What is Private Enetrprise? A private enterprise type of economic organization is one in which (1) the critical decisions in economic life are made by self-seeking individuals, guided by prices and disciplined by competition; (2) most of the means of production are privately owned and controlled; and (3) rewards are approximately in proportion to contributions.
BRIEF HISTORY OF PRIVATE ENTERPRISE
Some insight into the characteristics of the system can be gained by examining how and why this type of economic organization developed. Certain features of free enterprise can be found in all economic systems, even those of primitive man. However, the system cannot be found in anything like complete form until we reach the England and America of the late 18th and early 19th centuries. Free enterprise did not develop in these countries at this time as a result of a deliberate plan. Rather it came in by the “back door,” as the existing form of economic organization—mercantilism—gradually broke down. Mercantilism was a set of economic policies directed to the goal of making the nation stronger than its rivals. The policies called for substantial control by the government of the economic life of the people of the country and its colonies—what they should consume, what they should produce, where and at what wages they should work, where they should invest their money, etc. Mercantilist theory and mercantilist practice were based on the assumption that there was an inherent and inevitable conflict between the national interest and the selfish interests of the individuals who made up the nation.
The restrictions that the British parliament placed on the economic life of her American colonies were part of mercantilist policy. The discontent produced by these restrictions was one of the factors leading to the American Revolution. Within England, too, this system of controls became more and more unpopular and more openly violated. For example, it is estimated that, at one time in the 18th century, more than one-fourth of the population of the coastal areas of England was engaged in smuggling, particularly in bringing in forbidden goods from France. Gradually the detailed regulations such as the one making it a crime to wear anything made of colored calico, were modified or repealed. Step by step the economic life of England was freed from the excessive control of mercantilism, and free enterprise was under way.
Free enterprise came into existence as a reaction to detailed government control of economic life. Its further development was promoted when the free enterprise idea was presented in a positive form. Many writers contributed to the idea, but it was left to the Scottish philosopher, Adam Smith, to give the first reasonably rounded account of how such a system might be expected to work.
In his famous book, The Wealth of Nations, which, incidentally, appeared in the same year (1776) as our Declaration of Independence, Smith demonstrated that a country’s interests can be effectively served by permitting each person to make his own decisions and follow his own self-interest in economic life. This is the central idea of the free enterprise system.
HOW DOES THE PRIVATE ENTERPRISE SYSTEM WORK?
But how can an economic system work in which each person is left free to do as he pleases? How can the activities of farmers, miners, factory workers, businessmen, etc., be coordinated without some person or group exercising central control? Let us start our answer to this question by recalling the problems of an organization which must be solved by any kind of economic organization. The problems are: (a) to decide what is to be produced and in what amounts, (b) who is to perform each of the tasks involved, and (c) how much each person is to get as his share of the output.
The “what” decision. Under an enterprise system, the “what” decision is made by the consumer. Through the way, he spends his dollars he determines what is going to be produced and in what amounts. When he wants more cars and fewer horse drawn carriages, he casts more of his dollar “votes” for cars and fewer for carriages.
This control by the consumer of what is to be produced is often referred to as consumer sovereignty. We shall study the decision-making of consumers under the general heading of demand. The “who” decision. Profits and losses. The dollar “votes” of consumers represent the orders to the firms in the economy telling them what they should produce and in what amounts. However, each firm is free to produce whatever it pleases. What assurance is there, then, that the firms will produce the things wanted by consumers?
The answer is that the more votes there are for a good, the more dollars there are for the firms producing the good; the less votes, the fewer the dollars. The reward for obeying the consumers is profits; the penalty for disobeying is losses. It is the desire for profits and the fear of losses which lead the managers of the firms to do the bidding of consumers—to produce more cars and fewer horse-drawn carriages. Because profits can be made only by producing something that consumers want and consider useful, production for profits becomes just one way of getting production for use.
Profits and losses are part of the signal system of an enterprise economy. They guide firms into the production of the things more wanted by consumers and out of the production of the things less wanted by consumers. Profits and losses have a very important function to perform in an enterprise economy. We shall discuss the responses of firms to the dollar votes of consumers under the heading of supply.
