A free market is a competitive market where prices are determined by supply and demand. It is primarily found in countries where economic intervention and regulation by the state is limited to tax collection, and enforcement of private ownership and contracts. Free markets differs from situations encountered in controlled markets or a monopoly, which can introduce price deviations without any changes to supply and demand. Advocates of a free market traditionally consider the term to imply that the means of production is under private, and not state control or co-operative ownership. This is the contemporary use of the term "free market" by economists and in popular culture; the term has had other uses historically.
A free-market economy is one within which all markets are unregulated by any parties other than market participants. In its purest form, the government plays a neutral role in its administration and legislation of economic activity, neither limiting it (by regulating industries or protecting them from internal/external market pressures) nor actively promoting it (by owning economic interests or offering subsidies to businesses or R&D).
The theory holds that within an ideal free market, goods and services are voluntarily exchanged at a price arranged solely by the mutual consent of sellers and buyers. By definition, buyers and sellers do not coerce each other, in the sense that they obtain each other's property rights without the use of physical force, threat of physical force, or fraud, nor are they coerced by a third party (such as by government via transfer payments)[1] and they engage in trade simply because they both consent and believe that what they are getting is worth more than or as much as what they give up. Price is the result of buying and selling decisions en masse as described by the theory of supply and demand.
Free markets contrast sharply with controlled markets or regulated markets, in which governments more actively regulate prices and/or supplies, directly or indirectly, which according to free-market theory causes markets to be less efficient.[2] Where substantial state intervention exists, the market is a mixed economy. Where the state or co-operative association of producers directly manages the economy to achieve stated goals, economic planning is said to be in effect; when economic planning entirely substitutes market activity, the economy is a Command economy.
In the marketplace, the price of a good or service helps communicate consumer demand to producers and thus directs the allocation of resources toward satisfaction of consumers as well as investors. In a free market, the system of prices is the emergent result of a vast number of voluntary transactions, rather than of political decrees as in a controlled market. The freer the market, the more truly the prices will reflect consumer habits and demands, and the more valuable the information in these prices are to all players in the economy. Through free competition between vendors for the provision of products and services, prices tend to decrease, and quality tends to increase. A free market is not to be confused with a perfect market where individuals have perfect information and there is perfect competition.
Free-market economics is closely associated with laissez-faire economic philosophy, which advocates approximating this condition in the real world by mostly confining government intervention in economic matters to regulating against force and fraud among market participants. Some free-market advocates oppose taxation as well, claiming that the market is more efficient at providing all valuable services of which defense and law are no exception, that such services can be provided without direct taxation and that consent would be the basis of political legitimacy making it a morally consistent system. Anarcho-capitalists, for example, would substitute arbitration agencies and private defense agencies.
In social philosophy, a free-market economy is a system for allocating goods within a society: purchasing power mediated by supply and demand within the market determines who gets what and what is produced, rather than the state. A free market may refer narrowly to national economies, or internationally; specific reference to international markets is referred to as free trade (for goods) or lack of capital controls (for money). Early proponents of a free-market economy in 18th century Europe contrasted it with the medieval, early modern, and mercantilist economies which preceded it.
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Supply and demand are always equal as they are the two sides of the same set of transactions, and discussions of "imbalances" are a muddled and indirect way of referring to price.[3] However, in an unmeasurable qualitative sense, demand for an item (such as goods or services) refers to the market pressure from people trying to buy it. They will "bid" money for the item, while in return sellers offer the item for money. When the bid matches the offer, a transaction can easily occur (even automatically, as in a typical stock market). In Western society, most shops and markets do not resemble the stock market, and there are significant costs and barriers to "shopping around" (comparison shopping).
The model is commonly applied to wages, in the market for labor. The typical roles of supplier and consumer are reversed. The suppliers are individuals, who try to sell (supply) their labor for the highest price. The consumers of labors are businesses, which try to buy (demand) the type of labor they need at the lowest price. As populations increase wages fall for any given unskilled or skilled labor supply. Conversely, wages tend to go up with a decrease in population.
