The Six Pillars of the Free Market Economic System

Six distinct pillars are required to support a free market economy.  Proper function requires all six.  We will examine each pillar in some detail and will, thereby, begin to build understanding of how free markets work.

Pillar 1:  Private Property   It is essential that the right to own and control private property be well secured.  This is one of the three primary individual rights (life, liberty and property) that people widely agree should be guaranteed.  Without private property, there can be only chaos.  It’s hard to be peaceful if everybody is stealing everybody else’s stuff, so maintaining peace requires respect for private property.

Pillar 2:  Specialization   People must be free to specialize in whatever they do best.  Some may be very good at farming.  Others may be great at making shoes.  People are happiest doing what they like and are skilled at doing; their productivity will be much higher.  Not only can each person spend most of their time doing what they are best at doing, but they can further hone their skill and knowledge, as well as justify making or acquiring specialized tools to further boost productivity.

Pillar 3:  Voluntary Exchange   People must be free to voluntarily exchange goods and services with each other.

Suppose you specialized in farming.  Presumably, you would have lots of food available to you, more than you could consume yourself.  But you would lack all the other things you need.  You would have to trade some of your excess food with other specialists for the things you need that they have produced.  Of course, the same applies to everyone else who would need to trade some of what they produced for food.  When you need a new pair of shoes, you reach an agreement with a cobbler to trade, say, three bushels of corn for a pair of shoes.  Each such transaction is called a voluntary exchange.  Many such trades form a barter economy where various types of goods are swapped for all manner of other goods.

Each and every voluntary exchange is a powerful, almost magical thing that is grossly underappreciated.  As long as the exchange is completely voluntary on both sides, then both parties to the exchange must come out ahead.  Were this not true, the exchange simply would not occur.

Consider that the value of three bushels of corn is less to the farmer than to the cobbler.  Since it is his specialty, the farmer can produce three bushels of corn a lot more easily (at a lower cost) than can the cobbler, plus the farmer has lots of corn while the cobbler has little or none.  On the other hand, the value of a pair of shoes to the cobbler is less than to the farmer for the same complementary reasons.  As long as the value of the shoes to the farmer is higher than the value of his three bushels of corn AND the value of three bushels of corn to the cobbler is higher than the shoes, the exchange will take place; otherwise it will not.  If a voluntary exchange does occur, then it is guaranteed that the wealth of both the farmer and the cobbler has been increased.

Such exchanges must never be forced.  Obviously, it would then no longer be a voluntary exchange, and the guarantee that wealth must increase would be voided.

There is another aspect of the voluntary exchange that needs to be more widely understood and appreciated.  The value that the person on each side of the transaction assigns to the things being exchanged depends upon many complex factors that almost always are unique to the circumstances surrounding each exchange.  Each party to the exchange must make the value determinations themselves.  Specifically, it is just not possible for someone else or an outside entity to assign these values accurately.   This is one important reason (among others) why central planning systems never work well.

Voluntary exchanges (billions and billions of them) are the beating heart of a free market economy.  Some may hesitate to accept that a simple exchange can increase wealth, but it is absolutely true.  Consequently, it would be a good idea to re-read this section until the concept is crystal clear and you are comfortable with it.

Pillar 4:  Price System of Resource Allocation   A price system is one of the things that distinguish a free market economy from a simpler barter economy; it boosts the creation of wealth dramatically by assuring scarce resources are allocated to their highest and best (most productive) use.

In order to function, a price system must have money.  There are three functions that money performs:

