Free markets are economic exchanges where producers and sellers voluntarily exchange economic goods and services with no outside interference or coercion. In a free market both parties to the transaction exchange goods and services, because they expect a gain from the exchange; if there is no expectation of gain, there is no exchange. The gain from the exchange arises from the difference between the value each party gives to the goods or services received and the cost of obtaining them.
To increase efficiency in a free market, money and a market price emerge. First, money, or a standardized means of payment, is used to reduce the negotiation over the value of two different goods that are bartered by the individuals and to reduce the need to have individuals interested in the goods bartered in each transaction. Second, a market price emerges with the repetition of the exchanges to simplify the negotiation of each transaction; the market price reflects the consensus at which the particular good or service is exchanged between suppliers and buyers. Temporary changes in the price provide incentives to parties in the transaction to change their behavior. Price increases induce an increase of supply and reduction of demand, while price reductions induce a reduction in supply and increase in demand. These forces bring the market price back in line with the long-run norm. Thus, free markets and the accompanying price system are viewed as an efficient system in allocating goods and services in a cost-effective manner.
Market Imperfection And Market Failures
However, free markets are not always efficient means of exchange because of the existence of market imperfections and market failures; these prompt governments to intervene in free markets. First, market imperfection refers to a situation in which there is a deviation from the conditions of perfect competition, i.e., where there are multiple buyers, perfect information, free entry in the industry, and multiple producers with no significant market share generating a homogeneous product with the same production technology. In a perfectly competitive market, goods are exchanged at the market price, firms are price takers, and in the long run do not earn profits above the norm. However, the conditions that support perfect competition are not met in many instances. Barriers to entry in the industry, differences in production technology, or information asymmetries give rise to imperfect competition. This can take the extreme form of monopolies, i.e., when one firm controls most of the market and sets prices and quantities exchanged, or oligopolies, i.e., when a reduced number of firms dominate the market and can potentially collude to maintain a price increase. Governments are likely to intervene in the market to reduce the negative impact of such imperfection on consumers. They do so by regulating the industry, mandating specified levels of production or prices, setting limits on the power that the monopolist or oligopolists have over buyers or against new entrants, or even substituting private producers with state-owned enterprises to increase competition or to reduce prices.
Second, market failures exist when the free market is unable to provide goods and services to buyers. Market failures emerge when goods and services are subject to nonexcludability and nonrival consumption. Nonexcludability refers to the situation when an individual who does not pay for the product cannot be prevented from using or benefiting from it. In this case the free market does not work, because individuals will not pay for a product that they can obtain for free; as a result, the producer has limited incentives to generate the product. Nonrival consumption refers to the situation when the consumption of a product by an individual does not reduce the ability of others to consume the product. In this case the free market results in an undersupply of the product, because charging a price will prevent some people from benefiting from a product that could be provided at no cost. A mixed situation of part rival and part nonrival consumption gives rise to externalities, when one person does not receive the full benefits (positive externality) or does not pay the full cost (negative externality) of the impact of their action on other people.
Governments are likely to intervene in situations of market failures. They do so by subsidizing producers to serve consumers who are excluded, by imposing costs or providing incentives to producers of negative and positive externalities (respectively), or by undertaking the activities that are non-excludable and have nonrival consumption and paying for them with taxes.
Although the intellectual roots of the concept of free markets have been part of economic discussion for centuries, they tend to be associated with the work of Adam Smith. He postulates that the self-interest of individuals and their specialization resulted in a free market where the interaction of demand and supply would result in efficiency. Government intervention in free markets would only result in distortions. Competition, the so-called invisible hand, would force producers and buyers toward efficient terms of exchange and support economic growth.
Later, writers of the Austrian school of economics, like Ludwig Von Mises or Friedrich von Hayek, and the Chicago school of economics, like Milton Friedman, provided additional depth to the concept that free markets are better than governments at facilitating growth. Additionally, the authors argue that free markets would eventually lead to a free society.
Models Of Development
Despite this long intellectual lineage, during most of the 20th century free markets were subject to government controls throughout the world. The controls resulted in three alternative models of development. In capitalist developed countries, which were then known as the First World, governments followed the ideas of John Maynard Keynes and established high levels of regulation and controls over the capitalist system, i.e., private ownership of means of production and a price system to allocate resources. In communist countries, which were known as the Second World, governments implemented the ideas of Karl Marx and established a communist economic system, i.e., central planning of prices and quantities and state ownership of means of production. In developing countries, which became known as the Third World, governments followed a middle road, maintaining a capitalist system, but with high levels of government regulation, state ownership, and price controls designed to promote industrialization.
Moreover, in some of these countries governments, influenced by dependency theory (which argues that developing countries were kept underdeveloped by their dependency on industrialized countries for manufactures, machinery, and technology), followed an import substitution model. Under this model governments additionally limited imports and the operations of foreign firms to protect domestic firms from international competition and enable these firms to develop.
