Free Market Definition
Advantages, Disadvantages, and Examples
WRITTEN BY PAUL BOYCE | Updated 26 July 2022
What is a Free Market Economy
A free market is where the people in an economy are free to engage in economic activities and transactions without government interference. In other words, there are no subsidies, no regulations, and low or little taxes. The governments involvement is purely limited to defense, law, and policing.
Under a free market, the economy is run by voluntary exchanges that are based solely upon supply, demand, and the pricing mechanism. This is also known as ‘the invisible hand’ – originally coined by economist Adam Smith.
To explain, when a good is produced, if there is no demand, it will no longer be made. However, as demand increases, it sends a signal to the supplier to create more. Prices rise to provide an incentive to increase production until demand is met, whereby prices fall to the equilibrium point.
- A free market is where economic transactions take place without the involvement of government intervention.
- Free markets are usually characterised by the absence of tariffs, quotas, regulations, subsidies, and other government restrictions.
- Free markets tend not to exist in today’s world as most governments exert significant influence in the economy. Although Singapore and Hong Kong are the closest examples we see today.
Free markets and laissez-faire capitalism are often used interchangeably. Translated, ‘laissez-faire’ simply means ‘leave us alone’ – originating from 18th century France, under the rule of King Louis XIV. He asked the nations physiocrats how he should support the economy, with them replying ‘leave us alone’.
At the core of free markets is voluntary co-operation. That means that restrictive regulations can be a part of free markets – so long as they are agreed upon collectively.
Free markets rely on one key aspect – if people are not willing to pay above the cost of production, the good or service will not be produced. Anything else is inefficient as it is distorting how people value a said good. By introducing regulations, tariffs, or subsidies, prices become distorted – meaning people buy more of Product A because it is cheaper even though they prefer Product B.
Characteristics of a Free Market Economy
Limited Government Involvement
In a free market, governments have little if any involvement in the market. That means anything that may affect the normal supply and demand of a good. For instance, subsidies, tariffs, quotas, or regulations that may shift the supply or demand curve out of equilibrium.
In a free market, there may be some government involvement in the form of basic functions such as defense, law, and policing. However, this role is so small that any potential impact on the wider economy is insignificant.
Private Ownership of Resources
In a free market, resources are solely controlled by private entities. Government does not control any business, with its resources limited to its core functions such as defense, policing, and the rule of law.
This allows the profit incentive to dictate what is supplied to market. When governments control the market, goods are over or undersupplied, resulting in a disequilibrium between supply and demand. The reason being that governments are not constrained by profits. It won’t go out of business if it makes a loss – not like a private enterprise. In turn, it can keep producing a product people don’t want at a price they aren’t willing to pay.
Freedom of Choice
In a free market, you are free to choose. That means there are no regulations that prevent you using an unlicensed osteopath if you choose. It also means you are free to choose to drink and eat unhealthily without a tax to disincentivise consumption.
In a free market, there are not so many barriers to entry. Regulations can prevent new firms entering, whilst minimum wage laws can put pressure on small businesses. If we look at occupational licensing in the US for example, it not only reduces cross-state migration, but also restricts the number of people working in those occupations – thereby reducing competition. These among others restrict not only new competition, but also puts pressure on existing firms in the market.
Relies on Prices
Prices are what drives a free market and makes it function effectively. The price of a good sends a signal to the customer. The customer then sends a signal back by either purchasing or not purchasing. If the business is not selling the product, it may reduce the price and go through the same feedback mechanism.
When a good is selling, customers are sending a signal to the business. If that signal exceeds the existing supply, it sends a signal that the business needs to start producing more of that good. In turn, the business may not be able to meet supply straight away, so increase prices – either to capture the additional profit, or help fund extra capacity.
The role of self-interest as part of a free market is best illustrated by Adam Smith in his book ‘A Wealth of Nations’.
“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities, but of their advantages.”
