1.9: Capitalism and Economic Freedom

Capitalism and Economic Freedom

Capitalism is another term for a free market system or free enterprise system. All three of these terms are used to describe the same type of economic system. In this type of economy, people own the factors of production and make decisions based on their own best interest. Government limits its interference in the marketplace, and competition between sellers helps keep prices down for buyers. So what makes an economy capitalist?

According to economists, five conditions must be present for capitalism to exist:

1. economic freedom,
2. competition,
3. voluntary exchange,
4. private property rights,
5. and a motive to earn profits (incentives).

Universal Generalizations

• Goods and services are allocated through different economic systems.
• Capitalism is a competitive economic system in which private citizens own the factors of production.
• The United States has a free enterprise system in which its citizens carry on their economic affairs freely but are subject to some government intervention and regulation.

Guiding Questions

1. How do people, acting individually or collectively through the government, make decisions about the allocation of goods and services?
2. In what way has advanced technology and science affected the productivity and distribution of goods and services throughout the economy?

Characteristics of Capitalism

If economic freedom exists, everyone from producer to consumer has the freedom to enter into or leave the market. Producers can decide what to produce, how to produce, and for whom to produce. They may also decide where to set up their businesses, hours of operation, and who to hire. Consumers can decide what to purchase, from which companies to do business with, where to work, how to work, and what to do with their earnings. Competition among sellers helps to keep prices low for consumers, as producers are competing with each other over how to attract and keep customers. At the same time, buyers will compete with each other to find the best products at the lowest price. Voluntary exchange is the freedom for both buyers and sellers to enter into the marketplace to buy or sell products. Sellers must believe that what they are selling is worth the price they are charging, while buyers must believe that the product they want to purchase is worth the money that they will be exchanging for the product. People have the right to own private property, or the right to own and control their possessions as they wish. Finally, the profit motive is the belief that people have the right to risk their money in a business venture or as an investment. The end result, of course, would be that if people are willing to invest, then they will get a return on their money above the amount they invested, and therefore people are considered better off.

Besides the five conditions that must be present for capitalism to function, there must also be: a consumer, an entrepreneur, and government. Each of these elements plays a role in the free enterprise system. The consumer helps determine which products a company makes and continues to produce based on their demand. If a product is rejected, then the company will no longer make it. Today consumers in a free market economy are very powerful since they can take their money to any “marketplace” that they wish to shop at. Consumption is one of the basic ingredients to make the market economy work. Without consumption, the economic activity of a country would suffer.

The entrepreneur is the “risk taker”. He or she is the one that comes up with a product, or a better product than what is currently available on the market. They may even find a better way to shop for a product (Amazon) or deliver a product (FedEx). The entrepreneur is the one that is willing to risk failure while trying to gain a position in the marketplace. If successful, the entrepreneur will be rewarded with monetary success, and the market will benefit with a new or better product than one that is currently in the store. In fact, more products of better quality benefit the consumer as the prices will generally adjust downward as more competition enters the market.

Lastly, the government willingly limits its intervention in the economy. In the United States, the government plays various roles such as: regulator, protector, provider, consumer, and promoter. As a regulator, the government is charged with ensuring competition in the market. It oversees businesses and its own agencies to make sure that industries are playing by certain rules. In the role of protector, the government enforces laws to prevent businesses from abusing or taking advantage of consumers. The government is also a provider of certain goods and services such as national defense, roads, public education, hospitals, libraries, and public welfare. In addition, the government is a consumer of goods. It purchases goods and services from the private sector such as office goods, buildings, and automobiles to run its offices and operate on a daily basis. Finally, this government is a promoter of national goals. The president, Congress, and administration of federal programs work to promote the goals of this economic system. As a result, this economy is no longer the same one it was fifty or even one hundred years ago. The government now reflects the expectations of the people and has moved the economy to what may be termed as a “modified private enterprise economy” or a “mixed economy”. It is clear that the economic system may continue to evolve as people’s needs change over time.

Viewpoints:

"If eyes are opened, or opening, to the rights of man. The general spread of the light of science has already laid open to every view the palpable truth, that the mass of mankind has not been born with saddles on their backs, nor a favored few booted and spurred, ready to ride legitimately, by the grace of God. "

–Thomas Jefferson, letter to Roger C. Weightman, June 24, 1826

Writing in anticipation of the 50th anniversary of America’s Declaration of Independence, Thomas Jefferson optimistically believed that the example of American freedom and individual rights had opened the eyes of the world to the value of liberty. Nearly two centuries after Jefferson wrote, it is clear that America has indeed been the shining example of freedom for the rest of the world. Since Jefferson wrote, people around the globe have sought either to imitate the example of American freedom by replicating its institutions or to enjoy that freedom directly by migrating to the United States.

The example of American freedom is a powerful one. Nowhere else has the liberty of average citizens been greater, more secure, and more protected. Lovers of freedom have admired all its aspects; from our protection of religious conscience to our free elections, from our freedom of speech to our impartial judicial system to our ability to choose our own private associations and more. One of the most persuasive features of our freedom, of course, is America’s high degree of economic freedom and the wealth and widespread abundance that has resulted from it.

