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A CCEE publication that provides basic insights into the workings of a free market economy. This publication is well suited to teaching a younger readership.

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Published by heidi.conley, 2016-12-09 13:31:03

Free Enterprise: Our Heritage, Our Wealth Booklet

A CCEE publication that provides basic insights into the workings of a free market economy. This publication is well suited to teaching a younger readership.

Fifth Edition

A . PA U L B A L L A N T Y N E, Ph.D. | J O H N B R O C K , Ph.D.
DALE D BOER, Ph.D. | TIMOTHY TREGARTHEN, Ph.D.


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for Economic Education based in New York City. CCEE is the leading Colorado
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Colorado teachers and by extension, their students. CCEE accomplishes this by
presenting an ever-changing variety of accredited, graduate-level economics classes
for teachers. During the past two decades, CCEE has played a key role in the
adoption of legislation requiring the inclusion of economics, and later personal
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taught in Colorado’s public schools at every K-12 grade level.

Tax-Deductible Contributions to CCEE

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CCEE receives virtually all of its funding from private sources. Tax-deductible
contributions are gratefully accepted and may be made online at www.ccee.net
or mailed to the address shown on the back cover. Additional copies of Free
Enterprise: Our Heritage, Our Wealth are available for purchase, please contact
us for more information.

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Denver, Colorado 80231
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free
enterprise

Our Heritage
Our Wealth

Fifth Edition

Authors:
A. Paul Ballantyne
John Brock
Dale R. DeBoer
Timothy Tregarthen

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support from a grant from the
Bruni Foundation, Colorado
Springs, Colorado.

Copyright ©, 1993, 1995, 2004, 2005, 2012 by the Colorado Council for Economic Educa-
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reproduced in any manner whatsoever without written permission except in the case of brief
quotations. Printed in the United States of America.


COLORADO COUNCIL FOR ECONOMIC EDUCATION

Authors

DR. A. PAUL BALLANTYNE DR. JOHN BROCK

Dr. Ballantyne is Professor Emeritus of Dr. Brock is Director of the Center for Eco-
Economics at the University of Colorado, nomic Education and a Senior Instructor of
Colorado Springs. After teaching at UCCS Economics at the University of Colorado,
for 44 years, Professor Ballantyne retired in Colorado Springs. Prior to joining the
June 2011. He holds a B.A. from the Uni- University of Colorado in the mid-1990s, he
versity of Southern California, an M.A. from was a Professor of Economics at the United
the University of Iowa, and a Ph.D. from States Air Force Academy.
Stanford University. He taught at the Uni-
versity of Iowa, the U.S. Air Force Academy, He received a B.S. in economics from the
Colorado College, and in the University of Air Force Academy, an M.B.A. from the
Pittsburgh Semester at Sea Program. University of Southern California, and a
Ph.D. in economics from Cornell University.
Dr. Ballantyne received several teaching
awards at the University of Colorado, Dr. Brock was awarded the Air Force Acad-
including the Outstanding Teacher of the emy’s Outstanding Educator Award in 1984
Year Award in 1994. He was recipient of and the University of Colorado’s Outstand-
the Chancellor’s Award given for outstand- ing Teacher of the Year Award in 2002.
ing teaching, research and service, and is
listed in Who’s Who in America and also He has published articles as well as a hand-
in American Men and Women in Science. book on using experimental economics in
the classroom. Over the past 13 years, Dr.
For many years he consulted internationally Brock has taught and advised economic edu-
with the Russian Academy of Economic cators in South Africa, Indonesia, and many
Science in Moscow and with Sumy State countries in Latin America, the Middle East,
University in Ukraine, which awarded him and the post-Soviet region.
an Honorary Doctorate in 2004. He has
written in the areas of monetary theory,
economic development, economic educa-
tion, and macroeconomics.

ii


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

DR. DALE DĖBOER DR. TIMOTHY TREGARTHEN

Dr. DeBoer is an Associate Professor and Dr. Tregarthen is Professor Emeritus of
Chair of the Department of Economics Economics at the University of Colorado in
at the University of Colorado, Colorado Colorado Springs. He taught at the Univer-
Springs. He received his B.A. degree in Phi- sity from 1971 to 1996. He served as Chair-
losophy from the University of Washington, man of the Department of Economics from
and his M.A. and Ph.D. from the University 1974 to 1985. He received two University
of California, Davis. of Colorado Outstanding Teacher of the
Year Awards and the Chancellor’s Award.
He is the recipient of four teaching awards
including the University of Colorado’s Out- Dr.Tregarthen completed his graduate work
standing Teacher of theYear Award in 1999. in economics at the University of California
at Davis, where he was a Woodrow Wilson
Dr. DeBoer’s research focuses on the mac- National Fellow and a Regents Fellow. He
roeconomic implications of computing and was student body president at California
information technologies. He serves as a State University, Chico and where he received
consultant to the hedge fund industry and to his B.A. in economics magna cum laude.
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as a research consultant to the National He was Executive Editor of ɩ F .BSHJO
Early Head Start Program. magazine from 1985 to 1994. He founded
the freshman seminar program at UCCS
in 1991. He has been a visiting professor at
Colorado College and for the University of
Colorado’s Semester at Sea program.

He is the author of hundreds of articles on
a wide range of economic issues. He has
written two books and wrote a nationally
syndicated humor column on economics
from 1980 to 1985.

iii


COLORADO COUNCIL FOR ECONOMIC EDUCATION

Preface to the Fifth Edition

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Enterprise: Our Heritage, Our Wealth"T64DJUJ[FOTBMMPGVTBSFCFOFmDJBSJFTPG
BOFDPOPNJDTZTUFNUIBUJTEZOBNJDBOEWJCSBOUCVUXIJDIGSPNUJNFUPUJNFTVĊFST
setbacks (see Chapter 7, “Economic Crisis and Promise”). Notwithstanding these
setbacks, our free enterprise economy has generated historically unprecedented
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by the World Bank as a “high-income” country (see Table 1, p.2).

Although our free enterprise system has been very successful in creating a
comparatively high standard of living, the fundamental economic principles on which
it is based are not well understood by most Americans. As with the past editions,
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providing a succinct, engaging, and readable explanation of how a market economy
actually works. In the words of Roger W. Ferguson, Jr., former Vice Chairman,
Board of Governors of the Federal Reserve System, “By the time I graduated from
junior high school, I had read the Constitution; not until much later did I study
how prices are set in a market economy.” In today’s fast-paced, ever-changing, global
economy we believe that students need to have a solid understanding of the economic
principles that govern how free markets work before they leave high school.

CCEE acknowledges and thanks A. Paul Ballantyne, Ph.D., Professor Emeritus,
Department of Economics, University of Colorado at Colorado Springs (UCCS),
for his leadership in creating Free EnterpriseBOEGPSIJTUIJSUZmWFZFBSTPGTFSWJDFUP
the cause of economic education. New perspectives and insights, as well as updated
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Brock, Director of the UCCS Center for Economic Education and by Professor Dale
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BOEWFSZVTFGVMFYQMBOBUJPOPGUIFSFDFOUFDPOPNJDBOEmOBODJBMDSJTJTJO$IBQUFS

“Economic Crisis and Promise”, primarily authored by Professor DeBoer. We extend
our gratitude to CCEE Board member Jerry Bruni, and to the Bruni Foundation of
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Robert L. Clinton, President
Colorado Council for Economic Education
June, 2012

iv


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

Introduction to the First Edition

Our economic system is like the air. We aren’t always conscious of it, but it touches
virtually every aspect of our lives. Every day billions of economic decisions are
coordinated in a system of voluntary exchange that provides us with an abundance
of goods and services, creates jobs which provide us with the means to support
ourselves and our families, and sustains a measure of prosperity and freedom
unparalleled in human history.

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has been as unmistakable a success as socialism has been a failure” as ex-socialist
economist Robert Heilbroner recently stated. It is abundantly clear that systems
matter – economic systems as well as political systems.

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and man’s inhumanity to man were caused by a free enterprise economy. To save
the world, they outlawed market forces. As a result, millions of people starved,
priceless natural resources were squandered, the environment was ruined, sectarian
violence was exacerbated, and squalid living conditions became the norm at a time
when millions of people living in free enterprise economies were leaving this kind
of grinding poverty behind.

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free enterprise economy often, with the best of intentions, promote policies that
inhibit market operations and do more harm than good. People living in free
enterprise economies unquestionably have more liberty, a better quality of life,
more wealth, more concern for the environment, and a higher level of charitable
giving than people living under any other form of economic organization.

Ironically, teaching young Americans about our economic system has never
received the attention in the curriculum of our schools commensurate with the
importance of economic understanding. National polls indicate that most American
students neither understand how a market economy functions nor grasp the most
fundamental economic concepts underlying all economic systems.

