Chapter 2

Free Enterprise in The United States


Pillars of the Free Enterprise System
Traditional economies
Command economies
Market economies
Money's functions

Regardless of political systems, to operate efficiently a market system must have five components:

Freedom to Choose Our Businesses

In this country, the decision whether or not you should go into computer services or any other kind of enterprise (business) is basically yours alone to make. You will decide what fees to charge and what hours to work. Certain laws prohibit you from cheating or harming your customers or other people. But, in general, you will be left alone to run your business as you see fit.

Right to Private Property

Private property is a piece of land, a home, or a car owned by an individual, a family, or a group. It differs from a public building, or public property, such as the city hall, a park, or a highway, all of which provide a government service for all citizens. In the U.S. economic system, people's right to buy and sell private property is guaranteed by law. People must use the property in safe and reasonable ways, of course. In setting up computer systems for your customers, for example, you do not have the right to interfere with the electrical, telephone, or computer systems of other people.

Profit Motive

The main reason why you or any enterprising person organizes a business is to make money. You do this by earning more money than you spend. The amount of money left over after subtracting your business expenses from your business income is known as your profit. In the free enterprise system, business firms try hard to keep costs down and increase their income from sales. The better they succeed at this, the higher are their profits. Economists describe the efforts by business firms to earn the greatest profits as the profit motive.


Just as you are free to start a computer business, so is everyone else. The rivalry between sellers in the same field for consumers' dollars is called competition. If your business is profitable, it is likely that others will enter the same business hoping to be as successful as you are. They will be competing with you for the same customers. To win a share of the computer business, other sellers may try to offer more and better services, or services at lower prices. Because of the pressure of competition, business firms must constantly try to provide the best services and create the best products at the lowest possible prices.

 Consumer Sovereignty

In the end, it is the customers, or consumers, who determine whether any business succeeds or fails. In the U.S. free enterprise economy, consumers are said to have sovereignty-the power or freedom to have final say. Consumers are free to spend their money for Product X or for Product Y. If they prefer Y over X, then the company making X may lose money, go out of business, or decide to manufacture something else (perhaps Product Z). Thus, how consumers choose to spend their dollars causes business firms of all kinds to produce certain goods and services and not others.

The Pillars of the Free Enterprise System

We have said, all nations must answer the question of scarcity. All nations and societies must allocate their resources in order to meet their needs. This is where the essential dilemma between unlimited wants and limited needs comes into play. We have also noted that all nations must make choices. This is a matter of resource allocation. When we allocate limited resources we make choices. The cost of these choices is known as opportunity cost. When making these choices and dealing with scarcity, resource allocation and opportunity cost nations are answering what we have previously referred to as the three basic economic questions. These are are the questions all nations must ask when dealing with scarcity and efficiently allocating their resources. They are:

Free Enterprise at Work: The Circular Flow Model

The American free enterprise (capitalist) system is a wonder of wonders. Just how do we ensure that all of our citizens needs are provided for? How do we make sure that we produce what we need and that those goods are allocated fairly (distribution). Of course I am referring to the three basic economic questions. So, just how do we ensure they are being answered properly. Well, the reality is, we don't!

In America, and in all basically capitalist systems we rely on a rather complex theoretical model to tell us this whole free enterprise thing works. This model is called the Circular Flow Model. What the circular flow model tells us is that three basic elements of the economy will work and interact together to ensure that our needs and wants are provided for.

There are three basic elements, or what are referred to as sectors, of the economy that must interact. These sectors are:

Circular flow basically shows us that input from each sector and to each sector spurs on production and thus goods and services are created. Here is a graphical representation of circular flow:


As you can see, each sector of the economy feeds another. Households (consumers) provide businesses with payments in exchange for jobs and goods and services. Government provides consumers and businesses with payments in exchange for goods and services from business and taxes and resources from consumers. It is what is called a symbiotic relationship. We all rely upon one another.

Is the circular flow model complete? No, nor is it meant to be. It is merely a theory that explains how free enterprise works. Banks for example, a very important part of the economy, are left out.

Some societies do not accept the circular flow model theory. These societies, therefore, choose another economic system other than capitalism. Socialists and communists see the role of the government in a different light than capitalists do. They see a government that must in some cases should provide for all needs (command) and in other cases provide for some needs (socialist). They do not trust that this will all just work out the way the theory says it will.

Does circular flow work? The answer is yes and no. Yes, in that we are a wealthy, productive society. No, in that there are some citizens who fall through the cracks and do not have their needs met. We try to help them and thus move closer to socialism and increase the role of government. This is why we are really a mixed economy and not a pure capitalist economy.

Each nation and society thus must make choices and decisions based upon there own values. If a society values meeting more wants and needs at the expense of freedom of choice then they may choose a system radically different then our own. Thus we have seen the creation of a variety of economic systems.

