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.

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.

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.

• For example, the shoemakers’ guild controlled who was allowed to produce shoes, how many shoes they could produce and what price they could charge.
• In France, the cloth makers’ guild even dictated the number of threads that were allowed in the weave of the cloth.

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.

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.

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.

• For example, suppose that a significant numbers of consumers switch from buying sedan cars to buying four-wheel drives (4WDs), as in fact happened in Australia during the 1990s.

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.

• Or suppose that consumers decide that they want to eat less bread, pasta and other foods high in carbohydrates, as many did following the increase in popularity of the Atkins diet Opens in new window.

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.

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