Our students must understand not just the role of our economic system in allowing
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institutions of a free society and those of a free economy are inextricably linked.

v


COLORADO COUNCIL FOR ECONOMIC EDUCATION

If we value our freedom, it is our obligation to teach each new generation about the
ideas underlying our economic system and our political system, and the relationship
between the two. As Dr. Dwight Lee, O’Neil Chair of Global Markets & Freedom,
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thing provided by a market economy is not the abundance of material wealth, but
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freedom is, and fewer still are aware of how crucially their freedom depends upon
the institutions of the marketplace.”
Anyone truly interested in preserving liberty, improving the lot of the disadvantaged,
or promoting the wise use of natural resources must have a basic understanding of
the principles underlying a free enterprise economy. Free Enterprise: Our Heritage,
Our Wealth provides a lively and easily understood introduction to those principles
BOEXJMMBNQMZSFXBSEUIFFĊPSUTPGUIPTFDPODFSOFEFOPVHIUPSFBEJU
LaKay J. Schmidt, President 1976-1994
Colorado Council for Economic Education
July 4, 1992

vi


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

Table of Contents Chapter 6:

Authors .................................................... ii Non-Enterprise:
ɩ F"MUFSOBUJWF................................... 25
Preface to the Fifth Edition....................iv
Figure 4: Economic Freedom
Introduction to the First Edition............v Relative to GDP/Capita............... 26

Chapter 1: Figure 5: Wages, Income and
Productivity in Eastern versus
You’re Rich!............................................ 1 Western Germany ........................ 27

Table 1: International Income Figure 6: Percent of Households
ɩ SFTIPMETBOE%BUBGSPN in Eastern Germany with Selected
Select Countries .............................. 2 Amenities....................................... 28

Chapter 2: Table 2: Economic Growth:
U.S. and U.S.S.R. (1951-1990) .. 29
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Chapter 7:
Chapter 3:
Economic Crisis and Promise...... 33
Free Enterprise:
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Chapter 4: 'JHVSF&ĊFDUJWF'FEFSBM
Funds Rate..................................... 35
Free Enterprise and
Self-Interest ......................................... 11 Figure 9: Average 30-Year
Mortgage Rate ............................... 36
Figure 1: 2010 Large
Governmental Contributions to the Figure 10: U.S. Housing Price
International Red Cross/ Index............................................... 38
Red Crescent ................................. 13
Figure 11: U.S. Real GDP............ 39
Chapter 5:
Figure 12: U.S. Real Per
Free Enterprise: Capita GDP................................... 39
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Chapter 8:
Box 1: A Brief Discussion
of Demand and Supply Ten Myths About
Basics.............................................. 19 Free Enterprise ................................... 41

Figure 2: Employee Compensation Figure 13: Share of Output
and Investment .............................. 23 Controlled by the Four
Largest Firms, 2007 ...................... 42
Figure 3: Hourly Compensation
Costs for Manufacturing Figure 14: Worker
Workers, 2009 ............................... 24 Share of Income ............................ 43

Figure 15: Share of the Population
Living in Severe Poverty............... 44

Box 2: Tradable Pollution
Permits........................................... 47

vii


COLORADO COUNCIL FOR ECONOMIC EDUCATION

viii


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

Chapter 1:

you’re rich!

how much income does your family earn each year? Whatever it is, divide
it by six. If your income were $12,000 a year, dividing it by six would
cut it to $2,000. If your income were $24,000 a year, it would be $4,000. If
it were $96,000, it would be $16,000. Now imagine getting by on that lower
income – an income just one-sixth as great as you now enjoy. One-sixth! Could
you do it? Could you survive on such an income?

People in countries rated as “middle-income” economies by the World
Bank do – their incomes average roughly
one-sixth the level in the United States (See ...incomes per person in the
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roughly six times the purchasing power of middle-income countries...
incomes in the middle-income countries such
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Now consider incomes in the United States compared to those in countries
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your income by six, you now take less than one-quarter of that!

Feeling rich? You should be. If you live in the United States, your income
is several times greater than that received by more than three-fourths of the
approximately seven billion people in the world. What about the “high-income”
countries like Japan, Britain, Germany, and Mexico? Of the large industrialized
countries, the U.S. is the wealthiest country in the world! According to the World
Bank, income per person in the world’s other large industrialized countries
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1


COLORADO COUNCIL FOR ECONOMIC EDUCATION

Table 1:

INTERNATIONAL INCOME THRESHOLDS AND
DATA FROM SELECT COUNTRIES

Low-Income Countries Per capita income less than $995
Middle-Income Countries Per capita income between $996
and $12,195
High-Income Countries Per capita income greater than $12,196
Country Per Capita Income (2009)

United States $45,640 Income numbers are adjusted
Germany $36,850 GPSEJĊFSFODFTJODPTUPGMJWJOH
United Kingdom $35,860 ɩ FSFGPSF
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Japan $33,440 comparable to $290 in the United
Mexico $14,020 States.
Ecuador $8,100
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Source: World Bank. World
Philippines $3,540 Development Report, 2011.
Mali $1,190
Liberia $290

Here is another way of gauging living standards – think about the highest
wage you have ever earned. Was it as much as two dollars per hour? If it was,
you were among the highest paid workers on Earth. If you worked 40 hours
per week earning $2 per hour you would make an income greater than that
received by most of the world’s population.

All these calculations illustrate a simple point: we’re rich – you’re rich. Even
the poorest people in the United States receive incomes many times greater
than the average incomes of most of the people on Earth.

What accounts for this great prosperity? Why are incomes in one country
high and in another country low? Why is it that people in the United States
have an annual gross national income per person of $45,640 while the people
of Liberia, the poorest country on Earth, have an annual income per person of
$290? In this booklet we will examine the sources of our nation’s great wealth
and see how our economic system works to make us so prosperous.

2


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

Chapter 2:

the wealth of
nations

in 1776, the same year our nation declared its independence from England,
a Scottish economist, Adam Smith, wrote a book that sought to answer the
kinds of questions asked in the previous chapter. In fact, he called his book An
Inquiry into the Nature and Causes of the Wealth of Nations. Smith examined
the factors that cause one nation to be rich, another to be poor.

Smith equated wealth with income.
Today, we think of wealth in terms of the Today, we think of wealth in
ability to generate income. A nation that can terms of ability to generate
generate high levels of income is wealthy; one income.
that is capable only of low levels of income is
poor. What is it that allows a nation to create a high level of income? What is
it that makes a nation wealthy?

Money?

Does more money make a nation wealthy? Many of the people who lived
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novelist F. Scott Fitzgerald is said to have remarked to his fellow writer Ernest
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But what is true for one person is not always true for a whole nation.
Suppose the total amount of money in the United States were to double instantly.
Suddenly, everyone would have twice as much money in his or her wallet, twice as
much money in the bank, twice as much money squirreled away in the ashtray of
the car – twice as much everywhere. Would we be richer? If you think about it
for a moment, you will see that the answer is “no.” We would still have the same
number of cars, the same number of houses, the same amount of food, the same

3


COLORADO COUNCIL FOR ECONOMIC EDUCATION

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change the amount of goods and services available. What would happen is that
the prices of these goods and services would go up, but we would not be any richer.
We would not have created wealth by doubling the amount of money available.

In considering whether more money makes a country wealthy, Adam

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powers in trying to get rich. Countries such as

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higher prices. It does not in acquiring gold from the New World based

create wealth. on the mistaken belief that having more money

would make them rich. But as they obtained

more gold and minted it into coins – their form of money – they succeeded

mainly in causing prices to go up. Portugal was one of the most successful

looters of New World gold; it managed to force its prices up by 200 percent

during the 16th century.1

More money makes for higherprices. It doesnot create wealth. Ifit did, ending
poverty would be simple – print more money. Life in the real world is not so simple.

Natural Resources?

Another possible source of wealth is a nation’s stock of natural resources.
Surely the availability of such factors as fertile land, a good climate, mineral
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is more realistic than using monetary growth as the sole source of wealth. But
it too falls short as an explanation of wealth creation.

Consider Japan and India. Japan is a very successful country; one that 60
years ago many people expected would play an increasingly dominant role in the
world economy – as indeed it has. Yet Japan has very few natural resources. It
must import virtually every raw material it uses from other, generally poorer,
countries that do have natural resources available. On the other hand, India is
blessed with great natural wealth. It has roughly four times as much arable land
per person as Japan. Yet India is poor while Japan is rich. Income per person
in Japan is $33,440, more than 10 times as great as per capita income in India.

1See A. H. de Oliveria Marquez, History of Portugal, 1976, for a discussion of this problem.

4


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

For another example, compare incomes in North America with those in
South America. South America possesses abundant natural resources. In
Adam Smith’s day South America was considered by many to have the greater
prospect for economic development. But Smith put his bet on the prospects of
North America, particularly for what would become the United States. While
they can be advantageous, natural resources are no guarantee of wealth.

People?

What about a nation’s people? It would be nice to be able to pat ourselves
on the back and say that our great wealth is a result of our own cleverness or
skill. It would be nice to say that there is just something about us that sets us
apart from the great majority of the world’s people – people who must live in
conditions of desperate poverty. But if it is people who account for the wealth,
how are we to account for cases in which the same people generate very unequal
wealth?

Consider Korea. After World War II, Korea was split into two parts:
the Democratic People’s Republic of Korea (North Korea) and the Republic
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the short end of the resource stick – Korea’s
natural wealth is located primarily in the north. But the people – north and
south – were the same. Yet today, South Korea is rich with a per capita income
of $27,240, while North Korea is poor with a per capita income of $1,800.2
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of China is inhabited mainly by ethnic Han Chinese – the same people who
live across the border in the People’s Republic of China. Hong Kong has no
natural resources, except for a good harbor. It was little more than a refugee

2Data from the World Bank, World Development Report, 2011, except for North Korea from CIA
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5


COLORADO COUNCIL FOR ECONOMIC EDUCATION

camp as recently as 1950. But by 2011, Hong Kong ranked among the world’s
highest income countries with per capita income of $44,450 per year – more
than 6 times that of the People’s Republic of China’s $6,890.

If money, natural resources, and special characteristics of people do not
explain a nation’s wealth – its ability to produce income – what does? To answer
this question, we must examine how it is that income is created. Waving a
magic wand cannot create income in a nation. It can only be created through
the production of goods and services. By producing something, we earn income.
Take away the production and you take away the income.

Of course, we could create income for some people by simply taking away
income from someone else. But that would merely redistribute the existing
income; it would not create more income for the nation as a whole.

A nation must have people and access to resources to produce goods and

services. But it is only when these resources

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wealth lies in its ability to use If a nation fails to make good use of its natural

its resources productively. resources and people, it will be poor. If it

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productively. How does a nation accomplish this task?

6


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

Chapter 3:

free enterprise:
the key to wealth

aXFBMUIZ OBUJPO JT POF UIBU VTFT JUT SFTPVSDFT QSPEVDUJWFMZ ɩ F NPSF
productive a nation is, the wealthier it is. But what makes a nation
productive?

...key to a productive – and Smith’s answer to this question was a
thus a wealthy – nation lies simple one. He said that the key to a productive
in an economic system based – and thus a wealthy – nation lies in an
on individual freedom. economic system based on individual freedom.
It lies in a system of free enterprise.

A quick look around the world suggests the power of Smith’s insight.

Countries with free enterprise systems are rich. Countries that lack free
enterprise systems are poor. Writing in 1776,
when America’s prospects for even becoming a Countries with free
country were highly uncertain, Smith predicted enterprise systems are rich.
that our nation would enjoy great wealth. Countries that lack free
America would be a wealthy nation, he said, not enterprise systems are poor.
because it had natural resources, not because of
any peculiarity of its people, but because its people had the freedom of enterprise.

