Ch. 3: The American
Free Enterprise
System
Sec. 1: Advantages of the
Free Enterprise System
What is a Free Enterprise System?
 Capitalism –
 central idea – producers free to produce
the goods and services that consumers
want
 consumers influenced by desire to buy
goods and services to satisfy econ. Wants
 producers influenced by desire to earn
profits
 Free enterprise system –
Example: United States
 Monica Ramirez – starts business of
cosmetics for Latinas
creates Zalia Cosmetics
put whole saving account into
business – soon gained backers to
invest in business
outlets in major Hispanic markets –
business growing – gives back to
support Latina Entrepreneurs
 One of 585,000 new businesses in US in 2001 – can
see businesses everywhere
 all examples of how individuals choices are the
basis of a market economy
owners choose to start the enterprise
owners choose how to use their scarce
productive resources
managers and workers voluntarily exchange
labor for pay
consumers choose which goods and
services they will buy
 Govt. action usually limited –designed to protect or
encourage competition or enforce contracts
Example: Emerging Markets
Mexican Economy
Singapore
 Govt. plays much larger
role then US govt.
 rules and regulations
make starting
business difficult
 informal market has
grown as a result –
has driven retail stores
out of business
 street vendors and
vendors with stalls
 Govt. very closely involved with
economy (Singapore Inc.)
 Govt. says what benefits
employers must provide
employees
 Workers must put certain
percentage in Central
Provident Fund – govt. saving
scheme
 fund pays pensions, and
funds public projects (ed.,
health care, housing)
 Govt. supportive of free
enterprise
 keeps business rents, taxes
and costs low
How a Free Enterprise System
Works
 Key freedom – private property – can exchange
it voluntarily – heart of free enterprise
 Open opportunity – the ability of everyone to
enter and compete in the marketplace of his or
her own free choice
 ensures market reflect wide range of interests
& talents and provides incentive to be
efficient and productive
 Legal equality – a situation in which everyone
has the same economic rights under the law
 Free contract – for voluntary exchange to work,
people must be able to decide for themselves
 Which legal agreement they want to enter into –
business, job, or purchase commitment
 What motivates people to start a business?
 Profit motive – the incentive that encourages
people and organizations to improve their
material well-being by seeking to gain from
economic activities
 Producers seek highest possible price for
product
 Competition offsets drive and forces prices
down
 Helps producers find price that does not
deter buyer or inhibit profits
Example: Profit in Rocks
 Pet rock – Gary Dahl – a pet rock easier to care for than
regular pets
 wrote a manual on pet rocks – training , tricks…
 Aug. 1975 – packaged and sold with manual at gift shows
 major department store purchased 500
 became major story, with interviews and articles
 by end of year – sold more than 2 tons – he is millionaire
 1976 – consumers lost interest – Dahl gets out of the
business
Example: Competition Over
 Books different then pet rocks –Books
fierce
competition
 before 1995 – small chain stores and
neighborhood booksellers dominate market
 1995 – large chain stores – Barnes & Noble Inc.
and Border Group Inc. begin to compete
 can buy in high volume and pass savings to
consumer
 warm & welcoming atmosphere in stores –
reading areas, cafes, book signings
 1991 – independent booksellers account for 30%
on book sales in US
 by 2005 – down to 15%
 between 1995-2005 – 1,200 ind. Bookseller
went out of business
 New challenge for chains – Amazon.com
 huge database, quick & reliable delivery,
discount prices, easy to use web site
 by 2004 – sales at $134 million a week
 New challenge for Amazon – Overstock.com
& Buy.com
 undercut Amazon’s prices and has
excellent service
 Consumers benefit from competition
 Ind. Booksellers cannot match prices
 can provide personal service and focus on
local tastes or specialized topics
 example of those who keep pace with the
market and adjust accordingly
Economic Pacesetter: Milton Friedman:
Promoter of Free Markets
 Economics professor – b. July
31, 1912 – d. Nov. 16, 2006
 career teaching at U. of
Chicago – free market
ideas – “Chicago School of
Economics”
 Market should be free to
operate in all fields – even law
& medicine
 lowering licensing
standards would bring
more dr. and lawyers into
market
 would bring down costs of
services
 Govt. most important role is to
control the amount of money in
circulation
 with no control, economy would
experience inflation
 Advisor for 2 presidents and head of
state for several other countries
 1976 – won Nobel prize for
Economics
 1980 – wrote Free to Choose –
best seller nonfiction
 1977 – 2006 – served as scholar at
Hoover Institution, conservative
public policy research center at
Stanford University
Sec. 2: How Does Free
Enterprise Allocate
Resources
The Roles of Producers and
Consumers
 Profit – the money left over after the costs of
producing a product are subtracted from the revenue
gained by selling that product
 Seeking profit is one way producers help allocate
scarce resources in the economy
Example:
Producers Seek
Profit
 Neighborhood coffee shop
 owners charge highest
price consumers are
willing to pay
 possibility for good profit
encourages other to
open shops
 productive resources got
to the coffee shops
instead of other
businesses
 profit seeking helps in
allocation of resources
Example:
Consumers Vote
With Their Wallets
 When consumers buy a
product, they vote for it
vs. another product
 votes determine what
will be produced in the
future
 ex. – low carb diets –
interests peak and fall –
producers respond
based on votes of the
 Consumers-consumer
actions cause a
reallocation of resources
Government in the US
Economy
Modified free enterprise economy – includes some govt.
protections, provisions, and regulations to adjust the free
enterprise system
Modified Free
Enterprise

