The Free Market

Monday, December 5th, 2016 and is filed under Uncategorized

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We hear the phrase “the free market” tossed around a lot by folks in politics and economics, but the question remains in a lot of folks’ minds: what IS the free market?

A basic definition of the free market is of a marketplace as free of regulation as possible that enables those who produce goods to interact as freely as possible with those who seek to purchase the sellers’ goods.

What drives this marketplace? Demand.

What drives demand? Either an actual need or the desire simply to have something.

In this marketplace, a perfect price point is met. To find this price point, several things must be considered: the cost to manufacture the item, the margin of profit the seller seeks AND the margin the market will bear based upon what the consumer will pay. That’s pretty much it.

The latter is critical because it drives innovation. Once a price point is met, this doesn’t mean the seller is locked into a certain margin of profit for the rest of his product’s shelf life. It simply means that this is what the market will bear at the time.

How then does a seller increase his margin of profit? By seeking to create less expensive costs of production that enables him to continue to sell the product for the same price by enjoy a larger margin of profit. Some might look at a 5% increase in the margin of profit and think, “Is that worth it?” It depends on the cost associated with the discovery/invention of the more inexpensive cost of production. Let’s assume for a moment that a seller has set the cost to purchase his product at $100. It cost him $75 to make it (production/overhead, etc), which means every time he sells a product, he enjoys a 25% pre-tax profit. If he sells 1,000 products at $100, he grosses $100,000 and nets $25,000.

Let’s now assume that the seller wishes to make more profit on his product. Without improving it, he raises the price by $25. He may enjoy some modest success, but it is likely that a buyer will think, “I used to be able to buy this product for $100 and now it is $125. I think I will look for it somewhere else for $100.” This opens the door for competition, which is one of the prime movers in a free market.

What then can the seller do if he wishes to enjoy more profit if the market rejects his price hike?

Two things. He can take some of his profit and roll it into innovating a more inexpensive way to create his product. If he comes up with a solution that saves him, in the end, 5% on production costs, this means that he can now enjoy a 30% pre-tax profit. Off 1,000 products sold, that’s now a $30,000 pre-tax profit.

His other solution could be that he attempts to improve his product. His initial product, Product A, provided the buyer with A, B and C. With minimal cost on his part, he legitimately creates a slightly better product, Product B that provides the buyer with A, B, C and D, and slaps his hoped for $125 price tag on it.

Will the market bear his new pricing? There is a good chance that it will. Will it bear it for $125? The buyers dictate this. But, if the market does bear it, then the seller has legitimately increased his profit margin by anywhere from 30-50% and his pre-tax earnings rise from $25,000 to potentially $50,000.

What then does an enterprising seller do with his increased profit? More likely than not, he will roll a portion of it into either producing more products that he can then market or he will hire another employee who will ease the burden on him and potentially increase the selling power x2.

So why write this? Because a truly free market approach does not have a government picking winners and losers. It does not slap tariffs on for profit companies looking to produce their product more cheaply.

Instead, a government’s role in the free market is to ensure that one producer does not create a monopoly that crushes innovation AND provides the environment in which businesses can thrive and innovate to produce better and better products in a competitive marketplace.

Who wins in this scenario? The seller and the buyer.

This is how the free market works. It’s that simple.