What is it about a free enterprise system that fosters the creation of wealth?
What does free enterprise have that other economic systems lack? We will answer
those questions by examining the essential characteristics of a free enterprise
system. Later we will contrast those with the essential characteristics of other
systems.

Free to Agree

As its name suggests, a free enterprise system is based on freedom. But
XIBUJTJUUIBUQFPQMFBSFGSFFUPEPVOEFSTVDIBTZTUFN ɩ FFTTFOUJBMBOTXFS

7


COLORADO COUNCIL FOR ECONOMIC EDUCATION

JTUIBUUIFZBSFGSFFUPFOUFSJOUPWPMVOUBSZBHSFFNFOUTXJUIPOFBOPUIFSɩ JT
freedom, called the freedom of contract, lies at the heart of a free enterprise
TZTUFNɩ FGSFFEPNPGDPOUSBDUJTBQPXFSGVMGSFFEPN
POFUIBUNPTUPGUIF
world’s people lack.

To see its importance consider starting an imaginary business – a car wash.
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XFIBWFUPmOEQFPQMF
UPIFMQXJUIUIFXPSL5PHFUUIFNUPBHSFFUPIFMQ
XFIBWFUPPĊFSUIFNB
wage, or perhaps a share of the revenues. We have to get someone to provide us
XJUIBOBSFBUPPQFSBUFɩ BUQFSTPONJHIUBHSFFUPEPOBUFUIFTQBDFPSSFRVJSF
VTUPQBZGPSJUJOFJUIFSDBTF
UIFBHSFFNFOUJTWPMVOUBSZɩ FO
PGDPVSTF
XF
have to get people to come to our car wash. We agree to wash customers’ cars if
they will agree to pay the price of the wash. With all these agreements in hand,
PVSDBSXBTIoPVSFOUFSQSJTFoJTPĊBOESVOOJOH

0VSDBSXBTIJTNBLJOHMPUTPGQFPQMFCFUUFSPĊ0VSXPSLFSTBSFCFUUFSPĊ

that they agreed to work for us reveals that they value the opportunity to work

for us and to earn money, more than they valued whatever activity they gave up

XIFOUIFZDIPTFUPXPSLGPSVTɩ FQFSTPO

Our business, if successful, XIPQSPWJEFEVTXJUIUIFTQBDFJTCFUUFSPĊ

will make everyone the landlord chose to provide it because our

associated with it – use of the space is more valuable than whatever

customers, workers, use had been made of the space before. Our

suppliers, and us –CFUUFSPĊ TVQQMJFSTBSFCFUUFSPĊUIFZHBJOCZTFMMJOHVT
rags, soap, polish, and other materials. Our

DVTUPNFST BSF CFUUFS PĊ UIFZ XPVME OPU BHSFF UP QBZ GPS B DBS XBTI JG UIFZ

did not think the service was worth even more than the price we are charging.

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Our business, if successful, will make everyone associated with it – customers,

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TVQQMJFST
BOEVToCFUUFSPĊ

Failure

Of course, things might not work out so well. We might not have enough
customers. Our workers might think we aren’t paying enough and leave. We
NBZUVSOPVUUPCFBOVJTBODFUPUIFQSPWJEFSPGUIFTQBDFBOECFPSEFSFEPĊ
of the premises. We might lose money and decide to shut down the operation.

8


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

If failure comes, what is it we are failing to do? We are failing to make people
CFUUFSPĊ If we do not attract enough customers, we are failing to make them
CFUUFSPĊCZCVZJOHPVSDBSXBTIFT*GPVSXPSLFSTMFBWF
JUNFBOTXFBSFOPU
NBLJOHUIFNBTXFMMPĊBTUIFZDPVMECFJOTPNFPUIFSBDUJWJUZ*GXFBSFCPPUFE
GSPNUIFQSFNJTFT
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if we are the ones who decide we must close up shop, it is because we are not
NBLJOHPVSTFMWFTCFUUFSPĊ

Success

ɩ FMFTTPOPGGBJMVSFTVHHFTUTBMFTTPOPGTVDDFTT*GPVSDBSXBTITVDDFFET

JUJTCFDBVTFXFBSFNBLJOHQFPQMFBTTPDJBUFEXJUIJUCFUUFSPĊɩ BUJTBDSJUJDBM
point about free enterprise. People succeed in a free enterprise system only to the
FYUFOUUIBUUIFZNBLFUIFNTFMWFT"/%PUIFSQFPQMFCFUUFSPĊSince no coercion
is involved, there is no other reason that these voluntary exchanges would
otherwise occur.

0VS TVDDFTT JO NBLJOH PUIFS QFPQMF CFUUFS PĊ JT SFnFDUFE JO BOPUIFS
accomplishment: we have created new wealth. We have increased the incomes
of our workers and our suppliers. We have increased our own incomes. In some
sense, we have increased the wealth – or at least the wellbeing – of our customers.
We may have attracted them with a lower price or with a better product at a
higher price. In either case, we allowed them to buy more with their money,
thus increasing their purchasing power. With more purchasing power we, along
with our workers, suppliers, and customers, will be able to buy more goods and
services from other enterprises; this increases their incomes and their wealth.

Zero Sum?

ɩ FJEFBUIBUTVDDFTTGVMFOUFSQSJTFDSFBUFTXFBMUIJTUPPPGUFOPWFSMPPLFE

Some people might say that we did not create wealth, we merely took some business

away from some other car wash. People who

make this argument see economic activity as a ɩ FJEFBUIBUTVDDFTTGVM
game – like Monopoly® or poker – in which one enterprise creates wealth is
person gains but another loses. Such games are too often overlooked.
called zero-sum games; the gains of the winners

are just balanced by the losses of the losers. People caught in zero-sum thinking

miss the essence of a free enterprise economy, the creation of wealth through

FOUFSQSJTFɩ F[FSPTVNFSSPSJTBDPNNPOPOFUIBUXFTIBMMDBSFGVMMZFYBNJOF

9


COLORADO COUNCIL FOR ECONOMIC EDUCATION

It is surely true that we got some of our customers from competing car
washes. But why? Why did some of our customers leave other car washes? It
must be something about our car wash – our quality, our location, our price, or
perhaps our winning attitude – that makes a car wash from us a better choice
than one produced by our competitors. Our product is, for those customers
who chose us, more valuable than those of our competitors. It is not simply a
matter of having one less car washed at a competitor and one more washed at
PVSFOUFSQSJTFɩ BUPVSDVTUPNFSTDIPTFVTNFBOTXFQSPEVDFBCFUUFSWBMVF
for the customer. Our ability to do this suggests that we have created wealth
and greater well-being.

ɩ FXFBMUIXFDSFBUFXJMMCFQVUUPVTFFMTFXIFSFJOUIFFDPOPNZ4PNF
PG PVS DVTUPNFST XJMM mOE PVS QSJDFT MPXFS UIFZ XJMM IBWF NPSF NPOFZ UP
spend on other things. Some of them will now have more time to use in other
activities. Our workers and suppliers will have more income to spend. And, if
all goes well, we will have more income to spend and invest. All this additional
activity creates still more wealth.

Consider what it would mean if the “zero-summers” were right. Enterprise

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the failure of another. But if that were true, what would create wealth? We

have already seen that some societies enjoy great wealth – how could this

CF BDDPVOUFE GPS ɩ F BOTXFS
PG DPVSTF


ɩ FTFDSFUPGBXFBMUIZ is that it could not be accounted for. Zero-

nation, he argued, was an sum thinkers are simply wrong. Successful

economic system that allowed enterprise creates wealth. And what creates

people to create wealth. TVDDFTTGVMFOUFSQSJTF 1FPQMF*UJTUIFFĊPSUT
of people that create a successful enterprise

BOEDSFBUFXFBMUIɩ FTFFĊPSUTFOSJDIUIFQFPQMFXIPPSHBOJ[FUIFFOUFSQSJTF


the people who work for the enterprise, the people who supply the enterprise,

and the customers of the enterprise. Successful enterprise creates wealth and

in so doing enriches all who are associated with the undertaking. Adam Smith

insisted that this process of wealth creation would spring spontaneously from

the minds and enterprise of individual people provided that they were allowed to

do it.ɩ FTFDSFUPGBXFBMUIZOBUJPO
IFBSHVFE
XBTBOFDPOPNJDTZTUFNUIBU

BMMPXFE QFPQMF UP DSFBUF XFBMUI "O FDPOPNJD TZTUFN UIBU TUJnFE DSFBUJWJUZ


he warned, would be poor.

10


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

Chapter 4:

free enterprise
and self-interest

why does a free enterprise system work so well to promote wealth? Adam
Smith linked its success to what he argued was a basic tendency for
people to make choices that serve their self-interest. It was one of Smith’s most
important – and most misunderstood – observations.

%Fm OJOH4FMG*OUFSFTU

What is self-interest? Some people argue that self-interest is the same as
HSFFEPSTFMmTIOFTT#VUXIFUIFSTFMGJOUFSFTU
NFBOTTFMmTIOFTTEFQFOETPOUIFXBZTJOXIJDI Some people argue that self-
people interpret and act on their perception of interest is the same as greed
their self-interest. We can make some guesses PSTFMmTIOFTT
about what people regard as their “self-interest”
by observing their behavior.

First, “self-interest” must include a regard for one’s family. Why else would
XFTFFQBSFOUTNBLJOHTVDIFOPSNPVTTBDSJmDFTGPSUIFJSDIJMESFO

Second, “self-interest” apparently includes a concern about one’s friends
and neighbors. We can all think of cases in which friends and neighbors have
helped us and in which we have helped them.

ɩ JSE
iTFMGJOUFSFTUw NVTU JODMVEF B TVCTUBOUJBM JOUFSFTU JO UIF XFMGBSF
of one’s fellow citizens. As evidence, consider that over one million people
participated in the Komen Race for the Cure UPmHIUCSFBTUDBODFS
FWFOUTJO
2010. What does their “self-interest” include? Observe the huge number of
PSHBOJ[BUJPOTTUBĊFECZWPMVOUFFSFĊPSUT8IBUJTUIFiTFMGJOUFSFTUwPGUIFTF
volunteers?