When demand exceeds supply, suppliers can raise the price, but when supply exceeds demand, suppliers will have to decrease the price in order to make sales. Consumers who can afford the higher prices may still buy, but others may forgo the purchase altogether, demand a better price, buy a similar item, or shop elsewhere. As the price rises, suppliers may also choose to increase production, or more suppliers may enter the business.
Friedrich Hayek argues for the classical liberal view that market economies allow spontaneous order; that is, "a more efficient allocation of societal resources than any design could achieve."[4] According to this view, in market economies sophisticated business networks are formed which produce and distribute goods and services throughout the economy. This network was not designed, but emerged as a result of decentralized individual economic decisions. Supporters of the idea of spontaneous order trace their views to the concept of the invisible hand proposed by Adam Smith in The Wealth of Nations who said that the individual who:
"By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that it was no part of it. By pursuing his own interest [an individual] frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the [common] good." (Wealth of Nations)
Smith pointed out that one does not get one's dinner by appealing to the brother-love of the butcher, the farmer or the baker. Rather one appeals to their self interest, and pays them for their labor.
"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 own necessities but of their advantages."[5]
Supporters of this view claim that spontaneous order is superior to any order that does not allow individuals to make their own choices of what to produce, what to buy, what to sell, and at what prices, due to the number and complexity of the factors involved. They further believe that any attempt to implement central planning will result in more disorder, or a less efficient production and distribution of goods and services.
Critics, such as political economist Karl Polanyi, question whether a spontaneously ordered market can exist, completely free of "distortions" of political policy; since even the ostensibly freest markets require a state to exercise coercive power in some areas - to enforce contracts, to govern the formation of labor unions, to spell out the rights and obligations of corporations, to shape who has standing to bring legal actions, to define what constitutes an unacceptable conflict of interest, etc.[6]
General equilibrium theory has demonstrated, with varying degrees of mathematical rigor over time, that under certain conditions of competition, the law of supply and demand predominates in this ideal free and competitive market, influencing prices toward an equilibrium that balances the demands for the products against the supplies.[7][8] At these equilibrium prices, the market distributes the products to the purchasers according to each purchaser's preference (or utility) for each product and within the relative limits of each buyer's purchasing power. This result is described as market efficiency, or more specifically a Pareto optimum.
This equilibrating behavior of free markets requires certain assumptions about their agents, collectively known as Perfect Competition, which therefore cannot be results of the market that they create. Among these assumptions are complete information, interchangeable goods and services, and lack of market power, that obviously cannot be fully achieved. The question then is what approximations of these conditions guarantee approximations of market efficiency, and which failures in competition generate overall market failures. Several Nobel Prizes in Economics have been awarded for analyses of market failures due to asymmetric information.
Some models in econophysics[9] have shown that when agents are allowed to interact locally in a free market (i.e. their decisions depend not only on utility and purchasing power, but also on their peers' decisions), prices can become unstable and diverge from the equilibrium, often in an abrupt manner. The behavior of the free market is thus said to be non-linear (a pair of agents bargaining for a purchase will agree on a different price than 100 identical pairs of agents doing the identical purchase). Speculation bubbles and the type of herd behavior often observed in stock markets are quoted as real life examples of non-equilibrium price trends. Some laissez-faire free-market advocates, like Chicago school economists, often dismiss this endogenous theory, and blame external influences, such as weather, commodity prices, technological developments, and government meddling for non-equilibrium prices.
The distribution of purchasing power in an economy depends to a large extent on the nature of government intervention, social class, labor and financial markets, but also on other, lesser factors such as family relationships, inheritance, gifts and so on. Many theories describing the operation of a free market focus primarily on the markets for consumer products, and their description of the labor market or financial markets tends to be more complicated and controversial.
Joshua Epstein and Robert Axtell have attempted to predict the properties of free markets empirically in the agent-based computer simulation "Sugarscape". They came to the conclusion that, under idealized conditions, free markets lead to a Pareto distribution of wealth.[9]
The necessary components for the functioning of an idealized free market include the complete absence of artificial price pressures from taxes, subsidies, tariffs, or government regulation (other than protection from coercion and theft), and no government-granted monopolies (usually classified as coercive monopoly by free-market advocates) like the United States Post Office, Amtrak, patents, etc.
