Free Market Economy Definition

A free market economy is a type of economy that promotes the production and sale of goods and services, with little to no control or involvement from any central government agency. This economic system is primarily based on supply and demand. Order and power in a free market are decentralized, with individuals making all of their own voluntary economic choices.

In a free-market economy, firms and households act in their own self-interest to determine how resources get allocated, what goods get produced, and who buys the goods. A free market economy functions in the opposite manner as a command economy works, where the central government gets to keep the profits and choose how to use them.

Among all of the states throughout the globe, there is no entirely free market economy—all economies have some constraints upon them in the form of government regulations, to a greater or lesser degree. An absolutely free market does not include standard measures like import and export tariffs, prohibitions on certain products, sales taxes, and more.

Markets tend to be the freest in countries that emphasize the values of capitalism and private property, which naturally promote laissez-faire economics (a term often used synonymously with the idea of the free market).

Main Features of Market Economies

The central elements that make up a market economy include:

  • There is voluntary production and consumption of goods, with overall freedom for every individual to make their own choices
  • Overwhelmingly, there is private ownership and control of resources and property, including the means of production as well as the labor supply
  • Self-interest is the primary motivator for all economic decisions
  • The government’s role in the economy is limited (e.g. to preventing monopolies, allowing fair and equal access to markets for all, protecting the nation and its markets through military means)
  • Competition creates overall efficiency and low prices

Advantages Of A Free Market Economy

Advantages Of A Free Market Economy

Here are several of the key advantages of the free market system:

1. Consumer Sovereignty

In a free market, producers are incentivized to produce what consumers want at a reasonable and affordable price. In general, consumers have more choices for what goods and services to purchase. This choice is called Consumer Sovereignty.

2. Absence of Bureaucracy

Because free markets reduce cost and minimize red tape, they lead to more innovation via research and development. Entrepreneurs do not have to wait for the government to tell them what to make. They study demand, research trends, and meet their customers’ needs through innovation. This independence also encourages competition amongst firms to improve their products and services.

3. Motivational Influence of Free Enterprise

Guided by what’s often called the “invisible hand,” entrepreneurs take economic risks to fulfill consumer demand. Those entrepreneurs who succeed are rewarded with profits, so this tends to encourage innovation in the market as a whole.

The invisible hand is an economic concept where market demand acts as signals for producers. For instance, because consumers want and are willing to pay for bread, bakers have the economic incentive to produce bread. The concept was originally introduced by Adam Smith in his 18th-century work The Wealth of Nations.

4. Optimal Allocation of Resources

Resources (aka factors of production) in the market are better distributed and allocated. Since consumers are willing to pay for a certain quantity of a product, producers are willing to pay to acquire the raw materials required to produce that product. Otherwise, producers are likely to produce too much of a good that no one wants. In the same way, it also encourages firms to be more efficient as they seek to produce at the lowest price possible to maximize their profit.

Disadvantages Of A Free Market Economy

Disadvantages Of A Free Market Economy

There are also significant disadvantages inherent in a free market economy. These are the most prominent:

1. Poor Quality

Since profit maximization is the biggest motivation for firms, they may try to reduce their costs unethically. In many cases, the drive for profit maximization actually incentivizes unethical behavior. Examples of harmful effects of unethical cost reduction measures include polluting the environment or exploiting (overworking, under-paying, preventing workers from unionizing etc.) workers. Government intervention is necessary to limit these harms.

2. Merit Goods

Goods and services that are not profitable will not be produced or run. Rural communities will suffer as a result. Examples include transportation and postal services, as well as rural hospitals, which are necessary despite the fact that they may not be profitable to run. In such cases, the government must provide these goods and services so that people do not go with their basic needs unmet.

3. Excessive Power of Firms

Large firms can still dominate certain markets, even where there is some competition. This allows them to maximize their profits by exploiting suppliers (by squeezing their prices down) and consumers (by charging higher selling prices).

For example, Amazon is guilty of such practices in the book industry, where they have dictated unfair terms to publishers. Part of the reason that large companies are able to dominate markets is due to economies of scale. The large-scale companies with greater capital and labor resources can beat out smaller companies simply for their size alone, rather than for the quality of their product; if this process continues, they may eventually gain a monopoly over their market.

4. Unemployment and Inequality

In a free market economy, certain members of society will not be able to work, such as the elderly, children, or others who are unemployed because their skills are not marketable. They will be left behind by the economy at large and, without any income, will fall into poverty. Their caretakers will also be left out of the economy, because they will not be paid for their necessary caretaking work.

Remember: if there is no government, there is no way that these individuals can be helped in any systematic manner. The result is that inequality takes root: a few people can live in luxury while others cannot pay their medical bills, get enough food, access basic shelter, and so on.

Prateek Agarwal’s passion for economics began during his undergrad career at USC, where he studied economics and business. He started Intelligent Economist in 2011 as a way of teaching current and fellow students about the intricacies of the subject. Since then he has researched the field extensively and has published over 200 articles.

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