11


COLORADO COUNCIL FOR ECONOMIC EDUCATION

Or consider the charitable activities of the Bill and Melinda Gates
Foundation that has provided over $24 billion in grants since its inception.
What is the “self-interest” of the Gates?

$MFBSMZ
XFEFmOFPVSPXOJOUFSFTUTJOBXBZUIBUJODMVEFTUIFXFMGBSFPG
others. We run errands for a sick neighbor,

Acting in one’s self-interest is deliver meals to shut-ins, contribute food for
OPUUIFTBNFBTCFJOHTFMmTI the hungry. Acting in one’s self-interest is not

the same as being TFMmTI

#VU JG TFMGJOUFSFTU JT OPU TFMmTI
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OPUFYQFDUQFPQMFUPEJTSFHBSEUIFJSPXOOFFETPSBEWBOUBHFTɩ F#JCMJDBM
admonition is to love your neighbor as yourself. People who enjoy gardening,
HBSEFOɩ PTFXIPMJLFUPTFX
TFXɩ PTFXIPMJLFUPSVO
SVO8FQVSTVF
UIPTFBDUJWJUJFTUIBUHJWFVTQMFBTVSFBOETBUJTGBDUJPOɩ BUJTXIBUTFMGJOUFSFTU
is all about.

ɩ F mSTU NJTDPODFQUJPO BCPVU TFMGJOUFSFTU
UIFO
JT UP DPOGVTF JU XJUI
TFMmTIOFTT8FBSFBMMHFOFSPVTUPWBSZJOHEFHSFFT
CVUXFBSFHFOFSPVT8F
GVMmMMUIBUHFOFSPTJUZPGTQJSJUXIJMFTFSWJOHPVSPXOJOUFSFTUT

ɩ FTFDPOENJTDPODFQUJPOBCPVUTFMGJOUFSFTUDPODFSOTJUTSFMBUJPOTIJQUP
free enterprise. As we shall see, free enterprise systems do such a good job of
responding to individual interests that some people equate self-interest to free
enterprise. It is only in a free enterprise system, they presume, that people pursue
their self-interest. In some other economic system, people pursue …. what?
8IBUJOUFSFTUXPVMEQFPQMFQVSTVFPUIFSUIBOTFMGJOUFSFTU ɩ FJSOFJHICPST
interest? But what would that interest be, if not the neighbor’s self-interest?
And how would anyone other than one’s neighbor clearly know what that is?

Of course people pursue their self-interest, as there is no other interest to
pursue. People pursue their self-interest in a free
enterprise system and in any other system in which ɩ FQVSTVJUPGTFMGJOUFSFTU
UIFZmOEUIFNTFMWFTɩ FQVSTVJUPGTFMGJOUFSFTU is fundamental to human
is fundamental to human nature. It is not nature.
the product of any particular economic system.

12


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

We can askwhicheconomicsystemdoesthebestjobofinstillingagenerosity of
spirit intopeople’s concept of their own self-interest. We could ask, “In what system
do people give most generously of their time and resources?” In what economies
are resources most aggressively mobilized to come to the aid of victims of disaster?

Some answers to this question are illustrated by examining past instances
PGHJWJOH'PSJOTUBODF
JOUIFGPVSMBSHFTUQSPWJEFSTPGmOBODJBMSFTPVSDFT
to developing countries were the United States ($26.0 billion), Germany ($13.9
billion), the United Kingdom ($11.4 billion), and France ($10.9 billion).3 Notice
that all of these countries have free enterprise economies. Examining the pattern
of contributions to the International Red Cross and Red Crescent Movement
provides additional evidence. In Figure 1, notice that the large sources of
funding to this benevolent group come from free enterprise economies. It is
worth noting that these governmental contributions account for 86 percent of
all governmental funding received by the International Red Cross/Red Crescent
and 70 percent of funding from all sources during 2010. Clearly it appears
that it is in free enterprise systems that the pulse of generosity beats strongest.

Figure 1:

Source: International Red Cross and Red Crescent Movement Annual Report, 2010.

3U.S. Census Bureau. Statistical Abstract of the United States, 2011.

13


COLORADO COUNCIL FOR ECONOMIC EDUCATION

Serving Self-Interest

ɩ FHFOJVTPGBNBSLFUFDPOPNZJTJUTBCJMJUZUPHVJEFTFMGJOUFSFTU
FWFOJO
instances in which no generosity of behavior is intended, to the service of the
general interest. Why might we have started – as was discussed in the previous
chapter – a car wash business? Because of a humanitarian concern about people
driving in dirty cars? No, it was surely the opportunity to further our own – and
our family’s – interests that motivated our action. How did we entice people
UPXPSLGPSVT 8FPĊFSFEBXBHFUIBUNBEFXPSLBUPVSDBSXBTITPNFUIJOH
UIBUBQQFBMFEUPUIFJSTFMGJOUFSFTU)PXEJEXFBUUSBDUDVTUPNFST 8FPĊFSFE
a better product, or a better price, or both, than they could get elsewhere.

ɩ FBQQFBMJOBGSFFFOUFSQSJTFTZTUFNUPTFMGJOUFSFTUGPMMPXTEJSFDUMZGSPN
its reliance on voluntary contract. People are free to choose; they can spend
their money, and allocate their time, in whatever activities they want. If we
want to persuade them to do something we want them to do, we must arrange
for that act to be in their interest as well as our own. In the famous words of
Adam Smith:

It is not from the benevolence of the butcher, the brewer, or the baker that
we expect our dinner, but from their regard to their own self-interest. We
address ourselves not to their humanity, but to their self-love, and never
talk to them of our necessities, but of their advantages. 4

In a system based on voluntary choice, all attempts by individuals to enhance
their own interests must further the interests of others. As we have already
seen, it is only by serving the interests of others that we serve ourselves.

A free enterprise economy encourages the creation of wealth as it frees
individuals to pursue their own interests. In the next chapter, we turn to an
examination of the ingredients that make a free enterprise system tick.

4Adam Smith. An Inquiry into the Nature and Causes of the Wealth of Nations. New York: Modern
Library Edition, p. 14.
14


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

Chapter 5:

free enterprise:
the essentials

we have already noted one ingredient of free enterprise; it is the freedom
of contract. But it takes far more for free enterprise to work than that.
Below the essential characteristics of a free enterprise economy are discussed.

Government ...free enterprise could not
exist without government.
It may come as a surprise to see government
listed as a vital component of free enterprise
– isn’t government the antithesis of free
enterprise? In actuality, free enterprise could
not exist without government.

ɩ FFYJTUFODFPGHPWFSONFOUJTBTTVNFEJOUIFWFSZOPUJPOPGUIFGSFFEPN
to enter into contracts. Contracts are meaningless if they are not enforced.
Inevitably it is governments that act to enforce contracts. Without government
and the rule of law there could be no contracts.

Consider again our car wash. We started the car wash because we thought that
XFDPVMEFBSONPOFZ
BQSPmU
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UPSFUBJOUIFQSPmUTXFFBSO 8IBUJTUPQSFWFOUTPNFPOFFMTFGSPNTFJ[JOHUIFN
ɩ FBOTXFS
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But the actions of governments go further than this. Many governments

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BOE

wilderness areas. Some argue that these actions go too far and begin to infringe

on the ability of the free enterprise system to best function. Rather than enter

the debate on the appropriate role and size of government, we prefer to highlight

a core area of agreement – virtually everyone agrees that government must have

some involvement with the economy. Further, this role is vital to the successful

functioning of a free enterprise economy. 15


COLORADO COUNCIL FOR ECONOMIC EDUCATION

Private Property If individual choices are to be meaningful,
people must have resources at their command.
ɩ FFYDIBOHFPGQSJWBUFMZ *OPUIFSXPSET
UIFZNVTUIBWFQSPQFSUZɩ F
held property lies at the heart exchange of privately held property lies at the heart
of economic activity in a free of economic activity in a free enterprise system.
enterprise system.

Consider the resources that you own. Probably the most important is your
labor. In a free enterprise economy you may exchange your labor for income. You
may also own a house or an automobile or a big screen television. In each case,
you have the right to exchange these goods for income or for other goods.

ɩ FQSJWBUFPXOFSTIJQPGPOFUZQFPGSFTPVSDFoDBQJUBMoHJWFTGSFFFOUFSQSJTF
another name: capitalism. Capital includes the machinery, equipment, and
CVJMEJOHTVTFEUPQSPEVDFHPPETBOETFSWJDFTɩ FQSJWBUFPXOFSTIJQPGDBQJUBM
is one characteristic of a free enterprise, or capitalist, economic system.

While we often think of ourselves as owning particular things, what we really
own are the rights to use those things in certain ways. For example, the ownership
of a baseball bat gives one the right to hit a ball with it but not to use it to attack
the neighbor’s dog.

Two of the rights that typically go with ownership are particularly important:
they are the right of exclusion and the right of transferɩ FSJHIUPGFYDMVTJPO
means that the owner of a particular thing has a right to exclude others from its
VTFɩ BUNBZTPVOEIBSTI
CVUJNBHJOFXIBUXPVMEIBQQFOJGXFEJEOPUIBWF
this right. Suppose that the ownership of a car carried no right to exclude others
from using the car. Anyone could use your car whenever he or she wanted. If
that were true, would you bother to change the oil or to get regular tune-ups? It
is unlikely that you would as your inability to exclude others from the use of the
DBSXPVMENFBOUIBUZPVDPVMEOPUDMBJNUIFCFOFmUTPGZPVSFĊPSUTUPLFFQUIF
car in good running condition. It would no longer be in your self-interest to take
care of the car.

ɩ FSJHIUUPUSBOTGFS
PSUIFSJHIUUPTFMMUIFSJHIUTXFIBWF
JTFRVBMMZJNQPSUBOU
Suppose the ownership of a house carried with it no right of transfer. In other

16


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

XPSET
ZPVDPVMEOPUTFMMJUɩ FBCTFODFPGUIFSJHIUPGUSBOTGFSXPVMETUSJQUIF
marketplace of the mechanism through which assets such as houses are transferred
to other users who place a greater value on the asset. It would be impossible for
you to sell your house to someone who values it more than you. Stripped of this
right to sell, you would have less incentive to maintain and improve your property.
If there were no rights of transfer, resources would remain locked to their present
users forever – even if they no longer had any desire to keep the property.

An advantage of private property is seen in the formerly planned economies
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movements towards privatization of productive assets and been rewarded with
TJHOJmDBOU HSPXUI 'PS JOTUBODF
1PMBOE IBT QSJWBUJ[FE OFBSMZ BMM PG JUT LFZ
sectors and experienced growth of nearly 6.8 percent per year since 1990. On
the other hand, Ukraine, with nearly 76 percent of its productive assets still in
state hands, experienced contraction of nearly 10.8 percent per year during the
1990s.5 Fortunately, the Ukrainian economy has more recently experienced a
rebound in growth that corresponds with its movement towards privatization of
its productive assets.

Prices

1SJDFTBSFUIFOFSWPVTTZTUFNPGBGSFFFOUFSQSJTFFDPOPNZɩ FZDBSSZUIF
signals that guide decisions and that move goods and services around in the
economy. To get a sense of how well prices work,
think about the things you buy during a typical Prices are the nervous system
year. If you are like most people, you could list of a free enterprise economy.
hundreds of different items. Do you worry
about the availability of each of these items? For virtually everything you buy,
the answer is surely “no.” Indeed, as we look around in the marketplace we see the
appropriate quantities of nearly everything being made available every day. We
do not see shortages, nor do we see surpluses. Prices make that happen. Prices
CBMBODFUIFEFNBOEGPSHPPETXJUIUIFJSTVQQMZɩ FZBTTVSFUIBUUIFRVBOUJUZ
DPOTVNFSTXBOUUPQVSDIBTFNBUDIFTUIFRVBOUJUZQSPEVDFSTXBOUUPTFMMɩ JT
balance between supply and demand is no accident – prices make it happen.

5World Bank. World Development Report,8JOHɩ ZF8PP
FUBMEconomies in Transition,
1998; and Zenonomics Research Report: Ukraine, 2009.

17


COLORADO COUNCIL FOR ECONOMIC EDUCATION

To see how prices play this role, consider the market for a simple product,

lettuce. Wherever you live and whatever the season of the year, it is likely fresh

lettuce will always be available. But suppose that the lettuce crop was reduced this

season because of a deep freeze. Suddenly, less of the product is available to sell.

8IBUIBQQFOT ɩ FBOTXFSJTTJNQMFoUIFQSJDF

..the higher price induces the PGMFUUVDFJODSFBTFTɩ FIJHIFSQSJDFTFOETB

purchaser to naturally reduce signal to consumers that lettuce is now relatively

his or her consumption. more dear; therefore, the consumer is induced

to purchase less. Notice that no government

announcement is needed, the buyer correctly interprets the signal – in this case,

UIFIJHIFSQSJDFNFBOTUIBUMFTTJTBWBJMBCMFoBOEQVSDIBTFTMFTTɩ FSFGPSF
EFTQJUF

the freezing weather reducing the crop, stores continue to have lettuce to sell; it is

just sold at a now higher price. A shortage does not arise because the higher price

induces the purchaser to naturally reduce his or her consumption.

To fully appreciate how well this system works, consider what happens when
the price mechanism is not allowed to work. An example is provided by the market
for electricity in California during the fall of 2000 when the state experienced
particularly cold weather. Naturally people responded to this weather by turning
up the heat and thereby using more electricity. Since people were using more
electricity, a well-functioning price mechanism would signal this increased desire
GPSBHPPECZSBJTJOHUIFQSJDFɩ FQSJDFUPUIFDPOTVNFSPGFMFDUSJDJUZTIPVME
IBWFHPOFVQ#VUUIFHPWFSONFOUPG$BMJGPSOJBmYFEUIFQSJDFUISPVHISFHVMBUJPO
In the short term, consumers might view this as a desirable outcome – more
electricity at a constant price. But what happened on the supply side? Suppliers
PGFMFDUSJDJUZXFSFOPUJOTVDIBGPSUVJUPVTQPTJUJPOɩ FZIBEUPQVSDIBTFUIFJS
supplies in the open market. Since they needed more supplies to produce the
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UIF QSJDFPG UIPTFTVQQMJFTJODSFBTFE ɩ JT USBQQFEUIF
QSPEVDFSTJOBOVOGPSUVOBUFTJUVBUJPOPGJODSFBTJOHDPTUTCVUmYFETFMMJOHQSJDFT
Quickly they began losing money and the government of California, along with
the federal government, had to begin subsidizing their operations to keep them
in existence.6ɩ FTFTVCTJEJFTDPNFBUBDPTUoZPVQBZGPSUIFNXJUIZPVSUBYFT
Notice that the whole problem could have been avoided if the price mechanism
had been allowed to function. As consumers increased their demand, prices would
JODSFBTF1SPEVDFSTXPVMECFBCMFUPBĊPSEUPQSPEVDFUIFFYUSBFMFDUSJDJUZ
BT

6ɩ F&DPOPNJTU
January 13, 2001, reported these losses as totaling $10 billion.
18


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

Box 1: Basic demand and supply model

Brief Discussion of Demand and Supply Basics

A free market for lettuce is depicted in Figure A

Figure A, with price (P) on the vertical P S

axis and quantity (Q) per time period on

UIFIPSJ[POUBMɩ FNBSLFUEFNBOEDVSWF

is denoted “D” and the market supply P1
DVSWFi4wɩ F%DVSWFUFMMTVTUIFRVBOUJUJFT

of lettuce buyers are willing and able to D
QVSDIBTFBUFBDIQSJDFɩ F4DVSWFJOEJDBUFT

the amounts of lettuce sellers desire to sell Q1 Q
BUFBDIQSJDFɩ F%DVSWFUZQJDBMMZIBT

the downward slope shown in the Figure because as the quantity consumed

rises, buyers often derive less satisfaction from each additional unit and are

UIFSFGPSFXJMMJOHUPQBZMFTTGPSFBDITVCTFRVFOUVOJUɩ F4DVSWFUZQJDBMMZ

has the upward slope shown in the Figure because the cost of each additional

unit tends to rise in the short run as greater quantities are produced.

In a free market, the price and quantity of lettuce gravitate toward the

intersection of the D and S curves, the market equilibrium denoted P1
and Q1 in Figure A. At P1 the quantity demanded is equal to the quantity
supplied. However, at prices above (or below) P1 the quantity supplied will
be greater (or less) than the quantity demanded and the resulting surplus (or

shortage) will cause price to fall (or rise) toward P1.

)PXEPFTBEFFQGSFF[FBĊFDUUIFNBSLFU Figure B
S2
for lettuce? Since the freeze reduces the P S1
B
available supply of lettuce, the S curve A

shifts leftward causing the price to rise P2
to P2, as depicted in Figure B. While P1
consumers may not even realize that a

freeze occurred, the higher price has signaled

that lettuce is now in greater scarcity and D
Q
buyers reduce their quantity demanded, as

shown by the movement along the demand Q2 Q1

curve from point A to point B in Figure B.

19


COLORADO COUNCIL FOR ECONOMIC EDUCATION

the higher price being paid by consumers would allow them to cover their higher
DPTUT8JUIPVUBOZUIPVHIUPSFĊPSUUIFQSPCMFNCSPVHIUPOCZUIFDPMEXFBUIFS
would have been resolved – and without the risk of producers going out of business!

Another example of government interference lies further back in history. In the

former Soviet Union virtually all prices were set by a government agency, Gosplan.

Imagine the complexity of coordinating the prices of thousands of individual goods.

*NBHJOFUIFEJċDVMUZ PG LFFQJOHUIPTFQSJDFT BUUIFDPSSFDUMFWFMBTFDPOPNJD

conditions evolve. It should be no surprise that

Faced with the wrong prices, the prices were not right. It is even less surprising

Soviet consumers were forced that Gosplan gave up the attempt to get them
right. During one stretch from 1955 to 1966
to endure long lines …
wholesale prices in the Soviet Union did not

change at all, even though the population changed, climatic conditions changed, and

incomes changed.7*UXBTFBTJFSGPSUIFBHFODZUPHJWFVQUIFFĊPSUUPDIBOHFQSJDFT

than attempt to get them right. Faced with the wrong prices, Soviet consumers were

forced to endure long lines to buy nearly everything they desired. Soviet sociologists

estimated that the members of the average household in a Soviet city spent nearly

40 hours per week standing in line to buy – or more likely just attempting to

buy – basic goods. You never see this failing where prices are allowed to work.

1SPmUT

In a previous chapter we started a hypothetical new business, a car wash.
ɩ JTOFXCVTJOFTTXBTFTUBCMJTIFEJOUIFIPQFUIBUPVSSFWFOVFTXPVMEFYDFFE
PVSDPTUToMFBWJOHVTXJUIBQSPmU4PNFQFPQMFPCKFDUUPQSPmU1BSUPGUIJT
PCKFDUJPOMJLFMZTUFNTGSPNBNJTDPODFQUJPOPWFSIPXMBSHFQSPmUTBSF0QJOJPO
QPMMTTVHHFTUUIBUQFPQMFHFOFSBMMZCFMJFWFUIBUQSPmUTBDDPVOUGPSUPQFSDFOU
PGUIFQSJDFTUIFZQBZGPSHPPETBOETFSWJDFT*GQSPmUTXFSFUIBUIJHI
XFNJHIU
agree that they were objectionable. However, we do not have to try to decide if
UIFZBSFPCKFDUJPOBCMFɩ FBGUFSUBYQSPmUTFBSOFECZ64DPSQPSBUJPOT FYQSFTTFE
relative to gross output) averaged only 6 percent since the end of World War II.8

)PXFWFS
TVQQPTFUIBUQSPmUTJOBQBSUJDVMBSTFDUPSXFSFVOVTVBMMZIJHIo
20 or 30 percent. Rather than being concerned about this situation we should

7Gregory, P. and Stuart, R. Comparative Economic Systems, 1992, 4th edition, p. 281.
8Average rate calculated from Bureau of Economic Analysis data for 1947 to 2010.
20


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

BQQSFDJBUFUIFJNQPSUBOUSPMFTVDIVOVTVBMMZIJHIQSPmUTQMBZ)JHIQSPmUTTJHOBM
to other producers that a particular product line is highly desired by consumers.
In response to this signal new producers will enter this line of business and begin
QSPEVDJOHUIFQSPEVDUɩ JTOFXQSPEVDUJPOIBTUISFFPVUDPNFT'JSTU
JUTBUJTmFT
the consumer by making more of the highly desired product available. Second, it
MPXFSTQSJDFTBTNPSFPGUIFJUFNXJMMCFBWBJMBCMFJOUIFNBSLFUɩ JSE
BTUIFOFX
DPNQFUJUJPOQVTIFTEPXOQSJDFTJUSFEVDFTUIFQSPmUTGSPNUIFJSVOVTVBMMZIJHI
QPTJUJPO*OPUIFSXPSET
UIFIJHIQSPmUTJOEVDFUIFDPNQFUJUJPOUIBULFFQTQSPmUT
TPMPXoBOETPVOPCKFDUJPOBCMFɩ FGBMMJOQSJDFGSPNUIFFOUSZPGDPNQFUJUJPO
(and just as importantly, from changes in technology) has clearly been seen in the
information processing industry (i.e., computers, data processing, telephone, etc.)
over the past thirty years.

