free market

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A free market is a market without economic intervention and regulation by government except to regulate against force or fraud. The terminology is used by economists and in popular culture. A free market requires protection of property rights, but no regulation, no subsidization, no single monetary system, and no governmental monopolies. It is the opposite of a controlled market, where the government regulates prices or how property is used.

The theory holds that within the ideal free market, property rights 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 hypothesis of supply and demand.

Free markets contrast sharply with controlled markets or regulated markets, in which governments directly or indirectly regulate prices or supplies, which according to free market theory causes markets to be less efficient.^[2] Where government intervention exists, the market is a mixed 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 consumer, as well as investor, satisfaction. In a free market, price is a result of a plethora of voluntary transactions, rather than political decree as in a controlled market. 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. Early proponents of a free-market economy in 18th century Europe contrasted it with the medieval, early modern, and mercantilist economies which preceded it.

Supply and demand

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 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 reality, most shops and markets do not resemble the stock market, and there are significant costs and barriers to "shopping around" (comparison shopping).

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.

Gourmet coffee and electronics as examples of market forces in economics

For example, the gourmet coffee business, pioneered in the US by Starbucks, revealed a demand for high quality fresh coffee. Further, the Starbucks sales growth showed that consumers would pay significantly more for this type of coffee. Other food service retailers, such as McDonald's, Sonic, and Burger King, began offering such coffee to help satisfy the demand.

Increased supply can indirectly result in lower prices, particularly with computers and other electronic devices. Mass production techniques have been steadily reducing prices 20 to 30% per year since the 1960s.^{[citation needed]} The functions of a multi-million dollar mainframe computer in the 1960s could be performed by a $100 computer in the 2000s.

Spontaneous order or "Invisible hand"

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:

"intends only his own gain is 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 labour.

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.

Economic equilibrium

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.^[6][7] 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^[8] have shown that when agents are allowed to interact locally in a free market (ie. 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. Laissez-faire free-market advocates, especially Austrian school followers, often dismiss this endogenous theory, and blame external influences, such as weather, commodity prices, technological developments, and government meddling for non-equilibrium prices.

Distribution of wealth

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. The free market can be seen as facilitating a form of decision-making through what is known as dollar voting, where a purchase of a product is tantamount to casting a vote for a producer to continue producing that product.

The effect of economic freedom on society's and individuals' wealth remains a subject of controversy. Kenneth Arrow and Gerard Debreu have shown that under certain idealized conditions, a system of free trade leads to Pareto efficiency, but the traditional Arrow-Debreu paradigm within economics is now being challenged by the new Greenwald-Stiglitz paradigm (1986)^[9]. Many advocates of free markets, most notably Milton Friedman, have also argued that there is a direct relationship between economic growth and economic freedom, though this assertion is much harder to prove empirically, as the continuous debates among scholars on methodological issues in empirical studies of the connection between economic freedom and economic growth clearly indicate:^[10][11][12]. "there were a few attempts to study relationship between growth and economic freedom prior to the very recent availability of the Fraser data. These were useful but had to use incomplete and subjective variables"^[13]. 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, again under idealized conditions, free markets lead to a Pareto distribution of wealth^[8] .

On the other hand more recent research, specially the one led by Joseph Stiglitz seems to contradict Friedman's conclusions. According to Boettke:

Once incomplete and imperfect information are introduced, Chicago-school defenders of the market system cannot sustain descriptive claims of the Pareto efficiency of the real world. Thus, Stiglitz's use of rational-expectations equilibrium assumptions to achieve a more realistic understanding of capitalism than is usual among rational-expectations theorists leads, paradoxically, to the conclusion that capitalism deviates from the model in a way that justifies state action--socialism--as a remedy.^[14]

Laissez-faire economics

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, arguably patents, etc.

Deregulation

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.^{[citation needed]} 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.^[specify] 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.

Low barriers to entry

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.

Legal tender and taxes

In a truly 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.^{[citation needed]} Minarchists (advocates of minimal government) contend that the so called "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^[15][16]. A free market could be defined alternatively as a tax-free market, independent of any central authority, which uses as medium of exchange such as money, even in the absence of the State. It is disputed, however, whether this hypothetical stateless market could function.

Ethical justification

The ethical justification of free markets takes two forms. One appeals to the intrinsic moral superiority of autonomy and freedom (in the market), see deontology. The other is a form of consequentialism—a belief that decentralised planning by a multitude of individuals making free economic decisions produces better results in regard to a more organized, efficient, and productive economy, than does a centrally-planned economy where a central agency decides what is produced, and allocates goods by non-price mechanisms. An older version of this argument is the metaphor of the Invisible Hand, familiar from the work of Adam Smith.

Modern theories of self-organization say the internal organization of a system can increase automatically without being guided or managed by an outside source. When applied to the market, as an ethical justification, these theories appeal to its intrinsic value as a self-organising entity. Other philosophies such as some forms of Individualist anarchism (especially that of that 19th century) and Mutualism (economic theory) anarchism believe that in a free market competition would cause prices of goods and services to align with the labor embodied in those things. This goes against the contemporary mainstream view, which is held by most contemporary individualist anarchists, that prices would accord to the marginal utility of these things irrespective of the labor embodied in them.

