The Free Market

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Free Market

1. Why Markets Exist

Markets exist because no one is self-sufficient. None of us produces all we need to satisfy our needs and wants. We purchase shirts, foods, etc. Markets allow us to exchange things we have for the things we want.

Specialization

Instead of being self-sufficient, each of us produces just one or a few products. A nurse specializes in caring for the sick. Marine mechanics specialize in repairing machinery aboard sea crafts. A baker specializes in baking cakes, breads, and cookies.

Specialization is the concentration of the productive efforts of individuals and firms on a limited number of activities. Specialization leads to efficient use of resources, including capital, land, an labor. It is easier to learn one task or a few tasks very well than to learn them all.

Buying and Selling

Because we do not produce everything we need to survive, we need markets to sell what we have and to buy what we want. The typical person earns an income (specializing in a particular job) and uses this income to buy the products that he or she wants to consume.

2. Free Market Economy

Economic systems that are based on voluntary exchanges in markets are called free market economies. In free market economies, businesses and individuals exchange money and products. In this system, individuals and privately owned businesses own the factors of production. They also answer the three economic questions if what to produce, how to produce it, and who consumes it.

Households and Firms

The players in the free market economy are households and firms. A household is a person or group of people living in the same residence. Households own the factors of production - land, labor, and capital. Households are also consumers of goods and services.

A firm is an organization that uses resources to produce a product, which it then sells. Firms transform inputs (factors of production) into outputs (products).

Factor Market Firms purchase factors of production from households. This arena of exchange is called the factor market. Firms purchase or rent land (natural resources). They hire workers, paying them salaries for their labor. They borrow money from households to purchase capital, paying households interest or profits in return. Profit is the financial gain that is maid in a transaction.

Product Market

Goods and services that firms produce are purchased by households in the product market. Households purchase the products made by firms with the money the received from firms in the factor market. The flow between the factor market and the product market is truly circular.

3. Self-regulating Nature of the Marketplace

How do firms and households cooperate to give each other what they want? We live in a competitive society, and it is competition and our own self-interest that keep the marketplace functioning.

Competition

Consumers have the incentive to look for lower prices. Incentive is the hope of reward or the fear of punishment that motivates a person to behave in a certain way. People respond to both positive and negative incentives.

Consumers will respond positively to the incentive of lower prices, because spending less money on something lowers the opportunity cost of the purchase. At the same time, firms seek to make greater profits by increasing sales.

If a shirt manufacture finds that striped shirts are out-selling polka-dotted shirts, the manufacturers will have the incentive to make more striped shirts as they will sell more goods, which earns more profit.

If two manufacturers are selling the same type of shirts, for different prices. The lower price will sell and the higher price will not. In order to keep up with the competition, the first manufacture should also lower their pricing.

The struggle between producers for the dollars of consumers is called competition. Self interest is the motivating force behind the free market, but competition is the regulating force.

Incentives come in two forms. Monetary incentive is a reward that comes in the form of money (salary, profit). Non monetary incentives reward consumers na business in other ways, such as gifts, services, and other goods.

Self-Interest

Adam Smith ws a Scottish social philosopher who in 1776 published a booked titled The Wealth of Nations, in which he described how the market functions. He observed that the economy is made up of countless individual transactions. In each transaction the buyer and seller consider only their self-interest.

Self-interest is a persons own personal gain. Self-interest is the motivating force in the free market.

The Invisible Hand Self-interest spurs consumers to purchase goods and services and firms to produce them. Competition causes more production and moderates firms' quests for higher prices. The effect is that consumers get the product they want at the prices that closely reflect the cost of producing them. This happens without in central plan or direction. Adam Smith called this phenomenon the invisible hand of the marketplace.

4. Advantages of the Free Market Competition and the pursuit of self-interest serve the public interest. The free market on its own, meets many economic goals.

1. Economic Efficiency

Because it is self-regulating, a free market economy responds quickly to rapid changing conditions. Producers make what consumers want when they want it, and generally at prices they are willing to pay.

2. Economic Freedom

Free market economies have the highest degree of economic freedom of any system. This includes freedom of workers to work where they want, firms to produce what they want, and individual to consume what they want.

