Using principles & policies of Macroeconomics to explain Pitfalls of Free Market Economy

1. Session: 2014-16
Subject: Macroeconomics-Principles & Policies
Pitfalls of Free Market Economy
SUBMITTED TO: SUBMITTED BY:
Prof. Sayan Banerjee Pritam Pandey (2014205)
Associate Professor Pulkit Mittal (2014210)
IMT Nagpur Rachna Verma (2014214)
Rahul Parate (2014216)
Raj Shekhar (2014217)
Sankalp Jangam (2014252)
Group : 2
Section : D

2. Free
Market
Free to
Set Prices Free to Buy,
Own, Use
and Sell
Private
Property
Free to
Compete
Free to
Earn
Profits
Free to
Create
Capital
Formation
Free
Cooperati
ve and
Peaceful
Process
Free to
Choose
Your
Work
Free to be
an Investor
Free to be
an
Entrepren
eur
INTRODUCTION
Free Market
A market in which there is little or no government control, except to enforce private
contracts and the ownership of property. A completely free market is an form of a market
economy where buyers and sellers are allowed to transact freely based on a mutual agreement
on price without government intervention in the form of taxes, subsidies or any kind of
regulation. It is the opposite of a controlled market, in which the government directly
regulates how goods, services and labour may be used, priced, or distributed, rather than
relying on the market forces. In free market government plays a neutral role in its
administration and legislation of economic activity. Here price is determined by the various
market forces in the market. The characteristics of a free market are-
Laissez-Faire
Laissez-faire proposed an economic theory in 18th
century that says an economic
system should be free from government intervention or moderation, and be driven only by
the market forces. Laissez faire is French word which means "leave alone.” Supporters of
Laissez-faire system believe that there should be no system for minimum wage, duties or any
other restriction. This system is based on following assumptions-
1. Each individual is the basic unit in a society.
2. Every individual has a natural right to freedom.
3. The physical order of nature is self-regulating system and harmonious.

3. 4. Corporations are creatures of the government and therefore must be watched closely
by the citizenry.
The Classical Model: The Case for Laissez-Faire
Classical economists based their
predictions about full employment on a
principle known as Say’s Law. According to
Say’s Law, “Supply creates its own demand.”
In other words, in the process of producing
output, an organization also creates enough
income to ensure that all the output will be sold.
Figure shows that when organization produces
output, it creates income, payments that must be
made to the providers of the various economic
resources. Assume, for example, that firm wants
to produce $100 worth of output to sell to
households. To do that, firm must first acquire the economic resources necessary to produce
those goods and services. The owners of these economic resources are households, and they
expect to be paid—in wages, rent, interest, and profits. Therefore, $100 in income payments
flows to the household sector and if households spend all the income they receive, everything
that was produced will be sold. Supply will have created its own demand. Now question
arises what will happen if people start saving. Saving will lead to reduction in demand. In
such case demand decreases which will disturb the whole cycle. But economists believe that
saving won’t cause any problem as business would borrow all the saved money. And the
amount households wished to save would equal the amount businesses wanted to invest. This
is because of Interest Rate. The interest rate is determined by the demand for and supply of
money. If households desired to save more than investors wanted to borrow, the surplus of
funds would decrease the interest rate. Because the interest rate is both the reward households
receive for saving and the price businesses pay to finance investment, a declining interest rate
would both discourage saving and encourage investment. The interest rate would continue to
fall until the amount that households wanted to save once again equaled the amount
businesses desired to invest. At this equilibrium interest rate there would be no uninvested
savings. Businesses would be able to sell all their output either to consumers or to investors.
Some critics claimed that hording could reduce money supply too as a consequence
spending may reduce and unemployment may appear.
Economist on this claimed that short term
unemployment may appear, but in long term there will
be full employment due to flexible wages and prices.
To illustrate how flexible wages and prices guarantee
full employment, let us assume that the economy is
operating at a price level of 100 and a real GDP of
$1,000 billion. Now, suppose that consumers become
pessimistic about the future and hide some of their

