In a market economy, producers often spend large amounts to make sure that consumers—even very young children—know the names and logos of their products. This is because free-market consumers have freedom of choice, and they will often choose brand names they recognize. In this section, you’ll learn more about freedom of choice and the other major characteristics of a market economic system.
Limited Role of Government
Under capitalism, government plays a relatively limited role in the allocation of resources.
Economics & You Do you think the government has a right to control a nation’s resources, or should decisions about economic activity be left up to individuals? Read on to learn about the relatively limited role of government in a capitalist system.
In his book An Inquiry into the Nature and Causes of the Wealth of Nations, economist Adam Smith in 1776 described a system in which the government has little to do with a nation’s economic activity. He said that individuals left on their own would work for their own self-interest. In doing so, they would be guided as if by an “invisible hand” to use resources efficiently and thus achieve the maximum good for society.
Smith’s version of the ideal economic system is called capitalism, another name for the market system. Pure capitalism has also been called a laissez-faire system. This French term means “let [people] do [as they choose].” A pure capitalist system is one in which the government lets people and businesses make their own economic decisions without government interference. Capitalism, as practiced in the United States today, would be best defined as a market economic system in which private individuals own the factors of production but use them within certain legislated limits.
Smith’s ideas influenced the Founders of the United States, who limited the role of government mainly to national defense and keeping the peace. Since the 1880s, however, the role of government—federal, state, and local—has increased significantly. Among other things, federal agencies regulate the quality of various foods and drugs, watch over the nation’s money and banking system, inspect workplaces for hazardous conditions, and guard against damage to the environment.
The federal government also uses tax revenues to provide social programs such as Social Security and Medicare. State and local governments have expanded their roles in such areas as education, job training, recreation, and care for the elderly.
In a free market, economic activity is coordinated by private businesses and individuals responding to market signals.
Economics & You Have you ever bought something you were unhappy with? Would you ever buy that product again? Read on to learn how buyers influence the market. Looking more about structural Evolution of the U.S. Economy
The government’s relatively limited role in capitalist economies is only one characteristic of these economic systems. Now we will look at some of these systems’ other features.
Freedom of Enterprise
The American economy, besides being termed capitalist, is also known as a free-enterprise system. This term emphasizes that individuals are free to own and control the factors of production. If you go into business for yourself, you may become rich selling your product. You may instead end up losing money, however, because you—or any entrepreneur—have no guarantee of success.
The government places certain legal restrictions on freedom of enterprise. For instance, just because you know how to fix cars does not mean that you can set up an automobile-repair business in your backyard. Zoning regulations, child-labor laws, hazardous waste disposal rules, and other regulations limit free enterprise to protect you and your neighbors.
Freedom of Choice
Freedom of choice is the other side of freedom of enterprise. It means that buyers, not sellers, make the decisions about what should be produced. The success or failure of a good or service in the marketplace depends on individuals freely choosing what they want to buy.
If a computer game company releases a new game, but few people buy it, the company most likely will not use that particular game designer again. Buyers have signaled that they do not like that game designer’s work.
Although buyers are free to make choices in a free-market economy, the marketplace has become increasingly complex. At times, the government has intervened in various areas of the economy to protect buyers. Laws set safety standards for such things as toys, electrical appliances, and automobiles. In industries dominated by just a few companies—such as public utilities selling natural gas or electricity—the government sometimes regulates prices.
When a person invests time, know-how, money, and other capital resources in a business, the goal is to make a profit. Profit is the amount left after all the costs of production have been paid, including wages, rents, interest, and taxes. The desire to make a profit is called the profit incentive, or profit motive. The profit incentive motivates entrepreneurs to produce new goods and services.
The risk of failing is also part of the free-enterprise system. What happens when profits are not realized—when businesses fail? Losses signal entrepreneurs that they should move resources elsewhere. Thus, the interaction of both profits and losses leads to an economy that is more efficient, adaptable to change, and continually growing.
In a free-enterprise system, the lure of profits encourages competition—the rivalry among producers of similar products to win more business by offering lower prices or better quality. Effective competition often requires a large number of independent sellers, which means that no single company can noticeably affect the price of a particular product or service. If one company raises its prices, potential customers can simply go to other sellers.
Competition leads to efficient use of resources. How so? Businesses have to keep prices low enough to attract buyers, yet high enough to make a profit. This forces businesses to keep their costs of production as low as possible.
For competition to existing, barriers to entry into, and exit from, industries must be weak. For the most part, the United States has weak barriers to entry and exit, but there are exceptions. For example, a person cannot become a physician until he or she has received a license from a state government.
One of the most important characteristics of capitalism is the existence of private property or property that is owned by individuals or groups rather than by the federal, state, or local governments. You as an individual are free to buy whatever you have the funds to do so, whether it is land, a business, an automobile, or baseball cards. You can also control how, when, and by whom your property is used. What are called the rights of property, however, are actually the rights of humans to risk investment, own productive assets, learn new ways of producing, and then to enjoy the benefits of these choices result in profits.
The Founders of the United States recognized that such rights must not be violated, because these rights are the invisible engine for creating wealth and prosperity for all. The Constitution guarantees an owner’s right to private property and its use.
Thus, in principle, no level of government in the United States can seize or use private property, at least not without paying the owners.
- capitalism: an economic system in which private individuals own the factors of production
- laissez-faire: an economic system in which the government minimizes its interference with the economy
- free-enterprise system: an economic system in which individuals own the factors of production and decide how to use them within legal limits; same as capitalism
- profit: amount earned after a business subtracts its costs from its revenues
- profit incentive: desire to make money that motivates people to produce and sell goods and services
- competition: rivalry among producers or sellers of similar goods and services to win more business
- private property: whatever is owned by individuals rather than by government