Free Market Economy

A free market economy is an economic system in which prices for goods and services are set by the open market, not by a centralized government or authority.

Open market refers to the fact that the prices are transparent (i.e., known to all market participants), and it’s where goods or services can be bought or sold by any individual or firm at either fixed prices or negotiated ones.

A free market economy operates according to supply and demand, which reflects the needs of, as well as available resources for, producing goods and services.

How Does a Free Market Economy Work?

Most countries’ economies are mixed economies that contain both private and public elements. The extent to which government intervention, regulation of private enterprise and social programs facilitate generalized participation in the market economy varies across nations.

A free-market economy may be distinguished from a command economy (a type of planned economy) where resources are allocated through central planning. Generally speaking, people with more resources get their way in these kinds of economies because they have the ear (and often control) of the government officials.

In a free-market economy, most industries are privately owned and prices for most goods and services are determined by the supply (what is available) and demand (what people want or need).

Consumers make most of their own decisions about what to buy, rather than relying on the government or businesses to determine which products will be made available if any.

Without doubt, it’s true that some consumer information needs to be regulated in order to protect consumers from fraudulent advertising. But this should not amount to an outright ban on product marketing. Advertising plays an important role in ensuring transparency so producers can’t hide issues.

Characteristics of a Free Market Economy

The following are among the characteristics of a free market economy:

Supply and Demand Determine Prices

Prices are set by the individual, not mandated by the government or an outside force.

For example, the price of a product sold in a free market economy is determined by what consumers are willing to pay for that product and producers are willing to sell it for. In other words, supply and demand determine prices.

Private Property Rights

Private property rights are established and enforced by the government. Your property is yours to do with as you please, so long as any rules regarding its use are followed (e.g., zoning ordinances).

Free Participation

In a free market economy, participants are free to enter or exit markets without government permission. 

This is another way of saying that the economy itself is not centrally-planned and does not operate as a monopolistic system (i.e., there’s no one company/brand that controls all aspects of the market and determines what goods and services will be made available).

Benefits of a Free Market Economy

A free market economy offers the following benefits:

Economic Prosperity

When consumers are unconstrained by government-imposed prices or taxes, they can buy products at lower prices since there’s increased competition among producers to provide what consumers want. This allows for greater choice and more efficient allocation of resources.

Increased Consumer Choice & Better Quality Products

Because people in a free market economy don’t need to rely on central planners or providers to determine what will be produced or made available, they have much greater choice over the products that are sold compared with those under other economic systems (e.g., command economies).

What’s more, because competition exists between firms (in order to gain customers), products tend to be higher quality than those offered in a command economy.

Fair Competition

Free market economies promote competition. This is good for consumers because it encourages companies to produce the best possible goods and services at the lowest price possible.

When there’s fair competition, prices are kept low and quality is high. Consumers are also less likely to be taken advantage of by companies who are trying to gain market share by cutting costs on safety or customer service issues that can affect both individual customers as well as public health or safety concerns in general (e.g., food contamination).

Drawbacks of a Free Market Economy

A free market economy does have some drawbacks.

Economic Prosperity Can Lead to Economic Inequality

When an economy is more prosperous, the price of products tends to go up. This can disproportionately affect lower-income people, who are then less able to afford the same standard of living as people with higher incomes.

Economists don’t yet know how best to address this issue.

Some economists believe that redistribution of income through government taxation is the best way to address this problem while others feel it’s possible for everyone in society to benefit from economic growth if certain changes are made (e.g., educational reform).

Needless Waste or Overproduction of Products

Waste and overproduction are both problems in a free market since there is no one who has the authority to regulate production (or restrict it) in order to ensure that goods and services are produced at appropriate levels.

As a result, the economy can produce unnecessary goods or overproduce something due to an increase in demand, which results in prices falling too low for producers to make any profit off of their product (e.g., causing layoffs).

High Unemployment Rates

Unemployment rates tend to be high in free market economies because there is no provision for ensuring full employment (i.e., making sure everyone who is willing and able to work has a job).

While this isn’t necessarily a negative outcome by itself, unemployment rates need to be monitored closely so that economic policies can be adjusted as needed (for example, by increasing government spending).

Drive for High Profit Margins

Firms in a free market economy are motivated to increase their profits by any means necessary. They have an incentive to reduce costs, even if it means cutting corners on safety or taking advantage of their customers in some way.

As a result, firms might sell products that cause harm (e.g., food contamination) or fail to make products available when needed (e.g., during natural disasters).

Final Thoughts

A free market economy has many benefits. It allows for increased prosperity and better quality products because it stimulates competition between companies, which encourages efficiency and innovation (e.g., alternative energy sources).

Free market economies do have drawbacks, too. These include unemployment rates that are higher than necessary, the potential for wasteful production of goods, and economic inequality.

However, overall, a free market economy is an effective way to promote business growth while stimulating technological advancement.

In a true free market system, there is no central authority dictating what should be produced or set limits on production in order to prevent shortages or surpluses from occurring. Because of this, it's important that consumers have access to accurate information about potential products or services they might buy so that they can make informed decisions.
There are different measurements to determine economic growth, including GDP (gross domestic product) and GNP (gross national product). These are both measures of the total value of goods and services produced over a specific period of time. GDP is usually used when referring to individual nations while GNP is preferred for multinational corporations. While increased economic growth tends to be seen as positive, it's important to consider all its effects before passing judgment on whether an increase in GDP or GNP is good or bad.
A free market economy does not require a certain number of people or companies in order to function well. The more consumers and producers that participate, the better for everyone involved. Although there is room for growth (more competition has positive effects), an overabundance can be problematic as well (i.e., price wars).
In a command economy, the government dictates what goods and services will be produced by which companies. Companies that do not produce what they have been ordered to are penalized or shut down completely.
A mixed economy is one where multiple markets exist side-by-side depending on whether you are looking at a geographical or functional basis. For example, some countries might have both free and command economies while others may only have one type of economy (e.g., communist).

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.