The free market system is where the decision about what is produced is the outcome of millions of separate individual decisions made by consumers, producers and owners of productive services. The decisions reflect private preferences and interests. For the free enterprise to operate there must be a price system/mechanism. The price system is the situation where the vital economic decisions in the economy are reached through the workings of the market price. Thus, everything – houses, labour, food, land etc come to have its market price, and it is through the workings of the market prices that the “What?”, “How?”, and “For whom?” decisions are taken. The free market thus gives rise to what is called Consumer Sovereignty –a situation in which consumers are the ultimate dictators, subject to the level of technology, of the kind and quantity of commodities to be produced. Consumers are said to exercise this power by bidding up the prices of the goods they want most; and suppliers, following the lure of higher prices and profits, produce more of the goods. The features of a free market system are:
(i) Ownership of Means of Production
Individuals are free to own the means of production i.e. land, capital and enjoy incomes from them in the form of rent, interest and profits.
(ii) Freedom of Choice and Enterprise
Entrepreneurs are free to invest in businesses of their choice, produce any product of their choice, workers are free to sell their labour in occupations and industries of their choice; Consumers are free to consume products of their choice.
(iii) Self Interest as the Dominating Motive
Firms aim at maximising their profits, workers aim at maximising their wages, landowners aim at maximising their return from their land, and consumers at maximising their satisfaction
Economic rivalry or competition envisages a situation where, in the market for each commodity, there are a large number of buyers and sellers. It is the forces of total demand and total supply which determine the market price, and each participant, whether buyer or seller, must take this price as given since it’s beyond his or her influence or control.
(v) Reliance on the Price Mechanism
Price mechanism is where the prices are determined on the market by supply and demand, and consumers base their expenditure plans and producers their production plans on market prices. Price mechanism rations the scarce goods and services in that, those who can afford the price will buy and those who cannot afford the price will not pay.
(vi) Limited Role of Government
In these systems, apart from playing its traditional role of providing defence, police service and such infrastructural facilities as roads for public transport, the Government plays a very limited role in directly economic profit making activities.
Resource allocation in a free enterprise
Although there are no central committees organising the allocation of resources, there is supposed to be no chaos but order. The major price and allocation decisions are made in the markets. The market being the process by which the buyers and sellers of a good interact to determine its price and quantity. If more is wanted of any commodity say wheat – a flood of new orders will be placed for it. As the buyers scramble around to buy more wheat, the sellers will raise the price of wheat to ration out a limited supply. And the higher price will cause more wheat to be produced. The reverse will also be true. What is true of the market for commodities is also true for the markets for factors of production such as labour, land and capital inputs. People, by being willing to spend money, signal to producers what it is they wish to be produced. Thus what things will be produced will is determined by the shilling votes of consumers, not every five years at the polls, but every day in their decisions to purchase this item and not that. The “How?” questions is answered because one producer has to compete with others in the market; if that producer can not produce as cheaply as possible then customers will be lost to competitors. Prices are the signals for the appropriate technology. The “for whom?” question is answered by the fact that anyone who has the money and is willing to spend it can receive the goods produced. Who has the money is determined by supply and demand in the markets for factors of production (i.e. land, labour, and capital). These markets determine the wage rates, land rents, interests rates and profits that go to make up people’s incomes. The distribution of income among the population is thus determined by amounts of factors (person-hours, Acres etc) owned and the prices of the factors (wages-rates, land-rents etc).
Advantages of a Free Market System
Incentive: People are encouraged to work hard because opportunities exist for individuals to accumulate high levels of wealth.
Choice: People can spend their money how they want; they can choose to setup their own firm or they can choose for whom they want to work.
Competition: Through competition, less efficient producers are priced out of the market; more efficient producers supply their own products at lower prices for the consumers and use factors of production more efficiently. The factors of production which are no longer needed can be used in production elsewhere. Competition also stimulates new ideas and processes, which again leads to efficient use of resources. A free market also responds well to changes in consumer wishes, that is, it is flexible. Because the decision happen in response to change in the market there is no need to use additional resources to make decisions, record them and check on whether or not they are being carried out. The size of the civil service is reduced.
Disadvantages of a Free Economy
The free market gives rise to certain inefficiencies called market failures i.e. where the market system fails to provide an optimal allocation of resources. These include:
Unequal distribution of wealth: The wealthier members of the society tend to hold most of the economic and political power, while the poorer members have much less influence. There is an unequal distribution of resources and sometimes production concentrates on luxuries i.e. the wants of the rich. This can lead to excessive numbers of luxury goods being produced in the economy. It may also result to social problems like crimes, corruption, etc.
Public goods: These are goods which provide benefits which are not confined to one individual household i.e. possess the characteristic of non-rival consumption and non-exclusion. The price mechanism may therefore not work efficiently to provide these services e.g. defence, education and health services.
Externalities: Since the profit motive is all important to producers, they may ignore social costs production, such as pollution. Alternatively, the market system may not reward producers whose activities have positive or beneficial effects on society. Hardship: Although in theory factors of production such as labour are “mobile” and can be switched from one market to another, in practice this is a major problem and can lead to hardship through unemployment. It also leads to these scarce factors of production being wasted by not using them to fullest advantage.
Wasted or reduced competition: some firms may use expensive advertising campaigns to sell “new” products which are basically the same as may other products currently on sale. Other firms, who control most of the supply of some goods may choose to restrict supply and therefore keep prices artificially high; or, with other suppliers, they may agree on the prices to charge and so price will not be determined by the interaction of supply and demand. The operation of a free market depends upon producers having the confidence that they will be able to sell what they produce. If they see the risk as being unacceptable, they will not employ resources, including labour and the general standard of living of the country will fall..