The Free Market System

Assessing the Gains from Free Markets

A free market exists when the government places few restrictions on how a good or a service can be produced or sold, or on how a factor of production can be employed.

A free market is a type of economic system Opens in new window that is controlled by the market forces of supply and demand Opens in new window, as opposed to one regulated by government controls.

Relatively few government restrictions are placed on economic activity in Australia, the USA, Hong Kong and Singapore.

In countries such as Cuba and North Korea the free market system has been rejected in favor of centrally planned economies Opens in new window with extensive government control over product and factor markets.

Countries that come closest to the free market system have been more successful than countries with centrally planned economies Opens in new window in providing their people with rising living standards.

The Scottish philosopher Adam Smith Opens in new window is considered to be the father of modern economics because one of his books, An Inquiry into the Nature and Causes of the Wealth of Nations, Opens in new window published in 1776, was an early and very influential argument for the free market system.

Smith was writing at a time when extensive government restrictions on markets were still very common.

In many parts of Europe the guild system still prevailed. Under this system Opens in new window governments would give guilds, or organizations of producers, the authority to control the production of a good.

Smith argued that such restrictions reduced the income or wealth of a country and its people by restricting the quantity of goods produced.

Some people at the time supported the restrictions of the guild system because it was in their financial interest to do so. If you were a member of a guild the restrictions served to reduce the competition you would face. But other people sincerely believed that the alternative to the guild system was economic chaos.

Smith argued that these people were wrong and that a country could enjoy a smoothly functioning economic system if firms were freed from guild restrictions.

The Market Mechanism

In Smith’s day defenders of the guild system worried that if, for instance, the shoemakers’ guild did not control shoe production too many or too few shoes would be produced.

Smith argued that prices would do a better job of coordinating the activities of buyers and sellers than the guilds could.

A key to understanding Smith’s argument is the assumption that individuals usually act in a rational, self-interested way.

In particular, invididuals take those actions most likely to make themselves better off financially. This assumption of rational, self-interested behavior underlies nearly all economic analysis.

Adam Smith understood—as economists today understand—that people’s motives can be complex. But in analyzing people in the act of buying and selling, the motivation of financial reward usually provides the best explanation for the actions people take.

Firms will find that they can charge higher prices for 4WDs than they can for sedans.

The self-interest of these firms will lead them to respond to consumers’ wishes by producing more 4WDs and fewer sedans.

Then the prices firms can charge for bread and pasta will fall. The self-interest of firms will lead them to produce a less bread and pasta, which in fact is what happened in the late 1990s and early 2000s.

In the case where consumers want more of a product, and in the case where they want less of a product, the market system responds without a guild or anyone else giving orders about how much to produce or what price to charge.

In a famous phrase, Smith said that firms would be led by the invisible hand Opens in new window of the market to provide consumers with what they wanted.

Firms would respond to changes in prices by making decisions that ended up satisfying the wants of consumers.

The effect that price changes have on the behavior of firms and consumers is referred to in economics as the price mechanism.

Price mechanism, by definition, is the system in a free market where price changes lead to producers changing production in accordance with the level of consumer demand.

Entrepreneurs Opens in new window are central to the working of the market system.