Free Markets are Efficiency Essay Example | Topics and Well Written Essays - 2500 words

Free Markets are Efficiency - Essay Example In addition, the paper also focuses on the criticism and arguments surrounding the free market concept. The efficiency of free markets surrounds the effectiveness of an economy in the allocation of resources. The efficiency of a free market is dependant on satisfaction of several conditions that permit the agents in that economy to trade freely and attain the market equilibrium in quantity and price. For the purpose of this paper, a free market is one that has negligible government interference, or no such interference (Argelis & Pitelis, 2008: 1). With this in mind, we may define a free market as a market where the agents engage in selling and buying activities on own consent, without any legal compulsion. The prices at which a trade transaction takes place, or the quantities traded are not under control (direct or indirect) of third parties in the market. In essence, this implies that the market operates without legal restrictions or regulations. Simply, a free market is one where buyers decide freely the commodities to buy and their quantities at the prices of the sellers and sellers choose freely the commodities they are willing to manufacture and sell at their price that they decide to sell. The first welfare theorem or the invisible hand proposes that a free market provides a channel through which an economic system is able to reach the ideal level of production. According to Adam Smith in The Wealth of Nations, the different traders, like butchers and brewers, do not offer their services out of benevolence, but with a consideration of their own gains (Chang, 2002:5). Kenneth Arrow and Gerald Debreu later mathematically confirmed this theorem, indicating that in the event that all possible gains are exhausted from the exchange, then the free market attains an equilibrium equivalent to the Pareto efficiency in allocation of resources. In economics, the allocation of resources is Pareto efficient if there is no other feasible allocation preference by one pa rty, and which the other party equally likes, therefore making any further mutual benefiting allocation impossible (Hayek, 1945). For instance, party A and party B engage in a trade exchange. After several exchanges with emphasis on their level of endowment, party A and party B will reach a position on the curve (B and C), which is the Pareto optimal point of resource allocation (Lott, 2007: 82). The curve demonstrates the dual benefits of both parties for both reaching an equilibrium benefit of transfer and guiding the economy towards an outcome that observes the Pareto efficiency. Fig 1: Pareto optimality graph. From http://www.google.com/imgres?imgurl=http://pmbook.ce.cmu.edu/images/fig8_1.gif&imgrefurl=http://pmbook.ce.cmu.edu/08_construction_pricing_and_conctracting.html&usg=__d69xypDoP0EqqL9D0orgPd46Ezw=&h=399&w=404&sz=5&hl=en&start=3&sig2=s1ZXuuc1Dtp3tLmn-opTVA&zoom=1&tbnid=AORY7mH4F1EvoM:&tbnh=122&tbnw=124&ei=uZDpTrifAsqZiQfMnYWyBw&um=1&itbs=1 The Pareto-efficient outcome is only attainable on the certain conditions that are generally not applicable in practice, despite the mathematical proof by Kenneth Arrow and Gerald Debreu (Mankiw, 2009:153). These conditions include, but not limited to, imperfect competition like a monopoly, inevitable provision of public goods, presence of externalities, negligible transaction costs that are difficult to achieve, and social priorities that often favor a particular