Free Market Definition & Impact on the Economy

What Is a Free Market?

The free market is an economic system based on supply and demand with little or no government control. One of the central principles of a free market is the concept of voluntary exchange, which is defined as any transaction in which two parties freely trade goods or services.

Free markets are characterized by a spontaneous and decentralized order of arrangements through which individuals make economic decisions. Based on its political and legal rules, a country's free market economy may range between very large or entirely illegal.

Understanding Free Market

The term “free market” is sometimes used as a synonym for laissez-faire capitalism. When most people discuss the “free market,” they mean an economy with unobstructed competition and only private transactions between buyers and sellers. However, a more inclusive definition should include any voluntary economic activity so long as it is not controlled by coercive central authorities.

Using this description, laissez-faire capitalism and voluntary socialism are each examples of a free market, even though the latter includes common ownership of the means of production. The critical feature is the absence of coercive impositions or restrictions regarding economic activity. Coercion may only take place in a free market by prior mutual agreement in a voluntary contract, such as contractual remedies enforced by tort law.

The Free Market's Connection With Capitalism and Individual Liberty

No modern country operates with completely uninhibited free markets. That said, the most free markets tend to coincide with countries that value private property, capitalism, and individual rights. This makes sense since political systems that shy away from regulations or subsidies for individual behavior necessarily interfere less with voluntary economic transactions. Additionally, free markets are more likely to grow and thrive in a system where property rights are well protected and capitalists have an incentive to pursue profits.

Free Markets and Financial Markets

In free markets, a financial market can develop to facilitate financing needs for those who cannot or do not want to self-finance. For example, some individuals or businesses specialize in acquiring savings by consistently not consuming all of their present wealth. Others specialize in deploying savings in pursuit of entrepreneurial activity, such as starting or expanding a business. These actors can benefit from trading financial securities such as stocks and bonds.

For example, savers can purchase bonds and trade their present savings to entrepreneurs for the promise of future savings plus remuneration, or interest. With stocks, savings are traded for an ownership claim on future earnings. There are no modern examples of purely free financial markets.

Common Constraints on the Free Market

All constraints on the free market use implicit or explicit threats of force. Common examples include: prohibition of specific exchanges, taxation, regulations, mandates on specific terms within an exchange, licensing requirements, fixed exchange rates, competition from publicly provided services, price controls, and quotas on production, purchases of goods, or employee hiring practices.

Common justifications for politically imposed constraints on free markets include consumer safety, fairness between various advantaged or disadvantaged groups in society, and the provision of public goods. Whatever the outward justification, business firms and other interest groups within society often lobby to shape these constraints in their own favor in a phenomenon known as rent-seeking. When free market behavior is regulated, the scope of the free market is curtailed but usually not eliminated entirely, and voluntary exchanges may still take place within the framework of government regulations.

Some exchanges may also take place in violation of government rules and regulations on illegal markets which may be in some ways considered an underground version of the free market. However, market exchange is still heavily constrained because, on an illegal market, competition often takes the form of violent conflict between rival groups of producers or consumers as opposed to free market competition or rent-seeking competition via the political system. As a result, in an illegal market, competitive advantage tends to flow to those who have a relative advantage at violence, so monopolistic or oligopolistic behavior is likely and barriers to entry are high as weaker players are driven out of the market.

Measuring Economic Freedom

In order to study the effects of free markets on the economy, economists have devised several well known indexes of economic freedom. These include the Index of Economic Freedom published by the Heritage Foundation, and the Economic Freedom of the World and Economic Freedom of North America indexes published by the Fraser Institute. These indexes include items such as the security of property rights, the burden of regulation, and openness of financial markets, among many other items. Empirical analysis comparing these indexes to various measures of economic growth, development, and standards of living shows overwhelming evidence of a relationship between free markets and material well being across countries.

The Bottom Line

A free market is one where voluntary exchange and the laws of supply and demand are the basis for the economic system. Crucially, a free market is defined by the absence of government control. While no modern country has a completely free market, those that have relatively free markets tend to value private property, capitalism, and individual liberties.