In a free-market economy, production is carried out by independent businesses who offer their goods for sale in the market, and consumers are free to choose what and from whom they buy. To survive, businesses have to sell their goods and are therefore under pressure to produce goods that consumers want and at a price and quality that matches or is better than competitors.
Markets are places where we exchange goods or services with one another. In principle, we could directly exchange one thing for another – bread for shoes say – which is known as bartering. However, it’s more convenient to exchange goods for money and at some later time exchange the money for other goods, or in other words, sell and buy. It’s easy to see that money makes markets much more flexible than if the only way to exchange goods and services was through barter.
When we talk about a ‘market’ we are not thinking only of a traditional market in a public space where buyers and sellers come together – a familiar arrangement being small stalls set out in a hall or market square that buyers can walk among as pictured in Figure 4.1. Rather we mean all ways and forums in which sellers can offer goods for sale to buyers, including:
In the markets listed above, something that has been produced is being sold to an individual or business who will use or consume it. There are also commodity markets where large volumes of products such as oil, gas, coffee, gold, cotton and wheat, are traded – but typically between businesses, not with the final consumer. Then there are markets where what is sold are not products but ownership – especially of businesses (shares) and land. Beyond that are markets in foreign exchange and a complex range of ‘financial products’ from insurance to options to buy something in the future. These financial products are not ‘products’ in any real sense, but rather services and agreements; if you buy fire insurance you get not a product but a promise ... that if your house burns down, you will be given the products and services to rebuild it. We talk a little more about the financial sector in Chapter 22.
The important feature of a ‘market economy’ is not sales outlets, but the freedom to enter the market as a producer, i.e. for individuals or groups to establish private businesses producing goods and services and offering them for sale. The producers are free to choose what to make and adjust their prices as they think fit without regulation, and buyers are free to choose which seller to buy from.
Classical economics praises the market as being the most effective way of ensuring that the right things get produced – the things that people want. The mechanism operates as follows:
If demand for a good exceeds supply, its price rises, e.g. if more people want to buy eggs (and have the money to do so) than there are eggs being produced, then the price of eggs will rise. This means that the income of egg producers will go up compared to average incomes. Egg production then becomes a more attractive trade, so people will tend to move into it, increasing egg production. The extra production will cause egg prices to fall until egg producers’ incomes are approximately average again. Adam Smith called this the ‘invisible hand’. The same free-market mechanism will favour reputable producers over those whose products are of inferior quality.
Free markets do indeed match supply to demand, as described above, provided that we understand that by ‘demand’ economists mean the wants of people who have enough money to pay the asking price. But free markets do nothing for the starving in a famine stricken country: their demand for food is considered not to exist because they have no money to pay for it; charity and state aid are their only recourse. However notwithstanding such drawbacks, free markets have proved themselves to be a very good way to decentralise economic decision-making and through competition encourage producers to improve prices and quality.
The most idealistic exponents of the free market, argue that the best outcome will be obtained by having a totally unregulated market with ‘perfect competition’. To have perfect competition however, certain assumptions must be met. Critics of the model point out that these assumptions are seldom met in reality. In practice all free markets have to operate in a legislative environment that restricts and regulates their operation.
In today’s world, legislation outlaws the trading of slaves, and typically restricts or bans trade in certain classes of drugs, limits who can buy dangerous weapons, and forbids the sale of alcohol or tobacco to children. Regulation imposes standards that must be met in quality, safety and hours of work.
Periodically there are campaigns to reduce regulation, referring to it disparagingly as ‘red tape’ but the trend seems to be the other way. This is because as products become more technically complex it is increasingly difficult if not impossible for the consumer to control quality and safety: often long-term research is required into the effects of chemicals or additives that the consumer may not realise are present in the product and even if they do know, may be unaware of the implications.
So in the vegetable market of a medieval village, a consumer may be very nearly ‘perfectly informed’, as is required for the perfect competition model. But in the age of pesticides, GM crops and highly processed foods, this is less and less achievable even if we restrict ourselves to foodstuffs, let alone consider other technological products.
