What Is a Free Market Economy?

A free market is a type of economy with little to no interference from a central government. Instead, a free market is based on supply (from producers) and demand (from consumers).

The term free market is also referred to as laissez-faire (French for “leave to do”) economics. The concept is that economies function optimally without government regulation.

How Does a Free Market Economy Work?

In a free market, individuals and companies are in control of making their own economic decisions. Companies sell products and services to consumers and the costs are dictated by supply and demand.

In a free market economy, exchanges are made as a voluntary agreement. For example, if you decide to buy a television for $500, you are exchanging your money for the product.

If you decide to provide manual labor to a company for a $70,000 salary, you are exchanging your services (manual labor) for that salary. In each free market example, there are two commodities being exchanged.

The government isn’t forcing the company to maintain certain production quantities or sell at certain prices, just like no one is forcing the consumer to purchase the commodity. This is self-regulated by each side.

The idea behind a free market is that prices will self-regulate when supply and demand reach a point of equilibrium. In the real world, politics, natural weather events, consumer confidence, and various other factors do not allow for a perfect balance.

Free Market vs. Capitalism

The concepts of the free market and capitalism are intertwined. Economic freedom, consumer self-interest, and competition in the marketplace are main components in both free markets and capitalist economies.

  • A free-market system is focused on the free and unbridled exchange of goods and services.

  • Capitalism is focused on the creation of those goods and services in order to create profit and wealth. In a capitalist economy, both production and distribution of goods and profits are determined by the free market’s supply and demand.

Because all modern economies rely on certain constraints and regulations, no pure, free market economy actually exists. However, a capitalist economy is closest to a free market economy.

Free Market Systems

According to the 2020 Index of Economic Freedom, the United States is considered “mostly free” economically, coming in 17th place out of the free countries in the world. This ranking is largely due to the US government’s checks and balances that interfere with complete free-market principles.

Hong Kong, New Zealand, and Singapore rank at the top of that list. They exhibit more free-market traits by allowing businesses to operate with greater flexibility. These three countries also administer lower tax rates, minimal tariff policies, and fewer regulations than the United States.

What Are the Advantages of Free Markets?

Free markets have several economic benefits for both producers and consumers:

Increased Entrepreneurship

Generally, the pace of innovation is faster in free market economies. Companies in free markets do not rely on government agencies to guide them on how to make new products. There is also increased competition among companies, providing incentives to improve their products and create new ones to meet customer demands.

Customers Have More Control

Goods and services that prosper in free markets usually depend on customers creating demand. Since suppliers base prices on what customers will pay, customers have some say in determining the prices and features of products in free markets.

More Profit for Companies

Free markets have less “red tape” and do not have to satisfy government restrictions or regulations. This means that companies have greater and unconstrained profit potential. Of course, the management of a company (combined with market demands) will always impact profitability.

What Are the Disadvantages of Free Markets?

In free markets, there are potential dangers of: an economic crash, companies that prioritize profit over safety, and the domination of large companies over smaller ones.

Free Market Economy Crashes Can Be Severe

Because of minimal government intervention, free market economy failures can lead to catastrophic financial crashes like the Great Depression. At such times, the economic consequences to society can result in severe production cuts, job losses, and wealth destruction.

Companies Prioritize Profit Over Safety

Companies may sacrifice ethical behavior and safety concerns in order to achieve greater profit. This can affect both labor and consumers. For example, the former head of Peanut Corporation of America was sentenced to 28 years in prison after knowingly shipping peanuts with salmonella to customers.

Large Corporations Can Dominate

Large corporations can dominate free markets due to economies of scale. Larger companies are often able to outproduce smaller companies while providing cheaper goods and/or commodities. This may drive smaller companies out of business and allow larger corporations to gain a monopoly in the market, which can diminish consumers’ power in the market and cause it to become unbalanced.

Free Market vs. Regulated Market

A free market advocates for little-to-no governmental control while a regulated market is supervised and monitored by a governing body.

In a regulated market, the government typically manages supply and demand through tariffs and taxes.These are then used to regulate trade with the goal of protecting the domestic economy.

In a completely free market economy, prices for goods and services are established openly by the drivers of supply (producers) and demand (consumers). This means that they are able to stabilize without the intervention of government policy.

It’s important to note, however, that virtually all free market economies have at least some form of regulations and governmental constraints in place.

Free Market vs. Command Markets

In a command economy, the government has major control and determines:

  • what type of goods to produce,

  • the quantity that should be produced,

  • how much workers should be paid,

  • production quotas

  • prices of goods, services, and factors of production

Command markets are the opposite of free markets. They are the highest form of a regulated market.

What Are Examples of Command Markets?

Command markets are dictated by communist ideals.They are known as ‘repressed’ economies due to their number of regulations.

Historically, Russia and China have been classified as command economies. That said, their current economic systems have more capitalist policies and freer trading. In the 2020 Index of Economic Freedom, North Korea came in last place (180th) in terms of economic freedom. Venezuela and Cuba follow with highly-regulated economies.

Free Markets vs. Black Markets

The term black market describes the illegal exchange of commodities or goods. Black markets are essentially free markets at their core. The difference is that free markets operate legally without government interference while black markets operate illegally under the radar of government regulations.

A prominent model is the purchase and sale of illegal drugs. Within this black market, drugs are exchanged through a system of supply and demand. The participants in the transaction know that such activity is illegal. Regardless of laws and regulations, the illegal drug market endures.

The existence of international black markets demonstrates that goods and services will be exchanged as long as there is sufficient demand for them. Whenever regulation and taxation become too high – or supply and demand are imbalanced – consumers will look for a way to purchase goods or services cheaper, faster, and/or more easily. This keeps the black market in place.

Where Did the Concept of Free Markets Come From?

Though the term 'free market' was introduced in France during the 19th-century, the concept was fully developed in classical economist Adam Smith’s 1776 work, The Wealth of Nations. Here, Smith outlined his Invisible Hand theory, which has since served as the cornerstone for laissez-faire economic philosophy.

The Invisible Hand theory refers to the self-regulating nature of the marketplace. The idea was that individuals acting in their own self-interest would naturally determine how commodities were bought and sold.

Smith’s work dictated that government intervention in the marketplace was unnecessary. As market players competed with one another and engaged in commerce, they were fueled by their own needs. This competition led to a positive output in markets with the help of an “invisible hand.”

Critics of Free Markets

As free-market philosophy spread throughout the world, critics of capitalism and control-free markets emerged. Communist revolutionary Karl Marx believed that capitalism fostered an unfair imbalance between capitalists and workers.

Marx declared that capitalists would always end up exploiting workers. Workers would therefore have no choice but to rebel and take control of the means of production. Thus, Marxism asserts that capitalism and free markets are doomed from the beginning.

A free market can lead to profit and wealth creation. These profits can be built on worker and/or consumer exploitation, however, which makes free markets a double-edged sword (and is why they don’t exist in any pure form). Throughout the world, there are varying levels of free markets. In the United States, constraints are in place to stave off exploitation while allowing individualism and profit.