4. income. In this case aggregate demand will fall—the AD curve will shift from AD1 to AD2—
because households are spending less and thus demand decreases at a given price level. A
reduction in aggregate demand leads quickly to falling prices. Wages will also decline
because decrease in the demand for goods and services will be accompanied by falling
demand for labour, which will lead to labour surpluses and wage reductions. Thus, employers
will still be able to make a profit at the lower price level.
While an increase in aggregate demand from AD1 to AD3 would quickly push up
product prices. Due to this business may want to increase its production; if product prices rise
while input prices remain stable, producers can make a profit by expanding output to satisfy
the higher level of demand. But in the classical model, wage rates and other input prices are
also highly flexible, and they would tend to rise because increases in the demand for goods
and services would be accompanied by rising demand for labour and other inputs. Thus,
businesses would have no incentive to expand output. The higher level of aggregate demand
would lead to inflation, leaving output and employment unchanged.
GREAT DEPRESSION
Cause for the Great Depression was not just one reason but instead a combination of
domestic and worldwide conditions that led to the Great Depression. The effects of these
were large across the world. It not only led to the New Deal in America but more
significantly, it was a direct cause of the enhancement of extremism in Germany leading to
World War II.
1. Stock Market Crash
The stock market was crashed on Black Tuesday i.e., on 29 October 1929. It was one
of the major causes that led to the Great Depression in America. Two months after the stock
market crash, stockholders had lost more than $40 billion. Even though, the stock market
began to regain some of its losses by the end of 1930, but it was not enough and America
truly entered into the Great Depression.
2. Bank Failures
In 1930s over 9,000 banks failed. Bank deposits were uninsured, banks had no money
to pay back and thus as banks failed people simply lost their savings. Surviving banks was
unsure of the economic situation and concerned for their own survival, stopped being as
willing to give new loans. This impaired the situation leading to less and less expenditures.
3. Unemployment
Individuals from all classes stopped purchasing items with the stock market crash and
the fears of further economic woes. This then led to a reduction in the number of items
produced and thus a decrease in the workforce. People lost their jobs therefore they were
unable to pay for the items due to which more and more inventory began to accumulate. The
unemployment increased from 3% (1.6 million) to 25% (13 million) which meant, of course,
even less spending to help reduce the economic situation and one out of every four workers
was out of a job.

5. 4. GNP Drops
The U.S. GNP (Gross National Product) between 1928-1932 fell down nearly 50%
from $104 billion to $59 billion. As a consequences of these 90,000 businesses went
bankrupt.
PITFALLS OF FREE MARKET ECONOMY
Individual innovation runs the free market economy and the idea that hard work and
cleverness will be rewarded by success. All businesses exist to make a profit. Therefore, in
the free market system, an entrepreneur draws a margin in a field of competitors. Competition
is an important element of a free market system. Because it is a matter of survival when it
comes to difficult times.
The Great Depression of United State indicated that laissez faire fails and the reasons
for the failure of laissez faire are as follows:
1. Survival of the fittest: A competitive environment creates an atmosphere of survival of
the fittest. This causes many businesses to neglect the safety of the general public to
increase his profits. Like company may produce goods that are in demand but without
regulation that would be harmful to the customers or society as a whole because
businesses want to maximize profits and they might not consider the potentially negative
social impacts of their products. E.g. Pesticide
2. Unequal distribution of Wealth: Due to free market economy, wealth is not distributed
equally. A small percentage of society becomes wealthy while majority lives in poverty
and this gap is increased because it has no mechanism to reduce the disparity between the
peoples.
3. Overproduction of goods:-Since workers are never paid enough to buy back, in their
role as consumers, the ever growing amount of goods that they produce ,in the era of
automation, computerization and robotization, the gap between what workers produce,
can produce and what their low wage allows them to buy has increased considerably.
4. Unused industrial capacity:-Big pill of unsold goods has resulted in a large percentage
of machinery lying idle; people have needs but can't pay for and hence go unmet.
5. Growing unemployment:-Machines and raw materials are available, but using them to
satisfy the needs of the people who don't have the money to pay for what could be made
would not make profits for those who own the machines and raw materials and hence
profit matters.
6. Businesses in the market economy usually employ those which will be profitable and thus
we may find a lot of unemployment as more machines and less labour will be used to cut
cost.

