Economics Stack Exchange is a question and answer site for those who study, teach, research and apply economics and econometrics. It only takes a minute to sign up.
Sign up to join this community
I am trying to find the distinction between a free market and a perfectly competitive market, and I can't find the right definition on what makes them different. Can someone give me a clearly expressed definition on what makes one different from the other.
Please Note: I am looking for a reference based answer.
Perfectly competitive market: Numerous participants, so that no single participant has any influence.
A perfectly competitive economic model is meant to describe a situation in which there are many participants, and the influence of each one individually is negligible. The state of the economy is thus insensitive to the actions of any single agent; only the aggregate behaviour matters. (Source.)
Free market: Voluntary exchanges; no coercion (in particular, no government coercion).
"Free market” is a summary term for an array of exchanges that take place in society. Each exchange is undertaken as a voluntary agreement between two people or between groups of people represented by agents. (Source.)
Notes:
The Oxford Dictionary definitions provide a good starting point, and align well with how economists generally use these terms. However, as various comments have noted, formal definitions will differ. This will especially be true for "free market", because it is not a technical term in economics.
Perfect Competition: The situation prevailing in a market in which buyers and sellers are so numerous and well informed that all elements of monopoly are absent and the market price of a commodity is beyond the control of individual buyers and sellers.
Free Market: An economic system in which prices are determined by unrestricted competition between privately owned businesses.
For perfect competition, the key feature is that the market price is beyond the control of individual buyers and sellers. The way this is often formally stated is that the elasticity of demand is zero for every individual seller, and the elasticity of supply is zero for every individual buyer.
For the free market definition, the key point is that interactions are unrestricted. That means, for example, no government intervention. Wikipedia and a few other sources suggest that free markets preclude market power. If you take that view, then a free market implies perfect competition since no market power means zero elasticities.
However, most definitions of a free market do not rule our market power. In that case, the presence of any of a host of imperfections (e.g., imperfect information, barriers to entry) can generate market power, and therefore imperfect competition despite interactions being unregulated. The distinction then seems to be the lack of external intervention.
"Free market" is a vague everyday expression and has no formal definition, meaning that you will find it used with different meanings. Therefore it is not possible to "compare" it to the concept of "perfectly competitive market", which has an established formal definition in the Economics discipline, one that can be found in many places. And even when economists want to use a variant of the concept, they clearly spell out which proeprties hold and which not.
Just to list the properties of a perfectly competitive market in a static setting: no barriers to entry, no other costs except for the product price, identical consumers, identical supliers, single homogeneous perishable good, price-taking behavior from all participants, complete perfect and symmetric information (everybody knows everything there is to know and all knowledge is correct). And no government intervening with regulations or taxes.
If I am forgetting something, please edit accordingly.
Definitions taken from the 5th edition (2017) of "A Dictionary of Economics", published by the Oxford University Press:
A market in which people buy and sell voluntarily, without legal compulsion. Neither the quantities traded nor the price at which trade takes place are subject to control by third parties. This is not to say that such markets operate without legal regulation: the participants have to conform to laws concerning health and safety, weights and measures, labelling requirements, and so on. The essential point about these rules, however, is that they lay down the basis for property rights and contract law. The actual initiative to trade still lies with the market participants, on both sides.
An idealized market situation in which all information is known to all market participants, and both buyers and sellers are so numerous that each is a price-taker, able to buy or sell any desired quantity without affecting the market price. It was once thought that these were the assumptions necessary to describe a competitive economy. This is not the case. Provided all market participants have symmetric information (but not necessarily complete information) and act as if they were price-takers, the competitive equilibrium will emerge.
A perfectly competitive market is a special case of a free market. That is, a perfectly competitive market has all the essential characteristics of a free market, but the reverse is not necessarily true.
A free market is one that is free from "outside" interference, either from the government, or from large private sector parties with market power.
In a perfectly competitive market, there are no barriers to entry, all competitors are of equivalent size and power, and there are "many" such competitors. A free market doesn't always have these "guarantees," of competition, only "weaker" conditions such as barriers to entry and differences in size not being factors in restricting the market's freedom.
The key precondition of a perfectly competitive market is the zero (economic) profit condition. That is, all "agents" are earning zero profits after covering the costs of their factors of production. Because there are no surpluses, no one has an incentive to disturb the competitive equilibrium, and no rational agent will. In most free markets (other than a perfectly competitive one), there are economic surpluses to be obtained if someone muddies the waters to their own advantage, which is to say that there is no guarantee that those free markets will remain free.
According to Hayek in his book The Road to Serfdom, coercion is actually neccessary for a free market though of course it’s not seen as such as its part of the legal framework within which the free market operates.
For example, strong regulatory powers of scrutiny and intervention are required to prevent monopolies from forming; and also to break them up when they have formed.
A perfectly competitive market is a mathematical hypothesis used to understand the broad contours of economic theory. It misses out a great deal - for example, questions of assymmetry and power and where these are invested.