Index of economic freedom

The Heritage Foundation, a conservative think tank, tried to identify the key factors which allow to measure the degree of freedom of economy of a particular country. In 1986 they introduced 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:

• Trade policy,
• Fiscal burden of government,
• Government intervention in the economy,
• Monetary policy,
• Capital flows and foreign investment,
• Banking and finance,
• Wages and prices,
• Property rights,
• Regulation, and
• Informal market activity.

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, but this assertion has not been proven yet, both theoretically and empirically. 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.^[10][11][12].^[13].

"In recent years a significant amount of work has been devoted to the investigation of a possible connection between the political system and economic growth. For a variety of reasons there is no consensus about that relationship, especially not about the direction of causality, if any." (AYAL & KARRAS, 1998, p.2)^[13]

History and ideology

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 (ie 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.

Marxism

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.

Liberalism

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 what they see as the problems of an unrestrained free market, and accept its existence 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.

Criticism

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."

Critics of laissez-faire since Adam Smith^[17] 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.^[18]

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.

Externalities

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.

Differing Ideas of the Free Market

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." ^[19]

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..."^[20]

Martin J. Whitman

Not all advocates of capitalism consider free markets to be practical. For example, Martin J. Whitman has written, in a discussion of Keynes, Friedman and Hayek, that these "…great economists…missed a lot of details that are part and parcel of every value investor's daily life." While calling Hayek "100% right" in his critique of the pure command economy, he writes "However, in no way does it follow, as many Hayek disciples seem to believe, that government is per se bad and unproductive while the private sector is, per se good and productive. In well-run industrial economies, there is a marriage between government and the private sector, each benefiting from the other." As illustrations of this, he points at "Japan after World War II, Singapore and the other Asian Tigers, Sweden and China. The notable exception is Hong Kong which found prosperity on an extremely austere free market concept.

He argues, in particular, for the value of government-provided credit and of carefully crafted tax laws.^[21] Further, Whitman argues (explicitly against Hayek) that "a free market situation is probably also doomed to failure if there exist control persons who are not subject to external disciplines imposed by various forces over and above competition." The lack of these disciplines, says Whitman, lead to "1. Very exorbitant levels of executive compensation… 2. Poorly financed businesses with strong prospects for money defaults on credit instruments… 3. Speculative bubbles… 4. Tendency for industry competition to evolve into monopolies and oligopolies… 5. Corruption." For all of these he provides recent examples from the U.S. economy, which he considers to be in some respects under-regulated,^[21] although in other respects over-regulated (he is generally opposed to Sarbanes-Oxley).^[22]

He believes that an apparently "free" relationship—that between a corporation and its investors and creditors—is actually a blend of "voluntary exchanges" and "coercion". For example, there are "voluntary activities, where each individual makes his or her own decision whether to buy, sell, or hold" but there are also what he defines as "[c]oercive activities, where each individual security holder is forced to go along…provided that a requisite majority of other security holders so vote…" His examples of the latter include proxy voting, most merger and acquisition transactions, certain cash tender offers, and reorganization or liquidation in bankruptcy.^[23] Whitman also states that "Corporate America would not work at all unless many activities continued to be coercive."^[24]

"I am one with Professor Friedman that, other things being equal, it is far preferable to conduct economic activities through voluntary exchange relying on free markets rather than through coercion. But Corporate America would not work at all unless many activities continued to be coercive."^[25]

See also

• Adam Smith
• Anarcho-capitalism
• An Austrian Perspective on the History of Economic Thought
• Austrian School
• Ayn Rand
• Capitalism
• Economic liberalism
• Economics
• Free-market anarchism
• Free-market environmentalism
• Free market healthcare
• Free-market roads
• Free Market Socialism
• Free price system
• Free trade
• Friedrich Hayek
• Game theory
• History of theory of capitalism
• Libertarianism
• Ludwig von Mises
• Market economy
• Milton Friedman
• Minarchism
• Murray Rothbard
• Night watchman state
• Non-profit organization
• Nash equilibrium
• Open Source Initiative
• Political Economy
• School of Salamanca
• Self-organization
• Transparency (market)
• Underground economy
• Voluntaryism

Contrast

• Communism
• Freidrich Engels
• Gift economy
• Inclusive Democracy
• Karl Marx
• Leninism
• Libertarian socialism
• Limited liability
• Maoism
• Market abolitionism
• Market socialism
• Marxism
• Mixed economy
• Participatory economy
• Planned economy
• Quasi-market
• Socialism
• Statism
• Subsistence economy
• Trotskyism

Footnotes

References

• AYAL, Eliezer B. and KARRAS, Georgios. Components of Economic Freedom and Growth. Journal of Developing Areas, Vol.32, No.3, Spring 1998, 327-338. Publisher: Western Illinois University.
• BOETTKE, Peter J. What Went Wrong with Economics?, Critical Review Vol. 11, No. 1, P. 35. p. 58
• Stiglitz, Joseph. 1994. Whither Socialism? Cambridge, Mass.: MIT Press.

External links

• Free Market by Murray N. Rothbard
• Mises.org is the official website of the Ludwig von Mises Institute for Austrian economics and classical liberalism
• Foundation for Economic Education one of the oldest organizations promoting classical liberalism and free markets
• Free Enterprise: The Economics of Cooperation Looks at how communication, coordination and cooperation interact to make free markets work
• Fair versus Free by Milton Friedman
• Freedom to Work, to Earn, & to Buy by Harry Browne
• The Tradition of Spontaneous Order,