Free markets are based around the core concept that individuals should be free from coercion. That means regulations can be made if they are done on a co-operative basis. In a free market, an economic transaction is between the buyer and seller, and nobody else.
Free Market Advantages and Disadvantages
The free market is not perfect, but it does have many advantages over other economic systems such as a mixed or socialist economy. The main issue is that some people will value the advantages of a free market more than the disadvantages. At the same time, others find the disadvantages too great to agree with a free market approach.
In the end, the decision of whether a free market is the best approach will depend on individual values, beliefs, and preferences. Some will value the freedom of choice over all else and therefore potential issues such as negative externalities are only side issues.
Advantages of Free Market Economy
1. Efficient Allocation of Resources
The free market allows for supply, demand, and prices to all work in tandem. This means that when demand falls, producers know they need to change. That might be to introduce a new product or reduce prices. Quite simply, by making lower profits or a loss, the business is forced to adapt and cater to the customer.
This creates a more efficient allocation of resources as subsidies may help prevent such a firm from going out of business. So instead of forcing it to adapt to new consumer trends, it is stuck in its old ways – providing goods to consumers at a higher cost than they are willing to pay.
In a free market, there are no rules or regulations – meaning there is not only competition from domestic firms, but also the whole world. For instance, when tariffs, quotas and other trade barriers are put up, the rest of the world is excluded from competing.
In a free market, there are no trade barriers, so there is greater choice and competition from international competitions. At the same time, fewer regulations make it easier for new firms to enter the market and put pressure on existing firms.
3. Innovation and Economic Growth
In a free market, the incentive for profit drives people and businesses to create products that consumers want. If they don’t, they will go out of business. That forces companies to constantly innovate and improve efficiencies in order to create a good product at a low price. For example, we have seen big companies such as Blockbuster and Sears go under because they failed to develop.
A free market leaves only the companies that innovate and creates products consumers want. At the same time, driven by profit, they are incentivised to increase the efficiency of production. By reducing the cost of production, it frees economic resources for use elsewhere in the economy – contributing to higher growth.
4. More Choice
Free markets create additional competition not only domestically, but also from abroad. In turn, that creates more choice for the average consumer. At the same time, there are thousands of consumers with different tastes and preferences. If there is a profit to be made, those preferences will be catered to. We only need to look at the wide variety of cereal brands that are available today as an example.
5. Absence of Red Tape
A free market has no regulation or other restrictions that can make it hard to start and maintain a business. This helps to increase the flow of new businesses entering the market, thereby creating a greater competitive environment. At the same time, it makes it easier for companies to do business and concentrate on making a product that the consumer wants.
Disadvantages of Free Market Economy
There are natural monopolies such as utilities, sewer services, and train lines that present a big issue to free markets. In such markets, the cost to enter is huge. For example, a utility company may need to create a whole new supply network to customer’s houses – something that is economically inefficient. As a result, one company may be able to dominate the market and charge prices over and above the market rate.
2. Absence of Public Goods
In a free market, public goods such as free healthcare and education don’t exist – they are run by private enterprises. Ultimately, this may mean that many are unable to access such services as they are unable to afford them.
3. Negative Externalities
When there are no regulations or restrictions, it is said that businesses will be free to produce negative externalities such as pollution. If there are no set laws to limit or restrict a firm’s air, water, or waste pollution, then society as a whole pays the consequence.
4. Race to the bottom
One of the commonly stated disadvantages of the free markets is the said ‘race to the bottom’. In other words, in a bid to become as profitable as possible, businesses reduce quality and cut corners, such as safety, in order to maximise profits.
Free Market Examples
A truly free market has never fully existed, nor does it exist today. Instead, most countries in the world operate under a mixed economic system of free markets and socialism. Whilst countries such as the US operate under a free market model – it still relies on heavy government involvement. Examples include minimum wage laws, occupational licensing, labour laws, rent controls, and relatively high levels of taxation – among others.
Although most countries operate under a mixed system, there are a few that align closely with what can be seen as a free market. According to a 2020 report by Heritage, Singapore, Hong Kong, New Zealand, Australia, and Switzerland rank in the top 5 for the most economically free countries in the world.
