How the Free Enterprise System Works

how the free enterprise system works

Free enterprise is an economic system built on freedom that results in prosperity. The way this economic system works is rather simple. In a capitalist economy, there are many different people contributing in many different ways. Every person can be sorted into five distinct groups. These groups are determined by their means of earning money. The interactions result in a properly-functioning free enterprise economy.

 

The Five Groups of Free Enterprise

 

Laborers

The laborers carry out the day-to-day work of the economy. Laborers repair watches, operate machinery, perform surgery, and do many other tasks. A common misconception is that this group is exploited by the others, particularly capitalists. This is simply untrue in a functioning free enterprise economy, as laborers will only work if they choose to work. Laborers earn their living by selling their labor for wages.

 

Capitalists

Capitalists, business owners, or industrialists are the owners of the means of production. Capitalists start and own businesses such as electric utilities, insurance companies, iron mines, and shipping companies. Note that this group does not steal from other groups, particularly laborers, in a proper private enterprise system. Capitalists, as is with all other groups, can only trade with another person if their consent is obtained. Capitalists make money by selling goods and services for a profit.

 

Financial Institutions

Financial institutions are entities such as banks and credit unions. These entities store money for people and allocate that money primarily by lending it out. Just like the other groups, they can legally only  make money by voluntary trade in a capitalist economic system. Financial institutions make money by crediting borrowers with money and charging them interest.

 

Investors

Investors are people that use money to make money. Investors typically used to have a position in one of the other groups in order to generate enough wealth to be able to invest. Investors can buy into real estate, businesses, financial products, and many more investment vehicles. Investors earn their money by receiving a return on their investments, such as a share of profit from a business or rent money left after expenses from real estate.

 

Government

Government is an essential part of a free enterprise economy. Government carries out activities that cannot be done at all, or at least not well, by the private sector. Such activities include maintaining a military, and expanding infrastructure. One of the most important functions of government is creating laws and property rights. Free enterprise requires that individuals are able to own property; thus a property laws, rights, and records need to be created by someone. The only body that can do this is government. Government makes money by levying taxes on the other four groups.

 

government building, capitol building
Government performs important activities such as building roads and printing currency.

 

Interactions between Groups

Each group interacts with the others differently. Laborers and capitalists interact much differently than do financial institutions and investors. All the financial relationships between the groups are necessary for a healthy economy. If a free enterprise system is to succeed, laws and rights must be created to prevent the abuse of these financial relationships through force and deceit. Fortunately, force and deceit are the exception, not the norm, in most free market economies.

 

Laborers and Capitalists

Laborers give their labor to capitalists (i.e. business owners/ industrialists) in exchange for wages. If there are no monopolies,  monopsonies, or other obstructive forces controlling labor, then the usual laws of supply and demand will occur, and labor will be sold at for a quantity of hours and price per hour agreed upon by both parties. Thus, no exploitation occurs. Laborers may want higher wages than they currently have, but that doesn’t mean that they are forced into working and into working for low wages. There are many employers to choose from and many jobs under each employer. This allows laborers to have many opportunities to be able to sell their work.

 

Laborers and Financial Institutions

Laborers both deposit money in financial institutions and borrow from them. Laborers deposit money to prepare for emergencies, save money for large purchases, such as down payment on a new car, and earn interest. Laborers borrow money to buy houses, cars, and on using short-term loans, such as credit cards, make purchases such as food and clothes. Financial institutions such as wealth management services, help laborers to be able to manage their money and prepare for retirement.

 

Laborers and Investors

Laborers earn money for investors, such as by paying rent or working for a business an investor has an ownership stake in. At first, this relationship might seem beneficial only to investors. However, investors provide places for laborers to live in and work in, by building and buying real estate to rent, lease, and sell, and by supplying business with capital. In other words, investors allow laborers to earn money. An example would be a hotel. A group of investors might supply an entrepreneur with the money he or she needs to build the hotel. From there, the entrepreneur will hire laborers in search of a job. The result is that  more laborers have a place to work. The wages of laborers could not exist without the capital of investors just as the profits of investors could not exist without the work of laborers.

 

Laborers and Government

When laborers earn money through wages, they almost always pay taxes. Payroll taxes are one of the more significant taxes levied on laborers. The government benefits laborers in ways such as creating public roads for laborers to travel to work on. Laborers might also work for the government, such as by joining the military.

 

Capitalists and Financial Institutions

Capitalists borrow from financial institutions to expand their businesses. This is called leverage. Borrowing allows capitalists to earn more by expanding profit-generating production. Lending allows financial institutions to earn more due to the interest earned on new loans. Capitalists will typically deposit some money in financial institutions. However, deposits will usually only be enough to allow their businesses to have cash to operate with.

 

Capitalists and Investors

Investors supply capitalists with money to start or expand businesses. In exchange, investors receive a share of profits. Ownership positions are not always the way investors invest in businesses. Sometimes they do so indirectly, through the purchase of bonds. When investors purchase bonds from businesses, they earn interest. Investors allow capitalists to start businesses with little or none of their own money.

 

Capitalists and Government

Capitalists pay taxes on the income their businesses earn. They also pay payroll taxes on the wages their employees earn. The government sometimes gives capitalists small loans to encourage entrepreneurship and stimulate the economy. Sometimes capitalists team up with the government through public-private partnerships that produce financial benefits for both. The businesses of capitalists also sell certain services to government, such as construction services for public roads.

 

Financial Institutions and Investors

Financial institutions lend money to investors for certain investments, usually real estate. Borrowing money allows investors to purchase five, ten, twenty, fifty, or even more real estate investments. This allows investors to earn huge returns. In exchange, investors pay interest to financial institutions. Investors typically deposit even less money than capitalists in financial institutions. Investors might buy financial product investments sold by financial institutions, such as mortgage-backed securities. Investors also might use brokerages to trade stocks and mutual funds.

 

Financial Institutions and Government

Financial institutions pay taxes to the government on interest and other income they earn. Financial institutions fund the debt of the government through the purchase of government bonds, which they earn interest on. Governments also use financial institutions to be able to control the supply of money. Financial institutions increase the money supply when they create loans.

 

Investors and Government

Investors help to fund the debt of the government and are rewarded with interest payments. This provides the government with the capital it needs to function. Investors, like the other groups, must pay taxes. Investors must pay taxes on the periodic returns on their investments as well as profit on the sale of investments.

 


 

When all of the five groups of free enterprise interact with each other, a strong, working economy is formed. Each and every group is needed to achieve such a result. If laws and rights are set up properly, the five groups will work together harmoniously to achieve production, each free from exploitation.