It seems like the free market is constantly under attack. Even though millions of transactions occur in the free market on a daily basis and most companies operate in a fair and equitable manner, the news media and politicians never cease presenting examples of someone cheated or treated unfairly by some evil corporation. Because of this constant presentation of the negative side of the free market, many have come to believe that the free market is evil and needs to be controlled or even stopped.
In this section of teaching regarding free markets, we will look at how the free market operates keeping in mind that it is not perfect because imperfect people run it. However, history will prove that the free market is the most efficient economic system for dealing with the internal and external forces that affect market operation but first we need to lay the groundwork by defining some terms. If you already have basic economic knowledge, you will already be aware of these definitions so this will be a good review. If not, take time to learn these definitions.
Thomas Sowell (2007) defines economics as “the study of the use of scarce resources which have alternative uses”. Markets are where these resources are traded. Each community has an economy and a market for the trading of resources. The differences in economic systems are in how a community chooses to manage the use of these scarce resources.
At one extreme, we see economic systems that characterized by a strong central government that controls how resources are allocated. At the other extreme, we see systems where individuals freely enter into agreements to buy resources from each other with minimal governmental oversight. In truth, most economic systems today consist of aspects of both extremes with some leaning more towards centralized control and some leaning towards a free market approach.
Nations also move from leaning toward central control, back to free markets, and then back to centralized control depending upon who is in power at the time. Our study of cases where nations have made these shifts will provide evidence as to which type of system is more successful.
Internally, supply and demand determine how a market operates. As demand for a product or service increases the market goes into action to satisfy the demand. In an economic system with a centralized control, it is the job of the controlling entity to insure the economic system satisfies this demand. In a free market system, entrepreneurial individuals are encouraged to supply this demand because of the profit they can make in satisfying this demand.
If there are sufficient supply of the product to meet the demand all works well no matter what economic management system is used. However, if the economy lacks sufficient supply to meet demand, the system must find ways to satisfy the need. In a centralized control system, either the government finds additional supply or they ration supply in order to insure there are no shortages. In a free market system, the price goes up which prices some individuals out of the market thus lessoning demand. However, with this increase in prices comes an increase in profits, allowing suppliers to invest in additional supply or production that is more efficient. The increased profit potential also provides incentive for additional suppliers to enter the market (Sowell, 2007). In either case the market price for the product will decrease due to increased supply.
If supply is greater than demand, a surplus occurs. This will result in a decrease in prices and profits that will drive companies to reduce production. This will reduce supply until it reaches a point where it is in line with demand.
The law of supply and demand seems simple enough but there are also external forces (i.e. externalities) that can distort the market and disrupt this supply and demand principle. Examples of these externalities are technology, environment, political climate, war or acts of terrorism, and government intervention.
There are two types of externalities, positive and negative. A positive externality is defined as an unpaid for benefit to the market (Hackett, 2006). For example, the development of the technology of electronic fuel injection doubled the gas mileage of automobiles thus allowing for the more efficient use or petroleum and reductions in pollution.
Hackett (2006) defines negative externalities an uncompensated harm. The oil embargo of the 1970’s is an example of a negative externality. This politically based embargo led to the doubling of oil prices and rationing (e.g. people could only by gas on odd or even days based on whether their license plate number ended in an odd or even number).
An efficient economic system is one that deals with negative externalities while embracing positive externalities. In our studies, we will investigate how each type of economic system manages these externalities. The reader can then decide which system is most efficient.
Beginning with our next study, we will begin looking at the various economic systems in use today. We will look at how they manage supply and demand within their systems. We will also look at how they respond and react to negative externalities as well as how quickly they embrace positive externalities. The reader will then be able to logically decide for themselves which system is best, rather than having to depend on media hype. Armed with this knowledge, my hope is that the reader will be equipped to make better and more intelligent economic decisions and be able to discern the truth from hype and lies.
References
Hackett, S. C. (2006). Environmental and natural resources economics (3rd ed.). London: M.E. Sharpe.
Sowell, T. (2007). Basic economics (3rd ed.). New York: Basic Books.
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