Surveying the record of American productivity and prosperity is an inspiring task. In the space of just one-and-a-half centuries, American standards of living not only rose above those of most of the rest of the world, but they also rose beyond all expectation. Who among the most visionary forecasters of the mid-19th century could have imagined both the nearly unlimited economic opportunities available to Americans in the 21st-century and the fact that these opportunities would be available to everyone who labored to achieve them without regard to race, creed, noble birth, or the accidents of fortune?

Our ancestors would scarcely recognize a world where jet airliners whisk people from hemisphere to hemisphere in less than a day, where information about world events is available instantaneously, where corporations coordinate the economic activity of tens of thousands of employees around the globe (working in modern, climate-controlled high-rise offices, no less) while producing products to be sold to tens of millions, where diseases, plagues, and famines are a rare and tragic exception and not an accepted part of life.

Even the richest American in the early 19th-century would likely marvel at what is available to the average worker in 2008–the dizzying variety of food (from year-round fresh fruits and vegetables to exotic meats to instantly prepared meals-on-the-go), the comforts of life (from cheap clothing and transportation to modern housing and appliances), and the provision for optimal health (from MRIs and laser surgeries to organ transplants and universal vaccination), and beyond. That same 19th-century elite would be flabbergasted and stupefied by the fact that obesity–essentially, the consumption of too many calories and expenditure of too little physical labor–is a leading problem among the poor. In sum, by all economic measures, each successive generation of Americans enjoys indisputably better lives than previous ones. They work less and earn more, they can spend less on necessities and more on conveniences, and they live longer more pleasurable and more productive lives.

It is not just migrants and imitators, however, who have noticed the superior material results accrued by Americans as a result of their high levels of freedom. Over the past 20 years, scholars have increasingly directed attention to the problem of measuring different levels of prosperity around the world and correlating those observations with the differing levels of freedom. Since 1995, the Heritage Foundation and the Wall Street Journal have produced the annual Index of Economic Freedom, which scores the nations of the world on a multi-factor formula that determines their level of economic freedom. Since 1996, the Fraser Institute and Cato Institute have teamed with an international network of free market think tanks to produce and distribute the annual Economic Freedom of the World reports.

These studies’ conclusions are unambiguous and clear–-economic freedom not only correlates with economic growth and prosperity, but also is a direct cause of and necessary condition for it. Likewise, comparing these lists of the most economically free countries with the annual ranking of countries according to levels of political freedom and civil liberties by Freedom House, titled Freedom in the World, shows a direct link between levels of political and economic freedom.

Economic Freedom in America

The United States has consistently scored in the top 10 of each of these studies, confirming the high degree of economic and political freedom enjoyed by Americans. Despite the high-level of economic freedom in America generally, there is, nevertheless, a wide degree of variation in the United States itself. That uneven level of freedom forms the heart of our study and poses the central questions for it. How does economic freedom vary in the United States? What are the causes and the results of that variation?

Video: What is Economic Freedom?

Despite the high aggregate levels of economic freedom found in the United States, especially as compared with other nations, there is, nevertheless, a lack of uniformity in the distribution of that freedom. Within the United States, different groups of citizens experience different levels of economic freedom, often with drastic results. The lines that divide the levels of freedom in America are not based on class or race or sex. Instead, the origin of variation is found in the very nature of the American political compact–the federal nature of our republic. Because each of the 50 states has the sovereign power to direct local economic policy within its boundaries, there can be 50 different climates of economic freedom in the United States.

Supreme Court Justice Louis Brandeis once observed that the states could serve as “laboratories of democracy” by “try[ing] novel social and economic experiments.” Brandeis hoped that the states could experiment with economic policy and thereby encourage more economic planning, more regulation, and more intervention on the socialist model. His observation about the potential for the states to serve as laboratories is an apt one, even if the results are the opposite of what he might have expected. Instead of embracing the socialist model through state-level experimentation, Americans have demonstrated their belief in economic freedom by adopting the most basic strategy available to them–by doing what economist Charles Tiebout called “voting with their feet.” That is, given the freedom of Americans to move from jurisdiction to jurisdiction, we have found that Americans move away from states that impose regimes of less economic freedom in favor of those upholding more economic freedom.

Definitions, Assumptions, and Methods

At first glance, freedom can be a difficult concept to measure. Freedom, as a concept, is as old as written history itself. The earliest example of its written form dates to the 24th-century B.C. It initially seems quite simple–nearly everyone recognizes the visceral reaction when one’s freedom is restricted. When people do or do not feel restrained or curtailed by some authority, there we might find a rough measure of the extent of their freedom. Yet this is too simplistic. We cannot rely merely on self-reporting to measure something as important as freedom. We need a more objective standard by which we can determine whether a society or a government upholds and protects freedom or restricts and denies freedom. In short, we need a set of criteria based on an explicit definition of economic freedom whereby we can measure objectively the levels of freedom state-by-state. Thus, we must begin our study with a clear definition of freedom.

