The Encyclopedia of Libertarianism

Free-Market Economy

A free-market economy is a complex of voluntary exchange relationships. Some of these relationships are fleeting, as when someone buys a T-shirt from a street vendor, whereas others are more elaborate, as when a company agrees to supply to a customer certain specified cellular telephone services over the course of a year. Common to all voluntary exchanges is each party’s belief that his participation in the exchange will make him better off. This conclusion follows from the fact that all exchanges on free markets are voluntary. Because every person has the right to refuse any offer of exchange, each person accepts only those offers that he believes to be in his interest.

All that is necessary for a free-market economy to exist is security of private property rights and its natural twin: contract law to ensure that exchanges of these rights are truly voluntary. Each owner of each bundle of rights can choose whether, when, and how to use or exchange his property in whatever ways he deems best. The only restriction is that this use or exchange not physically harm others’ properties, nor obstruct others’ equal rights to use their properties as they choose.

Even with no production, the voluntary exchange of property rights means that parties to these exchanges are made better off. But people go beyond simple exchange; they produce. Producers in a free-market economy assemble various inputs into outputs that are then offered to consumers. If consumers willingly purchase some output at a price sufficiently high to enable the producer to cover all of his costs, the producer makes both himself and his customers better off. The world is materially wealthier as a consequence of this production decision.

At first glance, this conclusion might appear odd because there is no centralized decision maker in a free-market economy. Consumption and production decisions are made individually by each property owner according to his own assessment of how his resources can best be used to promote whatever ends he chooses to pursue. It appears intuitive that the results would be chaotic. However, decentralization  of decision making within a regime of private property rights not only does not lead to chaos, but, in fact, generates a coherent and prosperous economic order that would be impossible to achieve otherwise.

The great advantage of the free market is that it maximizes the amount of mutual accommodation at work to satisfy human wants. Mutual accommodation occurs whenever two or more people adjust their actions with respect to each other in ways that make each of them better off. Even if all human wants, resources, and production techniques were unchanging, the immense number of different wants and alternative ways of satisfying these wants implies that no single person or committee could possibly learn all that must be known to direct production as effectively as it is directed by the market. Decision making must be decentralized. Different bits of knowledge from literally millions of people are necessary to produce almost any products found in modern society.

Consider the ordinary pencil. No single person or committee can know what kind of wood is best used for the pencil shaft and where to find the trees that produce this wood and how to make the ax for felling the trees and where to find the graphite used for the pencil’s center and how to build the machines used to extract the graphite from the earth and how to refine the graphite and where to find and how to mix the bauxite and alumina necessary to make the aluminum ferrule that holds the eraser on securely and how to extract the oil from the ground and how to refine it so that it serves as the base of the paint to coat the pencil and how to accomplish all of the other multitude of tasks necessary for the production of a pencil. A few moments of reflection reveal that the amount of knowledge required to produce an ordinary pencil is incomprehensibly vast.

Pencils are produced only because millions of people, each one with highly specialized knowledge of one of these countless different pieces of the process necessary to produce pencils, cooperate in ways that result in their production and sale. This cooperation is directed by market prices, which do a far better job at coordination than could possibly be achieved by a central planner. If, say, pencil retailers initially overestimated the number of pencils demanded by consumers, these retailers will, in the future, purchase fewer pencils from pencil manufacturers. Needing to supply fewer pencils, pencil manufacturers reduce their demands for the inputs used to manufacture pencils. Consequently, the price of each of these inputs falls. These falling prices tell producers of these inputs (paint for the pencil casing, lead-and-graphite shafts for the core, aluminum ferrules, etc.) to produce fewer of these inputs. The production of a larger volume of different inputs for other purposes becomes more attractive.

The price system informs each of the myriad producers along the way to reduce the amount of effort and resources devoted to making parts for pencils (and, hence, to shift this effort toward the production of inputs whose prices have risen relative to those of pencil parts). The Nobel laureate economist F. A. Hayek perceptively explained this communications feature of the price system:

The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol, only the most essential information is passed on only to those concerned. It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system for telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer watches the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.

As essential as this system of decentralized decision making is when wants, resources, and production techniques are static, it is even more essential when these things change. In reality, constant change—change initiated by both consumers and producers—is the norm.

In light of what has so far been said, the reader can easily see that unexpected changes in consumer tastes, resource availability, and production techniques can be accommodated best by relying on people on the spot—each with a direct and personal stake in accommodating those changes—to arrive at ways to best respond to these changes. Relying on political authorities to accommodate these changes would be to rely on people who possess neither sufficient incentive nor the detailed knowledge necessary to respond appropriately.

What isn’t as obvious is the advantageous role played by decentralization in promoting beneficial change. Although the current pattern of resource use might be better than all other known alternatives, the number of possible ways to use resources is so colossal that even the best currently known set of resource uses almost certainly can be improved upon. Israel Kirzner is surely correct to insist that “we live in an open-ended world, in which as yet unseen opportunities always exist for improving human well-being through the discovery of new resources or of new ways of deploying resources productively.”

Discovering these unseen opportunities requires human creativity—creativity to produce heretofore unimagined goods and services, and creativity to devise and execute heretofore unknown means of producing outputs. If all production decisions are required to be made only centrally, by politically selected operatives, the amount of productive creativity at work will be minimal. The reason is that only people on the spot possess a sufficiently specialized knowledge of the myriad nuanced facts surrounding any particular piece of the economic landscape. The intimate familiarity of someone who is “on the spot” is likely to provide him with reliable hints about how that piece of the landscape might be improved. Such hints are reliable because they are the product of deep familiarity borne of specialization. Compared with a centralized decision maker, the on-the-spot person has a greater sense of both the possible (i.e., how the current way of doing things might be improved) and the impossible (i.e., the inevitable limitations pressing on his piece of the economic landscape).

Moreover, when decisions to experiment with new patterns of production are made by owners of private property, each experimenter bears the largest bulk of the costs—and receives a large part of the benefits—of such experiments. Internalizing the costs and benefits of economic experiments on those who actually decide which experiments to undertake and which to avoid is the best possible way of ensuring that we get the experiments necessary to generate progress without, at the same time, suffering waves of experiments that prove to be wasteful.

The great advantage of a free-market economy is that its foundation of private property rights means that decisions on resource use are decentralized; they are in the hands of people on the spot, each with unique knowledge of how best to use his resources to accommodate the wishes of other property rights owners within his purview. The prohibition against anyone coercing or defrauding another into accepting an offered exchange means that the resulting prices and other information generated by market transactions are reliable guides to how resources can effectively be used to satisfy human wants. The spur of profit prompts people not only to adjust to changes in familiar and predictable ways, but also to be alert to creative new ways to use resources. These market signals ensure that the countless instances of on-the-spot mutual accommodation that occur daily in markets coalesce into a vast productive order. If history is a guide, a free-market economy ensures continual improvement in humankind’s material welfare.


Further Readings

Cox, W. Michael, and Richard Alm. Myths of Rich & Poor. New York: Basic Books, 1999.

Hayek, F. A. “The Use of Knowledge in Society.” Individualism and Economic Order. F. A. Hayek, ed. Chicago: University of Chicago Press, 1948. 77–91.

Kirzner, Israel M. How Markets Work. London: Institute of Economic Affairs, 1997.

Lebergott, Stanley. Pursuing Happiness. Princeton, NJ: Princeton University Press, 1993.

Polanyi, Karl. The Great Transformation. New York: Octagon Books, 1975.

Rand, Ayn. Capitalism: The Unknown Ideal. New York: Penguin Putnam, 1986.

Originally published .