What’s it: The private sector refers to the part of the economy outside of government ownership or control. It covers the household and business sectors. Its contribution varies between countries, depending on how close they are to a free market economy or a command economy.
Although independent from government control, not all non-government organizations are profit-oriented. Some are socially oriented, such as non-governmental organizations and charities.
Then, there are for-profit social enterprises such as cooperatives, microfinance providers, and social enterprises, which earn profits to be reinvested in social activities. They operate to bring about social impact instead of maximizing owner wealth.
Private sector vs. Public sector
Businesses in the private sector are profit-oriented. They are owned and managed by individuals and private companies. They produce goods and services to satisfy consumer needs and make money. They seek to maximize the wealth of their owners, and to do so successfully, they must win over the competition.
In contrast, the public sector is not profit-oriented. This sector is under government control and provides goods and services to serve the people. It provides various public goods, which private companies are unwilling to provide because they are not profitable. For this reason, competition is almost non-existent in the public sector and is usually under government monopoly.
The private sector in macroeconomics
When we study macroeconomics, this sector is further divided into the business sector and the household sector. Apart from these two, there is the government sector and the external sector. And the external sector actually also consists of three other sectors: households, business, and government.
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And the spending of the four sectors, if we add them up, represents aggregate spending, measured by the gross domestic product (GDP). It consists of household consumption, business investment, government spending, and net exports.
The private sector roles under a free, command, and mixed market economy
The private sector dominates in a free market economy but not in a command economy. In a mixed economy, the public and private sectors play different roles, depending on the tendency of the economic system to be adopted by a country.
- Free market economy: the private sector plays a significant role in the economy. The market mechanism works freely without government intervention. Meanwhile, the public sector has a minimal role, more on aspects such as property rights enforcement.
- Command economy: the opposite of a free-market economic system. The private sector does not develop because the state determines and decides the resources allocation, including what goods and services are produced, how to produce them, and for whom they are produced.
- Mixed economy: combining public and private sector participation. The market mechanism works to allocate resources, but sometimes the government intervenes in the market for the public interest.
Today, almost all countries are under mixed economic systems. However, they vary on how the private sector contributes. Some countries are more inclined towards free markets, such as the United States, while others are more inclined towards command, such as China.
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The public sector usually plays a role in vital parts of the economy, such as health, education, defense, and law services. However, the private sector is usually reluctant to participate in it because it is not profitable.
Public goods such as street lighting, for example, are available to everyone and are not possible to charge. Thus, everyone gets its benefits without being able to exclude others from consuming it. Thus, private businesses can’t profit from producing them.
Then, in some countries, strategic industries are also under government ownership and control. Examples are energy, telecommunications, and public transportation. Therefore, apart from enabling affordability for the public, participation in such an industry also aims to:
- Prevent private monopoly
- Maintaining employment
- Maintaining environmental standards
Businesses in the private sector
Business organizations in the private sector fall into two categories:
- Unincorporated business – the business and its owners are not considered legally separate entities. Examples are sole proprietorships and partnerships.
- Unincorporated business – the business and its owners are legally recognized as separate entities from their owners. Thus, the legal and financial liability of the business is not the responsibility of the owner. It can be a private limited company and a public limited company.
A sole proprietorship is a business organization under the control of one person. The owner is fully responsible for the operations, business decisions, profits, and obligations of the business. Examples include hairdressers and butchers.
In addition to having fewer rules than other business organizations, the owner is entitled to all the business profits. But, the owner is also fully responsible for the business’s debts, which may have to lose personal assets to pay off the business’s debts.
Two or more people can establish a partnership. They share responsibility for the operations and finances of the business. And therefore, it has more resources than a sole proprietorship.
But, despite the resources, the partners must share the business’s profits, unlike a sole proprietorship where the business’s profits belong to the owner.
In addition, decision-making becomes more complicated because it requires agreement between partners. In contrast, under a sole proprietorship, the owner is the sole decision-maker.
Private and public limited company
A limited company separates the wealth of the owner and the wealth of the business. The business is a separate entity from the owner, and as such, the owner is not personally liable for the debts of the business. Then, the owner also has limited liability, only losing the initial investment if the company goes bankrupt.
Limited companies have greater resources than sole proprietorships and partnerships. To increase capital, they can issue shares or bonds in the capital market.
Businesses also have a more organized organizational structure. For example, operations are divided into several functional areas: operations, human resources, marketing, accounting, and information technology.
Limited companies fall into two categories:
Private limited companies do not issue and sell their shares to the public through the stock exchange. So, if you are an investor, you can’t buy it there.
Meanwhile, public limited companies list their shares on the stock exchange – and are also known as listed companies. As a result, the public can trade their shares.
Then, in operating the day-to-day business, the owner is not involved. Instead, they delegate day-to-day operations to management in their best interest – which sometimes raising agency problems.
Meanwhile, owners are entitled to dividends for compensation, a share of the company’s profits distributes to them. However, it is not always because management may decide to keep profits as capital (retained earnings).
Then, suppose the business is a listed company. In that case, the owner also can get capital gains from the increase in the company’s share price.