The Free Market is hailed by economists and politicians as the purest and most effective model for organizing economic activity (that is trade in goods and services) between producers and consumers. This is true, although these ideas rest on a foundation of assumptions and caveats that are rarely explained. This article will examine some aspects of what a free market truly is, why it is so good, and why most markets aren't free. What Makes a Free Market?
At talk of free markets our minds often quickly jump to taxes, import quotas, regulations, price controls, "picking winners and losers," and other policy debates that dominate our contemporary decision making. However, the media (and therefore, generally the public, too) often fails to consider the essential points about what defines a truly free market. So, we are left without the means to accurately evaluate the situation and think about what the potential benefits may be and how we might get there. What follows is not an economics treatise but a set of guidelines or rules of thumb for determining the validity of free market-based arguments in the policy sphere.
Why Are Free Markets So Good?
The short answer is that free markets produce the most goods or services at the lowest possible price. So, the maximum number of people can use the good or service (increasing standard of living), and they will pay the lowest possible price (reduce or contain the cost of living). In fact, since many buyers would be willing to pay more, there exists what economists call a "consumer surplus," the total amount of money buyers saved from what they would have been willing to spend. This is an idealized situation, one developed over a few centuries of economic thought and based on simplified mathematical representations of the way individuals make choices of what to buy for themselves. But, nevertheless, economists have found when studying actual people that these theories get remarkably close to what actually happens.
Now, let's consider some of the key features of what makes up a free market, and what some of the most common market breakdowns are. These breakdowns (sometimes called "market failures") are relatively common, we will see, and mean that economically free markets and laissez faire or unregulated markets are not at all the same thing.
1. Lots of buyers and sellers
This principle of a free market means that no one and no small group controls the price, and that any potential to meet a demand by selling a good or service will be met by one competitor or another.
This principle usually breaks down because there are not enough sellers. Digital or cable television providers or cell phone service providers typically find themselves in this position. With only a small number of sellers, prices can be expected to be higher (and thus the number of people with access to the service, lower) than if there were greater competition. Sometimes, there are only a few buyers: the U.S. government greatly dominates the purchase of all military equipment; or, in the future, the majority of all books may have to be sold through Amazon and Apple. All of these issues whether they are monopolies or oligarchies are one or more steps away from true free markets with perfect competition and reduce the benefits that society might have achieved otherwise.
2. Perfect information
The principle of perfect information sounds impossible, but it essentially means that both the buyers and sellers have equal amounts of information about the product they are trading. This implies that there are no sellers pushing low quality goods on unsuspecting buyers (like the used car salesman trying to unload a lemon). This also refers to equal information about the future. For example, this could imply that sellers do not know of a potential supply disruption before the buyers and vice versa.
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A breakdown of this principle in the trading of stocks and bonds is known as insider trading, and is criminalized in many places, although difficult to enforce. Regulations on labeling of foods and pesticides among other things are also attempts to prevent the unequal information basis between the buyer and seller. When buyers and sellers have unequal information, the price will not be set at the optimum value, and the free market breaks down. While this usually benefits the seller, there are cases where legal limits (like anti-price-gouging laws in the wake of a disaster) prevent sellers from acting on information that the buyers are free to consider and act on.
3. All costs of the transaction are included in the price the buyer pays
Costs that are not included in a transaction are called externalities. The most commonly discussed externalities involve environmental effects from one property holder to another property holder. If a farmer in the upper Mississippi basin buys more fertilizer than they need and after a rain storm that fertilizer washes off into the river, they have borne the direct cost of the wasted fertilizer. However, that fertilizer combined with the runoff of others eventually creates a "dead zone" in the Gulf of Mexico reducing the numbers of fish and shrimp. That portion of the cost is borne by fishermen and shrimpers who lose income, and it is borne by consumers of Gulf fish and shrimp who pay higher prices. Those secondary costs are not included in the price paid for fertilizer and so are considered externalities.
In some economic theory (though not necessarily practice), most taxation is an attempt to rectify externalities by transferring the additional costs of the transactions from the external cost bearers to the original buyers. This, for example, would mean taxing fertilizer and giving the revenue to Gulf fishermen. The problem in this case is that it creates something called "deadweight loss", which is another type of distortion away from the ideal free market, although presumably less than would have occurred with the full external cost being incurred.
With a little additional stretch of the imagination, one can also imagine that externalities include positive feelings like giving charity to good causes, or to put it more basically, sharing some of your own resources with a neighbor who has less. While there may be higher morals or principles involved on a personal level, this is how economists understand the value we place on the well being of others: "if you gave away 10 dollars, then you must have received a psychological benefit greater than what you would have received had you spent that money on yourself."
Why Most Markets Are Not Free?
Unfortunately, most markets are not free. Many of them are close enough, however, that free-market-like behavior dominates even though the specifics fail the test at one or more points. However, it should also be clear on reflection that laissez faire or the policy of not regulating markets often falls short in creating a beneficial, economically-free market. These free markets depend on certain social institutions like fair and independent courts and other forms of ensuring every participant plays by the rules. They do not necessarily arise organically on their own.
Many monopolies arise organically as smart business owners expand and buyout competitors. In other markets, monopolies arise because barriers to entry (such as large infrastructure investments) prevent new companies from being formed. In these cases sellers can maintain prices at a higher level, ensuring customers pay more, not as many customers can afford the product, and benefits are not maximized. Unfortunately, free markets in the areas of "natural monopolies" like water supply are sometimes inevitable, meaning that certain goods and services will be forever beyond the reach of free markets. On the other hand, patents, copyrights, and trademarks are artificially created monopolies that reveal an inherent conflict between the general market consumer and creative developers.
Inequalities in information are notorious among auto mechanics and their customers, and also, some say, among patients and their doctors. Insider trading is prosecuted, but probably only rarely considering how difficult it is to know what information is known by whom at any point in time. The most successful regulation in this area has been labeling laws for foods, medicines, and cosmetics, ensuring that consumers know what is actually in the products they purchase. Further development in this area is being made possible through public data portals and other forms of internet data sharing, and may result in a significant advance.
Externalities are an incredibly difficult problem faced by the globalized economy. Air pollution crosses provincial and national lines. The choices of one's neighbors affect one's own property value. Small changes in land use across a city (like 10% fewer trees or 20% more paving) can drastically alter flooding risk. Employers who do not offer health care in the US increase the tax burden on other local residents and businesses. In these areas, we typically find the most government intervention, although not always in the most free-market-promoting fashion. Whereas free market economists would usually recommend dynamic consumer-based taxes with revenue being used directly to compensate for whatever externalities exist, instead we typically see governments employ prohibitions and other rules that are easier to manage.
What To Do About It
This is a normative question, and one where philosophical values matter as much as the scientific analysis. Analysis can tell us when markets are not free, what the potential benefits may be to making them freer, and what the potential impact of different policy choices may be on the markets. Analysis cannot, however, tell us whether how we ought to value individual and social rights and responsibilities, nor how certain means for rectifying problems in the markets may violate some of those individual or collective rights not to mention moral or ethical standards. For those, we are left to negotiation and compromise between each other to reach a decision.
Supporters need to keep in mind that while free markets are legitimately the ideal solution to many problems, those markets require a certain amount of creative regulation and rule enforcement in order to exist and achieve the benefits promised. And detractors should reconsider how their criticisms may actually be reflective of market failures like those listed above and not intrinsic weaknesses of essential market dynamics.