In an absolutely free-market economy, all capital, goods, services, and money flow transfers are unregulated by the government except to stop collusion or fraud that may take place among market participants. As this protection must be funded, such a government taxes only to the extent necessary to perform this function, if at all. This state of affairs is also known as laissez-faire.
Internationally, free markets are advocated by proponents of economic liberalism; in Europe this is usually simply called liberalism. In the United States, support for free market is associated most with libertarianism. Since the 1970s, promotion of a global free-market economy, deregulation and privatization, is often described as neoliberalism.
The term free-market economy is sometimes used to describe some economies that exist today (such as Hong Kong), but pro-market groups would only accept that description if the government practices laissez-faire policies, rather than state intervention in the economy. An economy that contains significant economic interventionism by government, while still retaining some characteristics found in a free market is often called a mixed economy.
A free market does not require the existence of competition, however it does require that there are no barriers to new market entrants. Hence, in the lack of coercive barriers it is generally understood that competition flourishes in a free-market environment. It often suggests the presence of the profit motive, although neither a profit motive or profit itself are necessary for a free market. All modern free markets are understood to include entrepreneurs, both individuals and businesses. Typically, a modern free market economy would include other features, such as a stock exchange and a financial services sector, but they do not define it.
In a free-market economy, money would not be monopolized by legal tender laws or by a central bank, in order to receive taxes from the transactions or to be able to issue loans. Minarchists (advocates of minimal government) contend that the coercion of taxes is essential for the market's survival, and a market free from taxes may lead to no market at all. By definition, there is no market without private property, and private property can only exist while there is an entity that defines and defends it. Traditionally, the State defends private property and defines it by issuing ownership titles, and also nominates the central authority to print or mint currency. "Free-market anarchists" disagree with the above assessment – they maintain that private property and free markets can be protected by voluntarily-funded services under the concept of individualist anarchism and anarcho-capitalism.[10][11] A free market could be defined alternatively as a tax-free market, independent of any central authority, which uses a medium of exchange such as money, even in the absence of the State. It is disputed, however, whether this hypothetical stateless market could function.
The Heritage Foundation, a conservative think tank, tried to identify the key factors necessary to measure the degree of freedom of economy of a particular country. In 1986 they introduced the Index of Economic Freedom, which is based on some fifty variables. This and other similar indices do not define a free market, but measure the degree to which a modern economy is free, meaning in most cases free of state intervention. The variables are divided into the following major groups:
Each group is assigned a numerical value between 1 and 5; IEF is the arithmetical mean of the values, rounded to the hundredth. Initially, countries which were traditionally considered capitalistic received high ratings, but the method improved over time. Some economists, like Milton Friedman and other Laissez-faire economists have argued that there is a direct relationship between economic growth and economic freedom, and studies suggest this is true.[12] Continuous debates among scholars on methodological issues in empirical studies of the connection between economic freedom and economic growth still try to find out what is the relationship, if any.[13][14][15]
The meaning of "free" market has varied over time and between economists, the ambiguous term "free" facilitating reuse. To illustrate the ambiguity: classical economists such as Adam Smith believed that an economy should be free of monopoly rents, while proponents of laissez faire believe that people should be free to form monopolies. In this article "free market" is largely identified with laissez faire, though alternative senses are discussed in this section and in criticism. The identification of the "free market" with "laissez faire" was notably used in the 1962 Capitalism and Freedom, by economist Milton Friedman, which is credited with popularizing this usage.[16]
Some theorists might argue that a free market is a natural form of social organization, and that a free market will arise in any society where it is not obstructed (i.e. Ludwig von Mises, Hayek). The consensus among economic historians is that the free market economy is a specific historic phenomenon, and that it emerged in late medieval and early-modern Europe. Other economic historians see elements of the free market in the economic systems of Classical Antiquity, and in some non-western societies. By the 19th century the market certainly had organized political support, in the form of laissez-faire liberalism. However, it is not clear if the support preceded the emergence of the market or followed it. Some historians see it as the result of the success of early liberal ideology, combined with the specific interests of the entrepreneur.
