Free markets guarantee optimal outcomes in the economy only if these conditions are met:
- Buyers and sellers all have access to the same full and complete information about the good or service in question. This guarantees that both parties will be willing to negotiate without having to worry that the other guy has some secret information.
- Property rights are set up so that the only way buyers can get the good or service in question is by paying sellers for it. This ensures that sellers have an incentive to produce output. As a counterexample, consider trying to sell tickets to an outdoor fireworks display: Because everyone knows that they can see the display for free, nobody wants to pay for a ticket. And with nobody willing to pay for a ticket, producers have no incentive to put on a display.
- Supply curves capture all the production costs associated with making the good or service in question. This requirement helps ensure that markets can make the proper cost-benefit calculations. For instance, if a steel factory can pollute for free, there’s no way that the price of steel will incorporate the damage that the factory’s pollution does to the environment. On the other hand, if the government forces the factory to continuously pay for cleanup costs, these costs will be reflected in the market price, thereby allowing society to properly weigh the costs and benefits of the company’s output.
- Demand curves capture all the benefits derived from the good or service in question. This requirement also ensures proper cost-benefit analysis. If these first four conditions for free markets are met, market forces can reach a social optimum — but only if they’re free from interference. Hence the need for two more conditions: one that limits buyers and sellers, and another that constrains government intervention.
- There are both numerous buyers and numerous sellers, such that nobody is big enough to affect the market price. This is often called the price-taking assumption because everybody just has to take prices as given. This requirement eliminates problems such as monopolies, in which individual buyers or sellers are so powerful that they can manipulate the market price in their own favor.
- The market price is completely free to adjust to equalize supply and demand for the good or service in question. The sixth requirement stipulates that supply and demand must be allowed to freely determine the market price and market quantity unimpeded by government-imposed price ceilings or floors.