Monday, September 3, 2007

Free market economic system

The free market means that economic decisions are taken by private individuals and firms. Everything is owned and operated by private individuals. In a pure free market there would be no government intervention in the economy. However, in practise governments usually involve themselves in the implementation of certain laws and certain public services, even if only national defence and the protection of private property.. We often speak about America having a free market economy because most businesses are left to private enterprise. But, even in America the government spends about 35% of GDP.

Theoretical support for a free market was strongly supported by Adam Smith in his book, 'The Wealth of Nations'. The wealth of nations tried to explain that; when people try to maximise their individual utility it actually leads to the best outcome for the rest of society.

However, Adam Smith was aware of some limitations of the free market. For example, he was aware of how monopoly power could be abused. But, basically his theories crystallised the theoretical underpinnings of a free market approach. Many of his arguments remain relevant today.

Benefits of a free market

  • Firms have incentives to be efficient and provide goods and services demanded by consumers
  • It avoids the bureaucracy often involved in government intervention.
  • The profit motive provides an incentive to cut costs and make efficient use of scarce resources
  • Economic freedom is important for personal freedom.

Problems of a Free Market
"Capitalism is the astounding belief that the most wickedest of men, will do the most wickedest of things for the greatest good of everyone."
- John Maynard Keynes, as quoted in Moving Forward: Programme for a Participatory Economy (2000)

A free market has various problems. This is a silly mnemonic to help you remember them. PIMM FACED.

P - Public Goods are not provided in a free market. A public good is a good with the characteristics of non rivalry and non excludability. Examples include street lighting and national defence.

I - Inequality. A free market provides no social security net for those who are unemployed or on low income. Furthermore the nature of a free market is that the benefits tend to accrue to a small number of people who have the advantage of property and monopoly power

M - Monopoly. In an unchecked free market, monopolies can easily develop. This means the owners are in a position to set high prices and exploit both consumers and workers.

M - Merit Good - Education and health care. Under-provided because people underestimate the benefits of going to school e.t.c.

F - Factor immobility. Geographical unemployment. Occupational unemployment through lack of skills

A - Agriculture. - Agriculture is prone to market failure e.g. weather can harm crops

C - Cyclical Instability - economic recessions and the corresponding unemployment

E - Externalities - Over-consumption of goods like tobacco with negative externalities

D - De merit goods - Overconsumption of goods like alcohol, where people overestimate the personal benefits, underestimate the costs of getting drunk.

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