Support for the free market as an ordering principle of society is above all associated with liberalism, especially during the 19th century. (In Europe, the term 'liberalism' retains its connotation as the ideology of the free market, but in American and Canadian usage it came to be associated with government intervention, and acquired a pejorative meaning for supporters of the free market.) Later ideological developments, such as minarchism, libertarianism and Objectivism also support the free market, and insist on its pure form. Although the Western world shares a generally similar form of economy, usage in the United States and Canada is to refer to this as capitalism, while in Europe 'free market' is the preferred neutral term. Modern liberalism (American and Canadian usage), and in Europe social democracy, seek only to mitigate the problems of an unrestrained free market, and accept its existence as such.
In the classical economics of such figures as Adam Smith and David Ricardo, "free markets" meant "free of unnecessary charges"[17] and a "market free from monopoly power, business fraud, political insider dealing and special privileges for vested interests".[18] A "free market" particularly meant one free of foreign debt;[19] as discussed in The Wealth of Nations.[20] Alternatively, stated, it was a market freed from Feudalism and serfdom, or more formally, one free of economic rent, in the formulation by David Ricardo of the Law of Rent.
In Marxist theory, the idea of the free market simply expresses the underlying long-term transition from feudalism to capitalism. Note that the views on this issue – emergence or implementation – do not necessarily correspond to pro-market and anti-market positions. Libertarians would dispute that the market was enforced through government policy, since they believe it is a spontaneous order and Marxists agree with them because they as well believe it is evolutionary, although with a different end.
Support for the free market as an ordering principle of society is above all associated with liberalism, especially during the 19th century. (In Europe, the term 'liberalism' retains its connotation as the ideology of the free market, but in American and Canadian usage it came to be associated with government intervention, and acquired a pejorative meaning for supporters of the free market.) Later ideological developments, such as minarchism, libertarianism and Objectivism also support the free market, and insist on its pure form. Although the Western world shares a generally similar form of economy, usage in the United States and Canada is to refer to this as capitalism, while in Europe 'free market' is the preferred neutral term. The advocates of modern liberalism (American and Canadian usage), and in Europe those of social democracy, seek ostensibly only to mitigate what they see as the problems of an unrestrained free market, and accept the existence of markets as such.
To most libertarians, there is simply no free market yet, given the degree of state intervention in even the most 'capitalist' of countries. From their perspective, those who say they favor a "free market" are speaking in a relative, rather than an absolute, sense — meaning (in libertarian terms) they wish that coercion be kept to the minimum that is necessary to maximize economic freedom (such necessary coercion would be taxation, for example) and to maximize market efficiency by lowering trade barriers, making the tax system neutral in its influence on important decisions such as how to raise capital, e.g., eliminating the double tax on dividends so that equity financing is not at a disadvantage vis-a-vis debt financing. However, there are some such as anarcho-capitalists who would not even allow for taxation and governments, instead preferring protectors of economic freedom in the form of private contractors.
Critics dispute the claim that in practice free markets create perfect competition, or even increase market competition over the long run. Whether the marketplace should be or is free is disputed; many assert that government intervention is necessary to remedy market failure that is held to be an inevitable result of absolute adherence to free market principles. These failures range from military services to roads, and some would argue, to health care. This is the central argument of those who argue for a mixed market, free at the base, but with government oversight to control social problems.
Another criticism is definitional, in that far-ranging governmental actions such as the creation of corporate personhood or more broadly, the governmental actions behind the very creation of artificial legal entities called corporations, are not considered "intervention" within mainstream economic schools. This inherent definitional bias allows many to advocate strong governmental actions that promote corporate power, while advocating against government actions limiting it, while putting these dual positions under the umbrella of "pro free markets" or "anti-intervention."