*UJTJNQPSUBOUUPSFDPHOJ[FUIBUQSPmUTBSFDSJUJDBMUPUIFFYJTUFODFPGFOUFSQSJTFT
8FSFJUOPUGPSUIFPQQPSUVOJUZUPFBSOBQSPmU
GFXQFPQMFXPVMEFWFSFTUBCMJTIB
OFXmSN8JUIPVUmSNTJUJTVOMJLFMZUIBUXFXPVMEIBWFUIFHPPETBOETFSWJDFT
UPDPOTVNFUIBUXFTPIJHIMZWBMVF"mSNFBSOJOHBQSPmUTIPXTUIBUUIFmSNJT
EPJOHBHPPEKPCPGCFOFmUJOHPUIFSQFPQMF*GJUXFSFOPU
JUXPVMEMPTFNPOFZɩ JT
potential for losses is another important characteristic of the free enterprise economy.

Losses

-PTTFTUZQJDBMMZSFDFJWFMFTTBUUFOUJPOUIBOQSPmUT
CVUUIFZQMBZBOFRVBMMZ
JNQPSUBOU SPMF JO B GSFF FOUFSQSJTF FDPOPNZ +VTU BT IJHI QSPmUT TFOE B TJHOBM
that more enterprises should begin providing a product, losses send a signal that
UPPNBOZmSNTBSFQSPWJEJOHBQSPEVDUBOEUIBUTPNFTIPVMETIVUEPXO#PUI
messages are important.

8IFOBmSNJTMPTJOHNPOFZ
UIFDPTUTPGJUTFĊPSUTFYDFFEJUTSFWFOVFTɩ BU
NFBOTUIBUTPNFPUIFSVTFPGUIFmSNTSFTPVSDFTTIPVMECFUSJFE-PTTFTQSPWJEF
a powerful incentive to do just that!

Losses and the failure they bring are a harsh penalty. However, recall what
GBJMVSFNFBOT*UNFBOTUIBUUIFmSNJTGBJMJOHUPNBLFPUIFSQFPQMFCFUUFSPĊ#Z
MFUUJOHUIFmSNGBJM
XFBMMPXUIFSFTPVSDFTPGUIFmSNUPCFQVUUPPUIFSVTFTBOE
UPCFNBOBHFECZPUIFSNBOBHFSTɩ PTFPUIFSNBOBHFSTXJMMCFTFFLJOHBQSPmU
*GUIFZTVDDFFE
UIFZXJMMNBLFQFPQMFCFUUFSPĊ*GUIFZGBJM
UIFZUPPXJMMIBWFUP

21


COLORADO COUNCIL FOR ECONOMIC EDUCATION

leave the industry. It is only through failure that resources are redirected to better
VTFTBOEUPCFUUFSVTFSTVTFTBOEVTFSTUIBUXJMMNBLFPUIFSQFPQMFCFUUFSPĊ

ɩ FTUPSZPG)FOSZ'PSEJMMVTUSBUFTUIFJNQPSUBODFPGGBJMVSF'PSEUSJFEUISFF
UJNFT UP HP JOUP UIF BVUPNPCJMF NBOVGBDUVSJOH CVTJOFTT )JT mSTU UXP FĊ PSUT
GBJMFE*UXBTJOUIFmSTUGBJMVSFT
UIPVHI
UIBUIFHPUUIFJEFBUIBUXPVMEUSBOTGPSN
the industry and the country – that cars should not be expensive luxuries for the
rich to race, but utilitarian vehicles for everyone. He put that notion to work in
his third company, the Ford Motor Company. His personal success now seems
OFBSMZUIFTUVĊPGMFHFOE

But the importance of his success was and is experienced by us all – he
increased the well-being of society by introducing the automobile to the average
GBNJMZ)FTVDDFFEFEJONBLJOHTPDJFUZCFUUFSPĊUISPVHIIJTGSFFFOUFSQSJTF

Wages

.PTUPGVTEPOPUIBWFUIFIFBEZFYQFSJFODFPGTFFLJOHBQSPmUBOESJTLJOH

a loss. We work for the people who do,

Wages, ultimately, receiving a wage in return. Wages, ultimately,

are determined by our are determined by our productivity and by the

productivity and by the value WBMVFPGXIBUXFQSPEVDF/PmSNXBOUTUPQBZ

of what we produce a wage that exceeds the value of what a worker

produces. Doing so would be a recipe for failure.

8IBULFFQTB mSNGSPNQBZJOH XPSLFSTMFTTUIBO UIFWBMVF PG XIBUUIFZ
produce? Competition. If an additional worker can produce output valued at
$20 per hour, and his or her employer is only paying $5 per hour, it is highly likely
TPNFPUIFSmSNoPSNBOZPUIFSmSNToXJMMDPNFUPUIFXPSLFSBOEPĊFSBNVDI
IJHIFSXBHF*OBDPNQFUJUJWFFDPOPNZ
XBHFTSFnFDUUIFVOEFSMZJOHQSPEVDUJWJUZ
of labor. Several factors determine this productivity; some of these factors are
under the control of the worker, some are not.

ɩ FNBJOJUFNUIBUBXPSLFSDBODPOUSPMJTIJTPSIFSTUPDLPGhuman capital.
Human capital is just a fancy way of saying the set of skills and experience we bring
to the workplace. We can increase our human capital by pursuing education or
training. In general, the greater our human capital, the greater the wage we are paid.

22


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

0UIFSGBDUPSTBĊFDUQSPEVDUJWJUZBTXFMM0OFPGUIFNPTUJNQPSUBOUJTUIF
stock of capital goods with which we can work. A carpenter with the latest power
tools at his disposal will be more productive than one who has only a hammer and
BTBXɩ BUHSFBUFSQSPEVDUJWJUZUSBOTMBUFTJOUPBIJHIFSXBHF

ɩ JTTVHHFTUTBGVOEBNFOUBMFSSPSNBOZQFPQMFNBLF0GUFOQFPQMFTFFB
struggle between the interests of owners of tools and equipment – the capitalists
oBOEXPSLFSTɩ FZWJFXUIJTBTBDMBTTTUSVHHMFCFUXFFOHSPVQTBTUSVHHMFUIBU
UIFZTFFBTDFOUSBMUPBDBQJUBMJTUPSGSFFFOUFSQSJTFFDPOPNZ#VUUIJTDPOnJDUJT
OPUSFBM0XOFSTPGDBQJUBMFOIBODFUIFJSQSPmUTCZJOWFTUJOHJOOFXDBQJUBM#VU
this same investment increases the productivity of workers and pushes up wages.
In other words, by pursuing one’s own self-interest by increasing the capital stock,
the capitalist also aids his or her employees by making them more productive,
which leads to higher wages.

A look at the movement of wages and productivity over the last century in the
64NBLFTUIJTQPJOURVJUFDMFBS8BHFT
BEKVTUFEGPSJOnBUJPO
IBWFNPWFEJO
QBSBMMFMXJUIDIBOHFTJOQSPEVDUJWJUZBOEJOWFTUNFOU8IFOmSNTBSFJOWFTUJOH
heavily, productivity rises and wages increase as shown in Figure 2. When
JOWFTUNFOUGBMMTPĊ
QSPEVDUJWJUZGBMMTPĊBOEXBHFTEFDMJOF

Figure 2:

Source: Federal Reserve Bank of St. Louis.
23


COLORADO COUNCIL FOR ECONOMIC EDUCATION

Figure 3:

Source: Bureau of Labor Statistics.

Now we can also see the reason wages in the United States are higher than
those in many parts of the world (Figure 3). American workers receive high wages
CFDBVTFUIFZBSFNPSFQSPEVDUJWFɩ FZBSFNPSFQSPEVDUJWFCFDBVTFPGUIFJSPXO
IVNBODBQJUBMBOECFDBVTFPGUIFQIZTJDBMDBQJUBMXJUIXIJDIUIFZXPSLɩ BU
QIZTJDBMDBQJUBMSFTVMUTGSPNJOWFTUNFOUCZQSPmUTFFLJOHDBQJUBMJTUT8IBUJTHPPE
for the capitalist, in other words, is ultimately good for the worker.

Summing Up

A free enterprise economic system is one in which individuals have the freedom
to reach agreements with one another concerning the use of resources that they
privately own. People in such a system are free to start their own business, to
decide what company to work for, to decide what product to buy – they are free
UPDIPPTFɩ FHSFBUCFBVUZPGTVDIBTZTUFNJTUIBUPOFQFSTPODBOBEWBODFIJT
PSIFSPXOJOUFSFTUPOMZCZBEWBODJOHUIFJOUFSFTUTPGPUIFSQFPQMFɩ FHSFBUFS
the success a person has, the greater the degree to which that person has made
PUIFSQFPQMFCFUUFSPĊ

24


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

Chapter 6:

non-enterprise:
the alternative

what is the alternative to a free enterprise system? It is a system in which
people are not free to do the things we have discussed. It is a system in
which people do not have the freedom to reach agreements with one another,
in which people do not have the freedom to start their own businesses. It is a
non-enterprise system.