1. Provide a convenient medium of exchange – Money needs to be available whenever and wherever you need it.  In the past, that has meant easy to carry around in any reasonable amount, but technology is now in the process of obviating that need.  Money needs to be divisible to a fine enough level so that amounts exactly matching the value of any transaction can be easily transferred.  Money should be durable and difficult to duplicate or counterfeit.  It would also be nice if money were difficult to steal.
2. Act as a standard of value – Just as a meter stick (or a yard stick) measures distance, money should establish a measure of value.  It provides an easy way to compare the values of disparate things such as bushels of corn, pairs of shoes, houses, cows, etc.  The scale on a meter stick is fixed and enables distances to be measured reproducibly and accurately at different places and at different times.  Just as stretchy rubber would not make a good meter stick, something with a varying value calibration does not make good money.  A standard that changes is not a good standard.
3. Provide a mechanism to store value – As a farmer, you harvest your corn in the fall, but you may not need a new pair of shoes at that time.  Money enables you to sell your corn when you harvest it, store its value as money and buy shoes (as well as other things) later whenever you need them.  Thus, the use of money decouples the two ends of a transaction, enables them to happen at different times and also facilitates saving and lending.  Obviously, money’s ability to store value is seriously impaired to the degree that money does not act as a good standard of value.

A currency which performs all three functions well, is called sound money.  A free market economic system needs sound money and its operation will be degraded to the extent that its money is not sound.

Pillar 5:  Market Competition  There must be free and open competition among multiple sellers and multiple buyers for each commodity (a commodity could be either a product or a service).  Sellers compete with each other to sell their products and services at the highest possible price while buyers compete with each other to buy scarce commodities at the lowest possible price.

It is active market competition that always causes the price of each and every commodity to automatically seek what is known as “the market-clearing price.”  At the market-clearing price, the quantity produced is equal to the quantity consumed (purchased).  Supply and demand are in balance.  There will be neither a shortage nor a surplus of a commodity at its market-clearing price.

It is not hard to see how this works.  If there is a shortage of a commodity, competition among buyers will tend to drive prices higher.  Higher prices will reduce the amount purchased and also encourage suppliers to produce more of the commodity.  On the other hand, if there is a surplus, competition among sellers will tend to push prices lower.  Lower prices encourage more purchases while at the same time discouraging production.

At any particular price, there will always be some who place a higher value on the commodity (those are the ones who are willing to buy it).  And there will always be some who place a lower value on that commodity (those are the ones who are willing to sell it).  But the market-clearing price is the best representation of the true value of a commodity in the economy.

Prices are very important signals which regulate market competition and keep everything running as smoothly as possible.  The purpose of a business is to make a profit (we will learn more about why profits are so important in the next lesson).  Prices tell a business what products and services their customers most want and which will be most profitable.  Prices also tell a business what goods and services to buy in the operation of the business to minimize costs and maximize profits.  It is prices which automatically allocate the use of all scarce commodities to the uses which will create the most wealth!

Clearly, it would be a very bad idea to interfere with the important functioning of prices; there are so many things that would be disrupted.  Yet that does happen.

During the early 1970’s, middle-eastern oil producers reduced exports to the U.S.  The reduction in supply was about 5%.  When gasoline prices began to rise, the government ordered a price freeze which prevented prices from adjusting to the market-clearing price.  This very predictably created a shortage, with gas stations running out of product and cars lined up waiting for hours hoping to buy a few gallons.

Contrast that unfortunate episode with another one in the early 2020’s when our own government caused a reduction in domestic oil production.  This time, the government refrained from freezing prices.  Gasoline prices rose significantly to the market-clearing price.  Nobody liked higher gasoline prices, but there were no shortages or cars wasting time (and gasoline!) waiting in lines.  The available quantities of gasoline were smoothly and automatically allocated to the highest and best uses (greatest creation of wealth).

There are other examples of (always counterproductive) interference with prices, such as minimum wage laws (the price of labor).  Don’t mess with prices.  It just causes scarce commodities to be misallocated to less productive uses which reduce the rate of wealth creation.

Pillar 6:  Entrepreneurship  The amazing number of choices of products and services that our economy offers us certainly does not happen by accident.  People have to create them.  Someone has to decide: 1) what goods and services should be produced; 2) how should they be produced; and 3) for whom should they be produced.  Also, and very importantly, such people must be willing to assume the risk of investing money to produce the goods and services with the hope that they can be profitably produced and sold.  If things don’t go as expected their investment could be lost.  Such hardy, creative and valuable people are called “entrepreneurs.”

Without entrepreneurship, nothing happens.  Without entrepreneurship, there can be no free market economy; just as there can be no free market economy without any of the other five pillars.