Freedom of job choice. The managers of firms cannot produce goods without help. To begin with,, they need the help of workers. How are workers assigned to the various tasks under an enterprise system? The answer is that each worker decides where and at what job he is going to work. What assurance is there, then, that the workers will follow the wants of consumers, that they will work at the job of producing cars rather than carriages? The answer lies in the fact that the workers, like the managers of firms, are guided by self-interest. They wish to make higher wages and avoid wage cuts. If they want higher wages and continuous employment, they will work for the firms producing cars, the firms that have received the most dollar votes with which to pay workers. Wages, too, are an important part of the signal system of an enterprise economy. Relative wages, in combination with employment opportunities, guide workers into the production of the things wanted by consumers and out of the production of things that are not wanted. Profits and relative wages also determine in part where particular economic activities will be carried on. That is, if wages are higher in one part of a country than another, workers will tend to move from the low wage areas to the high wage areas, and firms will tend to move from the high wage areas to the low wage areas. This movement tends to equalize wages and makes for a better use of resources. We shall give particular attention in our chapters on wages and on wage problems to this function of relative wages.
Private property. It takes more than the labor of human beings to produce goods in a modern industrialized economy. It takes land, buildings, tools and machinery, raw materials, and power as well. What assurance is there that these nonhuman resources will do the bidding of consumers? The answer lies in one of the distinguishing features of free enterprise: private ownership of the means of production. Each unit of land, each building, each tool, and each machine is owned by some person or persons. The owners of these resources receive incomes from selling the services of their resources to the firms. The firms producing cars will be able to offer better opportunities—higher rents, higher interest rates, and higher prices—to the owners of the land, capital, and raw materials than will the firms producing carriages. The necessary nonhuman resources will move into the car industry and out of the carriage industry.
Self-interest, made effective by the device of private property, leads the owners of the nonhuman resources to put them to the uses which consumers desire. Rent on land, interest on capital, the prices of raw materials—all these are parts of the signal system of an enterprise economy. They serve to guide the nonhuman resources into the most productive uses.
It can be seen from this discussion that private property in an enterprise system is simply a device to assure that the nonhuman resources needed in production will be put to their best uses. Private property can be justified on the basis of the important function which it performs and need not be justified on any ethical grounds. We shall be concerned with the ethical question of private property when we turn to an examination of other types of economic organization.
The “how much” decision. The consumers have selected the things to be produced; the firms have used the resources, both human and nonhuman, to produce the desired goods and services.
The only problem remaining is how to divide this output among the people in the economy. On what basis is this division made under free enterprise? In the first place, each unit of each good (each car, each loaf of bread) goes to that person who is willing to pay the most for it. In effect, the prospective buyers of a given stock of a given commodity keep bidding up the price of the commodity. As the price goes up, the buyers who would prefer to spend their available resources on other goods keep dropping out. Eventually a price is reached at which the quantity that buyers are willing to take is just equal to the quantity available. This will be the going price, the price which “clears the market.” This is simply a rationing process under which goods go to those who are willing to give up the most to get them.
Other things being equal, this will lead to the goods being used in such a way as to satisfy the most wants. The total amount of goods a person will be able to buy will depend on the prices of the goods and on the size of his income. In general, the size of each person’s income depends on the productivity of the resources which he owns. For example, the more productive the labor of a worker, the more will firms be willing to pay for that labor, and the higher will be the income of the worker. By distributing income on this basis each person is given an incentive to put his resources in those uses where they will be the most productive (where they will contribute most to satisfying consumer wants). This way of distributing income is essential to the system because it provides the incentive needed to get people to do the bidding of consumers. At the same time, this way of distributing income always produces an unequal distribution of income. This fact can lead to serious problems if the people of the society are not willing to accept a substantial amount of inequality in the distribution of income. We shall have occasion to consider later how far and in what ways income can be redistributed in an enterprise economy without destroying the incentives and the signals which are necessary if it is to operate effectively.
