History of the free market economy

The free market economy describes the economic system where people voluntarily trade with others based on their own interest. A pure free market economy has little government intervention or regulation. In it, individuals and companies are free to trade with each other at will.

The market economy has existed in various forms since human beings began to trade with each other. Free markets emerged as a natural process of social coordination, not unlike language. No intellectual invented voluntary exchange or private property rights; it is likely that these have emerged as a natural consequence of human behavior.

Key ideas

A free market is one where voluntary exchange and supply and demand provide the foundation of the economic system, with very little government intervention.

A key characteristic of free market economies is the absence of coercive transactions or conditions on transactions.

No one invented the free market system; it emerged organically as a social institution for trade and the exchange of goods.

While some free trade purists oppose all forms of government intervention and regulation, certain legal structures such as private property rights, limited liability, and bankruptcy laws have helped stimulate free markets.

How did the free market come about?

Even without money, human beings have engaged in trade with each other. The evidence for this can be traced much further before written history. Trade was initially informal, but economic participants eventually realized that a monetary medium of exchange could help facilitate these beneficial transactions.

The oldest known means of exchange were agricultural goods—such as grain or cattle—probably dating to between 9,000 and 6,000 BC. It wasn’t until around 1000 BC that metallic coins were minted in China and Mesopotamia and became the first known example of a commodity that functioned exclusively as money.

While there is evidence of a banking system in ancient Mesopotamia and Rome, the concept would not emerge again until the 15th century in Europe. This did not occur without significant resistance; the church initially condemned usury. Slowly afterward, merchants and wealthy explorers began to change notions of business and entrepreneurship.

What are the markets

Most markets consist of groups of intermediaries between a first seller of a commodity, good or service and the final buyer. There are all kinds of intermediaries in the markets, from brokers on the big stock exchanges to the trader in a village. They can be simple with no equipment other than a phone, or they can provide storage and perform important services ranging from packing, sorting, and more. In general, the function of a marketplace is to collect products from scarce sources and funnel them to distributed stores. From the seller’s point of view, merchants channel the demand for their product; From the buyer’s point of view, merchants put products within their reach.

There are two main types of markets for products, in which the forces of demand and supply operate quite differently, while overlapping one another in some cases. In the first type, the producer offers his goods and services and takes whatever price buyers are willing to pay him; in the second, the producer sets the price and sells as much as the market wants to take. In addition, with the growth of trade in goods, there has also been a proliferation of financial markets, including stock and money markets.

Next we will see the fundamental pillars of one of the most well-known forms of market: the free market economy.

Pillars of the free market economy

There are two main pillars of the free market economy: voluntary exchange and private property. It is possible for trade to take place without one or the other, but that would not be a market economy, but a command economy.

Private property has existed long before recorded history. However, the arguments in favor of private ownership of the means of production would not occur until the seventeenth and eighteenth centuries.  One of the great defenders of private property was the political philosopher John Locke.

Pure free market economies are extremely rare in the modern world. This is so because almost all states intervene in it through taxes and regulations. Most countries in the world can best be described as mixed economies .

Free market vs capitalism

It is important to distinguish between free markets and capitalism. Capitalism is an organizational system for how goods are produced. In this system, business owners and investors (capitalists) assemble productive resources into a centralized entity, such as a company or corporation.

These business owners own all the tools, machinery, and other resources used in production, and keep most of the profits. At the same time, they hire employees as a labor force and give them salaries in return for their work. Workers do not own any of these tools, such as raw materials, finished products, or profits, they only work for wages.

On the other hand, a free market economy describes how the laws of supply and demand will be affected by the decisions of economic actors. A free market can describe the behavior of consumers in industrial capitalism, but it can also refer to the interactions of merchants in pre-industrial societies.

Historical resistance to market forces

Many historical advances in free market practices have met resistance from existing elites. For example, the market trend towards specialization and division of labor ran counter to the caste system of Feudal Europe. The market met resistance among the aristocracy who opposed freer, skilled workers.

Mass production and factory work were similarly challenged by politically connected guilds. Technological change was famously attacked by the Luddites between 1811 and 1817. Karl Marx believed that the state should take over all private property and the means of production. Consequently, the Luddites viewed machines as enemies because they generated mass unemployment. Marx saw in the market an enemy to defeat since he believed that it inevitably generated exploitation of the workers.

Central authority and government planning have remained the main challenges of the market economy throughout history. In contemporary language, this is presented as a struggle between communism and capitalism. While technical distinctions can be assessed along the lines between these words and their meanings, they represent modern manifestations of the conflict between voluntary markets and government control.

Most contemporary economists agree that free markets are more productive and operate more efficiently than command economies. But even there, there is still considerable debate about the right degree of government intervention and economic freedom.

