Free Market Economy | Economics Definition + Examples (2024)

What is the Definition of Free Market Economy?

The concept of a free market economy is closely tied to capitalism, wherein the supply and demand forces present in the market dictate the decisions by businesses on how to operate.

For instance, the pricing of specific goods and services is set based on consumer demand, and employee wages are a function of the supply of qualified employees (and their willingness to be employed in the role in question).

The free market economy is characterized by supply and demand determining the decisions made by market participants, all with minimal government intervention.

The profits created in a free market economy are intertwined with the market’s supply and demand forces, the production capacity of the businesses participating in the market, and the utilization of resources by consumers.

Due to the limited involvement of the central government, natural market forces are what determine the employment rates, total output with regard to productivity, and the pricing of goods and services.

The private sector produces the goods and services that circulate the economy. Most properties are privately owned by individual consumers (and businesses run by consumers) instead of governmental entities.

How Does a Free Market Economy Work?

The following attributes are some of the most notable characteristics of a free market economy:

• Ownership → In a free market economy, the private sector controls the economy for the most part, rather than the central government
• Incentive Structure → The primary motive for market participants is profit-oriented, wherein businesses that offer the most value to consumers (and society) on a relative basis are rewarded with greater monetary profits, i.e. entrepreneurship tends to be rewarded more.
• Market Dynamics → The supply and demand in the market sets the pricing in a free market, the allocation of resources, and the production levels (i.e. output) – therefore, businesses must strive to meet consumer demand and become more efficient.

Market Economy vs. Command Economy: What is the Difference?

While a free market economy is a decentralized economic system with minimal intervention by the central government, the government still has significant oversight and influence in a command economy (or planned economy).

The discretion provided to producers and consumers in a free market economy implies each transaction is entered into voluntarily. Thus, sellers can set their prices appropriately based on the prevalent market demand, with minimal governmental intervention or legislation.

In effect, competition within the economic system is oriented around offering consumers the most value, which also means that businesses that underperform are lagging behind their competitors for a reason, such as operating with less efficiency.

Over time, sellers in a free market will theoretically sell the goods and services that consumers demand while pricing settles near an optimal rate where the reward (i.e. profit) is maximized.

In a command or planned economy, however, the central government imposes policies, sanctions, and regulations to achieve its desired outcome as opposed to a self-regulated economy with voluntary engagement.

What are the Pros and Cons of Free Market Economy?

First and forecast, the distinct benefit of a free market economy is the incentive structure. Those that provide more value are rewarded with more profits (and vice versa), directly promoting entrepreneurship and acting in one’s self-interest.

In its purest sense, free market capitalism describes an economy in which supply and demand market forces, rather than a central government, regulate the production of goods and services, allocation of resources, and prices in the marketplace.

^{The Wealth Of Nations (Source: Adam Smith)}

But the drawback to that system with no governmental oversight is that the priorities of the businesses might not always be optimal for society. If all consumers (and businesses) acted in their self-interest, critical issues or certain matters may end up being neglected.

In comparison, the central government in a command economy dictates the allocation of resources and production levels and sets the prices of goods and services based on the government’s decision-makers.

For instance, a society based solely on profit maximization is likely to invest a marginal amount into issues such as healthcare and the pharmaceutical industry, considering the lower profit margins exhibited in such sectors.

As a result, the central government should attempt to identify areas that businesses might be ignoring for the sake of obtaining more profits and offer more incentives to ensure a balanced structure within an economy.

Another drawback to the free market economy is that the country becomes prone to wealth inequality (and a greater chance of monopolies emerging).

The natural supply-demand market forces are arguably the most effective in terms of increasing the productivity and output levels within an economy, but the pursuit of higher profits can also lead to misalignment in priorities.

Learn More → Free Market (Econlib)

Free Market Economy Country Example: US COVID Pandemic

Globally, the U.S. is regarded as one of the leading free-market economies with minimal governmental intervention.

Nonetheless, there still are some aspects of the U.S. government where the central government plays a critical role, which was seen during the COVID-19 pandemic.

The U.S. central government directed resources towards the crisis and offered incentives (i.e. funding, equipment, etc.) to institutions throughout the pandemic and intervened in the markets via the Fed’s monetary policies and the temporary lock-down period.

Hypothetically, an entirely profit-driven U.S. economy might’ve suffered much more negative consequences from the pandemic if the government had not stepped in with supplies, testing programs, etc.

Of course, there is controversy surrounding many of the Fed’s decisions and fiscal policies around that period – particularly now as the risk of a recession and inflation are seemingly discussed on a daily basis – but the fact remains that it was likely in the best interests of all Americans for the Fed to not “sit back” and let the supply and demand forces simply play out.

In closing, most global economies in developed nations function with combined elements of a free and command economy, which is often referred to as a “mixed economy”.