Free Markets

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 [Page 717]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.

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