The Free Market
In a free market economy, prices of goods and services, wages, interest rates, and foreign exchange values are determined by supply and demand. There is no interference from a government in the form of price controls, labor laws, or other regulations affecting the market price of the product. A free market is economically efficient and generally leads to high standards of living. The following are specific advantages of a free market system.
Note that in a free market system there is an important role for the government. The government does not interfere with prices, but it has a significant role to play in the areas of protecting private property, providing essential services such as infrastructure (roads, highways, etc.), providing oversight of key industries and the monetary system, providing a legal system and defending the country. So in a free market system, the role of the government is important, albeit limited.
Advantages of a Free Market System
1. Products are priced at their true worth.
The most important advantage of a free market system is that products are priced at their true “worth.” The product’s true worth is based on how much buyers and sellers value the product. This is reflected in the demand and supply of the product (and not on a government-determined price). When consumers value a product highly, then the demand for this product is high and consequently, the price of the product will be relatively high. The high price then gives businesses the incentive to produce the product (because profits will be high) and the consumers’ demand will be satisfied. On the other hand, if a government sets a product’s price at an artificially low level, then businesses will make no profit and have little incentive to produce the product, even if consumers really want the product.
In order to survive in the market place, producers look for the lowest cost and most efficient means to produce. A free market system therefore encourages efficient production.
In a free market system, prices of resources are determined just like prices of products. Why do some celebrities earn very high wages? The answer is that the demand for their services is very high and the supply of their services (their talent) is relatively low. You may not like that some people earn this much. However, the high demand increases the equilibrium price (wage). In response, the high price (wage) encourages some people to excel and satisfy the consumers’ demand. This responsiveness in the price system is what maximizes total economic value in society.
2. There are greater incentives to work and there is a higher standard of living.
A free market with relatively low taxation encourages people to work hard and innovate. This profit incentive provides competition and entrepreneurship. Entrepreneurship leads to creation of jobs and production of products, which raise people’s standards of living. Countries that have limited government interference in the free market have shown to be the most productive. The standard of living in politically and economically free, or mostly free, countries is the highest in the world, and poverty measured in absolute standard of living is the lowest.
3. There is greater freedom.
A free market allows people the freedom to choose their occupation and the products they can afford to buy. Countries that encourage free markets and discourage economic and social discrimination allow for greater degrees of income mobility. People have opportunities and the freedom to improve their economic positions through innovation and hard work. Even poor immigrants who come to the country with nothing but their own courage and determination often succeed and work their way up the economic ladder.
Disadvantages of a Free Market System
There are several disadvantages of a free market system.
1. There is greater income inequality.
In a free market system, a significant degree of income inequality is common. Workers who are more productive and innovative earn a higher income than workers who are less productive and innovative. Most people do not like too much income inequality. Governments usually narrow income inequalities by imposing higher tax rates on higher-income households, and by providing subsidies and government handouts to lower-income households. Despite government handouts, some products are priced beyond what lower income households can afford. If products are essential for survival (food, housing, health care and medicine), and the government feels that some households cannot afford them, it may provide subsidies or impose price ceilings. Price ceilings are government mandated prices below the equilibrium (market) price (see also one of the paragraphs below on price ceilings).
2. There are externalities.
Externalities are benefits or costs that are generated apart from the benefits or costs related to the trade itself. An externality can be positive or negative. An example of a negative externality is pollution caused by a factory. If a factory pollutes, the polluted area and its residents will suffer. This imposes a cost on the residents, even though the residents may not be direct parties to the trade of the product produced by the factory. Since this cost is not reflected in the price of the product, governments often impose pollution fees or taxes. These funds can then be used to clean up the polluted area or subsidize the expense associated with the pollution cost.
Examples of positive externalities are health care services, education and training. When doctors, hospitals and community health organizations provide services (for example, inoculations) to keep people healthy, it also benefits people who are not using the health services. When fewer people get sick, especially contagiously, fewer other people get sick, too. In other words, even people not purchasing health services benefit from health services. Consequently, governments feel justified to collect taxes from everyone (since everyone benefits) in order to subsidize health care services.
Education and training benefit society in general, as relatives, friends, and businesses share in the benefits from the increased knowledge of the trained individual (assuming this person interacts with these members of society).
3. There are greater incentives for corruption and illegal activities.
Because free markets lead to higher standards of living and higher incomes, the financial rewards for cheating and breaking the law (if the person or business is not caught) are also greater. For example, if a bank knows that by breaking the law and deceiving its customers it can earn an additional $500 million this year, the temptation for a bank to engage in this kind of behavior is great. Similarly, if financial rewards for athletes are significant, it encourages more athletes to cheat. In an economic system in which high incomes and high rewards don’t exist (usually a non-free market system), these temptations are less prevalent (even though many citizens in less free and less-developed countries now engage in cyber crimes in order to steal money from people and businesses in wealthier countries).
Illegal and unethical behavior harms the efficient operations of a free market. Proponents of free markets support governments who punish this type of behavior via a strong and honest legal system.
