Free Enterprise Primer

This primer on free enterprise is my oversimplified and unapologetic description of how a market economy works. It is meant not only to be informative about the subject, but also to create an appreciation for a unique system that has given us something as remarkable as supermarkets. —Bob McTeer

Consumer Sovereignty

In a free market system, the government doesn’t organize, direct and control economic activity. If the government doesn’t, who does? Who decides what is to be produced, and how, and in what quantities and quality, and who gets the fruits of production?

The answer is that you and I decide these important questions by the way we spend our money. The market system features consumer sovereignty, meaning that the consumer is king. We decide what will be produced by casting dollar votes for the things we want and by not spending on the things we don’t want.

If we want more hamburgers and fewer hot dogs, we spend our money accordingly. As hamburger sales pick up and hot dog sales languish, the derived demand for beef to make hamburgers will rise relative to the demand for pork to make hot dogs. As prices and profits rise in the hamburger and beef industries, new producers and suppliers are attracted, increasing the supply of hamburgers and moderating the upward pressure on prices. The initial rise in profits will be temporary since the supply will increase to match the higher level of demand.

While all these good things are happening in the hamburger industry, times are tougher in the hot dog business. The decline in hot dog demand pushes down prices and profits. Producers of hot dogs and pork will cut back production, and, if demand stays weak, some will leave the industry. The exodus will reduce excess supply until the producers that remain are restored to normal profitability.

Where will the hot dog workers go? In our simplified model of the world, they will go into hamburger and beef production. This is an important point, easy to see in our simple example but often overlooked in the real world. Under normal conditions of near full employment, expanding industries can grow in response to consumer demand only if others are allowed to shrink. If the adjustment process begins immediately in response to gradual changes, it need not be too painful.

Profit

The profit motive translates consumer demand into production. Nobody does consumers a favor; producers are simply trying to earn a profit, just as consumers are seeking their best deal. Profit is the driving force of capitalism—the incentive for production, the reward for anticipating or reacting to consumer preferences correctly, and a source of capital for expansion. Losses signal the need to cut back production of less-favored goods and make resources available for production elsewhere. Well-meaning attempts to protect or subsidize declining industries interfere with this adjustment process. Such attempts waste resources and limit the supply of products in greater demand.

Prices play a critical role in coordinating economic activity. Higher prices in strong industries ration the limited supply in the short run and attract new suppliers in the long run. Lower prices in other industries stimulate weak demand in the short run and encourage marginal producers to leave the industry in the long run. Rising wages in growing industries attract workers from weaker industries. All market participants respond to the millions of price signals sent out daily to correct both incipient shortages and surpluses. Each responds to the participant’s own self-interest, but in doing so, he or she contributes to a rational and efficient outcome.

Competition

With all of us looking out for ourselves, who looks out for the general welfare? Who regulates the system? That’s where competition comes in. Who is in the best position to see if McDonald’s is giving poor service, poor quality or charging too much? You are, with a little help from Wendy’s or Whataburger or Burger King. If Ford and Chrysler are unable to keep General Motors honest, Toyota and Honda will be happy to help.

Rising prices and profits play an important role in attracting supply to match rising demand. But that process is self-limiting. As supply increases, profits are competed back down to their "normal" level, defined as just sufficient to retain existing resources in the industry. College-level price theory courses teach that, given sufficient competition, product prices are driven down to their least possible average cost of production. Similarly, given competitive conditions in both product and resource markets, workers and other productive factors will be paid the value of their individual contributions.

Market prices, in conjunction with the profit motive and competition, also determine how production is organized. To maximize profits, producers will seek the least costly inputs and the most efficient production methods. They don’t have to be directed to hold costs down; in a competitive environment, their survival depends on it.

With competition driving down prices to average costs in the industry, firms with higher than average costs will experience losses. If they don’t have enough market power to raise prices, cost reduction becomes the only alternative to going out of business. This market discipline encourages a constant search for new efficiencies. Efforts to thwart that process may protect individual producers, but only at the expense of consumers and the efficiency of the overall economic system.

Income

The market system also determines who gets the goods and services that are produced. Of course, the people who buy them get them. But the real question is who earns how much income from the nation’s production and thus has the dollars to spend on it.

To make a long story in price theory short, workers and owners of other factors of production in a competitive environment will tend to receive incomes based on their marginal contributions to the nation’s output. Businesses, in following their profit motive, have a financial incentive to continue hiring workers as long as they expect each worker hired to add more to the firms’ revenues than to their costs. The more productive people, in terms of the market value of their contribution, will earn more than less productive people and will be able to claim a larger share of that output. In a competitive environment, workers and other productive resources are paid the value of their marginal output.

Work and Reward

The link between work and reward is another major driving force of capitalism. Working smarter is rewarded as much as working harder. So is seeking out new products or services or new markets or new techniques, since it is market value that is rewarded more than hours worked or units produced. The market system encourages creativity and risk-taking by rewarding their success. Imagine the difference in a system where everyone works for the state.