Singapore is ranked as the freest economic nation in the world. It operates a strict and fair legal system which is also considered the least corrupt in the world. At the same time, the size of government is relatively small – amounting to 17.2 percent of GDP. https://www.heritage.org/index/country/singapore?version=431 By comparison, the likes of the US and the UK spend around 40 percent of GDP.
The small size of government alone is a key sign of a free market, but economic freedom doesn’t stop there. Its average tariff rate is just 0.1 percent – which compares to over 1.6 percent in the US.
On top of this, it treats both domestic and foreign businesses equally, with almost 100 percent of the economy open to investment.
In a close second place, we have Hong Kong with a score of 89.1 in the economic freedom rankings. The nation operates under a one country, two system policy with China which allows it freedom in all areas except defense and foreign policy. Inevitably, this has an impact on the amount of freedom the nation has – especially with the extradition policy that was introduced in 2019.
Other than the issues in has with China, the country is relatively free. Government spending amounts to 18 percent of GDP – only slightly higher than Singapore. In addition, its overall tax burden is low. The highest corporation tax is 16.5 percent, whilst the standard personal income tax is 15 percent.
The regulatory system in Hong Kong is relatively relaxed – although it does offer a number of subsidies programs for business development, housing, energy, and transport. Yet Hong Kong operates a zero-tariff regime – meaning all goods coming in are tariff-free.
Further down in third place is New Zealand with a score of 84.1 in the economic freedom rankings. Once again, similarly to Singapore and Hong Kong, New Zealand is one of the least corrupt and most transparent nations in the world. However, its taxation system falls behind the higher-ranked nations. The top individual tax rate is 33 percent and the top rate of corporation tax is 28 percent – far higher than the other two nations.
The government spends roughly 38 percent of GDP – bringing it more in line with western nations’ level of spending. However, it is fiscally more responsible, with a total debt burden of less than 20 percent.
New Zealand also offers a low tariff regime, at an average rate of 1.4 percent. At the same time, it is open to foreign investment, which is also actively encouraged.
In fourth place, we have Australia which scores 82.6 in the economic freedom rankings. Similarly, to other highly-ranked countries, it has strong property rights, with expropriation an unusual occurrence – meaning the government doesn’t use its powers to take or purchase land from private entities.
It must be said that Australia falls behind the others in terms of taxation. Its highest personal rate is 45 percent, with a corporation tax rate of 30 percent. Government spending as a percent of GDP is 36 percent, but the overall debt burden is relatively low at just over 40 percent.
Whilst taxes are relatively high, Australia comes into its own as regulations generally go through a period of consultation between all parties until a consensus is achieved. Furthermore, tariff rates are exceptionally low at 0.9 percent – with foreign and domestic firms having equal rights in the market place.
In fifth place, we have Switzerland which scores 82.0 in the economic freedom rankings. It scores highly in terms of economic transparency and enforcement of property rights. Commercial and bankruptcy laws are applied consistently and efficiently.
Taxation levels are comparatively low with the top rate of tax being 11.5 percent and the corporation tax being held at 8.5 percent. Both these rates are exceptionally low by international standards.
Free Market Definition FAQs
A free market economy is where government has no control or influence over the economic transactions between two individuals. That means anything that can impact supply and demand curve – which includes subsidies, tariffs, quotas, regulations, and many other government policies.
No true free markets exist in today’s world, but Singapore is about as close as we can get. Its average tariff rate is 0.1 percent with the vast majority of imports being tariff-free. At the same time, its personal and corporation tax rates are among the lowest in the world – accompanied by a small government.
In comparison to many other countries across the world – the US is far from a free market. Its government spending is close to 40 percent of GDP, its debt is larger than the whole of the EU’s GDP combined. At the same time, its tax regime is comparatively average across the developed world, whilst it still imposes strict tariffs with an average rate of over 1.6 percent.