Free Enterprise

How Does a Free Enterprise Work?

Free enterprise refers to an economy in which the supply and demand in the market dictates the prices of goods and services, as opposed to the government, or a governing authority for that matter.

Since the balance of supply and demand in the market is the deciding factor in the prices of goods and services, businesses are incentivized to pay close attention to consumer preferences and adjust their customer acquisition strategies and pricing accordingly.

In theory, market competition causes businesses to continuously adapt their strategic initiatives across the long run, with pricing set for transactions—the delivery of a product or service in exchange for monetary compensation—at a level deemed a fair trade-off.

The supply and demand for a particular good or service constantly fluctuate, so companies are placed in a consumer-centric position where their business model must prioritize meeting the needs of the customer (or target end market) above all else.

• Competition (Supply-Demand) ➝ From the perspective of proponents of free enterprise, the central belief is that competition facilitates economic growth and development over the long term.
• Government Intervention ➝ In contrast, governmental intervention achieves the opposite by hampering growth (and removing the incentive to compete).

Suppose an economy is left to operate with minimal governmental intervention. Given those assumptions, the markets self-regulate for the businesses that sufficiently cater to consumer needs and provide enough value to reap the rewards rightfully.

Free Enterprise Quote — Peter Drucker

^{Free Enterprise System Quote, Peter Drucker (Source: Global Peter Drucker Forum)}

What are the Characteristics of a Free Enterprise Economy?

A free enterprise is an economic system based on competition (supply-demand) and individualism.

The most commonly cited characteristics attributable to a free market structure are the following:

• Competition (Supply-Demand) ➝ The supply and demand market forces and competition among businesses impact the prices at which goods and services are set and offered to consumers.
• Market-Driven Prices ➝ The prices of goods and services fluctuate based on the prevailing market conditions. Therefore, high demand for a product or service coincides with higher pricing (and vice versa).
• Customer-Centric Business Model ➝ For a business to generate more revenue and profit, the customer’s needs must be met, so the business model must shift toward delivering value creation on behalf of its target customers.
• Consumer Sovereignty ➝ In free market economic systems, consumers have the right to choose the option most appealing to their needs. Since consumers are presented with a wide range of products and services, their decisions influence what businesses produce based on their purchasing decisions (i.e. consumers create the demand, which companies must fulfill).
• Focus on Quality ➝ The quality of goods and services a business provides must be sufficient—or exceed the current offerings available in the market—to attract new customers (and, more importantly, retain them over the long haul).
• Limited Government Intervention ➝ The role of the government is reduced to matters that pertain to ensuring fair competition in the market (or anti-trust regulations), public safety (e.g., the COVID-19 pandemic), and related issues.
• Private Property Rights ➝ Individuals and businesses can own and control property and resources, including land, buildings, copyright, and intellectual property (IP).
• Economic Freedom ➝ Businesses and individuals have the right to make their own economic decisions, like what goods or services to produce, the production method, and to whom to cater (i.e. target customer).
• Voluntary Exchange ➝ Transactions are voluntary between both sides—i.e., the buyers and sellers—where each party agrees to the terms of the exchange without coercion.
• Entrepreneurship Incentive ➝ The free market economy allows individual consumers and business owners to start and operate a business, set prices, and choose suppliers and customers at their discretion, effectively promoting entrepreneurship among individuals given the profit motive.

What is the Role of the Government in a Free Market?

In free enterprise systems, the role of the central government is deliberately limited, aside from occasionally stepping in to protect the “best interests” of the general public and maintain economic stability.

While the purest definition of a free market system is restricted government control, certain circumstances require the government to intervene to ensure a fair playing field and that the market determines prices.

For example, the government could intervene to block the merger of two companies based on antitrust concerns, as competition is practically wiped out after the merger.

Hence, the necessity of government interference in such scenarios is to ensure that no single corporation (or entity) has enough control in the market to single-handedly establish the pricing at a rate that benefits itself, often at the expense of everyday consumers.

But to reiterate, free markets should involve minimal government intervention, with market prices set by supply-and-demand dynamics and competition.

Free Market System Quote — Milton Friedman

^{Milton Friedman Quote on Free Market System (Source: Milton Friedman)}

Free Enterprise Economy: What are the Pros and Cons?

Benefits of Free Enterprise Economic System

Free enterprise is a rather intricate concept where the real-life application diverges from the economic theory taught in academia.

• Economic Efficiency ➝ Economic efficiency is the main benefit of a free enterprise since promoting the efficient utilization and allocation of resources is an inherent component of the market structure.
• Customer-Centric Profit Motive ➝ Businesses are incentivized to provide the maximum value to customers, indirectly requiring reducing unnecessary costs to maximize output. The efficient use of labor, capital, and other resources is necessary for a company to improve its profit margins and establish a defensible economic moat.
• Consumer-Led Market Demand ➝ Consumers are the focal point of a free enterprise since their purchase decisions and selections, made according to their preferences, ultimately determine what businesses produce and toward which they pivot their resources.
• Profit Motive ➝ Profit potential is a critical motive for individuals to become entrepreneurs and undertake the associated risks, contributing to more innovation, economic growth, and job creation.

