An economy is a system whereby goods are produced and exchanged. Without a viable economy, a state will collapse. There are three main types of economies: free market, command, and mixed. The chart below compares free-market and command economies; mixed economies are a combination of the two.
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Free-Market Economies |
Command Economies |
| Usually occur in democratic states | Usually occur in communist or authoritarian states |
| Individuals and businesses make their own economic decisions. | The state’s central government makes all of the country’s economic decisions. |
In free-market economies, which are essentially capitalist economies, businesses and individuals have the freedom to pursue their own economic interests, buying and selling goods on a competitive market, which naturally determines a fair price for goods and services.
Command Economies
A command economy is also known as a centrally planned economy because the central, or national, government plans the economy. Generally, communist states have command economies, although China has been moving recently toward a capitalist economy. In a communist society, the central government controls the entire economy, allocating resources and dictating prices for goods and services. Some noncommunist authoritarian states also have command economies. In times of war, most states—even democratic, free-market states—take an active role in economic planning but not necessarily to the extent of communist states.
Example: During World War II, the United States largely took control of the American economy, forcing businesses to build tanks, planes, and ammunition instead of normal consumer goods. Supplies were also rationed. For example, to buy more toothpaste, people were obliged to return the empty tube because metal was in short supply.
Inefficiencies of Command Economies
Command economies are often very inefficient because these economies try to ignore the laws of supply and demand. In most cases, a black market arises to fill the demands overlooked by the central plan. Economic growth overall is often slower than in states with free markets. Some command economies claim to act to promote economic equality, but often the elites in the government live far better than others.
Mixed Economies
A mixed economy combines elements of free-market and command economies. Even among free-market states, the government usually takes some action to direct the economy. These moves are made for a variety of reasons; for example, some are designed to protect certain industries or help consumers. In economic language, this means that most states have mixed economies.
Example: Agricultural subsidies, which exist in many countries (including the United States), are a common way governments intervene in the economy. In some cases, these policies are designed to keep food prices low without bankrupting farmers. In other cases, they work to protect domestic agriculture. Even the price of milk is strongly influenced by government policy in the United States.
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A type of economic system that is controlled by the market forces of supply and demand
A free market is a type of economic system that is controlled by the market forces of supply and demand, as opposed to one regulated by government controls. It is opposite on the spectrum to a command economy, where a central government agency plans the factors of production and use of resources and sets prices. In a free market, companies and resources are owned by private individuals or entities who are free to trade contracts with each other.
Understanding the Free Market Economy
Economists define a free market as one where products are exchanged by a willing buyer and seller. Purchasing groceries at a given price set by the farm grower is a good example of economic exchange. Paying a worker a monthly salary is another instance where an economic exchange happens.
In a free or pure market economy, sellers of different goods don’t face any barriers. Essentially, one can sell any product they wish to sell and at any price. However, in the real world, such an economic system rarely exists. Tariffs imposed on imports and exports and legal restrictions such as the age restriction on alcoholic beverages are all barriers to a free market.
Overall, capitalist economies, which are established by most democracies, including the United States, are mixed systems composed of both free market and command economy components.
Characteristics of a Free Market
A free market economy is characterized by the following:
1. Private ownership of resources
Free economies exist because a significant portion of resources are owned by individuals or companies in the private sector and not a central government agency. In this way, the owners exercise total control over the means of production, allocation, and exchange of products. They also control the labor supply.
2. Thriving financial markets
One key factor that helps a free market economy to be successful is the presence of financial institutions. Banks and brokerages exist so that they give individuals and companies the means to exchange goods and services, and to provide investment services. The financial institutions then make a profit by charging interest or fees on transactions.
3. Freedom to participate
Another characteristic of a free market economy is that any one individual can take part in it. The decision to produce or consume a particular product is totally voluntary. It means that companies or individuals can produce or purchase as much or as little of a product as they want.
Benefits of a Free Market
The absence of governmental influence allows both companies and individuals a wide range of freedom.
1. Freedom to innovate
In a free market economy, business owners enjoy the freedom to come up with new ideas based on the consumers’ needs. They can create new products and offer new services at any time they want to. As such, entrepreneurs rarely rely on government agencies to notify them of consumers’ needs.
The entrepreneurs do their own research and identify popular trends. The innovation among different private companies can lead to competition as every company tries to improve on the features of its products to make them better.
2. Customers drive choices
With a free market economic system, it is the consumers who decide which products become a success and which ones fail. When presented with two options of products, the consumer evaluates the features of each and chooses whichever one they want to, ideally opting for the one that offers better value for money.
To a great extent, the consumer also influences the price set on a product. As such, producers need to strike a balance between the price point that earns them a profit but is still affordable by the average customer.
Drawbacks of a Free Market
Despite its benefits, a free economy also comes with a few drawbacks:
1. Dangers of profit motives
One disadvantage of a free market economy is that some producers are driven exclusively by their profit motives. Even though the primary goal of any business is to generate profit, such an objective should not be prioritized over the needs of workers and consumers. Put simply, a company should never compromise the safety of its workers or disregard environmental standards and ethical conduct just so it can make supernormal profits.
An example took place in the early 2000s, a time when unethical behavior became prevalent among companies such as WorldCom and Enron. In 2010, the Deepwater Horizon oil spill, which is one of the biggest environmental disasters in the United States, happened because the company used substandard cement and other cost-reducing measures.
2. Market failures
At times, a free market economy can spin out of control, causing dire consequences. Good examples of market failure include the Great Depression of the 1930s and the real estate market crash that happened in 2008. Market failures can lead to devastating outcomes such as unemployment, homelessness, and lost income.
Summary
A free market is a self-regulated economy that runs on the laws of demand and supply. In a truly free market, a central government agency does not regulate any aspect of the economy. By removing government regulations, the nature of the free market forces businesses to provide superior products and services that address consumers’ needs. A free market economic system also helps sellers to create affordable prices for everyone.
Additional Resources
Thank you for reading CFI’s guide to Free Market. To keep advancing your career, the additional CFI resources below will be useful: