What is Market Economy?

Did you know?

Pro members can track their course progress and get access to exclusive downloads, quizzes and more!

Find out more

Already got an account? Log in here.

Market economy is the free flow of products and services based on the supply and demand in the market.

Adam Smith famously coined the concept of the “invisible hand”, the invisible hand is the force that automatically allocates resources to production based on the demand and supply. The following questions are answered under the market economy:

  • What should be produced? The goods should be produced that has the highest demand.
  • How should you produce? A firm can maximize their profits by improving the quality of the product. In enhancing quality, businesses will be able to charge higher prices.
  • Who should you produce for? Businesses need to manufacture for customers willing to pay for their goods or services.

What is a Market Economy?

Market economies are open economies that allow the free flow of goods and services between producers and consumers based on demand and supply. In a market economy, economic decisions are regulated by the market itself, which will always find a way to re-balance.  

What does that mean? If a price in one industry increases due to higher consumer demand, the labour required to produce higher output increases proportionally. In that way, producers deliver the output that meets consumer demand. In contrast, the competitive forces keep the prices at a moderate level so that consumption increase in the long-term.

Market economies are characterized by:

  • An economic system that relies on demand and supply.
  • The quantity of the products that are produced is determined by the demand and supply.

Types of Economy

There are four types of economies, namely, traditional economy, command economy, market economy and mixed economy. A market economy is a system in which economic decisions are based on the demand and supply in the market. The market determines that goods and services should be produced, how many of the products will be created, and what the price of the goods are.

In a free-market economy, the resources are owned by individuals and the resource allocation are determined by these individuals, not the government. There are no recognized economies in the world that are 100% free-market economies.

Market Theory

Market economies use forces of supply and demand to determine the prices and quantities of goods and services needed in the marketplace. Entrepreneurs produce a product or offer a service to other consumers to buy. Buyers and sellers need to agree on the terms of the transaction based on the consumers’ preference of goods and the price of the product or service.

The allocation of resources across different business and production processes is determined by the profits that entrepreneurs hope to achieve by producing a product or service that a customer will value more than other products. Successful entrepreneurs will be rewarded with earnings that they can reinvest in future business.

Modern Market Economies

Majority of the economies in the modern world is something between a pure market and fully planned market economy. Developed nations usually make use of a mixed economy, they are often a free market that has some sort of government interference. These economies could sometimes be classified as market economies because they allow the market to determine most of the activities the government will only intervene when the market needs to be stabilized.

Government interventions include price-fixing, licensing, quotas and industrial subsidies. Market economies are characterized by decentralized economic decisions that are made by buyers and sellers during everyday business.

Even though the market economy is a popular system, one should consider what amount of government intervention is optimal for efficient economic operations.

Advantages of a Market Economy

The benefits of a market economy include:

  • Resources are automatically allocated to be utilized in the most effective way.
  • Consumers have a wide variety of products to choose from.
  • Innovation is encouraged because of the profit motive and self-interest of the market participants.
  • Competition ensures better quality products, hard-working labour and hence overall high efficiency.
  • The economy offers a high chance of wealth.
  • Products and services are produced based on customer demands and what they are willing to pay.

Disadvantages for a Market Economy

The weaknesses of a market economy include:

  • Damage to the environment – economic activities can damage the environment; the wellbeing of the environment is not the focus in the market economy. Government regulations will have to mandate the safety of the environment.
  • Monopolies – technology breakthroughs can result in monopolies. Monopolies tend to take advantage of consumers
  • The disparity between income and wealth – if the return on capital is higher than the economic growth it will cause an income and wealth disparity. Destabilizing the economy in the long run.
  • Automatic resource allocation – may result in specific not-very-profitable yet vital sectors left-off without enough resources which might have severe consequences over the long-run.
  • Crises prone – for example, the profit motive may result in the adoption of automation and worker exploitation thereby dropping the disposable income and hence reducing consumption and plunging the economy to a recession
  • No government intervention – can lead to manufacturers charging the customers whatever fee they want.
  • Inequality – It faces inequality problems among the citizens.
  • Profit as a motive – As the government is in no control of production, profit is the only the motive of production of goods.
  • Poor working conditions – There might be poor working conditions as there is no government regulation in place.
  • Unemployment – Unemployment may rise as there is no government check in the market.

Market Economy Example

The United States, Germany and Canada are examples of countries with a market economy where the free flow of goods and services facilitates and protects, both producers and consumers. 

  • No governmental control – goods and services are exchanged based on the market supply and demand; the government has no control over it.
  • The supply meets the demand – The products that are produced should be what the consumer wants. The consumer should be willing to pay for the product that they want.
  • Increased profitability – Firms should produce products that clients want, in doing that they will increase their profitability. By increasing their profitability, they will be able to utilize more workers to create more products and realize more income.
  • Innovation – Innovative companies will be able to produce products that consumers want. They will also be able to enhance the production process with new technology and equipment, making the product quality better and increasing customer satisfaction.

Market Economy Conclusion

  • A market economy is an economy that allows the free flow of goods and services based on the interaction of demand and supply.
  • Free competition is promoted between entrepreneurs in the market.
  • The characteristics of a market economy are:
    • The economic system relies on demand and supply.
    • The quantity produced of a good or service is determined by the demand and supply.
  • There are four types of economies, namely, traditional, command, market and mixed economies.
  • Government interventions include price-fixing, licensing, quotas and industrial subsidies.
  • Benefits of a market economy include increased efficiency, production and innovation.
  • Disadvantages include monopolies, no government intervention, poor working conditions and unemployment.