Question

Now, let's discuss Chapter 1 in the CapsimCore Business Primer eTextbook.

1. What are the four conditions that must exist for the free enterprise system to exist?
2. What are the implications of the relationship between supply and demand?

Answer 1

1. A free enterprise economy is based on a free and fair exchange between a willing buyer and a willing seller who reach a voluntary consensus on a purchase price. It is based on four conditions: private property rights, profit motive, equal individual rights and unrestricted competition.

Private Property Rights: It requires that all involved in the market are recognized as enjoying full personal control over their own property. Private property rights are what enable the free exchange of that property through sale.

Profit Motive: Ability to realize a profit. Free enterprise systems are based in part on the ability of buyers and sellers to reach agreements on prices and other terms for sales of goods and services. However, sellers are generally intent on maximizing their profits in order to generate more wealth.

Equal Rights for all market participants: all market participants in a free enterprise system enjoy equal rights. If a market is to be truly free, the buyers and sellers involved in that market must stand on equal, level footing.

Importance of Competition: The process of competition is what fuels innovation, the development of superior products and greater creativity in the system as a whole.

2. The inverse relationship between supply and demand explains how supply and demand are related to each other and how that relationship affects the price of goods and services. This introduces the concept of price elasticity.

For example, suppose a luxury car company sets the price of its new car model at $200,000. While the initial demand may be high, due to the company hyping and creating buzz for the car, most consumers are not willing to spend $200,000 for an auto. As a result, the sales of the new model quickly fall, creating an oversupply and driving down demand for the car. In response, the company reduces the price of the car to $150,000 to balance the supply and the demand for the car to reach an equilibrium price ultimately.

Also the supply and demand relationship affects more abstract things as well, including a nation's monetary policy. This happens through the adjustment of interest rates. Interest rates are the cost of money: They are the preferred tool for central banks to expand or decrease the money supply.

When interest rates are lower, more people are borrowing money. This expands the money supply; there is more money circulating in the economy, which translates to more hiring, increased economic activity, and spending, and a tailwind for asset prices and vice versa happens if the interest rates are higher.