How a Free Market Works

Today most of the modern developed economies are built on the free market principles first introduced by the famous economist Adam Smith. We all have many times heard about the supply-demand model which is always represented by the intersecting curves on the graph. I’ll try to illustrate the main concept of the free market in a bit simpler way not using those graphs.

First let’s understand 2 basic assumptions of the free market economy: the Law of Demand and the Law of Supply.

The Law of Demand states that as the price of a good increases consumer demand for that good will decrease and vice versa. Simply speaking if we used to buy a bottle of beer for 3 USD and one day we observe at some store the same bottle for 5 USD we would hardly buy it. On the other hand if the same beer would be offered to us just for 2 USD we would readily buy a dozen of.

The Law of Supply states that as the price of a good increases, the quantity of goods offered by suppliers increases and vice versa. Here we should think from the supplier or producer standpoint. If your company manufactures a fashionable clothes, you would be interested to have a shop in Milano, where people used to pay well for it, rather than in Mexico where lots of low income population can’t afford an expensive wear. In other words seller always keen to produce and sell more at a higher price to maximize profits.

Bear in mind that both of above laws are valid only if all other factors remain equal. For instance when comparing Milano and Mexico in above example we have apparently ignored the huge difference in the size of population of those two cities.

Once these 2 laws are understood we may switch to the main point of the free market economy – how the price and quantity of goods determined. Let’s take mobile phones for example. Bearing in mind the Law of demand let’s suppose how many phones customers of our market are ready to buy at each particular price:

150$ - 1000 items
140$ - 1500 items
125$ - 2200 items
110$ - 3600 items

At the same time manufacturers are ready to produce and sell at following prices and quantities:

100$ - 850 items
120$ - 1200 items
140$ - 1500 items
150$ - 2000 items

Looking at above two tables we may notice when the volume of production equal to 1500 items both customers and suppliers agree with the price. Such coincidence normally determines the price and the quantity of the product to be sold and bought at the market. Consequently 140$ could be named the market price for mobile phone in our example.

For such market following rules are valid:

Increase in demand leads to the increase of the market price and vice versa.
Increase of supply leads to the decrease of market price and vice versa.

To understand why it works this way, we get back to above case with mobile phones. We have determined that the optimal volume to be produced at that virtual market would be 1500 items with the price equal to 140$ per item. Let’s imagine that at this market demand for mobile phones suddenly rose. That will end up with the situation when all mobile phones are sold out but certain customers still remain unsatisfied. Knowing the desire of seller to sell at a higher prices (Law of Supply) those customers will start to offer more than 140$ for the phone to secure the deal. Thus average market price will go up.

Let’s now take reverse case when demand to phones has fallen or supply has risen what resulted in surplus of phones at the market. In this case suppliers knowing the desire of customer to buy cheaper (Law of Demand) will decrease the price to sell unrealized phones. Thus average market price will go down.

Laws of demand and supply can be depicted on the graph as a curve lines, visually showing how these rules work. Intersection of lines will be the market price. Moving lines inward or outward will demonstrate the increase or decrease of market price.