms was superior to one dominated by a few large, highly efficient companies operating in national markets (see Antitrust).

Despite these constraints, which worked sporadically and unpredictably, the benefits of capitalism were widely diffused. Luxuries quickly were transformed into necessities. First, the luxuries were cheap cotton clothes, fresh meat, and white bread; then sewing machines, bicycles, sporting goods, and musical instruments; then automobiles, washing machines, clothes dryers, and refrigerators; then telephones, radios, televisions, air conditioners, and freezers; and most recently, microwave ovens, videocassette recorders, answering machines, personal computers, sophisticated cameras, and compact disc players.

That these amenities had become available to most people did not cause capitalism's critics to recant, or even relent. Instead, they ingeniously reversed themselves. Marxist philosopher Herbert Marcuse proclaimed that the real evil of capitalism is prosperity, because it seduces workers away from their historic mission—the revolutionary overthrow of capitalism—by supplying them with cars and household appliances, which he called "tools of enslavement." Some critics reject capitalism by extolling "the simple life" and labeling prosperity as mindless materialism. Critics such as John Kenneth Galbraith and Vance Packard attacked the legitimacy of consumer demand, asserting that if goods had to be advertised in order to sell, they could not be serving any authentic human needs. They charged that consumers are brainwashed robots of Madison Avenue who crave whatever the giant corporations choose to produce and advertise. They complained that the "public sector" was being starved while frivolous private desires were being satisfied. And having seen that capitalism reduced poverty, instead of intensifying it, critics such as Gar Alperovitz and Michael Harrington proclaimed equality as the highest moral value, calling for higher taxes on incomes and inheritances to massively redistribute wealth, not only nationally but also internationally.

Other critics (like Ralph Nader and Mark Green) focused their fire on giant corporations, charging that they are illegitimate institutions because they do not conform to the model of small-scale, owner-managed firms that Adam Smith extolled in 1776. In fact, giant corporations are fully consistent with capitalism, which does not imply any particular configuration of firms in terms of size or legal form. They attract capital from thousands (sometimes millions) of investors who are strangers to each other and who entrust their savings to the managerial expertise of others in exchange for a share of the resulting profits.

In an influential 1932 book, The Modern Corporation and Private Property, Adolf A. Berle, Jr., coined the phrase "splitting of the atom of ownership" to lament the fact that investment and management had become two distinct elements. In fact the process is merely an example of the specialization of function or division of labor that occurs so often under capitalism. Far from being an abuse or defect, giant corporations are an eloquent testimonial to the ability of individuals to engage in large-scale, long-range cooperation for their mutual benefit and enrichment.

As noted earlier, the freedoms to invest, to decide what to produce, and to decide what to charge have always been restricted. A fully free economy (true laissez-faire) never has existed, but governmental authority over economic activity has sharply increased since the eighteenth century, and especially since the Great Depression. Originally, local authorities fixed the prices of necessities, such as bread and ale, bridge and ferry tolls, or fees at inns and mills, but most products and services were unregulated. By the late nineteenth century governments were setting railroad freight rates and the prices charged by grain elevator operators, because these businesses had become "affected with a public purpose." By the 1930s the same criterion was invoked to justify price controls over milk, ice, and theater tickets.

Simultaneously, from the eighteenth century on, government began to play a more active, interventionist role in offering benefits to business, such as tax exemptions, bounties or subsidies to grow certain crops, and tariff protection so domestic firms would devote capital to manufacturing goods that otherwise had to be imported. Special favors became entrenched and hard to repeal because the recipients were organized while consumers, who bore the burden of higher prices, were not.

Once safe from foreign competition behind these barriers to free trade, some U.S. producers—steel and auto manufacturers, for example—stagnated. They failed to adopt new technologies or to cut costs until low-cost, low-price overseas rivals—the Japanese, especially—challenged them for their customers. They responded initially by asking Congress for new favors—higher tariffs, import quotas, and loan guarantees—and pleading with consumers to "buy American" and thereby save domestic jobs. Slowly, but inevitably, they began the expensive process of catching up with foreign companies so they could try to recapture their domestic customers.

Today the United States, once the citadel of capitalism, is a "mixed economy" in which government bestows favors and imposes restrictions with no clear or consistent principle in mind. As Soviet Russia and Eastern Europe struggle to embrace free-market ideas and institutions, they can learn from American (and British) experience about not only the benefits that flowed from economic individualism, but also the burden of regulations that became impossible to repeal and trade barriers that were hard to dismantle. If the history of capitalism proves one thing, it is that the process of competition does not stop at national borders. As long as individuals anywhere perceive a potential for profits, they will amass the capital, produce the product, and circumvent the cultural and political barriers that interfere with their objectives.