It goes without saying that we want economies to grow.
When economies grow, incomes increase, along with a higher overall standard of living.
It also leads to more innovation, which in turn leads to even more economic growth.
But which economic system leads to the most economic growth? Most economists argue that
market economies do. However, as we will learn in this tutorial, they are far from perfect.
As we learned in the previous tutorial, market economies are economic systems in which production
and prices are determined by unrestricted competition between privately owned businesses
and consumers. When economists talk about markets, they typically are talking specifically about
free markets, and generally promote them as the best way to drive economic growth.
Consumers and producers usually cooperate to give each other what they want.
But why should they cooperate when we live in such a competitive society? According to Adam Smith,
a pioneer in the field of economics who helped develop how we understand the subject today,
competition and our own self-interest actually help to keep the marketplace functioning.
Smith was a Scottish philosopher who noticed that buyers and sellers consider only their
own self-interest, or personal gain, when making deals. In his classic book
The Wealth of Nations, Smith wrote, “It is not from the benevolence of the butcher, the brewer,
or the baker that we expect our dinner, but from their regard to their own interest.”
Smith also observed that people respond in a predictable way to both positive and
negative incentives. Incentives are hopes of a reward or fear of a penalty. For example,
consumers will buy more in response to the positive incentive of lower prices,
or buy less in response to higher prices. Here’s another example. A restaurant realizes it can make
more money if it just sells smoothies instead of a full menu of food, so it stops selling food in
order to make more of a profit. Economists refer to the struggle among producers for the money of
consumers as “competition”. While self-interest is the motivating force behind the free market,
competition is the regulating force. According to Smith, voluntary trade in a free market produces
huge benefits that are far greater than those of a regulated, planned economy. Each free exchange
creates signals about which goods and services are desirable and how difficult they are to bring to
a market. These signals, captured in the price system, lead to the aforementioned competition
that leads to pursuing self-interest. Smith used a metaphor to describe this phenomenon
called The Invisible Hand. He said this Invisible Hand guides all free markets.
Free market economies have four distinct advantages. First, because free markets
are self-regulating, they can respond efficiently to rapidly-changing conditions. Producers attempt
to provide only stuff that consumers want, and at prices consumers are willing to pay.
Second, free market economies have the most economic freedom of any system.
Producers get to produce what they want, and consumers get to buy what they want. Third,
because competition encourages innovation, free market economies encourage economic growth. And
fourth, free market economies end up creating a wider variety of goods and services than any other
economic system because consumers, in essence, have the power to decide what gets produced.
This concept is called consumer sovereignty. As great as free market economies are,
they are not perfect. Here are four distinct disadvantages to free markets.
First, free market economies contain natural monopolies. A monopoly is when a single seller
dominates a market. A natural monopoly is a type of monopoly that happens when extremely high
start-up costs in a specific industry can make it difficult for competitors to enter the industry.
For example, utilities, such as sewer or electricity services, require a huge supply
network that would be economically inefficient, and not worth it for most producers to invest in.
Second, free market economies can lead to fewer public goods and services. Remember, public goods
and services describe products that no one can be prevented from consuming, and anyone who consumes
them can do so without reducing their availability to others. However, in a free market, their
availability is often reduced. So if a society decides that education is a public service,
in other words, everyone deserves it, a free market can’t guarantee that this value is upheld.
Third, free market economies can lead to negative externalities. When there are absolutely no
regulations or restrictions, businesses may try to get away with anything in order to make a profit.
A common example of this is that a business may not care about pollution.
Perhaps it decides that the easiest way to get rid of its waste is by dumping it into a river,
which can be extremely damaging to ecosystems. Finally, free market economies can lead to what
economists refer to as a “race to the bottom.” In other words, as producers attempt to become
as profitable as possible, they often reduce quality and cut corners, in order to make money.
This can lead to things like unsafe working conditions or unsafe products.
As we will learn over the next few tutorials, societies have responded to these disadvantages
of free market economies in various ways. However, governments have had
mixed success in responding to them, and there is a constant struggle for balance
between allowing markets to be free, in order to reap the benefits of a free market, and regulating
markets with government intervention in order to curb the disadvantages. This is a complicated yet
crucial concept to understand, so let’s move forward and learn more about economic systems.