6. 7. Dangers of Profit Motive:-The primary objective for any company in a free market
economy is to make profit. Hence, companies may sacrifice worker safety, environmental
standards and ethical behavior to achieve profits. The early 2000s there were unethical
behavior, rampant at companies such as Enron and WorldCom. The Deep water Horizon
oil spill in 2010, one of the largest environmental disasters in U.S. history, largely
attributable to the use of substandard cement and other cost-cutting measures.
8. Certain goods and services may not be provided: There are certain goods which might
not be provided by the market economy. Those which people might want to use but don’t
want to pay may not be available because the firms may not find it profitable to produce.
For example, public goods like street lighting.
9. Consumption of harmful goods may be encouraged: Free market economy might find
profitable to provide goods which are in demand and ignore the fact that they might be
harmful for the society.
10. Ignore Social cost: In order to maximize profits, businesses might not consider the social
effects of their actions.
11. Unequal distribution of income:-In a free market with very limited government,
benefits will be low, the health service poor and schools under funded. If life starts with
very little, and do not get a good education, then there will be very little protection from
destitution. A command economy might not have the efficiency and the enterprise for the
success to make millions, but at least a strong government will try to make sure that
nobody falls through the safety net. It will be a fairer economy, even though it is likely to
be less successful overall.
12. The environment:-Free market economies may produce more pollution, which is bad for
the environment. Hence command economies can make sure that the production
processes that they chose are as environmentally friendly as possible. They should be able
to make sure that the level of output is the social optimal level of output. Government
may try to force firms into producing the social optimal level of output through the use of
taxes, but those governments with a limited role will not be keen to use taxes. Although
the tax on petrol is high in the UK, it still doesn't cover the problem caused by the exhaust
emission, in health as well as the environment. Petrol prices have risen, but in real terms,
this rise has not been as high as for bus and rail fares. In the USA, petrol is very cheap.
The minimal tax on these good does not begin to cover the environmental damages.
Example: According to a 2003 report by the U.S. Public Interest Research Group
(PIRG), since the cable industry was deregulated in 1996, cable TV rates have
skyrocketed; cable rates increased by more than 50% between 1996 and 2003. Clearly, in
this case of deregulation, increased competition did not reduce prices for consumers.
13. Competition in the marketplace provides the best possible product to the customer at the
best price. When a new product is invented, it usually starts out at a high price, once it is
in the market for a period of time, and other companies begin to copy it, the price goes

7. down as new, similar products emerge. In a competitive market, the poor versions of the
product or the overpriced will be pushed out of the market because consumers will reject
them. And the other parties usually copy the product because they can see the potential
which that product can make from market and if they didn’t copy it the matter of survival
came into existence.
14. The free market system determines the winners and losers in each industry based on the
demands of the customer, whether industrial, business customers, or consumers, people
who buy for personal use.
15. In a free market economy business man takes risk with a hope for better profit. The risk is
considered a disadvantage, when the business don’t succeeds, the profit and control of the
businesses future is determined by the owner, not the government. And if the government
interferes in that process then this will demotivate the others investors to invest and take
risk because they know that at the end government will take charge so what is the
motivation for doing innovation. That is one of the main reasons that in free economy
products such as roads, bridges and street lighting may not be produced because
entrepreneurs may not find it profitable.
16. Free market is promoting individual growth not the overall growth of the society. And
history is evidence that individual growth may end up in the situation of survival because
if other people in society don’t have sufficient amount of funds to buy the product which
industry is making then at the end industry only will suffer losses.
17. Free market economy can fail to provide certain goods and services
e.g. Suppose firm makes good money from selling food crops in free economy but not on
medicines so firm will sell only food crops so in this way many firms fails to provide
necessary goods and services to rest of people because of profit motive.
18. The free market economy encourage the consumption of harmful good
e.g. After analyzing the market responses firm get to know that drug consumption is very
good among particular society and it gives firm good amount of money too, so instead of
teaching people about its causes, now firm will make sure that proper awareness about
availability of drugs should reach among people so that, firm sales will get improve over
a period of time so as firms profits.
19. Factors of production (labour / capital) will be employed if only it's profitable to do
e.g. Suppose there is a organization in a free economy, nobody is there to enforce, so any
restriction on organization, so at that point of time will make sure that all resources
should be properly used and at the time of emergency can retract them otherwise will be
dead soon. So organization will take decisions rashly as long as organization is in profit.

8. 20. The free market economy can have the social effects of production may be ignored
e.g. While selling drugs in the market as a entrepreneur firm didn’t see the another side of
story now firm’s employees also became drug addict as a result firm’s overall
performance of doing business get decreased, and if firm leave that part, living in between
drug addicts may also create depression.
21. The market system allocates more goods and services to those consumers who have
more money than others
e.g. Suppose a firm lend money in free market, and a new opportunity came into picture
so both poor person and rich person approach firm for money so firm gave money to rich
person because I firm knows from their money will come back with interest whereas poor
person looses that opportunity and became more poorer.
22. Lack of Economic Stability: Due to the economy functioning in a free market scenario
where the market is run by demand and supply and there is no government intervention,
therefore production of goods takes place only if it will profit the business. Thus there is
economic instability as the business enterprises indulge in greed and overproduction due
to which the economy swings from robust growth and catalytic recessions.
For example, if an economy functions in a free market economy then their production of
goods will be guided by the demand and supply forces, as they will be interested in
making profits rather than satisfying the customers so in-order to earn profits the
economy will indulge in greed so that they earn profits which will lead to overproduction.
Therefore due to this overproduction if this matches the demand of the customers then it
will benefit the economy and will on the paths of growth but if the demand falls very
short of supply then the will run into losses which in the long run may lead to recession.