Figure 2.4 showed flow of resources and
products moving in a circular flow
between businesses and households

Figure 3.4 shows how govt. fits in

Govt. exacts costs and gives benefits

green arrows show flow of money

blue arrows show flow of products and
resources

govt. is both consumers and producer
 consumer in the resource market –
spending to buy factors of prod.
 consumer in product market – spending
money in exchange for products
 a producer – providing goods &
services to households & businesses

collects money from businesses &
households in form of taxes
 covers costs of what is produced with
this money
 uses money to make purchases in the
resource and product market

Figures 3.5 & 3.6 – show govt. a major
consumer of resources and products

govt. employs about 22 million workers –
16% of labor force

govt. consumption is over 2 trillion
Sec. 3: Government and
Free Enterprise
Providing Public Goods
 Most production decisions made in the marketplace through the
interaction of buyers and sellers – the free enterprise sector
 decisions made by different levels of govt. – the public sector
 which sector produces a good or service?
 if all costs borne by and benefits go to the buyer and seller, the free enterprise
sector
 Market failure – people who are not part of the marketplace
interaction benefit from it or pay part of the costs
 when this happens – govt. sometimes provides goods or service
 Public goods – goods and services that are provided by the govt.
and consumed by the public as a group
 public goods are funded with taxes
Example: Characteristics of
Public Goods
 Public goods have 2 characteristics:
 1. people cannot be excluded from the benefits of
the product even if they do not pay for it
 2. one person’s use of the product does not reduce its
usefulness to others
Street lighting
 Impossible to exclude people
from using it
 the benefit is not diminished
because other people use it
 no way for private business to
establish a realistic price and
collect
 local govt. provides and
collects taxes to cover cost
National defense
 Everyone benefits from it
 the benefit is not
diminished because other
people feel secure
 Given the benefit – you
would readily pay for sense
of security
 Everyone pays through
taxes to national govt.
Example: Free Riders
 No incentive for business to produce public goods –
people will not voluntarily pay for it
 people receive the benefit of these goods whether they
pay or not
 Free rider – is a person who chooses not to pay for a
good or service but who benefits from it when it is
provided
 one type of market failure
Fireworks Shows

Shows are very expensive – no
way to charge people for
watching the show
 can charge for a very good
spot, but others will still be able
to see it
 those who do not pay – free
riders

Little interest in providing
fireworks displays as a business
opportunity
 to address problem – govt. to
provide certain goods and
services
 city govt. puts on the show
and pays for it with taxes
 costs and benefits shared
throughout the community
Police Force
 Everyone is protected
whether they pay or
not
 best way to ensure
that those who benefit
pay their share is for
govt. to provide the
service by paying for it
with taxes
Public and Private Sectors – Shared
Responsibilities
 Some goods provided by either sector
 often toll goods – goods consumed by the public as a
group, but people can be excluded from using them
 open for all to use, but have to pay a toll to use
 initial funding for toll goods is provided by the public
sector, but day to day is provided by the private sector
Public and private share
responsibility for the nation’s
infrastructure
 Ex. – highways, mass transit,
power, water, sewer systems,
education, health care
systems, fire and police services
 if not have these things –
economy would come to a
halt
 lose ability to move troops in
case of attack and evacuate
in emergency
 Infrastructure – essential to
economic health
Managing Externalities
 Externality – a side effect of a transaction that affects
someone other than the producer or the buyer
 Negative externality – is an externality that is a
negative effect or cost for the people who are not
involved in the original economic activity
 ex – manufacturing company discharges pollution into a
river – cost of pollution is borne by those who live near the
river – even if no connection to company
 Positive externality – is an externality that is a positive
effect or benefit for people who were not involved in
the original economic activity
 neighbor plants a rose garden – everyone benefits from
beauty
Example: Paying For the Negative
Externalities
Industrial pollution
 Company has little incentive to
pay extra to reduce pollution
 those living around it are going
to suffer from it, bear the cost
of clean-up and bear the
medical costs if ill
 Limiting negative externalities is
important role of the govt.
 govt. taxes or fines polluters
 money raised can offset higher
medical costs
 Tax or fine provides incentive
for owner to reduce pollution
Example: Spreading Positive Externalities
 Local business benefit from student
purchases
 Workers benefit as businesses expand
 Community benefits – taxes collected
form students, more skilled and
knowledgeable population
 local govt. can spend more to provide
public goods
 govt. tries to increase positive
externalities
 Subsidy – is a govt. payment that helps
cover the cost of an economic activity
that is considered to be in the public
interest
 comes from taxes , so everyone shares
the cost
 ex. – given to drug companies to
develop new vaccine
 will benefit the whole community once it
is in effect
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