What is a Free Enterprise System? Effects and How it works?

The kind of economic system that a country operates determines how the country’s economic activities function. The free enterprise system is the economic bedrock for countries that operate the capitalist system. A lot of developed countries and large economies such as the United States use capitalism as their economic system.

The free enterprise system is a less restrictive economic system that does not have large-scale government interference on job creation, production of goods and services, consumer freedom, and other socio-economic affairs of the society when compared to restrictive economic systems such as communism.

With the free enterprise system, how individuals and organizations spend money when purchasing goods or services, the prices paid for these purchases, the goods or services bought, where it is bought as well as the client’s experience during the course of the purchase is largely driven by those who offer these goods and services for sale. Furthermore, these goods and service providers make free decisions devoid of government interference on how to operate their business and what goods or services to offer customers. Here, we shall discuss what a free enterprise system is, its characteristics, as well as how it works.

See also: Crony Capitalism

What is a free enterprise system?

A free enterprise system is an economic system that relies on the market forces of demand and supply to determine the prices of goods and services as well as allocate resources. In a free enterprise system, the government does not determine the production of goods, services, or prices. Instead, the various companies that produce the goods and render services determine the price based on the extent of demand and availability of supply as they compete for profit among themselves.

Hence the prices of goods and services fluctuate based on demand and supply. Prices usually go up with increased demand and minimal supply and the prices come down with decreased demand and excess supply. The free enterprise system also refers to a legal system where buying and selling of goods or services are regulated privately without government interference. Therefore, markets existing in a free enterprise system are defined by competitive bidding for goods and services, voluntary contracts, and private property rights. This means that all commercial interactions are largely determined by the parties involved in the transaction.

The Nobel prize-winning economist, Friedrich August Von Hayek defined the free enterprise system as spontaneous order. This means that the regulation and planning of the free enterprise system arose from the coordination of decentralized knowledge among the various individuals and companies that make up the market. He further believed that the free enterprise system made room for entrepreneurship, creativity, and innovation among the various companies that offer goods and services to the public. Thus allowing citizens to enjoy economic prosperity and the societies that practice this system to bloom.

In a free enterprise system, consumers are allowed to spend their money in any way they deem fit as the government places minimal restrictions on commercial activities; be it owning businesses or the kind of business that individuals and corporate entities partake in. This often leads to having several companies that offer similar goods and services which in turn, lowers the prices of most of these goods and services in the long run. Thus, consumers get value for their money by having the chance to choose from various options.

Additionally, the government does not determine the type of job its citizens will engage in, in this type of system. These and many more freedoms are enjoyed by citizens whose countries have adopted the free enterprise system. The free enterprise system is also known as a free market, free trade, private enterprise, laissez-faire economy, or market economy.

See also: Enterprise value vs market cap: differences and similarities

Characteristics of a free enterprise system

  1. Competition
  2. Economic freedom
  3. Entrepreneurship
  4. Limited government interference
  5. Price System
  6. Private property
  7. Profit motive
  8. Specialization
  9. Voluntary exchange

The characteristics of the free enterprise system are those features that are peculiar to the free enterprise system. These characteristics are listed above. Let us now discuss each of them below:

Competition

A key characteristic of the free enterprise system is that it encourages competition. This competition arises as a result of the varying needs of individuals and the variety of products and services offered in the market. Businesses, especially those within the same sector compete with each other for customers, hence they tend to produce similar goods and offer similar services at highly competitive prices. This further leads to consumers having a wide variety to choose from and also ensures the production and offering of quality products and services since the consumers have a number of options to choose from.

Companies continuously compete with each other to offer the kinds of products and services that consumers are looking for in this economic system. Hence, they try to attract more customers by offering the best products or services at the cheapest possible price.

Economic freedom

The free enterprise system offers economic freedom to individuals and corporate entities that live in countries where it is practiced. With this freedom, a person can choose the kind of product or service they want to buy or sell. They can choose their occupation, employer, and in which part of the country they want to work. They can also choose to invest their money however they deem fit, quit their job, or get involved in other economic activities as desired.

Entrepreneurship

This economic system further encourages the creation of businesses as there are no restrictions on who can start a business or get involved in an already existing one. Hence, most countries such as the United States that have this economic system in place tend to have a large number of entrepreneurs. Therefore, the number of businesses in a country that is not owned by the government and the ease with which an individual or group of individuals can start a business further tell on the level of the free enterprise system in the country.

Limited government interference

In theory, there is no government interference in a free enterprise system but in practice, the government still plays a role in the free enterprise system, albeit a limited one. The government’s role in this system is restricted to enforcing fair play among the various companies that are competing with each other, enforcing contracts between buyers and sellers, protecting the rights of individuals, and regulating the prices of necessities such as food and water. Simply, the government serves as an unbiased umpire in the free enterprise system.