Another claim made by some market purists is that ‘free markets always clear’. This assertion means that the market mechanism will ensure that there are no unsold goods. While the market does usually work this way, there are cases when it won’t. Usually the market does clear, because producers will either lower prices until they are able to sell all their produce, or reduce or stop production if they cannot sell the products at a price which at least covers their costs: it makes no sense to spend more producing something than you can earn by selling it. Note however that sometimes a producer may sell even at below cost price, at least for a while – for example:
But the market does not always clear. In case (1) above, if the extra cost incurred in taking a product to market is greater than the price it can be sold for, then it may be cheaper just to dump the product or leave it to rot – as for example, if there is a glut of apples for sale and prices have fallen, it could cost an orchard owner more to pick their apples and transport them to market than the price they will fetch. A more important exception to market clearing is the labour market since workers cannot ‘un-produce’ themselves if their labour isn’t selling. In Chapter 7 we shall examine in more detail the ‘free markets always clear’ claim as applied to labour markets.
Many organisations and think tanks exist today to promote free-market, neoliberal ideas. They tend to align themselves with the political right and see their mission as the defeat of ‘big government’. Such organisations go far beyond promoting markets as practical and useful; rather they are the perfect system and work for everyone, including the poorest. The belief that the free operation of markets and private business will lead to the best economic outcomes, is often argued by citing passages from Adam Smith’s ‘The Wealth Of Nations’, published in 1776.[12]
“Every individual... neither intends to promote the public interest, nor knows how much he is promoting it... he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.” – The Wealth Of Nations, Book IV, Chapter II.
“It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our necessities but of their advantages.” – The Wealth Of Nations, Book I, Chapter II.
These passages are beautifully expressed, and the metaphor of the ‘invisible hand’ is far more memorable than saying something like “markets allow decentralised decision-making, with cooperation where there is mutual advantage”. However, Smith has chosen a very homely scenario to illustrate his point: the butcher, brewer and baker, freely competing to provide his dinner. It is an effective illustration and I use similar analogies of trade between artisans in Chapters 5 and 12 to explain the operation of the market. But when Smith was writing, the ‘invisible hand’ was not merely provisioning his dining table. It was busy inducing shipowners to make huge profits from the slave trade, and parents to send their children down coal mines to fuel the nascent industrial revolution. Not so much an ‘invisible hand’, more a ‘visible whip’.
Smith’s writing, so often selectively quoted to support neoliberal views, is really far more nuanced. He was well aware of the power imbalance between workers and owners.
“The workmen desire to get as much, the masters to give as little, as possible. The former are disposed to combine in order to raise, the latter in order to lower, the wages of labour. It is not, however, difficult to foresee which of the two parties must, upon all ordinary occasions, have the advantage in the dispute, and force the other into a compliance with their terms. The masters, being fewer in number, can combine much more easily: and the law, besides, authorises, or at least does not prohibit, their combinations, while it prohibits those of the workmen.” – The Wealth Of Nations, Book I, Chapter VIII.
At their extreme, the ideas some neoliberals promote appear to be almost the mirror opposite of communism, so that:
Surely we can value choice, competition and enterprise, without making the ‘free market’ into some sort of pure and perfect goal. The curse of economics is that it so often turns into a religion. I prefer to approach it as an engineer: let’s first simply try to understand how the economy operates, and then see what we think we could improve.
Free-market economies have an extensive ‘private sector’ of independent businesses, producing goods and services. Consumers can choose who they buy from. Such economies decentralise economic decisions. Producers move into fields where there is more demand and thus more profit, and consumer choice incentivises better quality and lower prices. Markets do match supply to demand but only to financial demand; those without money have to rely on charity. The increasing complexity and variety of products available means that consumers cannot easily judge quality and safety, and therefore need regulation to protect them from potentially harmful products. The promotion of the largest possible role for private business and free markets in the economy, is a cause of the political right, particularly in the USA and UK.
In the next chapter (Chapter 5) we attempt to visualise the exchanges or ‘swaps’ that are going on when goods or services are traded in the market. And in the chapter after that – given that free-market economies now dominate the world – we will consider what it’s like to live in one.