Drawbacks of Free Enterprise Economic System

The drawback to a free enterprise economy is that the structure can create significant disparities in wealth and income, reducing the overall competition in the market.

• Economic Disparities (Wealth Inequality) ➝ To comprehend the mechanics of free markets, the distinction between equality of opportunities and equality of outcomes must be drawn. In short, the “winners” in the market—such as Amazon (AMZN), Apple (AAPL), Microsoft (MSFT), Meta Platforms (META), and Alphabet (GOOGL)—will inevitably accumulate far more resources and profits relative to the rest of the market, as exhibited by their outsized market capitalization (or “market cap”).
• Limited Competition ➝ Therefore, free enterprise economies are susceptible to forming oligopolies or monopolies, which could necessitate government intervention if deemed appropriate. Under an economic system categorized as a monopoly, competition is absent in the market, as one enterprise controls the entirety of the market. On the other hand, an oligopoly occurs when a few established companies control most of the revenue generated in a particular market.
• Prioritization of Near-Term Performance ➝ Companies, or more specifically, the management teams, are often near-term oriented, especially if they are publicly traded, because they must report quarterly earnings (10-Q, 10-K). If a company prioritizes short-term profits over long-term sustainability, the near-term-oriented strategy could lead to unfavorable outcomes for employees, consumers, and operational performance over the long run.
• Competition-Based Pricing ➝ Certain products have lower margins than others, to state the obvious, so a widespread focus on profit maximization among market participants could cause unprofitable goods and services to be produced in lower quantities (and vice versa). Furthermore, the concentration of competition on high-margin products can lead to competition-based pricing, which coincides with margin compression in the long run.
• Resource Misallocation ➝ In fact, essential consumer goods and services, like public transportation, often fall under the category of being less profitable. Hence, the government—either at the local, state, or federal level—must intervene and fund certain initiatives, or else no investment capital will be allocated toward funding them.

Free Enterprise vs. Capitalism: What is the Difference?

Free enterprise and capitalism are two terms often used interchangeably, but the two are distinct economic systems, contrary to a common misconception.

• Free Enterprise ➝ Free enterprise refers to an economic system based on private ownership of capital and resources, with minimal government intervention and regulation, as mentioned earlier. The fundamental principles that constitute a free enterprise are fair competition, the reliance on supply and demand to set prices, and the freedom of individuals and businesses to make their own economic decisions.
• Capitalism ➝ On the other hand, capitalism is an economic system characterized by private ownership of capital and production, with the underlying objective of profit generation and wealth creation. Compared to a free enterprise, capitalism is a more open-ended term that does not necessarily imply free markets or limited government intervention per se.

Capitalism can take several forms with varying degrees of government control and regulation over the economy, so proponents’ perspectives frequently differ (and often contradict).

The main difference is a free enterprise advocates for truly free, competitive markets with minimal government interference. In contrast, capitalism is a more high-level theory promoting private ownership and profit motives, which can coexist with strict regulation and governmental intervention.

Free Enterprise Example: Google vs. OpenAI Competition

The competitive nature of a free market system encourages public and private companies to innovate and improve their products or services, contributing toward technological innovation and economic growth.

For a real-life example, the seemingly exponential growth of AI research and development firm OpenAI significantly influenced Google’s business model and resource allocation, particularly on the artificial intelligence (AI) front.

Google has historically received much regulatory scrutiny for its dominant position in the search engine, with a market share of over 90%+ and accusations of anti-competitive practices.

However, the sudden emergence of ChatGPT presented a material risk to the historically robust, ad-based business model of Google, where consumers could someday rely less on Google Search to obtain the answers to their search queries.

Most recently, OpenAI’s development of multimodal AI models—i.e. GPT-4o—can process and generate responses in various mediums, such as text, audio, imagery, and computer code.

The rapid development of OpenAI’s product capabilities has forced Google to enhance its AI models, releasing products like Gemini AI, for instance, offering similar multimodal functionalities.

At the annual Google I/O developer conference in 2024, Google showcased Project Astra and Gemini 1.5 Pro, highlighting their progress in developing advanced AI functionalities to compete and offer a superior product.

The announced projects and new initiatives include features like reading and summarizing textbooks, enhancing Gmail with AI-driven summaries, and integrating AI into augmented reality glasses.

The rapid innovations demonstrate Google’s commitment to establish itself as the frontrunner of AI technology in response to OpenAI, which illustrates the impact of competition on a company’s urgency to invest in research and development (R&D).

The rivalry between OpenAI and Google—irrespective of which company ultimately comes out on top—is a net positive for society as a whole because consumers are the ultimate beneficiaries.