Economic freedom is an application of political freedom. The most basic distinction at the heart of the concept of freedom is the distinction between voluntary action and compulsion or coercion. Where individuals can choose their thoughts and actions, where they are free from physical coercion, they are free. We operate from a negative definition of freedom–it means the absence of physical restraints that halt or forcibly redirect one’s thoughts or actions. In the economic realm, this means that economic freedom is the freedom to produce and trade goods and services according to one’s own judgment, unrestrained by the physical coercion or compulsion of others, including the government. One must be free to acquire, use, and dispose of private property. Individuals must be free to enter into voluntary contractual relationships. The root identification here is that no man has a moral right to stake a claim on the productive activity of another against his will.

The implementation of freedom in society requires the identification and protection of individual rights, including property rights, and the creation of a government restrained by the rule of law, with the sole purpose of that government being the protection of those rights. Under this ideology, the proper functions of government are the provision of a realm of freedom for individuals to engage freely in economic transactions. To provide these freedoms, a government must protect its citizens from bodily harm or physical coercion from criminals or hostile foreign powers. It must also provide a system of courts and laws that objectively define the rules of social interaction among individuals–that is, they must prohibit the initiation of force and place the retaliatory use of force under the control of a properly delimited government. Under such a system, individuals are free to exercise their rights in any manner that does not violate the rights of others. In the economic realm, this means that the government must provide a legal system whereby individuals’ rights to property and contract are upheld and where disputes can be settled by law, not violence.

Consumers making choices in a supermarket.

In summary, we define economic freedom as the right of individuals to pursue their interests through voluntary exchange of private property under rule of law.

In order to make the measurement of different levels of economic freedom more objective, this requires that we specify a series of indicators and tie them to whether they advance or inhibit the proper functions of government in regard to an economy. In cases where an indicator leads, for example, to a greater ability of individuals to contract voluntarily with their fellow citizens, such a variable indicates a greater degree of freedom. Where an indicator leads to a diminished capacity for individuals to acquire, use, or dispose of their private property, for example, such a variable indicates a lesser degree of freedom.

This central insight has been the heart of a continuing project of studying and evaluating economic freedom in America. This 2008 Report is the third edition of the U.S. Economic Freedom Index, which began in a 1999 study by John D. Byars, Robert E. McCormick, and T. Bruce Yandle, and was revised in 2004 by Ying Huang, Robert E. McCormick, and Lawrence J. McQuillan. It measures the differing levels of economic freedom on a state-by-state basis. By applying a methodology similar to the comparison of economic freedom between countries, we have endeavored to measure different levels of economic freedom between states. That is, we have compiled criteria that illustrate a range of characteristics that indicate levels of freedom and that can vary between states. We define economic freedom as the right of individuals to pursue their interests through voluntary exchange of private property under rule of law.

What Others Have Said

The literature on economic freedom has been growing significantly in recent years. Since the original publication of this index, scholars have focused more attention on the basic questions we investigate and their implications. Does economic freedom vary in significant ways in the United States? Can we observe a movement of people and human capital across state borders in response to differing levels of freedom? Is economic growth and personal income higher in states with more economic freedom?

In a wider conception, however, the literature on economic freedom was already well established and historically rich when this index was first published. Great minds throughout history have observed and remarked on the relationship between political and economic freedom and have arrived at the same conclusions. Our purpose here will be to survey their thought briefly and then review the modern literature.

Eric Daniels is a research assistant professor at the Clemson Institute for the Study of Capitalism at Clemson University in Clemson, South Carolina.

Additional Resources:

Benefits of Economic Freedom

Follow the link below to read an article by James M. Roberts and Ryan Olson on the benefits of economic freedom.

How Economic Freedom Promotes Better Health Care, Education, and Environmental Quality

Video: Voluntary Exchange

View the video below for a break down of the term "voluntary exchange."

Video: Capitalism and the Hunger Games

In this video, economics teacher Jacob Clifford uses The Hunger Games to discuss the advantages and disadvantages of capitalism.

Answer the self check questions below to monitor your understanding of the concepts in this section.

Self Check Questions

1. Identify the role of the economy in a free enterprise economy.
2. Give at least three examples of voluntary exchange you have made in the last week. Are you better off than you were before these purchases? How do you know?
3. Describe the role of the entrepreneur. Can anyone be an entrepreneur? What does an entrepreneur need? Would you like to be an entrepreneur?
4. What are the 5 major characteristics of a free enterprise system?
5. What are the consequences of consumer economic decisions? How does the consumer impact the economy? What is the main goal of the consumer?
6. How have our economic goals changed over the last 100 years? Will our economic goals continue to change over time? How do you know the goals will change? Give an example of 2 changes in economic goals.
7. How do people and businesses benefit from economic freedom?
8. Of the roles that the government plays in the economy, which role do you believe is the most important? Why? Which role is the least important? Why?