A free market is one in which decisions about what to produce and in what quantities are made by

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Main Features of Market Economies
Advantages Of A Free Market Economy
1. Consumer Sovereignty
2. Absence of Bureaucracy
3. Motivational Influence of Free Enterprise
4. Optimal Allocation of Resources
Disadvantages Of A Free Market Economy
1. Poor Quality
2. Merit Goods
3. Excessive Power of Firms
4. Unemployment and Inequality
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Not all economies are organized in the same way. The three major ways they can be organized are as a market economy, a command economy, or a mixed economy.

In a market economy, consumers and businesses decide what they want to produce and purchase in the marketplace. They make these decisions by “voting with their dollars.” Producers decide what to produce given the demand they see in the marketplace in terms of their sales and the prices they get for their goods and services. In a pure market economy, also known as a laissez-faire economy (from the French “allow to do”), the government plays a very limited role in what is produced. The government does not direct, and may even lack the power to direct, the private sector to produce certain goods and services.

In a market economy, the private-sector businesses and consumers decide what they will produce and purchase, with little government intervention. A laissez-faire economy is one in which the government plays a very limited role. In a command economy, also known as a planned economy, the government largely determines what is produced and in what amounts. In a mixed economy both market forces and government decisions determine which goods and services are produced and how they are distributed.

Welfare refers to government efforts to provide for people's basic needs. Also known as public assistance, because it comes from the public sector, these efforts take the form of government sponsored work projects and, more commonly, payments made by the government to support basic needs of those who cannot afford them. The federal food stamp and Medicare programs are both forms of welfare.

In a command economy, also known as a planned economy, the government largely determines what is produced and in what amounts. It directs producers to make and deliver goods and services in specified amounts. In practice, command economies are associated with socialism and communism, two closely related forms of government. Socialism and communism are characterized by collective ownership of the means of production and central planning functions that try to produce what people want and need, in the quantities and at the time required. The underlying philosophy of socialism is “from each according to his abilities, to each according to his needs.”

In command economies, the people (in the form of the state) own the means of production. The state, which is seen to embody the will of the people, decides what will be produced according to a plan based upon what the state calculates to be people's need and desire for various goods and services. The state also plays an important role in determining how goods and services are distributed, that is, in deciding who gets how much of what.

In a mixed economy both market forces and government decisions determine which goods and services are produced and how they are distributed. In general, market forces prevail in mixed economies. The government does not direct the private sector to produce certain goods and services in certain quantities at certain times. However, the government's influence in the economy stems from the amount of money (raised in the form of taxes and borrowings from the private sector) that it spends and, through various forms of welfare, redistributes.

Today, the economies of most industrial countries are considered mixed economies. In Western European nations the government usually plays a larger role in the economy than in North America. Since the fall of the Soviet Union in 1991, the only two major planned economies are those of North Korea and the People's Republic of China. However, China has begun to incorporate some market mechanisms, such as competition, into its economy.

As we will see, markets, like governments, can be inefficient in delivering some goods and services. They are considered most inefficient at delivering what are known as ”public goods.” Essentially, a public good is something that everyone wants, such as clean air or a well-educated populace, but no one wants to pay for. While the U.S. society is experimenting with market incentives to obtain these goods—for instance, tradable exemptions from emissions controls and school voucher programs—markets have a generally poor record of delivering public goods. Universal health care is arguably a good example of this.

Although many people characterize the U.S. economy as a “free market economy,” it is clearly a mixed economy. The federal government alone accounts for about 19 percent of the U.S. economy (depending on what forms of government spending are counted). Adding state and local governments brings the public sector share up to about 28 percent. With that kind of economic clout, government at various levels has a lot to say about what is produced in our society and who gets what. Nevertheless, the United States relies on markets to a larger degree than any other major industrial nation in the world, so from a relative standpoint, it is indeed a free market economy.

Excerpted from The Complete Idiot's Guide to Economics © 2003 by Tom Gorman. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.

To order this book direct from the publisher, visit the Penguin USA website or call 1-800-253-6476. You can also purchase this book at Amazon.com and Barnes & Noble.

Overview of Economics: Three Economists and Their Theories

A free market economy is a type of economy that promotes the production and sale of goods and services, with little to no control or involvement from any central government agency. This economic system is primarily based on supply and demand. Order and power in a free market are decentralized, with individuals making all of their own voluntary economic choices.

