What is a Free Market?

The “free-market” is a term that people use daily in economic and political conversation, and is nearly a sure thing when playing GOP debate bingo.  Often we’ll hear the terms “free market,” “capitalism,” and “laissez-faire” used almost interchangeably or combined into a mega talking point.  The free market has different definitions in different schools of economic thought but the striking thing is that in fundamental economic theory the free market is almost meaningless.  This is a topic I’ll be exploring further in an upcoming article, but let’s start with some basics for now.

First, the free market means different things.  In today’s use the free market could mean:

– A market or economy free of government intervention

– A market or economy where the means of production is privately-owned, like capitalism

– A highly competitive market or economy with few barriers to market entry 

– A market or economy where supply and demand determine price

From these definitions you might imagine a situation where a market falls in all categories, it’s more or less the economic situation classical liberalism strives for.  However, you could also imagine many markets where the conditions in the categories are not all present such as a capitalist economy with government regulation.  You can also have an economy in which only monopolies exist and no competitors are allowed to enter; under the first definition this is also a free market.

The problem comes in the way it was historically crafted.  In Adam Smith’s The Wealth of Nations he used the phrase “an open and free market”  as an antidote to the failed attempt of the English to establish a monopoly on wool.  In this sense a free market is free both of monopoly control and government intervention.  Nowadays economists usually denote an open market as one in which competitors can easily enter but still loosely tie it to the definition of a free market.

The first two definitions were effectively combined in Milton Friedman’s 1962 work Capitalism and Democracy.  The free market became a political system as much as an economic one embodied in the policies of laissez-faire capitalism.  The notion of a free market is inevitably tied to government policies because of the way we use it today.

However, in the general equilibrium theory, the mathematical foundation for notions like supply and demand, there needs to really be no difference between the government and any other economic agent.  The government may simply be viewed as a firm that enforces contracts for clients and provides other services that other economic agents subscribe to through what Rousseau would call a social contract.  When broken down to the theoretical principles it becomes hard to distinguish the government from other actors in an economy.

In theory, money and currency is not the base unit, it does not dictate rational actions.  Instead it is utility, the amount of meaning, pleasure, or value that a person (or firm) views in anything.  Broken down further, this means that every action is some sort of trade for utility.  Taking time to enjoy a sunset, has an opportunity cost in terms of time and utility.  You could be doing something else with that time and concentration and if you were a rational actor you would be maximizing your utility by viewing the sunset instead.  Of course economics starts with the assumption of rational actors, therefore any action somebody takes must be maximizing their utility.

A free market in this context becomes meaningless, it just means that any economy would be a free market as it has achieved equilibrium based on everybody’s utility maximization (actions) throughout history.  It is a larger invisible hand, similar to evolution, that creates order from chaos, the same way that anarchy will lead to a different political structure.

The problem is that the way we use free market in the vernacular rarely leads to our idealized version of free markets.  Free market as laissez-faire capitalism does not produce open markets.  If what we desire are highly competitive open markets then intervention is necessary to prevent monopolies.  Most agree that monopolies are a bad thing (except for specific circumstances) because they stifle competition and innovation.  Monopolies hurt consumers, and so while we relish success, we denounce control and view monopolies as dangerous.  Any firm able to exert coercive force on the market essentially starts intervening the same way a government would.  The only way to keep things highly competitive is to diversify the market as much as possible and therefore the only way a free market like this could exist is through constant government intervention.