9. 23. Exploitation of workers: As said before that in the free market
economy there is over production of goods and services,
therefore for this employees are also required for production.
The employees are made to work much beyond their normal
working hours, longer and harder due to which fewer wages are
given by the owner to them as a result of which profit of the
owner increases as productivity increases and costs are reduced.
The employers due to intense competition find new ways to
reduce wage cost and in turn the exploitation of workers is
intensified.
24. Increase of corruption: Due to economic instability, there is a wide gap in the economy
as rich get richer and poor get poorer due to which there are unfair practices prevalent in
the economy, all want to earn profits therefore business enterprises gets involved in under
the table activities. For example, in the free market economy the business fronts get
involved in all types of unfair practices to get their work done from procurement of
materials to getting business contracts to using all methods possible for increasing profits
which in turn leads to corruption.
25. Distorted investment priorities: As stated above that in a free market economy profits
are more important than public welfare, therefore the policies are made in order to earn
profits and increase wealth than social well-being like public health, public education.
For example, in our country the investment policies are made keeping in mind the public
welfare concerns thus the investment is directed towards infrastructure improvement,
improving public services and serving the customers better. Government as well decides
the various policies keeping in mind the welfare of the public. But on the other hand
countries having free market economy decide on investment policies which are not
aligned with the public welfare.

10. FREE MARKET ECONOMY: ENVIRONMENTAL CONCERN
There are few examples of free market failure that led to some major environmental
issue.
Case 1: Spilling of oil tankers in1989.
The oil industry fought and defeated laws requiring double-hull oil tankers to prevent
spills, even after the single-hulled oil tanker Exxon Valdez spilled 11 million gallons
into Prince William Sound in 1989.
Case 2: Pollution in Cuyahoga River.
The Cuyahoga River in Northeast Ohio was so polluted with industrial waste that it
caught fire several times between 1936 and 1969 before the government ordered a $1.5
billion cleanup.
The critics of a free market system argue that although some aspects of the market
may be self-regulating, other things, such as environmental concerns, require government
intervention.
THE REGULATED ECONOMY: PROS & CONS
Regulation is a rule or law designed to control the behavior of those to whom it
applies. Those who fail to follow these rules are subject to fines and imprisonment and could
have their property or businesses seized.
Advantages:
 Customer safety is considered.
 Health and safety of general public is protected as well as of environment.
 Economic stabilization.
Disadvantages:
 Restricts growth by creating big government bureaucracy.
 Customers have to pay more due to creation of huge monopolies.
 Over regulation squashes innovation part.

11. CONCLUSION
It is imperative to find out delicate balance between an unregulated free market and a
regulated economy. The following example illustrates how U.S. has been keeping a good
balance between two.
The Federal Deposit Insurance Corporation (FDIC) was created to ensure that the
depositors won't lose their deposits even if banks fail by insuring depositors' money after the
great depression. For regulating the stock market the Securities and Exchange
Commission (SEC) was created which ensures honest disclosure on all stock transactions and
fights insider trading.
Banning CFCs prevents the depletion of the ozone layer.
Several ways in which the economy has become out of balance as a result of
deregulation include:
 The deregulation of the savings and loan (S&L) industry in 1982 led to fraud and
abuse, causing the federal government to spend $500 billion to stabilize the industry
after 650 S&Ls went under.
 The meltdown of a nuclear reactor at Three Mile Island, caused due to unskilled
crews released radiation into the air and water. The secretary of state of Pennsylvania,
was fired for voicing his concerns about the lack oversight of the nuclear industry and
the inadequate preparedness of the state to respond to such emergencies.
 The lack of adequate regulation of silicone breast implants led to a situation in which
manufacturers knew that the implants leaked but continued to sell them anyway,
leading to a settlement of $4.75 billion to 60,000 women affected in 1994.
There are no perfect economies neither free market economies nor the regulated
economies. The key lies in striking a balance between free market and the government
intervention required to protect people and the environment. When this balance is achieved,
the public interest is protected and private business flourishes.

12. REFERENCES
 http://www.history.com/topics/great-depression
 http://americanhistory.about.com/od/greatdepression/tp/greatdepression.htm
 http://www.freerepublic.com/focus/f-news/955773/posts
 http://www.quotessays.com/free-economy.html
 http://wps.aw.com/wps/media/objects/11/11640/rohlf_keynes_and_classical.pdf
 http://www.enotes.com/homework-help/what-advantages-disadvantages-free-market-
eco-389689
 http://www.slideshare.net/omermirza/microeconomics-assignment-usama-shehzad-sr-
ii-s