3. Economic Growth

Competition encourages innovation, free markets encourage growth. Entrepreneurs are always seeking profitable opportunities contributing new ideas and innovations.

4. Additional Goals

Free markets offer a wider variety of goods and services than any other system, because producers have incentives to meet consumer' desires. Consumers, in essence, decide what gets produced. This is called consumer sovereignty.

Despite its advantages, no pure market economy exists on any meaningful scale. The same features that make free markets attractive also represent the weaknesses of the free market. The goals of economic equity and economic security are difficult to achieve in a pure market system.

Centrally Planned Economies

How Is A Centrally Planned Economy Organized

Centrally planned economies operate in direct contrast to free market systems. Centrally planned economies oppose private property, free market pricing, competition, and consumer choice.

In these economies, the government answer the three key economic questions of production and consumption. A central bureaucracy makes all the decisions about what item to produce, how to produce them and who gets them. After gathering information, the bureaucracy tells each firms how much and what to produce.

1. Government Control of Factor Resources and Production In this centrally planned economy, the government owns both land and capital. It owns its labor too, by controlling where individuals work and what wages their are paid. The government decides how much to produce, and how much to charge.

Farmers are told what to plant, how much glass to make, which trucks to use, etc. Competition is absent from the system.

Let's follow the production process for military uniforms and consumer products (sweaters).

The top planners decide that more military uniforms than sweaters will be made. They send this decision to the materials committee.

Knowing how much cotton is available, the materials committee decides how many sweaters and how many military uniforms will be made. The send their decisions to the cotton makers, the button makers, and the elastic makers.

The cotton, buttons, and elastic arrive at sweater factories and uniform factories where they are manufactured into sweaters and uniforms.

2. Socialism and Communism Socialism is a social and political philosophy based on the belief that democratic means should be used to distribute wealth evenly throughout a society. Real equality, socialists argue, can only exist when political equality is coupled with economic equality. Although socialist countries may be democracies, they require a high degree of central planning to achieve economic equality.

Communism is characterized by centrally planned economy with all economic and political power resting in the hands of the central government. Unlike socialists, communists believe that a socialist society can only come about after a violent revolution. While socialists allow democracy, communist nations are authoritarian. Communist nations are always dominated by a controlling party or dictator.

The Former Soviet Union Imperial rule in Russia came to an end when Czar Nicholas II was forced from the throne. A provisional republican government was set up, but by November, it too was toppled. It was taken over by the Bolsheviks, revolutionary socialists led by Vladmir Lenin. Once in power, they renamed themselves communists. Central planning was introduced during the 1920s and continued to operate until the breakup of the Soviet Union in 1991.

In order to build prestige and national power, the Soviet planners allocated the best land, labor, and capital to the armed forces, space program, and production of capital goods such as farming equipment and factories.

Soviet Agriculture

The central government created large, state-owned farms and collectives for most of the country's agricultural production. On these farms, the farmers were provided with all equipment, seed, and fertilizer. Farmers worked daily for wages set by economic planners.

Agricultural workers were guaranteed work, and income. The government established quotas, and distribution. Under these conditions, individuals had few incentives to produce more or better crops. While Russia had been a major exporter of wheat until 1913, before long the Soviet Union could not keep its own people fed.

Soviet Industry

Soviet factories were also state-owned. Planners favored the defense industry, the space program, and heavy industry. The makers of consumer goods and services paid the opportunity cost for this concentration of resources. They were stuck with leftover, lower-quality resources with which to create their products.

Like agriculture, industry was characterized by a lack go incentives. Jobs were guaranteed and wages were set by the government. One the production quota was met, there was no need to produce more goods. Workers had little incentive to work harder or to innovate. It was illegal for workers to exhibit any entrepreneurial behavior and to start their own business.

Soviet Consumers Consumers experience the opportunity cost of central planners' decisions. A joke in the Soviet Union was, "We pretend to work and they pretend to pay us." A worker's wage wages were not worth much because consumer goods were scarce and usually of poor quality. Manufacturers had the incentive to focus on quantity, not quality. The manufacturers who would make suits would loosely stitch buttons and mismatch the jacket and trousers. When they arrived at the store, the owners would have no choice but to accept the quality.