Price System

Products and services are offered based on the price system. This means that a consumer has to pay a certain amount in order to acquire the product or service they want. The price of a good or service is largely determined by the forces of demand and supply, hence the more available a product or service, the cheaper its price while products and services that are scarce tend to be priced higher.

Furthermore, the price of a good or service is also determined by its perceived value, thus luxury items tend to be priced higher than regular ones. The ability of producers and consumers to come to an agreement on the price of a product or service is a key characteristic of the free market system.

Private property

In the laissez-faire economy, the property is not owned by the government, it is rather owned by individuals and businesses. Therefore, individuals and companies are the ones that determine the use of their property and assets. They are also free to sell these properties or assets when they desire, thus, they have full control of their property and can do as they wish with them.

Profit motive

Due to the large level of competition that is prevalent in this system, most businesses that exist is for-profit. The business owners and investors use their funds to fund various businesses with the aim of generating profits from such ventures. Additionally, the government does not restrict people from partaking in profit-generating ventures so far as it is within the confines of legally acceptable business.

Specialization

Due to the high competition and the profit motive of most businesses that exist in the free enterprise system, there is a high level of specialization prevalent too. By specializing in the production of particular goods or rendering specific services, companies can sell their products and services at higher prices, thereby making better profits and having lesser competitors in the market. They will also be able to employ the best talents since they will equally be able to provide better salaries to their employees. For instance, one of the outstanding products of the beverage company Coca-Cola that differentiates it from other beverage companies is its soft drink, Coca-Cola.

Voluntary exchange

Free trade allows buyers and sellers to freely and willingly interact and carry out various transactions. The customer is not restricted to buying from only one producer nor are the producers restricted to selling to only particular individuals. This voluntary exchange of money from consumers to goods and service providers is also referred to as consumer freedom. Individuals and companies are free to buy and sell whatever they desire, in the quantity and quality they desire without coercion or interference by the government.

Characteristics of a free enterprise system
Characteristics of a free enterprise system

See also: Mercantilism vs communism differences and similarities

How the free enterprise system works

The free enterprise system is one that operates freely without government interference with the prices of goods and services being determined by the market itself. It is a market in which competition exists due to the availability of different manufacturers of similar products and services and also due to the varying needs of consumers for diverse products and services. Since the extant companies spring up mainly to fulfill the needs of the consumers, it means that the products and services offered are created to meet customer demands.

As a result, the laws of demand and supply are foundational concepts upon which the free enterprise system exists. This means that the prices of the goods and services available to the consumer are largely dependent on both demand and the extent of its supply (availability). The recent Covid-19 pandemic has further exemplified how the free enterprise system works; with people all over the globe resorting to online shopping to meet their needs for the products or services they require. Additionally, the availability of goods and services is also driven by the producer’s need of making a profit while meeting a need.

For instance, an entrepreneur could decide to start providing cleaning services for parents who are too occupied with work to take care of their cleaning needs. In providing this service, the entrepreneur creates employment opportunities for others and also fills the need of working parents. Thus, these parents are willing to patronize the business voluntarily without compulsion as it meets their needs. The entrepreneur further makes a profit from the payments received for the services provided which can in turn be used to pay employees and themselves.

Each step in the free enterprise system is driven by itself and the consequent benefits accruing to either the producer of the goods or service or the person in need of the good or service (consumer). This leads us back to Friedrich August Von Hayek’s position that this economic system is one of spontaneous order. In a nutshell, the system is driven by competition, the laws of demand and supply, consumer freedom, prices, and profit.

See also: Mercantilism vs capitalism differences and similarities

Effects of a free enterprise system

As with all economic systems, both extinct and extant, the free enterprise system has both positive and negative effects in the societies where it is adopted. We shall discuss both the positive and negative effects of the free enterprise system but before then, let us see an outline of these in the following table:

ProsCons
It drives efficiency and innovation when producing goods or servicesCompanies could exploit consumers and employees in their bid to minimize expenditure and maximize profits
Companies in the market can make unlimited profitsEthical and safety protocols could be overlooked in the bid of getting more profits
Societies that practice the free enterprise system tend to have high economic growth ratesCorruption could be on the increase when business practices are left unchecked
There is no restriction on who can participate in the economyBreaking into the business scene becomes increasingly difficult
Pros and cons of the free enterprise system

Positive effects of the free enterprise system

  1. Economic growth
  2. Efficiency and innovation
  3. Equal opportunity
  4. Unlimited profits

Economic growth

Societies that operate the free trade system generally have higher economic growth rates when compared to societies that practice other restrictive systems like communism. The economy grows rapidly due to the ever-increasing number of entrepreneurs who not only create new businesses to meet the varying needs of consumers but also due to the consequent increase in possible exports and imports that arise due to these new businesses.