However, the economic crisis that started with the oil embargo of 1973, which led to stagflation, i.e., inflation and economic stagnation, questioned the viability of models of high government control over free markets. As a result, governments started to relinquish control over the economy and allow free markets to operate. In 1976 Chile became one of the first countries to embark on the economic reform needed to restore free markets, resulting in its growth. However, since the economic liberalization was done by a military dictatorship, an association between an authoritarian regime and free markets was established. As a result, other developing countries did not implement economic reform until much later.
Reduced Government Control
In the early 1980s, the idea of free markets started to gain acceptance in industrialized countries when the United Kingdom, under Prime Minister Margaret Thatcher, and the United States, under President Ronald Reagan, started a process of economic liberalization, prompting imitation by other developed countries. In developing countries free markets did not gain acceptance until Bolivia, which was suffering from hyperinflation after the Latin American debt crisis of 1982, established a program of economic reform in the mid-1980s. This program of reinstating free markets and reducing government control over the economy stopped hyperinflation and brought economic growth. Since the program was implemented in a democracy, it became an example for other developing countries that a dictatorship was not needed for free markets to be implemented and deliver economic growth. Communist countries also undertook economic reforms to replace their planned economies with a capitalist system and create free markets. China started the transition to free markets in the early 1980s, while countries in Eastern Europe and the former Soviet Union started in the late 1980s.
As a result of these transformations, the idea of free markets as the more effective and efficient path toward development has taken hold in most countries in the world. The reason is not only that free markets have shown their ability to generate efficiency and growth, but also that governments, not only markets, have been shown to suffer from imperfections, particularly in planning an economic system and facilitating growth. Some of the consequences of misguided and/ or misplaced government intervention are the distortion of incentives as individuals change their behavior according to what the regulations reward, the emergence of rent seeking as individuals and firms focus on extracting concessions from the government rather than achieving efficiency, or the appearance of black or informal markets as individuals and firms circumvent constraints on prices or quantities that can be sold. As a result, from a free market point of view, it tends to be accepted that it is better to leave economic relationships to markets. This does not mean that governments do not have a role to play in the economy. On the contrary, governments have an important role in providing the infrastructure that supports market transactions. This includes macroeconomic stability, the establishment of the rule of law and protection of property rights, the provision of public goods, and the protection of the weak.
Nevertheless, although most countries have reinstated free markets as the mechanism to govern economic relationships, criticism emerged in the late 1990s and 2000s as part of the antiglobalization movement. This movement emerged in opposition to the spread of free market ideas and the consequent changes in the integration of the world and globalization of markets. The debate regarding the best way to organize economic relationships has become one of free markets versus so-called fair markets. Free markets are perceived as too focused on efficiency and wealth accumulation and not caring about the distribution of wealth. To replace this, the concept of fair markets was introduced to represent economic exchanges in which minimum levels of payment for labor and equitable distribution of wealth are included as objectives to achieve.
In some cases this has resulted in a market in its own right, such as for so-called fair trade products—products traded where producers, usually of commodities or handicrafts in developing countries, receive a higher wage or price than the prevailing market one. In other cases, the concept of fair market has been used to reassert control of the market by the government. In the extreme this has resulted in the nationalization of firms, as seen in Bolivia or Venezuela in the mid-2000s. Thus, the debate concerning which model to use to govern economic relationships is still alive.
The empirical literature analyzing the impact of free markets on countries tends to find that free markets do in fact help countries achieve economic growth and development. Recent developments in the literature argue that for free markets to operate most efficiently, complementary institutions, such as those that protect property rights and the rule of law, need to be present. The literature also finds that the benefits of free markets do take time to materialize and that some government intervention does achieve positive results.
- Jagdish Bhagwati, In Defense of Globalization (Oxford University Press, 2004);
- Stephen F. Copp, The Legal Foundations of Free Markets (Institute of Economic Affairs, 2008);
- Richard Allen Epstein and Geoffrey Wood, Free Markets Under Siege: Cartels, Politics, and Social Welfare (Hoover Institution Press, 2008);
- Milton Friedman, Capitalism and Freedom (University of Chicago Press, 1962);
- James K. Galbraith, The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too (Free Press, 2008);
- Friedrich August von Hayek, The Road to Serfdom (Chicago University Press, 1944);
- Susan P. Joekes and Phil Evans, Competition and Development: The Power of Competitive Markets (International Development Research Centre, 2008);
- Dani Rodrik, “Goodbye Washington Consensus, Hello Washington Confusion? A Review of the World Bank’s Economic Growth in the 1990s: Learning from a Decade of Reform,” Journal of Economic Literature (v.44/4, 2006);
- Adam Smith, An Inquiry Into the Nature and Causes of the Wealth of Nations (Oxford University Press,  1998);
- Daniel Yergin and Joseph Stanislaw, The Commanding Heights: The Battle for the World Economy (Touchstone, 2002).
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