What are the advantages of a free market economy what are the disadvantages of a free market economy?

A type of economic system that is controlled by the market forces of supply and demand

Table of Contents Show

• Understanding the Free Market Economy
• Characteristics of a Free Market
• Benefits of a Free Market
• Drawbacks of a Free Market
• Additional Resources

A free market is a type of economic system that is controlled by the market forces of supply and demand, as opposed to one regulated by government controls. It is opposite on the spectrum to a command economy, where a central government agency plans the factors of production and use of resources and sets prices. In a free market, companies and resources are owned by private individuals or entities who are free to trade contracts with each other.

Understanding the Free Market Economy

Economists define a free market as one where products are exchanged by a willing buyer and seller. Purchasing groceries at a given price set by the farm grower is a good example of economic exchange. Paying a worker a monthly salary is another instance where an economic exchange happens.

In a free or pure market economy, sellers of different goods don’t face any barriers. Essentially, one can sell any product they wish to sell and at any price. However, in the real world, such an economic system rarely exists. Tariffs imposed on imports and exports and legal restrictions such as the age restriction on alcoholic beverages are all barriers to a free market.

Overall, capitalist economies, which are established by most democracies, including the United States, are mixed systems composed of both free market and command economy components.

Characteristics of a Free Market

A free market economy is characterized by the following:

1. Private ownership of resources

Free economies exist because a significant portion of resources are owned by individuals or companies in the private sector and not a central government agency. In this way, the owners exercise total control over the means of production, allocation, and exchange of products. They also control the labor supply.

2. Thriving financial markets

One key factor that helps a free market economy to be successful is the presence of financial institutions. Banks and brokerages exist so that they give individuals and companies the means to exchange goods and services, and to provide investment services. The financial institutions then make a profit by charging interest or fees on transactions.

3. Freedom to participate

Another characteristic of a free market economy is that any one individual can take part in it. The decision to produce or consume a particular product is totally voluntary. It means that companies or individuals can produce or purchase as much or as little of a product as they want.

Benefits of a Free Market

The absence of governmental influence allows both companies and individuals a wide range of freedom.

1. Freedom to innovate

In a free market economy, business owners enjoy the freedom to come up with new ideas based on the consumers’ needs. They can create new products and offer new services at any time they want to. As such, entrepreneurs rarely rely on government agencies to notify them of consumers’ needs.

The entrepreneurs do their own research and identify popular trends. The innovation among different private companies can lead to competition as every company tries to improve on the features of its products to make them better.

2. Customers drive choices

With a free market economic system, it is the consumers who decide which products become a success and which ones fail. When presented with two options of products, the consumer evaluates the features of each and chooses whichever one they want to, ideally opting for the one that offers better value for money.

To a great extent, the consumer also influences the price set on a product. As such, producers need to strike a balance between the price point that earns them a profit but is still affordable by the average customer.

Drawbacks of a Free Market

Despite its benefits, a free economy also comes with a few drawbacks:

1. Dangers of profit motives

One disadvantage of a free market economy is that some producers are driven exclusively by their profit motives. Even though the primary goal of any business is to generate profit, such an objective should not be prioritized over the needs of workers and consumers. Put simply, a company should never compromise the safety of its workers or disregard environmental standards and ethical conduct just so it can make supernormal profits.

An example took place in the early 2000s, a time when unethical behavior became prevalent among companies such as WorldCom and Enron. In 2010, the Deepwater Horizon oil spill, which is one of the biggest environmental disasters in the United States, happened because the company used substandard cement and other cost-reducing measures.

2. Market failures

At times, a free market economy can spin out of control, causing dire consequences. Good examples of market failure include the Great Depression of the 1930s and the real estate market crash that happened in 2008. Market failures can lead to devastating outcomes such as unemployment, homelessness, and lost income.

Summary

A free market is a self-regulated economy that runs on the laws of demand and supply. In a truly free market, a central government agency does not regulate any aspect of the economy. By removing government regulations, the nature of the free market forces businesses to provide superior products and services that address consumers’ needs. A free market economic system also helps sellers to create affordable prices for everyone.

Additional Resources

Thank you for reading CFI’s guide to Free Market. To keep advancing your career, the additional CFI resources below will be useful:

There are four types of economies: traditional, command, market, and mixed (a combination of a market economy and a planned economy).

A market economy, also known as a free market or free enterprise economy, is a system in which economic decisions, relating to things such as the prices of goods and services, are determined by supply and demand.

Command economies, on the other hand, utilize central planning by a central authority to make all economic decisions.

• In a market economy, supply and demand drive economic decisions.
• The production of goods and services, investments, pricing, and distribution are in the hands of private enterprises.
• In a command economy, economic decisions concerning production and pricing rest with a central authority, such as a government.
• A market economy promotes free competition among market participants.
• Notable benefits of a market economy are increased efficiency, production, and innovation.

The assumption behind a market economy is that supply and demand are the best determinants for an economy's growth and health. These market forces influence what goods should be produced, how many goods should be produced, and at what price the goods should be sold.

These factors also influence other economic decisions, such as how many individuals companies should employ. The advantages of a market economy include increased efficiency, productivity, and innovation.

In a truly free market, all resources are owned by individuals. The decisions about how to allocate their resources are made by those individuals, rather than by central governing bodies. This economic theory, known as laissez-faire, asserts that governments should have no hand in business. If they do, their interventions often lead to market inefficiencies.

The fact is, governments always have some involvement so there are no recognized economies that are 100% free. However, government is limited in how it regulates transactions within a market economy. Most of the rules it enacts are to protect consumers, the environment, market participants, and national security.

Unlike other types of economies, a market economy increases the efficiency of businesses. Governments, in their limited roles, promote increased efficiency and free and increased competition.

In the face of competition, a business tends to do whatever is necessary to lower its costs and achieve a higher number of sales to increase profits.

Competition forces businesses to find ways to achieve a competitive advantage so that they can capture a larger market share for their product or service. This leads them to figure out how to reduce costs, improve their product, and so on in order to capture that extra market share.

Increased productivity is also associated with a market economy. In any economy, people need money to purchase goods and services. In a market economy, this need leads to increased motivation because workers want to earn more money to supply their needs and to live comfortably.

People motivated to work increase productivity and output for the economy. In a command economy, where wages, levels of production, prices, and investments are set by a central authority or government, there is less worker motivation because no matter how much harder they work, they will not see additional monetary benefit.

The United States is considered to have a market economy, whereas countries like China and Cuba are considered to have economic systems more like a command economy.

A country's market economy supports increased innovation. Firms and individuals are encouraged to innovate to gain a competitive edge. With money as a main motivating factor, companies look to create new products and technologies to generate more revenue and higher incomes. Innovation also leads to a greater variety of goods and services, which provides a wider selection for consumers.

In a command economy, the government controls production, including supply and demand, so there is no reason for companies to compete. 

Competition usually leads to better quality products at lower prices for consumers. To stand out from the competition, companies innovate not only the ways of production but also to improve product quality. Innovation leads to better technology that can provide benefits to a society at large.

A market economy is one in which the forces of supply and demand determine the course of actions that companies take to provide products and services to customers and earn profits. Private ownership is in the forefront of such an economy while government plays a limited role. Companies and their employees are rewarded financially for their efforts.

This differs from a command economy where a central authority imposes its economic decisions on businesses.

It can. Businesses and the people who work for them can be rewarded with additional income and other benefits for their work efforts in a market economy. Therefore, companies compete to create products and services that consumers will want to buy. In turn, this drives innovation in various forms.

Yes. Capitalism is an economic system in which private companies make the decisions concerning the production and distribution of goods and services. A government or other central authority does not. Capitalism and a market economy are considered the same thing.

A market economy is one in which the allocation of resources and the prices of goods and services are determined by market forces, primarily supply and demand. Market economies have little government intervention, allowing private ownership to determine all business decisions concerning how a business is run. This type of economy leads to greater efficiency, productivity, and innovation.