It is hard to imagine that non-enterprise
systems would appeal to many people. ..the sad fact is that much of
However, the sad fact is that much of the the world’s population lives in
world’s population lives in non-enterprise non-enterprise economies.
FDPOPNJFTɩ JTVOIBQQZTJUVBUJPOJTSFMBUFE
to the observations we made earlier about the fact that much of the world’s
people are terribly poor. Non-enterprise economies deliver poverty.

ɩ FSFBSFUXPCSPBEGPSNTPGOPOFOUFSQSJTFFDPOPNJFT0OFJTTPDJBMJTN

JOXIJDIUIFHPWFSONFOUBDUTBTUIFQSJNBSZPXOFSPGDBQJUBMɩ FPUIFSJT
economic fascism. In economic fascism the capital may be privately owned, but
extensive government regulation dictates how it will be used, the prices that will
be charged, and the wages the workers will receive. Both systems have proven
to be failures at delivering high living standards.

Socialism

Socialist systems have been around for a very long time. Indeed, the very
mSTU&VSPQFBOTFUUMFSTPG"NFSJDBFTUBCMJTIFETVDIBTZTUFNɩ FZBHSFFEUP
hold their productive resources in common, to work for the common good and
UPTIBSFUIFQSPEVDUTPGUIFJSMBCPSFRVBMMZɩ JTTPDJBMJTUJEFBMWBOJTIFEXJUI
the collapse of the community. With the fruits of each person’s labor shared
equally, people did not work hard enough to maintain the existence of the

25


COLORADO COUNCIL FOR ECONOMIC EDUCATION

DPNNVOJUZɩ FGPVOEFSTPGUIFTVCTFRVFOUDPNNVOJUJFTEJEOPUSFQFBUUIF
MFTTPOPGGBJMVSFGSPNUIFmSTUDPNNVOJUJFTɩ FZFTUBCMJTIFEUIFJSDPNNVOJUJFT
on the basis of private property, freedom of contract, and free enterprise. Our
TPDJFUZJTUFTUBNFOUUPUIFTVDDFTTPGUIFTFFĊPSUT

If only the modern practitioners of socialism had seen their failure as
quickly! Leaders of the former Soviet Union, having installed a system of
monopoly government ownership of capital in their own country, succeeded
in exporting their ideas to Eastern Europe, China, and scattered outposts in
"GSJDB BOE -BUJO "NFSJDB ɩ FTF FYQFSJNFOUT JO OPOFOUFSQSJTF FDPOPNJD
systems have proven to be failures.

In Figure 4, we use the Index of Economic Freedom as a way to assess the
degree to which an economy can be considered free enterprise (or conversely,
OPOFOUFSQSJTF
ɩ FJOEFYSBUFTDPVOUSJFTBSPVOEUIFHMPCFBDDPSEJOH
to their degree of freedom of enterprise, accounting for such things as the extent
of business regulation, the amount of government interference in markets, tax
levels, restrictions on international trade, and the degree of private property

Figure 4:

Index of Economic Freedom
(higher values indicate greater economic freedom)
Source: Heritage Foundation and the Dow Jones and Company, Inc. Index of Human Freedom, 2010.
26


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

rights protection. Consistent with the discussion of the past chapters, the
greater the degree of economic freedom a country permits, the greater the
amount of income per person it tends to generate over time.

Another striking indication of the failure
of socialism is in the former country of East ...the greater the degree of
Germany. Following the tragedy of World economic freedom a country
War II, East and West Germany followed permits, the greater the
TIBSQMZEJĊFSFOUQBUITɩ F4PWJFU#MPD
XIJDI amount of income per person
installed a socialist economic system, absorbed it tends to generate over time.
UIFFBTUɩ FXFTUFTUBCMJTIFEBGSFFFOUFSQSJTF
economy. While East and West Germany started at the same level with much
in common – the same people, the same language, the same heritage – over
nearly 60 years the two separate economic systems generated vastly divergent
outcomes. At the time of the collapse of communism in the early 1990s, East
Germany found itself in economic ruins with income per person running at only
about one-third of that of West Germany. As Figure 5 shows, enormous strides
IBWFCFFONBEFTJODFVOJmDBUJPO
XJUIFBTUFSO(FSNBOZOPXHFOFSBUJOHBWFSBHF
wages that are 78% (up from 49%) of that in western Germany. Finally, Figure
Q
SFnFDUTUIFIJHIFSTUBOEBSEPGMJWJOHJOFBTUFSO(FSNBOZJMMVTUSBUFECZ
the dramatic increase in the availability of hot water, central heating, telephone
TFSWJDFBOEPUIFSBNFOJUJFTUIBUPDDVSSFEJOUIFmSTUZFBSTBGUFSVOJmDBUJPO

Figure 5:

Source: Easterlin, R. and Plangol, A. “Life satisfaction and economic conditions in
East and West Germany.” Journal of Economic Behavior and Organization, 68, 2008, pp. 433-444.

27


COLORADO COUNCIL FOR ECONOMIC EDUCATION

Figure 6:

Source: The Economist. September 30, 2000, pp. 25-38.

Finally, we see in Table 2 that the former Soviet Union was unable to sustain
economic growth over time. Its growth rate declined substantially in the 1980s,
prior to its collapse. Since World War II, the former Soviet economy was unable
to keep pace with economic growth in the U.S. economy.

It is easy to see why socialism failed. With the government owning
FWFSZUIJOH
XIP IBE UIF JODFOUJWF UP mOE OFX BOE CFUUFS XBZT UP QSPEVDF
HPPETPSUPQSPEVDFBOZHPPETBUBMM "MMXPSLFSTXFSFTUBUFFNQMPZFFTɩ F
government set all prices. None of the keys to free enterprise success existed;
failure was inevitable.

Economic Fascism

Economic fascism is even more widespread than socialism. Many of the
economies of Latin America and Africa adopted this economic system. To see
how economic fascism operates, consider again our car wash. If we wanted
to start a car wash in a fascist system, we would begin by getting government
approval – lots of government approval.

28


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

Table 2:

Economic Growth: U.S. and U.S.S.R. (1951-1990)

Time Average Annual Growth Rate (%)
Period
U.S.S.R. U.S.
1951-60
1961-1965 7.2 3.5
1966-70
1971-75 4.4 5.0
1976-80
1981-85 4.1 3.4
1986-90
3.2 2.7

1.0 3.7

0.6 3.1

-4.1 3.2

Source: Robert C. Stuart and Paul A. Gregory. ɩ F3VTTJBO&DPOPNZ
Past Present and Future, Harper Collins College Publishers, 1995, p. 35, and

Bureau of Economic Analysis. Survey of Current Business, August 2000.

Hernando de Soto, the great Peruvian political economist, has written
about what it takes to start a business in his own heavily regulated country. A
myriad of permits must be obtained; bribes must be paid. He estimated that
it cost more than $1,200 – at that time, roughly the equivalent of two years
wages for the average Peruvian worker – to obtain permission to start a small
business. De Soto compares this to the requirements just across the border
JO$IJMF
XIJDITIJGUFEUPBGSFFFOUFSQSJTFTZTUFNJOUIFFBSMZTɩ FSF

starting a new business required a permit costing $10; the process of getting
government approval took only about a week.9 It is easy to see that in a system
PGFDPOPNJDGBTDJTNPVSDBSXBTIXPVMECFVOMJLFMZUPFWFSHFUPĊUIFHSPVOE

5PVOEFSTUBOEXIZTPNFDPVOUSJFTDIPPTFUPTUJnFDPNQFUJUJPO
XFNVTU
see how self-interest works in a system of extensive government involvement
in the economy. Suppose you owned an established car wash in an economy
in which everyone was accustomed to extensive government regulation. You
XPVMEIBWFBIFBMUIZBQQSFDJBUJPOPGQSPmUToZPVSPXOQSPmUTJOQBSUJDVMBS

9de Soto, H. ɩ F0UIFS1BUI
1989, Basic Books, NY.

29


COLORADO COUNCIL FOR ECONOMIC EDUCATION

To protect your profits, it would be sensible to arrange to have the

HPWFSONFOU NBLF JU EJċ DVMU GPS BOZ OFX DBS

...it is competition that washes to get started. You would lobby for

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to enter. You might even bribe government

PċDJBMT
XIP JO B IJHIMZ SFHVMBUFE TZTUFN DPVME TBZ iZFTw PS iOPw UP OFX

FOUFSQSJTFT "GUFS BMM
JU JT DPNQFUJUJPO UIBU LFFQT QSPmUT MPX ,FFQJOH PVU

DPNQFUJUJPOXJMMLFFQZPVSQSPmUTIJHI

0G DPVSTF
ZPV XPVMEOU DPVDI ZPVS FĊPSUT JO TVDI UFSNT :PV XPVME
speak of the need to have an orderly marketplace to protect the public from
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#VUUIFSFTVMUPGZPVSQBSUOFSTIJQXJUIHPWFSONFOUPċDJBMTXPVMECFUPCMPDL
DPNQFUJUJPOBOECPPTUZPVSPXOQSPmUT

ɩ BUJTUIFUSBHFEZPGFDPOPNJDGBTDJTN
A system of extensive government controls A system of extensive
XPSLTUPJOTVMBUFBIBOEGVMPGFTUBCMJTIFEmSNT government controls works
from competition. Freed of the discipline of to insulate a handful of
competition, firms charge high prices, pay FTUBCMJTIFEmSNTGSPN
MPX XBHFT BOE FBSO FOPSNPVT QSPmUT 'PS competition.
the handful at the top, this is an enormously
lucrative system. For the rest of the population, it is a sentence of grinding poverty.

ɩ F&OEPG/PO&OUFSQSJTF

ɩ F MBTU TFWFSBM EFDBEFT IBT TPVOEFE XIBU NBZ CF UIF EFBUI LOFMM GPS
non-enterprise economies. People all over the world are beginning to realize
that Adam Smith was right. Free enterprise creates wealth. Non-enterprise
assures poverty.

People who were forced to live under socialism scrapped it when given the
freedom to do so. Virtually every nation that had been socialist before 1990
has discarded socialism and is functioning as a market economy. Cuba and
North Korea appear to be the only pure socialist nations standing against this
tide; but in the recent past even these stalwarts have made movements towards
liberalization.

