Characteristics of a Free Market (Capitalist) Economy

Characteristics of a Free Market (Capitalist) Economy

In a pure free market economy, the economic questions would be answered by the individual buyers and sellers acting independently in the market place. In order for this system to function, the following principles must be present:

Private Ownership and the Freedom to Buy and Sell.The goods and services must be able to be owned by individuals who are free to buy them or sell them at the best price they can get.

Free Competition.Sellers of goods and services must have the freedom to sell whatever they want for any price. There must be competition between firms in order to keep prices low.

Prices are Set by the Forces of Supply and Demand.The prices of goods are set by how much of a given good is available and how much the consumers want to buy it.

Consumer Sovereignty.The decisions about what a society will produce must be made by consumers. They make these decisions by buying products. Every time a consumer buys something, he/she is voting with money.

Profit Motive.Businesses will try to make as much money as possible. They will only be able to do this by providing the goods and services that the people in the society want and need.Adam Smith, the famous free market economist, called this "the invisible hand" which guides individual businesses to serve the best interests of society by providing the goods and services demanded by the people.

The above ideas were first articulated by Adam Smith. Adam smith was a Scottish philosopher in the 18th century. He wrote a famous book entitled, An Enquiry Into the Nature and Causes of the Wealth of Nations.Adam Smith believed that an economic system worked best if people had the right to choose what they bought and sold. He believed that when people looked out for their own self interest, without government interference, the economy would work itself out to everyone's benefit. Consumers would look for the best possible prices. Producers would look for consumers' needs and for the most efficient methods of production. If people wanted or needed something, somebody would be sure to make it in order to profit. The producer would have to sell it at a reasonable price or nobody would buy it. The consumer would be willing to pay a reasonable price or nobody would make it. Left alone, the desire to make and save money would regulate the economy like an "invisible hand"
Supply and Demand

Prices in a Free Market System

Demand

Demand is the quantity of a good that people want to buy. In general, the higher the price of a good, the less people will want to buy it. The opposite is also true. The lower the price of a good, the more people will want to buy it. The Demand Curve shows the relationship between price and the quantity that is demanded:

Supply

Supply is the amount of a good that producers are willing to make and sell in the market. In general, the higher the price of a good, the more producers will want to make. Producers of products usually do not want to make goods that are selling at relatively low costs. The Supply Curve shows this relationship:

Equilibrium Price

In a free market system, prices are determined by the interaction of supply and demand. The price of a product will tend to adjust itself to a level where the amount demanded and the amount supplied is equal. At this point, the market price is said to be "at equilibrium." In a free market economy, the equilibrium price will constantly adjust itself to changes in supply and demand. In theory, the phenomena of equilibrium prices ensures that in a free marker system:

There are no surpluses.

There are no shortages.

Firms are encouraged to make the goods people want most.

Goods are made available at the cheapest possible price.

The following graph shows where the equilibrium price is:

Supply and Prices

The equilibrium price will change as the level of supply changes. An increase in the total supply of a product is shown by drawing a new supply curve to the right of the old supply curve. By doing this,we can illustrate how when the supply of a good increases, the market sets a new equilibrium price which is lower than the old one. Sellers of the product will tend to shift their prices down to the new equilibrium, for example:

A decrease in supply would have the opposite effect.We wouldillustrate that with a new supply curve to the left of the original supply curve.

Factors Influencing Supply

TechnologyWorker ProductivityWeatherGovernment RegulationPrice of Commodities

Demand and Prices

The equilibrium price will change as the level of demand changes. An increase in the total demand for a product is shown by drawing a new demand curve to the right of the old demand curve. By doing this, we can illustrate how when the demand of a good increases, the market sets a new equilibrium price which is higher than the old one. Sellers of the product will tend to shift their prices up to the new equilibrium, for example:

A decrease in demand would have the opposite effect. We would illustrate that with a new demand curve to the left of the original demand curve.

Factors Influencing Demand

IncomePopulationSubstitutesConsumer TastesFuture Expectations

The Business Cycle

Booms and Busts

A free market economy does not grow at a constant rate. It goes through a series of booms and busts called the business cycle. The following graph illustrates the business cycle:

Explanation

A. The letter A on the graph represents a decline in GDP, sometimes called a recession (defined by economist as 6 months of negative growth) or bust. During a decline, consumer spending decreases as consumers and investors become cautious about the future. This causes factories to slow production and lay off workers. The increased unemployment tends to reduce spending in the marketplace even further, contributing to the economy's decline.

B. The letter B on the map represents the lowest point of the recession and is often referred to as a trough. This is a period of high unemploymentand low prices. Prices have dropped because there is less money being circulated in the economy.

C. The letter C on the map represents a boom, sometimes called prosperity. A boom is a period of prosperity. Most people have jobs. As a result they tend to be buying goods and services. This keeps the economy strong. This period will see the highest levels of inflation as producers try to slowly increase their prices in order to get a bigger share of the thriving market.

D. The letter D on the map represents a depression. A depression is a very big decline that lasts for a relatively long period of time whereas a recession is only a small decline. During a depression, unemployment is very high and there is very little money circulating in the marketplace. A depression is a serious problem for a country. The most famous depression was the Great Depression in the 1930's.

E. The letter E represents a recovery. During a recovery, the economy is improving. As people begin spending more, producers are encouraged to increase production. This means more jobs and, in turn, even more spending. A recovery was the intended effect of Franklin Delano Roosevelt's New Deal in the 1930's

The oil industry is a good example of the business cycle at work. Fluctuating prices for (and production of) oil have occurred since the beginning of the industry (Drake's Oil Well). During the 1930s, the price of oil even fell below the price of water! Nowadays, in Alberta we can see the effect thatchanging oil prices have on our economy. When prices are low, we tend to have higher unemployment and a slower economy. When they rise again, we are able to increase spending at all levels.

When an economy has been prosperous for a long time, raw materials tend to get used up, skilled laborers become scarce, and stockpiles of goods in warehouses increase. This causes some factories to lay off workers. All these factors will eventually work together to cause a recession

Recovery will eventually come during a recession or depression. Sometimes it is caused by new consumer demands. Other times it is the result of inventories finally being used up or debts being paid off. At still other times, the economy gets a boost from the government as a result of increased government spending. This was the case in Canada and the United States when public works programs and World War II brought massive government spending into the economy.

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