A market economy is where economic decisions are made by the free market. That means production of goods and services are regulated by the laws of supply and demand. Producers sell their goods and services at the highest possible price that consumers are willing and able to pay. Workers also bid their services at the highest possible wages that their skills allow.
It is generally thought that any market economy got its start as a traditional or command economy. However, most societies in the modern world have elements of all three, and are therefore mixed economies.
Characteristics of a Market EconomyA market economy is defined by six characteristics:
1. Private Property -- Most goods and services are privately-owned. This allows the owners to make legally binding contracts to buy, sell, lease or rent their property. In other words, their property gives them the right to profit from ownership. However, there are exclusions to what is considered private property. For example, since 1865 the U.S. does not allow you to buy and sell other people, or even yourself. This includes your own body or body parts. (Source: University of Auburn, Market Economy)
2. Freedom of Choice -- Owners, businesses, consumers and workers are free to produce, sell and purchase goods and services in a free market. Their only constraint is the price they are willing to buy or sell for, and the amount of capital they have.
3. Motive of Self-interest -- The market is driven by everyone trying to sell their goods or services to the highest bidder, while at the same time paying the least for the goods and services they need. Although the motive is selfish, it works to the benefit of the economy over the long run. That's because this auction system fairly prices all goods and services, accurately depicting true supply and demand at any given point in time.
4. Competition -- The forces of competitive pressure keeps prices moderate, and ensure that goods and services are provided most efficiently. That's because, as soon as demand increases for a particular item, prices rise thanks to the law of demand. As competitors see there is additional profit to be made, they start production, adding to supply. This lowers prices to a level where only the best competitors remain. This force of competitive pressure also applies to workers, who are competing with each other for the highest-paying jobs, and consumers, who are competing for the best product at the lowest price.
5. System of Markets and Prices -- A market economy is completely dependent on an efficient market in which to sell goods and services. In an efficient market, all buyers and sellers have equal access, and the same information upon which to base their decisions. Prices rise and fall freely depending purely on the laws of supply and demand.
6. Limited Government -- The role of government is simply to ensure that the markets are open and working. For example, it is in charge of national defense so no other country can destroy the markets. It also makes sure that everyone does have equal access to the markets. For example, government exerts penalties on monopolies, which unfairly restrict competition. The government watches to make sure no one is unfairly manipulating those markets, and that all information is distributed equally. (Source: National Council on Economic Education)
Market Economy Advantages
Since a market economy allows the free interplay of supply and demand, it also ensures the most desired goods and services are produced. That's because consumers are willing to pay the highest price for the things they want the most. Businesses will only produce those things that return a profit.
Good and services are produced in the most efficient way possible. The most efficient producers will receive more profit than less efficient ones.
Innovation is rewarded. Producers who are innovative will come up with more efficient methods of production. Innovation of new products will meet the needs of consumers in better ways that existing goods and services. This innovation will spread to other competitors so they, too, can be more profitable.
The businesses and individuals who are most efficient and innovative will accumulate more capital. They can invest this in other efficient and innovative companies, giving them a leg up and leading to an overall higher quality of production. (Source: Harper College, Pure Capitalism and the Market System)
Market Economy Disadvantages
A market economy functions through competition. However, there are many people in a society who are at a natural competitive disadvantage, such as the elderly, children, and mentally or physically challenged people. In addition, the caretakers of those people are also at a disadvantage, because their energies and skills are taken up with caretaking, not competing. Thus, a society based on a pure market economy must decide whether it's in its larger self-interest to set aside resources to make sure they get their needs met, or whether to let them just fall by the wayside.
A market economy rewards those who are good at being competitive. Therefore, the society reflects the values of those people and organizations. This explains why a market economy may produce private jets for some while others starve and are homeless. (Source: Brown University, Louis Putterman, Markets vs Controls)
Market Economy ExamplesThe U.S. is most commonly thought of the world's premier market economy. One reason for its success is the U.S. Constitution, which had many provisions that facilitated and protected the market economy's six characteristics. Here's the most important:
- Article I, Section 8 protects innovation as a 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 others' goods and services.
- Amendment IV protects private property and limits government powers by prohibiting people against unreasonable searches and seizures.
- Amendment V protects the ownership of private property, and Amendment XIV prohibits the state from taking away property without due process of law.
- Amendments IX and X also limit the government's power by reserving all rights not specifically outlined in Constitution automatically to the people.