In a free enterprise economic system, the decisions about what to produce are made in response to —

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Legoland, Billund, Denmark: Picture of a Planned Economy?

In the modern world today, there is a range of economic systems, from market economies to planned (or command) economies.

Market Economies

A market is any situation that brings together buyers and sellers of goods or services. Buyers and sellers can be either individuals or businesses. In a market economy, economic decision-making happens through markets. Market economies are based on private enterprise: the means of production (resources and businesses) are owned and operated by private individuals or groups of private individuals. Businesses supply goods and services based on demand. Which goods and services are supplied depends on what is demanded by consumers or other businesses. A person’s income is based on his or her ability to convert resources (especially labor) into something that society values. The more society values the person’s output, the higher the income they will earn (think Lady Gaga or LeBron James).

Examples of free-market economies include Hong Kong, Singapore, Australia, and the United States.

Free Markets 

In a market economy, decisions about what products are available and at what prices are determined through the interaction of supply and demand. A competitive market is one in which there is a large number of buyers and sellers, so that no one can control the market price. A free market is one in which the government does not intervene in any way. A free and competitive market economy is the ideal type of market economy, because what is supplied is exactly what consumers demand.

Price controls are an example of a market that is not free. When government intervenes, the market outcomes will be different from those that would occur in a free and competitive market model. When markets are less than perfectly competitive (e.g., monopolistic), the market outcomes will also differ.

Planned (or Command) Economies

Command economies operate very differently. In a command economy, economic effort is devoted to goals passed down from a ruler or ruling class. Ancient Egypt was a good example: A large part of economic life was devoted to building pyramids (like the one at the left), for the pharaohs. Medieval manor life is another example: The lord provided the land for growing crops and protection in the event of war. In return, vassals provided labor and soldiers to do the lord’s bidding. In the last century, communism emphasized command economies.

In a command economy, resources and businesses are owned by the government. The government decides what goods and services will be produced and what prices will be charged for them. The government decides what methods of production will be used and how much workers will be paid. Some necessities like health care and education are provided for free, as long as the state determines that you need them. Currently, North Korea and Cuba have command economies.

The primary distinction between a free and command economy is the degree to which the government determines what can be produced and what prices will be charged. In a free market, these determinations are made by the collective decisions of the market itself (which is comprised of producers and consumers). Producers and consumers make rational decisions about what will satisfy their self-interest and maximize profits, and the market responds accordingly. In a planned economy, the government makes most decisions about what will be produced and what the prices will be, and the market must follow that plan.

Most economies in the real world are mixed; they combine elements of command and market systems. The U.S. economy is positioned toward the market-oriented end of the spectrum. Many countries in Europe and Latin America, while primarily market-oriented, have a greater degree of government involvement in economic decisions than in the U.S. economy. China and Russia, while they are closer now to having a market-oriented system than several decades ago, remain closer to the command-economy end of the spectrum.

The following Crash Course video provides additional information about the broad economic choices that countries make when they decide between planned and market economies. The narrators talk fast, so you’ll need to listen closely and possibly watch the video a second time!

Economic systems determine the following:

• What to produce?
• Who to produce it?
• Who gets it?

In a planned economy, government controls the factors of production:

• In a true communist economy, there is no private property—everyone owns the factors of production. This type of planned economy is called a command economy
• In a socialist economy, there is some private property and some private control of industry.

In a free-market (capitalist) economy, individuals own the factors of production:

• Businesses produce products.
• Consumers choose the products they prefer causing the companies that product them to make more profit.

Even in free markets, governments will

• Maintain the rule of law
• Create public goods and services such as roads and education
• Step in when the market gets things wrong (e.g., setting minimum wage, establishing environmental standards)

In reality, economies are neither completely free-market nor completely planned. Neither exists in “pure” form, since all societies and governments regulate their economies to varying degrees. Throughout this course we will consider a number of ways in which the U.S. government influences and controls the economy.

Self Check: Economic Systems

Answer the question(s) below to see how well you understand the topics covered in the previous section. This short quiz does not count toward your grade in the class, and you can retake it an unlimited number of times.

You’ll have more success on the Self Check if you’ve completed the Reading in this section.

Use this quiz to check your understanding and decide whether to (1) study the previous section further or (2) move on to the next section.

Free enterprise, or the free market, refers to an economy where the market determines prices, products, and services rather than the government. Businesses and services are free of government control. Alternatively, free enterprise could refer to an ideological or legal system whereby commercial activities are primarily regulated through private measures.

In principle and in practice, free markets are defined by private property rights, voluntary contracts, and competitive bidding for goods and services in the marketplace. This framework is in contrast to public ownership of property, coercive activity, and fixed or controlled distribution of goods and services.

In Western countries, free enterprise is associated with laissez-faire capitalism and philosophical libertarianism. However, free enterprise is distinct from capitalism. Capitalism refers to a method by which scarce resources are produced and distributed. Free enterprise refers to a set of legal rules regarding commercial interaction.

Another definition of free enterprise is in terms of economics and was offered by the Nobel-winning economist Friedrich Hayek. Hayek described such systems as "spontaneous order." Hayek's point was that free enterprise is not unplanned or unregulated; rather, planning and regulation arise from the coordination of decentralized knowledge among innumerable specialists, not bureaucrats.

• Free enterprise refers to business activities that are not regulated by the government but are defined by a set of legal rules such as property rights, contracts, and competitive bidding.
• The argument for free enterprise is based on the belief that government interference in business and the economy hampers growth.
• A free enterprise legal system tends to result in capitalism.

The first written intellectual reference to free enterprise systems may have emerged in China in the fourth or fifth century B.C., when Laozi, or Lao-tzu, argued that governments hampered growth and happiness by interfering with individuals.

Legal codes resembling free enterprise systems were not common until much later. The original home of contemporary free markets was England between the 16th and 18th centuries. This growth coincided with, and probably contributed to the first industrial revolution and birth of modern capitalism. At one time, the English legal code was completely free of international trade barriers, tariffs, barriers to entry in most industries, and limitations on private business contracts.

The United States also used a largely free-market legal approach during the 18th and 19th centuries. In modern times, however, both the United States and the United Kingdom are better classified as mixed economies. Countries such as Singapore, Hong Kong, and Switzerland are more reflective of free enterprise.

In the absence of central planning, a free enterprise legal system tends to produce capitalism although it is possible that voluntary socialism or even agrarianism could result. In capitalist economic systems, such as that of the United States, consumers and producers individually determine which goods and services to produce and which to purchase. Contracts are voluntarily entered into and may even be enforced privately; for example, by civil courts. Competitive bidding determines market prices.

The U.S. economic system of free enterprise has five main principles: the freedom for individuals to choose businesses, the right to private property, profits as an incentive, competition, and consumer sovereignty.