Whom you work for makes all the difference. In a free enterprise system, you work for yourself. You get to keep your earnings—after taxes, of course. You can acquire private property with your earnings, enhance its value and pass it on to your children if you wish. You may change jobs or firms or locations. Everyone is free to pursue his or her own interests rather than the interests of the nation.

The Invisible Hand

You may ask, isn’t that selfish? The answer is yes. But Adam Smith showed us more than 200 years ago in The Wealth of Nations that pursuit of self-interest in a competitive market economy is, as if by some "invisible hand," consistent with promoting the public interest. Each of us can work where we get the highest wage, shop where we get the lowest price, borrow where we get the lowest rate. In all these transactions, we face counterparts with the opposite motivation, but the outcome of all the bargaining is rational and efficient. Prices are established that coordinate the millions of daily transactions and bring order out of chaos.

What happens if producers produce too much of one thing and not enough of another? Prices (and profit prospects) will rise in the scarce area and fall in the overproduced area, shifting the pattern of production in the right direction. What happens if too many workers want to make automobiles and not enough want to farm? Wages in Detroit will decline relative to those on the farm, and workers will shift in their own self-interest.

Large shifts like this occur gradually, of course, and it may just be that more farmers’ sons and daughters stay on the farm and fewer children of auto workers follow in their parents' footsteps. What happens if people aren’t saving enough to finance a higher level of investment? Interest rates and incomes will rise to encourage more saving. What happens if costs in Dallas get too far out of line with those in the suburbs? People and businesses will migrate, not necessarily until costs are equalized, but until the differential offsets other considerations.

Freedom of Choice

The point is that a modern economy is very complicated. Billions of decisions and choices have to be made daily. The task is simply too complicated for governments or planning boards. Who better to make these decisions than the people most intimately involved— people who know their unique circumstances better than anyone else can.

The degree of individual freedom offered by the free enterprise system is almost infinite. It goes way beyond majority rule. A vote for hamburgers or hot dogs at the class picnic will leave a lot of people disappointed even if the majority prevails. The market system offers variety by allowing choices to be made at the individual rather than the group level. How may flavors of ice cream can you buy at the mall? How many models of automobiles can you buy in Houston. How many styles of jeans?

In The Hunt for Red October, an escaping Russian asks Jack Ryan what he would find most amazing about America. The answer: Supermarkets! Cherish the economic system that gives you supermarkets.

Addendum: The Role of Government For simplicity, this primer on the free enterprise system explores the workings of an idealized free enterprise system without acknowledging that the system has never existed in such a pure form. The main complicating factor in the real world arises from the role of government. Indeed, in the United States we do have a "mixed economy," with government playing a major role alongside the private sector. And to the extent that government plays a role, we don’t have a textbook free enterprise economy. To the extent that the government’s role is limited, however, our discussion of capitalism and free markets approximates reality. Free enterprise is characterized by voluntary exchange and private property rights. In the private sector, exchanges made voluntarily presumably leave both parties better off. That presumption is absent in government transactions since they are not entirely voluntary. An element of coercion is involved, even if the tax laws and spending priorities are determined through democratic processes. (If you question the coerciveness of government, consider how you feel on April 15.) Property rights and individual liberty are compromised when governments demand a share of a person’s property or income for their own use. Most advocates of free enterprise agree that government has a role to play, although many regard it as a necessary evil. Some services, such as national defense, a court system and a police force, can only be provided collectively and are generally regarded as proper functions of government. At the other end of the spectrum, however, are functions that many regard as inconsistent with individual liberty. These might include programs to redistribute income or to advance the cause of one group at the expense of others. The latter would include subsidies, protection from competition and the like. When the government can legally rob Peter to pay Paul, there is great potential for abuse. There will always be an abundance of worthy causes seeking government sponsorship. But the test should not only be whether the cause is worthy, but also whether government is the appropriate entity to deal with it. National priorities and government priorities are two different things. To say that national defense should have a large share of the federal government’s budget and child care or decent housing should not is not to denigrate the importance of the latter. Such a statement simply recognizes that child care and housing concerns can best be handled at the individual or family level and national defense cannot. In a world of finite resources, a decision by the government to undertake a new project is a decision to forego others. Each dollar spent by the government is a dollar not spent by its former owner—the taxpayer—on something he or she deemed important. Collective decision making preempts individual decision making. Since governments get their funds from the people, helping one group or cause can only be done at the expense of another group or cause. In addition to comparing and evaluating the outcomes of such choices, we must be concerned that at some point the confiscation of private income for public purposes will inhibit the creation of wealth that is to be shared. The bottom line is that while limited government is necessary and consistent with an essentially free economy, there are limits to how large the size and scope of government can grow without killing the goose that lays the golden egg.