Economic systems are divided up into three basic types. These types are:

Traditional Economic System

A traditional economic system is one in which people's economic roles are the same as those of their parents and grandparents. Societies that produce goods and services in traditional ways are found today in some parts of South America, Asia, and Africa. There, people living in an agricultural village still plant and harvest their own food on their own land. And the ways they produce clothing and shelter are almost exactly the same as those used in the past. Tradition decides what these people do for a living and how their work is performed.

Market Economic System

A market economic system is one in which a nation's economic decisions are the result of individual decisions by buyers and sellers in the marketplace. The U.S. has a market economic system. When you finish school, you may go to work where you choose, if a job is open. You are also free to go into business on your own. Suppose that you decide to open a business. You will risk the money that you have saved or borrowed in the hope that you will be successful. The price that you charge for your goods or services will be influenced by the prices charged by your competitors (other businesses selling the same items). The success that you have will depend on the demand by consumers for your goods. You may do extremely well. But if people do not want what you are selling, you will go out of business.

Command Economic System

In a command economic system, the main decision maker is the government. No person may independently decide to open and run any kind of business. The government decides what goods and services are to be produced. And the government sells these goods and services. The government also decides how the talents and skills of its workers are to be used.


We have classified economic systems according to the way they answer three basic questions of what, how, and who. A fourth question that should be asked is, "Who owns the means of production?" An economy's means of production are its capital: factories, farms, shops, mines, and machinery. The means of production are used to produce other goods and services.

If the government owns and operates almost all of the nation's means of production, then that nation's economic system is called communism. China has a communist economic system. Almost all of the means of production are publicly owned-that is, owned by the government. Government planners decide the answers to the basic economic questions. Farming on private plots of land is sometimes allowed. In recent years, the Chinese government has been allowing more and more private businesses to operate.

If the government owns and operates many of the nation's major industries-such as banks, airlines, railroads, and power plants-but allows individuals to own other businesses, including stores, farms, and factories, that nation's economic system is called socialism.

Sweden is an example of a country whose economic system is often described as socialist. Most of its major industries, such as coal mining, electric power, gas, telephone, and railroads, are owned by the government. Under Sweden's national health insurance system, the people receive free medical services all their lives.

If almost all the stores, factories, and farms in a nation are owned and operated by private individuals or businesses, then its system is called free enterprise, or capitalism. The U.S. has a free enterprise, or capitalist, economic system.

No country has an economic system that is 100 percent communism, socialism, or capitalism. All countries today have mixed economic systems or mixed economies, with some free enterprise and some government ownership.

In the U.S., as in most capitalist countries, there are many examples of government ownership. Public colleges, high schools, and elementary schools, for example, are owned and operated by state or local governments. Other publicly owned enterprises are the postal service, many municipal bus lines and trains, a few electric power plants, and housing projects.


Medium of exchange:  It is used to trade for goods and services.

Store of value: It is used to save wealth for a future time.

Standard of value: It is used to compare the worth of one product with that of another

Our economy was not invented, it evolved.  Ever since this evolution started people have been interested in how it worked and why.  One of the most famous of these people was Adam Smith.  His studies were written about in his published book, The Wealth of Nations (1776).  His studies of course were those in the field of economics.  He was the first that tried to explain the market system.  Smith believed that each producer and consumer would make economic decisions based on self-interest. (Given a choice between two similar products, a consumer would choose the less expensive item. Producers would prefer to supply items that consumers will buy rather than those they will not buy.)  Individuals acting in self-interest would compete, or try outdo one another.  (Consumers would compete with one another to purchase the best goods for the lowest prices.)  The result of competition would be that everybody would get wanted goods and services.  Then, the best interests of the entire society would be met.  Smith said that the market economy seemed to be controlled by an “invisible hand.”  He meant that each individual who “intends only his own gain” is “led by an invisible hand to promote an end which was no  part of his intention.....By pursuing his own interests he frequently promotes that of society....”



1. Full Employment: There should be a job for everyone ready, willing and able to work.

2. Economic Growth: The average living standard should improve as the output of goods and services increases.

3. Price Stability: There have been times when prices, in general, increased, or decreased rapidly.  Such times create hardships in many sectors of the economy.   Most prices should remain relatively constant over time.

4. Economic Freedom: Everyone should have a high decree of freedom to choose how to earn a living and how to spend their money.

5. Economic Security: For whatever reason-physical handicap, old age, accidental injury-there are people who are unable to pay their own way.  Economic security means that their needs should be met.

6. Equity: Equity requires being fair or impartial.  the economic system should offer all citizens equal economic opportunity.

7. Efficiency: Efficiency is a measure of how much one gets for what one uses.  Economic efficiency refers to the entire economy's ability to get the most out of its limited resources.