Corporate opposition to the free market

Although it may seem like a paradox, throughout history large corporations have also been fiercely and decisively opposed to the free market.

The main corporations that have opposed the free market are those that retain monopolies over certain products, through patents or market power, or those that have monopolies over certain jurisdictions and countries. In short, when a company is protected by the state, as in the case of a public company or a government-friendly company, it can prevent the competition from taking away its customers.

Critics of the free market system argue that it does not always tend to work well, and that it requires some government intervention. Monopolies can arise naturally in a market and thus prevent the free market system from working properly.

Who discovered the principles of the market economy?

The study of market economies often goes back to Adam Smith , who described the relationships between producers and consumers in the Wealth of Nations. David Ricardo later formalized a mathematical model of this relationship in Principles of Economics and Taxation. 

What are the characteristics of the market economy?

Market economies are characterized by the existence of private property and voluntary transactions between economic actors. Although there may be some involuntary transactions, such as taxes, producers and consumers in a market economy are primarily free to pursue their own interests.

How does a market economy work?

In a market economy, the allocation of resources is determined by the outcome of many small transactions by thousands of self-interested economic actors. Anytime certain products are in high demand, prices for these products tend to increase, creating financial incentives for producers to increase production. This is known as the law of supply and demand. This system is the opposite of the command economy , where resources and goods are distributed and organized by a central authority.

Criticism of the free market economy

Generally a free market economy should be more efficient than other economic systems. However, critics argue that the free market economy is not always efficient.

First, prices may not fully reflect the costs and benefits of certain products and services, especially the costs to the environment.

Public goods generally receive little investment, are exploited to the detriment of others or future generations, unless such exploitation is prohibited by the state. Second, a free market could tempt competitors to ally themselves, which makes antitrust legislation necessary. Antitrust laws and similar regulations are especially necessary in cases where certain market players, such as companies, acquire too much market power.

Third, transaction costs could mean that some exchanges are conducted hierarchically rather than spot, where payment and delivery take place at the same time. Likewise, the Pareto optimal allocation of resources in a free market could violate the principles of distributive justice and would require government intervention.

In response to these criticisms, economists Ronald Coase, Milton Friedman, Ludwig Von Mises, and Friedrich Hayek, among others, have argued for the need to strengthen markets because “they can be adjusted to internalize presumed market failures in many situations.” . For example, many goods traditionally conceptualized as public goods, and which need to be provided by the government, have been shown to be open to free market contracting. Libertarians are strong advocates of the idea that a free market system provides the best economic system.

Evolution of the free market economy in the 20th and 21st century

While there is no such thing as a pure free market economy in practice, the 20th century has proven to be a hotbed of discussion between free market purists and state interventionists.

Among the economists closest to a kind of free-market purism are Friedrich Hayek , Milton Friedman, and Ludwig Von Mises . And while perspectives close to free market purism have been defended by rulers such as Margaret Thatcher and Ronald Reagan, during the 20th century, great economists also emerged who tried to moderate this position.

Among the economists and thinkers who have helped moderate free market economics positions are John Maynard Keynes , John Hicks, Edmund Phelps, and Paul Samuelson , who have argued for the importance of government action to correct market failures.

In general terms, neo-Keynesian economists have proposed a synthesis between classical free market economics and Keynesian postulates.

After the 2008 economic crisis, economists such as Ben Bernanke , who was also chairman of the Federal Reserve, pushed New Keynesian thinking back . With the bailouts of the big banks, Bernanke showed that the role of the state was crucial in dealing with crises in a free market economy. Again, in the economic crises of 2020, Fed Chairman Jerome Powell attested to the importance of government action in dealing with crises.

Consequently, if the history of the free market economy has shown anything, it is that it cannot be imposed absolutely. The free market has its limitations and flaws. These failures are generally known as market failures or externalities. In order to solve these failures, coordinated action between the state, society and the market is always necessary.

Is the free market an ideology?

While the state has contributed significantly to the construction of markets, with tools such as property rights, armed action to defend markets and corporations, many economists and thinkers consider that the free market is not an organic reality.

Economists like Paul Krugman and Joseph Stiglitz argue that the free market has become an ideology. Stiglitz speaks specifically of market fundamentalists to refer to the staunch defenders of the free market economy. These economists, and others such as Yanis Varoufakis, argue that the free market is a social reality imposed by the elites who benefit from this system.

Thus, the task of political action must be to find the best economic solutions that combine economic freedom (for its benefits) with government control (to limit its failures). This last position is the one defended today by most orthodox economists, even in institutions that were once pro-free market such as the IMF and the World Bank .

In short, today the free market economy is subject to much criticism, although practical benefits are granted. Even so, it is mainly considered an ideology, rather than an organic or natural reality. Similarly, the pure form of free market economy has never been applied and is even considered harmful.

With information from Investopedia and Britannica .