A market economy is a system where the laws of supply and demand direct the production of goods and services. Supply includes natural resources, capital, and labor. Demand includes purchases by consumers, businesses, and the government.
Definition of a Market Economy
A market economy is an economy where private and public ownership of businesses is the norm. Laborers and workers work for these companies. Land, buildings, materials, resources, and money are owned by businesses and consumers.
These entities can conduct business with each other as they see necessary, and consumers can buy and sell at their discretion. Businesses sell their products and services at the highest price consumers will pay. Prices are also determined by competition. If one business sells something for $2.00, a business selling the same item might charge $1.95 to attract more shoppers.
This competition lets people and other businesses look for the lowest prices they can find. Workers promote their skills and services at the highest possible wages they can attract—employers seek to get the most skilled employees at the lowest possible wages.
Market economies offer freedom of choice and enterprise for consumers and businesses.
How a Market Economy Works
For a market economy to work, there must be at least six characteristics present.
Most goods and services are privately owned. Owners can profit from their ownership by selling or leasing property, products, or services.
Freedom of Choice
Owners are free to produce, sell, and purchase goods and services in a competitive market. They only have two factors that are somewhat outside of their control. First, a buyer must be willing to pay the price they set for their goods or services. Second, the amount of capital they have is determined by the costs to produce and sell their goods and the price they can sell them.
Motive of Self-Interest
Most businesses have been created with the interests of the people that started them in mind. A market economy provides opportunity, gives people a chance to work for themselves, and lets them provide for their families in the manner that is best for them.
Self-interest is one of the primary factors behind a successful market economy. Pioneer economist and philosopher Adam Smith (1723 – 1790) wrote that "It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."
Everyone sells their wares to the highest bidder while negotiating the lowest price for their purchases. Although the reason is selfish, it benefits the economy over the long run. It creates an auction system that sets prices for goods and services that reflect their market value. The system also creates an accurate picture of supply and demand at any given moment.
The force of competitive pressure keeps prices low. It also ensures that society provides goods and services more efficiently. As soon as demand increases for a particular item, prices rise thanks to the law of demand.
Competitors see they can enhance their profit by producing the same item, adding to supply. That lowers prices to a level where only the best competitors remain. This competitive pressure also applies to workers and consumers. Employees vie with each other for the highest-paying jobs, and buyers compete for the best product at the lowest price.
A System of Markets and Prices
A market economy relies on an efficient market in which to sell goods and services. A market is said to be efficient when all buyers and sellers have equal access to the same information about prices, supply, and demand. As a result, price changes are pure reflections of the laws of supply and demand. There are five determinants of demand:
- product price
- buyer's income
- prices of related goods
- consumer taste
- buyer's expectations
There are six determinants of supply:
- number of sellers in the market
- level of technology used in production
- amount of regulation, taxes, or subsidies
- the price of other goods
- the expectation of future prices
The determinants of supply and demand are what drives the shifts that occur in the market system.
One of the government's roles is to ensure that the markets are open, working, stable, fair, and safe. For example, the government creates regulatory agencies to ensure that products are safe for use and consumption and that businesses are not taking advantage of consumers.
It also works to ensure that everyone has equal access to the markets. The government penalizes companies that command too much of a piece of the market, known as a monopoly. Regulating agencies work to ensure no one is manipulating the markets and that everyone has equal access to information.
Pros and Cons of a Market Economy
Supply and demand driven by consumers and businesses
Competition encourages efficiency
Innovation is rewarded with profits
Successful businesses invest in each other
Competition leaves out the disadvantaged
Caretakers of the disadvantaged tend to be left behind
Not everyone can realize their full potential
Self-interest tends to rule over concern for the whole
Consumers and businesses drive supply and demand: Since a market economy allows the free interplay of supply and demand, it ensures that the most desired goods and services are produced. Consumers are willing to pay the highest price for the things they want the most. Businesses will only create those things that return a profit.
Competition breeds efficiency: Goods and services are produced in the most efficient way possible. The most productive companies will earn more than less productive ones.
Innovation is rewarded with profits: Creative new products will meet the needs of consumers in better ways than existing goods and services. These cutting-edge technologies will spread to other competitors so they, too, can be more profitable. This sharing of knowledge illustrates why Silicon Valley is America's innovative advantage.
Businesses invest in each other: The most successful businesses invest in other top-notch companies. That gives them a leg up and leads to increased quality of production.
Competition leaves out the disadvantaged: The key mechanism of a market economy is competition. As a result, there is no system to care for those at an inherent competitive disadvantage. That includes older adults, children, and people with mental or physical disabilities that keep them from working.
Caretakers of the disadvantaged tend to be left behind: The caretakers of the disadvantaged are also at a disadvantage. Their energies and skills go toward caretaking, not competing. Many of these people might become contributors to the economy's overall comparative advantage if they weren't caretakers.
Not everyone can realize their full potential: The human resources of society may not be optimized. For example, children in lower-income families often work lower-income jobs to help the family pool resources to survive. If a market economy were concerned about progress rather than self-interest, these children might be afforded more opportunities for education and find a career in a field they are interested in.
Self-interest tends to rule over concern for the whole: Society reflects the values of the winners in the market economy. A market economy may produce private jets for some people while others have no food or place to call home. A society based on a pure market economy must decide whether it should care for the vulnerable.
Society can grant the government a significant role in redistributing resources. That is why many market economies are also mixed economies.
How Does the Constitution Protect the U.S. Market Economy?
The United States is the world's premier market economy. One reason for its success is the U.S. Constitution. It has provisions that facilitate and protect the market economy's six characteristics. Here are the most important:
- Article I, Section 8, protects innovation as property by establishing a copyright clause.
- Article I, Sections 9 and 10, protects free enterprise and freedom of choice by prohibiting states from taxing each other’s goods and services.
- Amendment IV protects private property and limits government powers by protecting people from unreasonable searches and seizures.
- Amendment V protects the ownership of private property. Amendment XIV prohibits the state from taking away property without due process of law.
- Amendments IX and X limit the government's power to interfere in any rights not expressly outlined in the Constitution.
The Preamble of the Constitution includes a goal to ensure the government supports the welfare of everyone. As a result, the government can take a larger role than a market economy might dictate. The government's role in ensuring more people are taken care of led to social programs such as Social Security, food and nutrition services, foster care programs, and Medicare.
- A market economy functions under the laws of supply and demand.
- It is characterized by private ownership, freedom of choice, self-interest, buying and selling platforms, competition, and limited government intervention.
- Competition drives the market economy as it encourages efficiency and innovation.
- Market economies marginalize those that are unable to compete, contributing to income inequality.