When do “free” markets work well?

Today’s post is about free markets and when they work well. There’s a lot of debate about when we should let markets operate freely and when the government should step in and regulate. I think part of the controversy comes from people seeing this as a binary choice-either we always want free markets, or we never do. But the reality is more nuanced. There’s a set of conditions that must hold for a market to work well without government intervention.

Let’s start with what it means for a market to work well. Economists define this as maximizing the total benefit that society gets from the market. Notice, this definition says nothing about fairness or who benefits more-just about making the biggest economic pie possible. In economics, this is called efficiency.

But what if we don’t like how the benefits are distributed? There’s another economic principle that says instead of distorting the market, we should redistribute the resources that people have, like through a wealth text. That can be tricky in practice, and I’ll try to cover it in a future video, but for now, the key idea is that we want to fix fairness without shrinking the total pie.

So, what has to be true for a free market to work efficiently? Economists point to five key conditions, called competitive market assumptions.

First, the production and consumption of the good can’t directly affect anyone else.
For example, a coal-fired power plant without pollution controls violates this condition because the pollution harms people who aren’t involved in the transaction.

Second, firms and buyers must be “price takers.” This means no single firm can raise its price without losing all its customers. But in many real-world markets, firms do have some power to set prices. Companies like Apple, Google, and Meta, for instance, can raise prices and still keep plenty of customers-that’s called market power.

Third, firms must maximize profits, and consumers must maximize their well-being. At first, this might sound technical, but it’s fundamental. If businesses are making decisions based on things other than profits-like keeping inefficient factories open for political reasons-or if consumers are making choices that don’t align with their own best interests, the market outcome won’t be efficient.

Fourth, firms and consumers must know the market price and understand the product perfectly. If buyers can’t judge a product’s quality, markets can break down. For example, if used car buyers can’t tell the difference between a well-maintained car and a lemon, sellers of good cars may leave the market, making things worse for everyone.

Finally, there can’t be transactions costs-where buyers pay more than sellers receive. In reality, buying and selling often involve extra costs. For example, when you convert dollars to euros, you won’t get the exact market rate-the exchange service takes a cut. Or if you sell something on eBay, you don’t get to keep the full price because eBay will charge you a fee.

At this point, you might be thinking, “This sounds impossible! Is there any market where all these conditions hold?” And you’d be right-there really aren’t. But some markets come close. Simple agricultural commodities, like corn and soybeans, are good examples. A bushel of corn is a bushel of corn, and no single farmer controls the price. But even in agriculture, pollution from fertilizers and pesticides violates the first condition.

So where does this leave us? I like to think of perfect competition as a useful benchmark for evaluating real-world markets. The closer a market comes to meeting these five conditions, the better it will function in terms of maximizing total benefits. And because economists have studied what happens when each condition is violated, we can design targeted policies to fix specific market failures.

So the bottom line is this: Don’t think of markets in black-and-white terms. Instead, think of them in terms of how close they are to perfect competition. That’s admittedly more complicated — but also much more useful. And in future blog posts, I’ll break down different types of market failures and what we can do about them.

Originally published at https://mytwocentsandcounting.substack.com.