By Jennifer Nicoll Victor, Ph.D., George Mason University
Economics is closely intertwined with politics. Governments set economic policies that affect global markets, employment, wages, working conditions, and other factors about economic livelihoods. In turn, economics affects politics, sometimes in mysterious ways. In United States, though there is a free market system, there are examples of both free markets and controlled practices.
In 1776, the Scottish economist Adam Smith articulated ideas about free market economics in his seminal book, The Wealth of Nations. The work describes the principles behind what has become known as the doctrine of laissez-faire economics—a French term that literally means, “allow to do” or “let it be”. The idea is that if markets for goods and services are left untouched, or unregulated, they will naturally develop an efficient balance or equilibrium. The unseen forces that guide the economy into balance was expressed by Smith as an “invisible hand”.
To better understand the idea of laissez-faire economics, it’s helpful to examine a basic supply and demand graph.
In this graph, the vertical Y-axis represents price and the horizontal X-axis represents quantity. The supply curve represents the incentives of producers and has a positive slope. When prices are low, suppliers have incentives to produce only a few goods. When prices are high, suppliers prefer to produce and sell more goods. The demand curve is opposite. It has a negative slope and represents the incentives of consumers. When the price of products is very high, consumers demand a low quantity. When the price of goods is very low, consumers demand more. The point of intersection between the supply and demand curves represents an equilibrium point.
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Industrial Revolution and Free-market System
Smith’s ideas were compelling and ushered in a new era of liberal economic thinking. But in the 1800s, the Industrial Revolution was in full swing. And with great advances in technology and machinery, the producers of the world had greatly expanded capacity to make goods, and in many cases, lower their costs. As one might expect, the changing technology had real-world implications for the free-market’s ability to find equilibria.
In 1867, the influential German philosopher and economist, Karl Marx, wrote about how the free-market system did not adequately consider the role of workers and that laissez-faire capitalism would lead to their exploitation.
In late-19th and early-20th century America, there were examples of abusive labor practices, 50- or 60-hour work weeks, low wages, dangerous conditions, and even child laborers. According to Marx, the solution to problems like these was for workers to own the means of production, so that there would be a stronger tie between the producers, managers, and entrepreneurs, on the one hand, and the workers who performed the labor to create goods, products, and services, on the other.
Learn more about the early innovators in the U.S. textile industry.
Economic Philosophies of Adam Smith and Karl Marx
To some extent, one can think of the economic philosophies of Adam Smith and Karl Marx as the extreme points along a continuum.
At one end is a purely free-market capitalist system, with no regulation or formal organization. At the other end is a purely socialist system where the collective rights of laborers are favored over an individual’s ability to produce and exchange goods.
In reality, no country in the world has an economic system that is a pure version of either one of these examples.
Adam Smith’s free-market ideas are so well supported by the mathematics behind them, that it might make you wonder why markets don’t work perfectly all the time. It turns out, however, that under some conditions, the invisible hand doesn’t do its magic and equilibrium is not found. This is referred to as market failure.
Why Does a Market Failure Occur?
First, the desire to create public goods imposes particular challenges on societies and markets. When individuals seek to create something to which access cannot be controlled, it’s difficult to get people to contribute toward that thing. In other words, public goods create the conditions for free-riding, which results in collective action problems.
Second, some industries have significant barriers to entry. Often, high start-up costs are a common barrier for a producer trying to enter a market. For example, in a perfect market, a number of airlines at different price points and service levels would be created to meet the market demand. However, an airline is a very expensive company to start, so the barriers to entering the airline market means that there are often insufficient suppliers relative to the demand for the service.
The third source of market failure are sectors that lack sufficient competition between suppliers. This is often referred to as a monopoly. Monopolies form when one or a small handful of producers dominate a particular economic sector. In many industries where monopolies exist, the problem is that a single producer can drive up prices beyond an equilibrium price point.
Learn more about American capitalism.
Other Sources of Market Failure
Fourth, some industries naturally have negative externalities that are a direct consequence of the production of their goods. For example, coal and steel are gigantic industries with huge markets. However, the process of producing them is extremely taxing to the laborers and to the environment. These negative consequences are known as negative externalities and one can think of them as a type of market failure.
The last form of market failure comes from asymmetric information. In some industries, producers and consumers have access to different levels of information about products. When consumers don’t really know how a product was made, what ingredients are inside it, or the price at which other producers are selling a product, then producers have more information about the markets than consumers do. When this happens, it’s impossible for the invisible hand to produce the equilibrium spot.
Common Questions about the US Economic System
The idea behind the doctrine of laissez-faire economics is that if markets for goods and services are left untouched, or unregulated, they will naturally develop an efficient balance or equilibrium.
Adam Smith favoured purely free-market capitalist system, with no regulation or formal organization. On the other hand, Karl Marx supported a purely socialist system where the collective rights of laborers were favored over an individual’s ability to produce and exchange goods.
When sectors lack sufficient competition between suppliers, it is often referred to as a monopoly. Monopolies form when one or a small handful of producers dominate a particular economic sector.