In a free-market economy, firms and households act in their own self-interest to determine how resources get allocated, what goods get produced, and who buys the goods. A free market economy functions in the opposite manner as a command economy works, where the central government gets to keep the profits and choose how to use them.

Among all of the states throughout the globe, there is no entirely free market economy—all economies have some constraints upon them in the form of government regulations, to a greater or lesser degree. An absolutely free market does not include standard measures like import and export tariffs, prohibitions on certain products, sales taxes, and more.

Markets tend to be the freest in countries that emphasize the values of capitalism and private property, which naturally promote laissez-faire economics (a term often used synonymously with the idea of the free market).

Main Features of Market Economies

The central elements that make up a market economy include:

There is voluntary production and consumption of goods, with overall freedom for every individual to make their own choices
Overwhelmingly, there is private ownership and control of resources and property, including the means of production as well as the labor supply
Self-interest is the primary motivator for all economic decisions
The government’s role in the economy is limited (e.g. to preventing monopolies, allowing fair and equal access to markets for all, protecting the nation and its markets through military means)
Competition creates overall efficiency and low prices

Advantages Of A Free Market Economy

Here are several of the key advantages of the free market system:

1. Consumer Sovereignty

In a free market, producers are incentivized to produce what consumers want at a reasonable and affordable price. In general, consumers have more choices for what goods and services to purchase. This choice is called Consumer Sovereignty.

2. Absence of Bureaucracy

Because free markets reduce cost and minimize red tape, they lead to more innovation via research and development. Entrepreneurs do not have to wait for the government to tell them what to make. They study demand, research trends, and meet their customers’ needs through innovation. This independence also encourages competition amongst firms to improve their products and services.

3. Motivational Influence of Free Enterprise

Guided by what’s often called the “invisible hand,” entrepreneurs take economic risks to fulfill consumer demand. Those entrepreneurs who succeed are rewarded with profits, so this tends to encourage innovation in the market as a whole.

The invisible hand is an economic concept where market demand acts as signals for producers. For instance, because consumers want and are willing to pay for bread, bakers have the economic incentive to produce bread. The concept was originally introduced by Adam Smith in his 18th-century work The Wealth of Nations.

4. Optimal Allocation of Resources

Resources (aka factors of production) in the market are better distributed and allocated. Since consumers are willing to pay for a certain quantity of a product, producers are willing to pay to acquire the raw materials required to produce that product. Otherwise, producers are likely to produce too much of a good that no one wants. In the same way, it also encourages firms to be more efficient as they seek to produce at the lowest price possible to maximize their profit.

Disadvantages Of A Free Market Economy

There are also significant disadvantages inherent in a free market economy. These are the most prominent:

1. Poor Quality

Since profit maximization is the biggest motivation for firms, they may try to reduce their costs unethically. In many cases, the drive for profit maximization actually incentivizes unethical behavior. Examples of harmful effects of unethical cost reduction measures include polluting the environment or exploiting (overworking, under-paying, preventing workers from unionizing etc.) workers. Government intervention is necessary to limit these harms.

2. Merit Goods

Goods and services that are not profitable will not be produced or run. Rural communities will suffer as a result. Examples include transportation and postal services, as well as rural hospitals, which are necessary despite the fact that they may not be profitable to run. In such cases, the government must provide these goods and services so that people do not go with their basic needs unmet.

3. Excessive Power of Firms

Large firms can still dominate certain markets, even where there is some competition. This allows them to maximize their profits by exploiting suppliers (by squeezing their prices down) and consumers (by charging higher selling prices).

For example, Amazon is guilty of such practices in the book industry, where they have dictated unfair terms to publishers. Part of the reason that large companies are able to dominate markets is due to economies of scale. The large-scale companies with greater capital and labor resources can beat out smaller companies simply for their size alone, rather than for the quality of their product; if this process continues, they may eventually gain a monopoly over their market.

4. Unemployment and Inequality

In a free market economy, certain members of society will not be able to work, such as the elderly, children, or others who are unemployed because their skills are not marketable. They will be left behind by the economy at large and, without any income, will fall into poverty. Their caretakers will also be left out of the economy, because they will not be paid for their necessary caretaking work.

Remember: if there is no government, there is no way that these individuals can be helped in any systematic manner. The result is that inequality takes root: a few people can live in luxury while others cannot pay their medical bills, get enough food, access basic shelter, and so on.