Public Goods and the Free Rider Problem
Public goods are goods and services provided by the government without a direct charge to the user of the good. Examples of public goods are public education, public transportation, public roads, bridges, highways, defense, a legal system, and police and fire protection. In general, it is difficult or undesirable for these goods to be provided by private businesses. Defense, for example, has to be provided by a government because it is difficult to charge individuals for this service. Thus, the private sector may under-allocate resources relative to our needs in the case of public goods.
Typical of publicly provided goods and services is that some people contribute very little or nothing to the revenue (taxes) that the government collects. This means that they get to use the good or service for free, without any cost. This is called the free rider problem. Even for people who contribute taxes, their marginal cost of using the public good or service is less than their marginal benefit and therefore there tends to be over-consumption of this good or service.
Let’s take a look at public transportation, for example. If public transportation were to charge each user the actual cost of the service, it may charge, for example, $4 per ride. People will use the service as long as the benefit of each ride exceeds the marginal cost of each ride ($4). However, if the government decides that the cost of public transportation will be borne by society and not by each individual user, the following will happen. Each ride still costs the government $4. If there are 200 riders, the total cost to the government is $800. Let’s say that there are 8,000 taxpayers contributing to the funds to pay for public transportation. This means that each taxpayer contributes an average of $0.10 to pay for public transportation.
If we increase the number of riders from 200 to 201, the total cost to the government increases by $4. As the cost is borne by 8,000 taxpayers, the marginal cost for each tax-paying citizen is only $0.10. For most riders the marginal benefit of using public transportation is greater than $0.10, so the tendency is for users to over-consume this product, as long as the government continues to not charge for individual use of the public transportation. This free rider phenomenon is typical of all publicly provided goods, and is a disadvantage because it leads to over-consumption and inefficiency. For this reason, most economists support private production, as long as individuals can be charged for the service separately. Defense, police, and fire protection, by nature, must be publicly provided. Banking, insurance, and retirement plan services, for example, can be privately provided. Many of these services are, indeed, provided by the private sector. However, some are not. Some economists would like to see government unemployment insurance programs (Unemployment Compensation), government banking insurance programs (the Federal Insurance Deposit Corporation), public health care programs, and government retirement systems (Social Security) be replaced by private companies. Even the provision of roads and highways can, in the future, be provided by private companies, as new and less-expensive computer scanning equipment becomes available.
Free Market Interferences
When a government interferes with the workings of the free market, inefficiencies in the market occur in the form of shortages, surpluses, misallocations of resources, malinvestments, and business losses. Government interferences in the area of prices, wages, interest rates, profits, etc. may benefit some groups or individuals. However, from a macroeconomic and efficiency (productivity) point of view, these actions are usually harmful.
A price ceiling is a price below the free market price. Let’s say a product’s equilibrium price is $10 and the government requires manufacturers to sell the product for $8. Consumers prefer buying the product at this lower price. However, producers, faced with lower revenue, will have much less incentive to make the product. Some may produce the product with cheaper ingredients and at a lower quality to try to bring the cost down to less than $8. Other manufacturers will stop producing the product. A shortage of the product likely results.
A price floor is a price above the free market price. Sometimes governments require the price of a product to be higher than the market price. Governments do this to help suppliers. If the market price is $10, and the government establishes it at $14, then producers have an incentive to produce more. They will experience higher profits per product. However, the higher price turns away consumers. Consequently, less of the product will be sold in the market, and surpluses result.
The government’s purpose for interfering with market prices is to remedy social problems, such as poverty and homelessness. Economic evidence shows that this interference is usually accompanied by other, sometimes more severe, problems in the long run.
In the case of rent control in large cities, the government requires landlords to keep the rent of their apartments and houses below the free market level. The result is that it becomes unprofitable for many landlords to invest in property or build additional properties. The rent that the government allows is not worth the landlord’s expenses and investments. Furthermore, it is more attractive for builders and landlords to invest in areas in which there is no rent control. Consequently, the supply of properties in the rent-controlled area decreases and shortages occur. The tenants who rent at the government-controlled price may feel fortunate at first. However, the property will suffer from poor maintenance because the landlords have no incentive to invest money in it and because there is a long waiting list of tenants. Rent control also prevents thousands of people from acquiring anything at all because the artificially low rent discourages potential builders from building additional dwellings.
Correcting Income Inequalities
The government reduces income inequalities by imposing high taxes on the wealthy and providing government handouts to the poor. By doing this, the government runs the risk of taking away incentives for workers to be productive. If a productive worker and a non-productive worker receive the same rewards (after taxes and government handouts), why work hard?
Given that some functions of government are essential to the effective operation of our economy, it is essential that government collects at least some taxes. It also seems fair that high-income earners contribute more to the government than low-income earners. However, a government is wise to ensure that more-productive workers are rewarded appropriately for their efforts. If a government redistributes incomes too much by levying high rates of taxation, people lose the incentive to innovate, produce, work hard, and create jobs. Too much redistribution of incomes leads to a decrease in employment and a decrease in a country’s standard of living, as has been evident in the failing economies of past and current communist nations.