Two prominent Canadian authors (both very hostile to the "Chicago School" philosophy) argue that government at times has to intervene to ensure competition in large and important industries. Naomi Klein illustrates this roughly in her work The Shock Doctrine and John Ralston Saul more humorously illustrates this through various examples in The Collapse of Globalism and the Reinvention of the World.[21] While its supporters argue that only a free market can create healthy competition and therefore more business and reasonable prices, opponents say that a free market in its purest form may result in the opposite. According to Klein and Ralston, the merging of companies into giant corporations or the privatization of government-run industry and national assets often result in monopolies (or oligopolies) requiring government intervention to force competition and reasonable prices.[21]
Critics of laissez-faire since Adam Smith[22] variously see the unregulated market as an impractical ideal or as a rhetorical device that puts the concepts of freedom and anti-protectionism at the service of vested wealthy interests, allowing them to attack labor laws and other protections of the working classes.[23]
Because no national economy in existence fully manifests the ideal of a free market as theorized by economists, some critics of the concept consider it to be a fantasy – outside of the bounds of reality in a complex system with opposing interests and different distributions of wealth.
These critics range from those who reject markets entirely, in favour of a planned economy or a communal economy, such as that advocated by Marxism, to those who merely wish to see market failures regulated to various degrees or supplemented by certain government interventions. For example, Keynesians recognize a role for government in providing corrective measures, such as use of fiscal policy for economy stimulus, when decisions in the private sector lead to suboptimal economic outcomes, such as depression or recession, which manifest in widespread hardship. Business cycle theory is used by Keynes to explain 'liquidity traps' by which underconsumption occurs, to argue for government intervention with central banking. Free market economists consider this credit-expansion as the cause of the business cycle in refutation of this Keynesian criticism.
One practical objection is the claim that markets do not take into account externalities (effects of transactions that affect third parties), such as the negative effects of pollution or the positive effects of education. What exactly constitutes an externality may be up for debate, including the extent to which it changes based upon the political climate.
Some proponents of market economies believe that governments should not diminish market freedom because they disagree on what is a market externality and what are government-created externalities, and disagree over what the appropriate level of intervention is necessary to solve market-created externalities. Others believe that government should intervene to prevent market failure while preserving the general character of a market economy. In the model of a social market economy the state intervenes where the market does not meet political demands. John Rawls was a prominent proponent of this idea.
Some advocates of free market ideologies have criticized mainstream conceptions of the free market, arguing that a truly free market would not resemble the modern-day capitalist economy. For example, contemporary mutualist Kevin Carson argues in favor of "free market anti-capitalism." Carson has stated that "From Smith to Ricardo and Mill, classical liberalism was a revolutionary doctrine that attacked the privileges of the great landlords and the mercantile interests. Today, we see vulgar libertarians perverting "free market" rhetoric to defend the contemporary institution that most closely resembles, in terms of power and privilege, the landed oligarchies and mercantilists of the Old Regime: the giant corporation."[24]
Carson believes that a true free market society would be "[a] world in which... land and property [is] widely distributed, capital [is] freely available to laborers through mutual banks, productive technology [is] freely available in every country without patents, and every people [is] free to develop locally without colonial robbery..."[25]
The free market is believed to self-regulate in the most efficient and just way. Adam Smith described this behavior with the metaphor of an invisible hand urging society towards prosperity.
Charles Darwin's theory of evolution was very appealing to economists, sociologists and political scientists (most notably Walter Bagehot and William Graham Sumner) who adapted and rationalized the invisible hand by incorporating the popular idea of the survival of the fittest.[26] They proposed – among others – that in a fully competitive economic environment (as they thought was the case of ecosystems) the most potent individuals would thrive and in turn society would prosper (in analogy to the observed biodiversity and abundance of life on earth). Such arguments lead to the consolidation of neoliberalism and laissez-faire. A notable difference, however, is that selection in biotic systems is "actual" whereas in cultural systems it is "virtual": it can be avoided/invisible due to changing or limiting human perception. This permits economic non-responsiveness to selective pressure through externalities and control of mass-media, for example, introducing significant potential for maladaption. See discussions on evolution and Sociocultural evolution for more information.
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