30


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

In Latin America, the recognition is growing that economic fascism is a
GBJMVSFɩ FPMEFYDVTF
UIBU-BUJO"NFSJDBJTQPPSCFDBVTFUIF6OJUFE4UBUFT
is rich, has been thoroughly discredited by the dazzling success of small, once
poor, free enterprise economies such as Hong Kong, Taiwan, Singapore, and
South Korea. First Chile and now Brazil are leading the way in Latin America
in casting aside the bureaucratic controls of economic fascism.

ɩ FTUSVHHMFGPSGSFFFOUFSQSJTFJTBEJċDVMUPOF/POFOUFSQSJTFJTBGBJMVSF
– except possibly for the people who happen to be part of the ruling elite. For
UIFN
JUJTBDPNGPSUBCMFTPVSDFPGHSFBUXFBMUIBOEUIFZXJMMmHIUUPNBJOUBJO
it. But it is a struggle that the ruling elites of non-enterprise economies are sure
to lose. People cannot be held down in needless poverty forever.

Imagine, for a moment, a world of free enterprise. It is a world in which
people advance their wealth only by serving the interests of others – not by
seizing the fruits of other people’s labor. It is a world in which everyone stands
to gain by the advancement of everyone else. It is a world in which war as a
policy tool no longer makes sense. It is a world of unprecedented prosperity
for ordinary people. And it is a world we can achieve!

31


COLORADO COUNCIL FOR ECONOMIC EDUCATION

32


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

Chapter 7:

economic crisis
and promise

aOZPOF XIP SFBE UIF OFXTQBQFS PS USJFE UP m OE B KPC EVSJOH UIF (SFBU
Recession of 2008 – 2009 or during its aftermath, recognized that the
HMPCBMFDPOPNZXBTVOEFSHSFBUTUSFTTɩ JTBDLOPXMFEHFNFOUSVOTDPVOUFS
to the ideas presented in this monograph. If free enterprise is such a superior
FDPOPNJDTZTUFN
IPXDBOJUHFOFSBUFTVDIBQPPSPVUDPNF ɩ FSFBSFNBOZ
possible responses, from denial that the outcome resulted from an imperfection
in the free enterprise system, to placement of the blame squarely on politicians.
0VSBQQSPBDIJTEJĊFSFOU8FSFDPHOJ[FUIBUUIFGSFFEPNJOIFSFOUJOBGSFF
enterprise system opens the door for periodic crises and downturns. To some
EFHSFF
UIF(SFBU3FDFTTJPOSFnFDUTUIJTMJNJUBUJPOPGBGSFFFOUFSQSJTFTZTUFN

Does this mean that the system should be rejected? Not in our opinion.
ɩ FGSFFFOUFSQSJTFTZTUFNJTOPUQFSGFDUɩ FTZTUFNTPVUDPNFJTBOFYQSFTTJPO
of human desires and needs. Sometimes in the pursuit of those ends people
make mistakes. No individual or group of people is infallible. Most of the time
those mistakes do not compound into widespread crisis. Investor Bob may buy
BiTVSFCFUwTUPDLUIBUCFDPNFTXPSUIMFTTUXPEBZTMBUFSɩ JTIBSNT#PC
CVU
the damage applies mainly to Bob. Manager Anna may buy materials just as
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unemployed, but the economy does not collapse.

Unfortunately, at other times harm does
compound. Homeowner Sally may buy a Unfortunately, if the timing
house right before home prices crash. Her is wrong, individual bad
loss when added to the losses of many others decisions can compound and
in similar situations spirals into a loss for spiral into global problems.
builders, bankers, and the stock market.
Almost everyone is harmed. Unfortunately, if the timing is wrong, individual
bad decisions can compound and spiral into global problems. A free enterprise
system does not preclude this spiraling aggregate harm.

33


COLORADO COUNCIL FOR ECONOMIC EDUCATION

Isn’t this an argument for some other system? No. Every economic system

is prone to human-based failings – all economic systems are human-based

systems. As long as people make mistakes,

Economic crises occur in free economic systems will occasionally experience

enterprise systems and every crisis. As evidence, consider the collapse
of the planned Soviet economic system or
other economic system. the currently failing planned North Korean

economy. Economic crises occur in free enterprise systems and every other

economic system. However, from the evidence linking economic freedom to

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to accept a free enterprise system with the promise of high living standards

and the occasional risk of system failure, or to accept another system with

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is not much of a choice. While not perfect, the promise of the free enterprise

system is better than the promise of other systems. It seems that the free

enterprise system is the worst economic system “except for all other forms

that have been tried from time to time” (with apologies to Winston Churchill).

Exploring the Current Crisis

Even though we do not conclude that the recent crisis should lead to a
rejection of the free enterprise system, it is still worthwhile exploring the sources
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nature of economic relationships that drive modern economic functioning.
While this brief discussion cannot explore all possible causes of recent economic
problems, this discussion highlights several main contributors.10

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consumer wants, but it is also the primary store of wealth for most households.
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UIF TPVSDFT BWBJMBCMF UP G VOE UIF QVSDIBTF PG BO
asset are a driving force behind purchases. During the years leading to the surge
in housing prices, the cost and availability of funds for purchases dramatically
changed. Primary to these changes were the increases in global liquidity driven
by Federal Reserve actions and economic growth in Asia. With the rapid growth

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%ɩ F(FOFTJTPGB$SJTJT

2008 (available for download at http://www.ccee.net/newsletters.htm). For a much more
extensive discussion, please see the government’sɩ F'JOBODJBM$SJTJT*ORVJSZ3FQPSU(available
for download at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/content-detail.html).

34


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH
Figure 7:

Source: Federal Reserve Bank of St. Louis

of China and other Asian economies during the past decades came markedly
higher levels of personal income and savings – savings in search of a secure outlet.
Asian economies found safe haven in developed western economies, resulting in
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7. Compounding this expansion in liquidity from foreign savings, the Federal
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ɩ FDPNCJOBUJPOPGIJHIHMPCBM

Figure 8:

Source: Federal Reserve Bank of St. Louis
35


COLORADO COUNCIL FOR ECONOMIC EDUCATION

Figure 9:

Source: Federal Reserve Bank of St. Louis

savings and loose Federal Reserve monetary policy acted to lower the average
30-year mortgage rate by more than two percentage points from 2000 to 2005
(see Figure 9). By itself this would tend to drive up the demand for housing.

Compounding the effect of high levels of liquidity in the mortgage
market, the environment constraining lending decisions changed markedly
from 1995 to 2005. First, government policy surrounding mortgage lending
changed. Revisions to the Community Reinvestment Act in 1995 and 1999
allowed and encouraged the government sponsored enterprises Freddie Mac
and Fannie Mae to invest in the secondary market for subprime mortgages.

Second, as the government was encouraging more lending at the risky end
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mortgage-backed financial derivatives. The key to these new financial
instruments is that they were an outgrowth of the computing and information
technology revolution of the 1990s. Prior to the late-1990s, the inexpensive
computing power required to bring mortgage-backed derivative securities to
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brought to market. In hindsight, it is clear that these instruments were
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new, technology-driven products.

36


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

'JOBMMZ
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Partially, the deregulatory ethos that drove airline travel deregulation (to mostly
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George W. Bush. Compounding this systemic movement towards deregulation,
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liquidity. Building on this, the price surge changed individual behavior. Rising
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speculative behavior was not new, but the scale of the activity was. How could
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easy answer is that growth in liquidity allowed ɩ FmSTUTUFQUPXBSETUIF
GPS TJHOJmDBOUMZ HSFBUFS TQFDVMBUJWF BDUJWJUZ recent crisis was driven by
than the markets had traditionally seen. growth in liquidity.
Beyond this, non-speculator homeowners also
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In other words, as home prices surged homeowners borrowed against their
SJTJOHFRVJUZɩ JTQPTFTOPQSPCMFms while home prices are rising, but turns
against homeowners when prices fall. When the housing price bubble burst in
late 2006 (Figure 10, p. 38), many homeowners found that they owed more on
their mortgage than their homes were worth. By summer 2011 almost one-
quarter of all mortgages were “underwater,” with loan balances greater than
home market value.11ɩ FTFDIBOHFTJOUIFIPVTJOHNBSLFUGPSNFEUIFTFDPOE
step in the crisis.

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leveraged derivative mortgage-backed products, which had become so widely
owned throughout the financial industry, collapsed. Why did so many
individuals and institutions buy these products? Because the risk of a housing
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attractive to ignore. Additionally, the government provided another push by
revising the 1933 Glass-Steagall Act to allow commercial bank and investment
bank activities to become intertwined. With this change coming only in 1999,
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37


COLORADO COUNCIL FOR ECONOMIC EDUCATION

Figure 10:

Source: Federal Reserve Bank of St. Louis

their behavior to the new market conditions prior to the rapid fall in housing
prices. As housing prices declined and the mortgage-backed securities market
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– both commercial and investment – became increasingly averse to making new
loans. As lending activity dried up, liquidity contracted, reversing the process
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makes the recent recession the fault of rapidly changing government policy
compounding human mistakes that were fueled by high levels of market liquidity.
"OVOMJLFMZDPOnVFODFPGFWFOUTUIBUXFXFSFVOGPSUVOBUFUPFYQFSJFODF

Because of the extent and nature of the contraction (see Figure 11), the recovery
was slower than past recessions. Worse, the economy currently faces challenges
from many sources ranging from retiring baby-boomers to domestic budgetary
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recent crisis and the sluggish economic recovery show all indications of being the
start of long-term economic challenges.

11CoreLogic. Q1 Negative Equity Report, 2011.
38


FREE ENTERPRISE: OUR HERITAGE, OUR WEALTH

Fortunately, the Great Recession came at a time when the U.S. economy
enjoyed one of the highest per capita income levels in the world and at a time
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ɩ FTF
strengths come thanks to the economic system under which we live – the free
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CVUJTB
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Figure 11:

Source: Federal Reserve Bank of St. Louis

Figure 12:

Source: Federal Reserve Bank of St. Louis
39


COLORADO COUNCIL FOR ECONOMIC EDUCATION

40


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