Furthermore, the larger market creates an enabling environment for better competition among the various companies in existence, this further increases job opportunities and the availability of products and services that are tailored to meet the need of specific consumers. Thus, the economic growth of such a country is sustained and keeps increasing over time.

Efficiency and innovation

The free enterprise system is largely driven by competition since there is no restriction on who can be involved in the production of goods or services. This serves as a means of driving up efficiency and innovation because the various competing companies want to maximize the resources available to them. By this, companies produce the best products or services within the confines of the resources available to them; they optimize their production efficiency and reduce all wastes and expenses. Additionally, the tight competition present drives up the innovation culture since all competitors will strive to make products and render services that best meet the demands of customers.

Equal opportunity

Since there is no interference by the government on who can take part in what kind of business, the free enterprise system creates equal opportunities for everyone in society to be part of either the production or consumption of goods and services. Hence irrespective of one’s gender or religious inclination, one can benefit from the system once they get involved in it.

Unlimited profits

Due to the fact that the free enterprise system is largely dependent on market forces of demand and supply, it gets without saying that producers who are able to create products and services that meet the needs of the consumers will definitely make profits since they are filling a need that is already there. Consequently, the more innovative a company is in creating unique products that meet the specific needs of a large percentage of the population, the more likely they are to make sales.

This will make the company more likely to make higher profits, especially when the producers of that same product or service are few. Hence, companies are able to make unlimited profits based on the type of products or services they offer consumers.

Negative effects of free enterprise system

  1. Corruption
  2. The exploitation of customers and employees
  3. An increased barrier to entry
  4. Overlooking ethical and safety protocols

Corruption

The existence of a free enterprise system could lead to an outbreak of corruption in the economic system of the country. Since the level of competition between companies are high and the drive for making profits is equally high, producers could get involved in questionable business practices in order to drive up sales and revenue. For instance, bribes could be given by companies in order to secure contracts. They could also offer wrong budgets or substandard products so as to increase the amount they will make as profit from a project. When these continue unchecked, corruption becomes the order of the day in such societies.

The exploitation of customers and employees

Free market economies are ideally self-regulating and without government intervention, this can, however, be a drawback to both the company employees as well as its customers. Employees could be paid meager salaries by their employers especially when there is a high availability of labor. They may further choose not to pay extra benefits such as allowances for overtime work, health insurance, and pension funds. This becomes increasingly prevalent when labor unions are not functional and the government has no say in the activities of companies.

The prices of goods and services could also be increased through the creation of artificial scarcity. This is because consumers are likely to be more willing to pay higher prices for products or services that are not readily accessible and available. Additionally, when demand for certain goods or services outgrows the available supply, prices could be driven up too. This has become the norm in most countries, especially in the month of December when a lot of people seek to buy a lot of products due to the yuletide. As such, consumers are at the mercy of the companies that produce the goods or services they require.

An increased barrier to entry

Although the free enterprise system encourages entrepreneurship and the creation of more businesses, it also creates an increased barrier for new individuals to break into the market. Manufacturers who have more capital are more likely to break into the market than those with little capital. This often results in a situation where the most popular products or services in the market are not necessarily the best but those who have the funds to create large quantities and equally market them to consumers. Hence, monopolies become prevalent.

Overlooking ethical and safety protocols

Since most manufacturers of goods and services are motivated by the profits they make from the products they offer, their drive for profits could push them into overlooking ethical concerns and safety protocols in their production processes. When safety protocols and ethical concerns are overlooked, it could have detrimental effects on the company employees as well as the environment in which they operate. Lives and properties could be lost, and sicknesses and injuries could also occur.

See also: Profitability of a Business: How to measure and improve profit

Conclusion

The free enterprise system refers to an economic system that is controlled by the private sector with minimal government interference. This system enables competition between companies, spurs innovation and creativity, encourages economic growth, and fosters efficiency. Individuals are free to trade and spend their money however they deem fit. The prices of goods and services are set by the demand and supply.

Although the argument for the existence of a free enterprise that is devoid of government interference is that government involvement in the economy and business hampers growth, the absolute noninvolvement of government could lead to dire consequences. This includes increasing the prices of goods and services without just course, overworking workers without adequate compensation, increased corruption, and overlooking various ethical standards amongst many others.

The free enterprise system in practice is a constantly changing concept that has evolved over the years to currently mean an economic system with minimal government interference as opposed to one without government interference. Minimal interference comes into play to balance various ethical and environmental issues in the face of continuous global warming. They further regulate matters of minimum wage and other compensations available to employees, thus the government serves more like a referee in the game of football.

Last Updated on November 2, 2023 by Nansel Nanzip Bongdap