Free enterprise

Chapter 3

CHAPTER 3: SECTION 1

Characteristics of Free EnterpriseHow Does Free Enterprise Answer the Three Economic

Questions?In a free enterprise economy, business firms will produce the goods that consumers want to buy. For example, General Motors and Ford Motor Company decide what style and make of cars they will produce based on what they think the car-buying public wants to buy.The individuals who own and manage the business firms decide how goods will be produced.

In a free enterprise economy, goods are produced for people who are both willing and able to buy them. For example, a person may have $1,000 to spend on a new computer, but be unwilling to replace his or her old computer. In this case, the potential buyer is able, but not willing, and a sale will not take place.

Free Enterprise

In a free enterprise system, individuals own most, if not all, of the resources.

Five Features of Free EnterprisePrivate property can be described as any good that is owned by an individual or a business, such as a car, a house, or a piece of machinery. Any good that is owned by the government is referred to as public property.

• Sometimes the government may have a need for private property. Under the right of eminent domain, the government can take ownership of private property even without the consent of the owner. In such cases, the government will compensate owners for their loss. Eminent domain has been used to obtain private land for such uses as building new schools, highways, and government buildings.

Freedom of Choice.

• Workers have the right to choose what work they want to do and whom they will work for. Businesses have the right to choose the products they will produce and offer for sale. Likewise, buyers have the right to choose the products they will buy.

Voluntary Exchange• In free enterprise, individuals have the right to

make exchanges or trades that they believe will make them better off. Trading $10 cash for a book is an example of a voluntary exchange.

Competition• Free enterprise also gives way to competition.

Consumers are likely to benefit from competition between sellers. Workers can also benefit from competition. The competition between employers for labor services will often result in higher wages.

Economics Incentives• Under free enterprise, money acts as an incentive to

produce. If you produce goods and services that people are willing and able to buy, you receive money in return.

Laws, Institutions, and RegulationsA country’s legal system determines, to a large degree, how free enterprise operates.Legal systems and institutions can either help or hinder free enterprise.

The Circular FlowThe circular flow of economic activity in the U.S. economy shows the relationship among the key players in the economy.Households sells resources to businesses, and businesses pay for these resources.Businesses sell goods and services to households, and households pay for these goods and services.Households pay taxes to government, and government provides goods and services to households, such as roads, schools and national defense.Businesses pay taxes to government, and government provides goods and services to businesses.

The Circular Flow of Economic Activity

The circular diagram is useful because it helps us see how a change in one economic activity (such as paying taxes) will lead to a change somewhere else in the economy (such as the amount households spend on goods and services produced by businesses).

CHAPTER 3: SECTION 2

Profit and Loss in Free EnterpriseProfits and Losses

Profit equals total revenue (price of a good times the units of the good sold) minus total cost (average cost of a good times the number of units of the good sold).

Profit is the amount of money left over after all the costs of production have been paid. Profit exists whenever total revenue is greater than total cost.

A loss occurs when the total cost exceeds total revenue.

Profits and LossesTOTAL REVENUE=

price of a good x number of units sold

TOTAL COST=

average cost of a good x number of units sold

PROFIT = total revenue > total cost

LOSS = total cost > total revenue

For example, suppose you sell 10 headphones at $100 each, for a total revenue of $1,000. If it costs you an average of $70 each to produce those headphones, your total cost to produce 10 headphones is $700. Do you have a profit or a loss on your sale of 10 headphones?

Answer: Profit of $300

Profit and Loss as “Signals”

In a free enterprise economy, some businesses are earning profits and some are taking losses. Profits and losses are

1. signals to the firms actually earning the profits or taking the losses, and

2. signals to firms standing on the sidelines

A firm on the sidelines will see what product is profitable and possibly enter that market.

A firm may discontinue a product that is producing losses, and reallocate its resources to a profitable product.

Resources flow toward profit and away from losses.

CHAPTER 3: SECTION 3

The Ethics of the Free Enterprise SystemEthics and Free Enterprise

Ethics consists of the principles of CONDUCT, such as right and wrong, morality and immorality, and good and bad.An ethical economic system should have four characteristics. Supporters of free enterprise say that the free enterprise economic system has these characteristics.

• Allow individuals to CHOOSE their own occupations or professions.

• Produce the goods and services preferred by both the majority and the MINORITY.

