Free market economics
Free market economy or laissez faire is usually defined as an economy, where government plays virtually no role in the economic decision-making. It is an extreme case of market economy, which is based on the assumption that price mechanism correctly reflects the current situation in the economy and regulates production and consumption in the country (Arnold, 2008). Resource allocation in such economy is subjected to the supply and demand laws of the market. In the market economy only the most profitable goods are being produced. However, pure free market economy is an idealized scenario, which cannot exist in the real world. Government interference in the form of taxes and legislation has always been an integral part of any economy (Arnold, 2008).
Laissez faire economics was first introduced by the Scottish economist Adam Smith in his book “The wealth of nations” (Mankiw, & Taylor, 2006). In his work he described many concepts of the free market economy, which form the basis of the classical economics today. Perhaps his most famous theory was the theory of the invisible hand, which suggests that people acts are driven by self-interest and all companies operate under a perfect competition. This means that the optimum level of production and consumption is reached when supply and demand in the market equalize, thus determining the price for a product (Mankiw, & Taylor, 2006).
However, pure market economy is not as efficient as first proposed by Adam Smith. In some cases the pursuit of self-interest by the individuals does not result in the optimal level of production for the society as a whole. This phenomenon is referred to as market failure. Such failures often arise in non-competitive markets, due to externalities, public goods and asymmetrical information distribution. Perfect competition in the market economy assumes a large number of sellers, who are competing based on price. However, in the real world market power is not equally distributed in the market. In this case some of the agents become monopolies, which can set prices above the optimum level by restricting production, thus increasing their profits (Hirshleifer, Glazer, & Hirshleifer, 2005). According to the free market theory, the price of a product reflects all the costs incurred during production. However, in reality some of the costs, such as pollution, are hidden. In this case the optimum level of consumption is not equal to the actual one, thus failing to regulate economy in the most efficient way (Anderton , 2006). Public goods are also an example of a market failure and often represent positive externalities. The benefits of some products, such as education or healthcare, are not fully realized by the consumers. Therefore, free market will always produce less of them, than it is optimal for the society. The situation is similar when it is impossible to exclude from consumption those, who have not paid for it. Thus, construction of the roads, used by the whole population, has to be subsidized, since it is impossible to prevent the non-payers from using the roads. Lastly, not all of the information is equally available to all the participant of the market. Therefore, prices often do not correctly reflect the value of the product, causing the shift of the optimum level of supply and demand (Hirshleifer, Glazer, & Hirshleifer, 2005).
As free market economy fails to reach optimum, governmental intervention is sought. While free market implies zero governmental intervention, the other extreme, command economy, suggests that resources should be allocated by the government in a centralized fashion. All factors of production are owned by the state and people act based on the desire to reach the common good, rather than based on their self-interest (Anderton , 2006). However, in reality both pure command economy and free market economy do not exist. Most of the economies today are mixed, thus resource allocation occurs not only based on the market mechanisms but also through governmental intervention, which helps to enhance efficiency.
Anderton , A. . (2006). Economics. London, United Kingdom: Longman.
Arnold, R. A. . (2008). Economics. Mason, the United States of America: Thomson Higher
Hirshleifer, J., Glazer, A., & Hirshleifer, D. A. (2005). Price theory and applications:
decisions, markets, and information. New York, United States of america: Cambridge
Mankiw, N. G., & Taylor, M. P. (2006). Microeconomics. London, United Kingdom: