Top 4 Features of a Free Market Economy

The following four points will highlight the four chief features of a free market economy.

Feature 1 # Property Rights:

Property rights are social institutions that govern the ownership, use and disposal of resources, goods and services.

There are different types of property which individuals and firms can privately own:

(1) Real property which includes land, buildings, durable goods such as plant, capital equipment etc.

(2) Financial property which includes shares and bonds, bank deposits, money kept at home.

(3) Intellectual property, which is the latest addition to the list of property, represents the products of creative effort and includes books written, audio and video material, computer programmes.

It is interesting to note here that Bill Gates have become the richest man of the world by possessing intellectual property in the form of computer programmes such as windows, Microsoft Office.

The right of private property is a fundamental feature of a capitalist economy. The right of private property means that productive resources such as land, factories, machinery, mines, etc. are under the private ownership. In other words, an individual has a right to acquire and to use the means of production. Besides, the owner is free to sell or dispose of his property in any way he likes.

Because of this right of private property, goods like land, factories, mines, machinery, houses, and other producer and consumer goods are privately owned by the people. They use these means of produc­tion for their individual benefit. Moreover, the right of private property includes in itself the right of inheritance.

The right of inheritance means that on the death of a person, his sons or daughters or some relatives become the owners of his property. No doubt, there are always some restrictions on the right to private property imposed by the Government for social harmony and benefit.

But, except for some restrictions capitalist economic system tries to protect and enforce the right of private property. The two attributes of property rights, namely, the right of the owner to use the property as he likes and the right to sell it provide incentives to the owners to use their property efficiently.

It is important that government should enforce the property rights. If property rights are not enforced, then the incentives to use the property efficiently is weakened and the potential gain from its efficient use will be lost. Enforcing intellectual property rights is proving to be a big challenge these days in view of the modern technologies that make it relatively easy to copy books, audio and video material and computer programmes.

Feature 2 # Freedom of Private Enterprise:

Allied to the property rights is freedom of enterprise which is another basic feature of a market economy. Freedom of enterprise means that everybody is free to engage in whatever economic activity he pleases. In other words, he is free to choose to work in any industry he likes or adopts any occupation or trade he desires.

More specifically, freedom of enterprise means that an entrepreneur is free to set up any firm or business unit to produce goods or make investment in shares or bonds of corporate sector. True, he may not have enough capital to invest in business or a produc­tive unit like factory or he may not have enough ability or training to follow certain occupations.

But subject to these limitations and to the laws passed by the Government in public interest, an individual or firm is free to engage in any economic activity he feels most desirable or profitable. In India before 1991, there was a system of industrial licensing which restricted the freedom of enterprise. For setting up industrial units in various industries, the private sector firms had to obtain licenses which were not easily available.

Similarly, for procuring necessary raw materials and inputs such as steel, cement, businessmen had to get permits from the government to purchase these products and to get permits businessmen had to bribe the government officials. This license-permit system greatly restricted the freedom of enterprise of the private sector firms. This not only caused allocative inefficiency but also obstructed economic growth of the country.

Under the structural economic reforms initiated in 1991 by Dr. Manmohan Singh who was then Finance Minister .industrial licensing has been largely abolished and the system of permits has been done away with. Grant of licenses to import goods, machines and raw materials has been greatly liberalized and custom duties have been drastically reduced.

As a result, private sector now enjoys greater freedom to invest in industries they think it profitable and diversify their productive capacity by producing multiple products. Abolition of industrial licensing system and liberalization of imports and ending of permit system has tended to promote competition in the Indian economy. The greater competition has helped to keep inflation under check and to achieve higher industrial growth rate.

Feature 3 # Profits and Prices: Incentives and Information:

No individuals would work and save if adequate incentives are not provided to them in the form of wages and interest respectively. Similarly, the firms will not produce goods and services and bear risk of losing money if sufficient incentives are not given to them. Profits are earned from undertak­ing the task of producing goods and services and introducing new products and new techniques of production. Profits earned by the firm depend on prices of goods and services produced and cost incurred.

In a perfectly competitive market firms are price takers, that is they take price of a product or service as given. With a given price, firm’s profits will be larger, if cost per unit of output is smaller. Therefore, in order to maximise profits, firms try to minimise cost for producing a given level of output. Thus profits serve as incentive for the firm to produce efficiently.

The working of price system ensures that those individuals and firms will get goods who are willing and able to pay for them. Prices of goods and services indicate how much money individu­als are prepared to pay for them. In other words, prices convey information to the firms about how individuals value different goods and services.

The goods and resources which are relatively more scarce, will have higher prices in the market. On the other hands, the goods and resources which are relatively less scarce will have low market prices. The profit motive induces firms to respond to the prices of different goods. The firms will earn more profits if they produce goods which people want most efficiently, that is, economies the use of scarce resources and use relatively more those resources which are relatively less scarce in supply.

Thus, by producing efficiently the firms are able to increase profits. It is important to note that for profit motive to be effective the firms must be allowed to keep a good part of the profits earned by them and not taxed away by government. As seen above, this is implied by property rights enjoyed by the firms. Similarly, if incentives to individuals or households have to be provided to work hard and acquire skills and training, they should be permitted to retain a good amount of what they earn from their work or what they receive as a return on their investments.

Importance of Information and Incentives:

It follows from above that for market economies to solve its basic economic problems and work efficiently individuals and firms must have adequate information and have incentives to act on the available information. In market economies it is prices through which individuals and firms get information about the relative scarcity of goods and resources. Relatively more scarce goods and resources tend to have higher prices than the relatively less scarce resources.

Further, in market economies incentives play a crucial role for the working of individuals and firms. Professor Stiglitz, a Nobel laureate in economics writes, “incentives can be viewed as being at the heart of economics. Without incentives, why would individuals go to work in the morning? Who would undertake the risks of bringing out new products? Who would put aside savings for a rainy day?”

Emphasizing the importance of incentives he further writes, “Providing appropriate incentives is a fundamental economic problem. In modem market economies, profits provide incentives for firms to produce the goods individuals want and wages provide incentives for individuals to work, property rights also provide people with important incentives not only to invest and to save but also to put their assets to the best possible use.”

It follows from above that property rights are important features of market economies and play a significant role in their efficient working:

Incentives vs. Inequality:

While incentives play a significant role in market economies for their working efficiently to solve the basic problems of what to produce, how to produce, for whom to produce and how much to invest for bringing about economic growth, but they involve a cost which must be taken into account.

The cost of providing incentives is the inequality in the economy they cause. Any system of incentives must provide compensation to individuals and firms in terms of higher wages, larger profits, higher return on investment for better performance or higher efficiency. If pay for work, return on investment is tied to performance etc. then since performances differ, the compensation for them too will differ and this will bring about inequality in incomes.

This raises the question how much incentives should be given for better performance or higher efficiency so that inequality of incomes is not much higher. Since the greater the incentives given, the greater will be the inequality of incomes, there is incentive -inequality trade-off. If a society provides greater incentives to promote efficiency and growth, there is likely to be more inequality of incomes.

It may be noted that one basic problem facing governments of market economies is to devise a tax system (i.e. kinds of taxes and rates of taxes) that tends to reduce incentives on the one hand but provide revenue to finance welfare programmes for those who have low incomes. Thus, provid­ing incentives to earn higher wages or return and profits encounters serious problem of increasing inequalities of income in a society.

Feature 4 # Competitive Markets:

In ordinary speech the word market means a place where buyers and sellers meet to buy and sell goods. In economics, market has a wider meaning and is interpreted to mean any arrangement that enables buyers and sellers to exchange things; they may contact each other through telephone, fax or direct computer link to negotiate prices of goods they buy and sell. In our above example, rational and self-interested consumers and profit-maximising firms contact each other through any media and buy and sell things on the negotiated price.

The self-interested consumers are interested in low prices of goods they buy and, on the other hand, the profit-maximising firms will be interested in charging a higher price of the goods they produce and offer for sale in the market. However, through their interaction they may agree to buy and sell goods at the agreed price.

In the basic competitive model of a market economy, it is assumed that neither the consumers, nor the firms have any market power to influence the prices of the goods and services they want to buy and sell. In fact, the economists generally assume that perfect competition prevails in the market.

Under perfect competition, there are a large number of firms producing a good and since no one is in a position to influence the price, they take prices of goods as given and constant, that is, each firm is a price taker. Each firm must accept the price prevailing in the market. This prevailing price is determined by the interaction of all firms and buyers.

If a firm in this perfectly competitive market charges a higher than the prevailing price, it will not be able to sell any quantity of the goods because his customers will switch to other firms producing and supplying the same good.

Similarly, in such a perfectly competitive market since each consumer cannot influence the market price, it must accept it as given and make a choice about how much to buy the various goods and services, given his budget constraint and preferences for different goods. Thus, in the basic competi­tive model of a market economy, rational and self-interested consumers and profit-maximising firms interact to determine prices of goods and resources. These prices play a crucial role in determining social choices regarding what, how and for whom to produce.