• REWARDS (or PUNISHES) producers according to how well (or poorly) they respond to the preferences of the buying public.

• Provide people with numerous FREEDOMS, including the freedom to work where they want to work, the freedom to start their own businesses if they want, the freedom to acquire property, the freedom to buy and sell the goods they want to buy and sell, and even the freedom to FAIL.

Economic Principles in Key Documents

The Bill of Rights shows a high regard for PRIVATE property. • The Bill of Rights notes that “private property [shall not] be

taken for public use, without just COMPENSATION.”The Declaration of Independence encourages free TRADE - an essential ingredient of free enterprise.

• The Declaration of Independence lists COMPLAINTSagainst the king of Great Britain, George III. One complaint is that the king prevented the 13 colonies from “TRADINGwith all parts of the world.”

The Constitution preserves COMPETITION – an important feature of free enterprise – by denying states the right to tax each other’s goods.

• Article 1, Section 8, of the U.S. Constitution states that “no tax or duty shall be laid on articles EXPORTED from any State.” To preserve competition, it was important to allow the free trade of goods ACROSS state lines.

Economic Rights and Responsibilities in a Free Enterprise Economy

People in a free enterprise economy usually share three sets of rights and responsibilities:

• OPEN DISCLOSURE

• The right to sell an item comes with the responsibility to disclose any relevant facts about the item in question.

• OBEYING THE LAW

• One has the right to use private property as one wishes, within the limits of the law.

• BEING TRUTHFUL

• The responsibility attached to the right to compete is that one must compete in a truthful, legitimate manner.

CHAPTER 3: SECTION 4

EntrepreneursImagine Being an Entrepreneur

An entrepreneur is a person who has a special talent for searching out and taking advantage of new business opportunities.

Entrepreneurs play an important role in society by taking risks to develop new products or new ways of doing things that benefit the public.

Most people are not entrepreneurs; entrepreneurs are a tiny minority of the population.

Entrepreneurs, Profit, and Risk

People will not risk their time and money to develop new products unless they can potentially earn a profit.

Not all entrepreneurs are successful.

However, a few end up as millionaires and even billionaires, and it is the prospect of such success that motivates entrepreneurs.

CHAPTER 3: SECTION 5

The Role of Government in a Free Enterprise Economy

Government as Enforcer of ContractsA contract is an agreement between two or more people to do something.

• Government punishes people who break their contracts. In other words, the government enforces contracts.

• Without government to enforce contracts, the risk of going into business would be too great for many people.

Could the free enterprise system function without a government to enforce contracts? Probably not as well, because the risks of going into business would be too great.

Government as Provider of Non-excludable Public Goods

Goods are categorized as two major types: private goods and public goods.

• A private good is a good in which one person’s consumption takes away from another person’s consumption. Examples include food and gas.

• A public good is a good in which one person’s consumption does not take away from another person’s consumption. An example would be a movie in a movie theater.

A public good can be excludable or non-excludable.

• An excludable public good is a public good that individuals can be excluded (physically prohibited) from consuming. An example would be a college lecture, which is available only to enrolled students of the college.

• A non-excludable public good is a public good that individuals cannot be excluded from consuming.

Free riders are people who receive the benefits of a good without paying for it.

Who will want to produce a nonexcludable public good?Economists say that in a free enterprise system, no one will want to. After all, people will not pay for something they get anyway.However, even in a free enterprise economy, people want non-excludable public goods, such as national defense or flood protection (dams). Who will produce these goods? The government will provide non-excludable public goods and pay for them with taxes.One way for people to communicate what nonexcludable public goods they want is through the voting process.

Externalities

There are two kinds of externalities: negative and positive externalities.

• A negative externality is an adverse side effect of an act that is felt by others.

• A positive externality is a beneficial side effect of an action that is felt by others.

Some people argue that education generates positive externalities. What you learn at school will not only help you earn a living, but also help you become a better citizen and a more informed voter.

Following that argument, if the public benefits from your education and the education of others, then the public should pay for that education. Some people argue that government should pay for all activities that generate positive externalities for society.

When it comes to negative externalities, some might say that the role of government is to reduce the negative externalities. Government can reduce the negative externalities through the following: the court system, regulation, and taxation.

• If you have a complaint against a negative externality, the courts are available to hear your case and find a resolution.

• The government creates regulations, such as speed limits and pollution standards, to deal with negative externalities.