Economic progress. The level of living of a people can be improved by moving resources from low-productivity to high-productivity uses, from uses where they satisfy few wants to uses where they satisfy more wants. However, sustained and rapid improvement in levels of living usually requires more than this. It requires not only a better use of the given resources but also an improvement in the quality of resources, an increase in the quantity of resources available (particularly, the nonhuman resources), and an improvement in the techniques of production. These are the three basic elements in economic progress. How is economic progress promoted under an enterprise system? The answer again is self-interest. Self-interest leads the worker to increase his productivity so that he contributes more wherever he works. Self-interest leads other people to search for new sources of raw materials, and for ways of making existing supplies go further. It leads the managers of firms to seek new and better ways of doing things. Self-interest is the driving force behind economic progress in an enterprise economy. That it is a potent driving force is demonstrated by the record of progress in the United States under this system. That it involves stresses and strains will become clear when we enquire into the causes of the business cycle. We know that economic progress is possible under private enterprise. We shall have occasion later to consider whether it is equally possible under a centrally directed type of economic organization.
The role of saving. One thing is clear: progress is not cost-less. It requires frequent and sometimes unwelcome personal adjustments. In addition, it requires saving. Resources which could be used to make more things of immediate usefulness—more food, more clothing, more cars and refrigerators—must be devoted to increasing the quantity and improving the quality of resources, and supporting those who are busy devising new and better ways of organizing resources. Saving, from the point of view of society as a whole, occurs when resources are released from the production of consumption goods. These savings are always made by individuals, voluntarily or involuntarily. They occur whenever a person refrains from spending all his income. But whether such savings result in social saving depends upon the use of the savings. If they are borrowed and spent by a spendthrift, there is no saving from the social point of view. What A saves, B spends. Only as they are used to maintain and improve the apparatus of production do they permit a people as a whole to live better in the future.
Saving is necessary to economic progress under any type of economic organization. Under centrally directed systems, the central planning group decides how much is to be saved, who are to do the saving, and how the savings are to be used. Under the enterprise system, these three decisions are left to individuals.
The role of competition. The system just described will not work efficiently under any and all conditions. Perhaps the most important requirement is that of competition. A brief but precise definition of competition is difficult to construct. We shall content ourselves with a meaningful but rather inexact definition at this time. Competition is rivalry for income by the method of offering more for less. It was Adam Smith’s recognition of this force that led him to predict that, in any society in which competition was protected and encouraged, there would be an essential harmony between individual self-interest and the national interest; that individuals, in striving to promote their own interest, would, without being aware of it, promote those of their fellows. Competition is the disciplining force in all buying and selling activities. Buyers compete against buyers, sellers against sellers, workers against workers, employers against employers, savers against savers, landlords against landlords, and so on, throughout the whole range of economic life.
International trade. So far we have been discussing the operation of an enterprise economy as if there were no other countries in the world but the one under study. Actually every country that attempts to use an enterprise system is part of a world economy. As we shall see, trade between the peoples of different nations develops for the same reason that it does between the people of Indiana and the people of Florida. By specializing, by taking advantage of the distribution of natural and human resources, the people in each area can produce more than would be possible without trade.
The role of government. The enterprise system is often (and rightly) associated with the concept of laissez-faire. Literally interpreted, this phrase means “leave it alone.” When applied to economic life laissez-faire is usually understood to mean that the government should let the people do as they wish and should keep its hands off the economy. But this is only a half-truth. Though an enterprise system is designed to operate without detailed central control and direction, the government nevertheless has a very important role to play in making the system work.
Providing a reliable money. One of the most important responsibilities of government is related to the use of money in economic life. Money is anything that is generally accepted in exchange for goods and services. The primary function of money is to simplify the processes of exchange. In the next chapter we shall describe the importance of money in our modern world in which almost everything is produced for sale and not for the producer’s own use. we shall show what governments can do to provide a reliable money and what happens when a people lose confidence in the goodness of their money.
Providing the “rules of the game.” As we have already indicated, self-interest is a powerful force. It is doubtful whether any human society could get along without it. Yet it must be channeled and directed if it is not to be destructive. Competition is one of the channeling forces. But government must set the rules of the competitive game. First of all government must define permissible action in such a way that the game is played competitively. Maintaining competition is one of the most important (and most vexing) responsibilities of government. It is evident that the definition of permissible action must prevent persons from getting ahead by fraud, robbery, murder, etc. In other words, it is the responsibility of government to maintain law and order. Further government must enforce contractual obligations. Free individuals cooperate with one another on the basis of written and unwritten contracts. If these contracts are not honored, the whole system breaks down. Fortunately the enforcement problem is not serious since the overwhelming majority of contracts express the mutual interest of the parties that make them.