There are four types of economies: traditional, command, market, and mixed, which is a combination of a market economy and a planned economy. A market economy is a system in which decisions relating to the production, pricing, and consumption of goods and services are determined by supply and demand. This system is also known as a free market or free enterprise economy. Although their governments have some influence, most of the world's largest economies are market economies. Keep reading to learn more about this type of economy and its benefits.
Key Takeaways
- Supply and demand drive economic decisions in a market economy.
- The production of goods and services, investments, pricing, and distribution are in the hands of private enterprises.
- A market economy promotes free competition among market participants.
- Notable benefits of a market economy are increased efficiency, production, and innovation.
- Economic decisions concerning production and pricing rest with a government or other central authority in a command economy.
Understanding Market Economies
The assumption behind a market economy is that supply and demand are the best determinants of an economy's growth and health without any influence from external sources, such as government intervention. These market forces influence:
- The goods that are produced
- Production levels
- The price at which the goods are sold
These factors also influence other economic decisions, such as how many workers companies should employ.
In a truly free market (zero government intervention), all resources are owned by individuals. The decisions about how to allocate their resources are made by those individuals rather than by central governing bodies. This economic theory, known as laissez-faire, asserts that governments should have no hand in business. In this theory, their interventions often lead to market inefficiencies.
Purely free market economies don't exist. That's because governments always have some involvement, so there are no recognized economies that are 100% free. However, a government may be limited in how it regulates transactions within a market economy. Most of the rules it enacts are to protect consumers, the environment, market participants, and national security.
The United States is considered to have a market economy, whereas countries like China and Cuba are mixed economies with more command economy tendencies.
Advantages of a Market Economy
The advantages of a market economy include increased efficiency, productivity, and innovation.
Business Efficiency
Unlike other types of economies, a market economy increases business efficiency and competition. Governments work in their limited roles to promote this by creating and enforcing legislation that limits activities that detract from a competitive environment. They also support business efficiency but regulate how businesses treat consumers and workers to maximize efficiency.
Efficiency is usually measured in terms of costs and profits. High efficiency is typically viewed as low costs and high profits, whereas low efficiency is viewed as high cost and low profits. Competition plays a role in efficiency because it forces businesses to do whatever is necessary to lower costs, control more of the market, andachieve higher sales to increase profits, as long as it is legal.
Increased Productivity
Increased productivity is also associated with a market economy. In any economy, people need money to purchase goods and services. In a market economy, this need leads to increased motivation because workers want to earn more money to supply their needs and to live comfortably.
People who are motivated to work increase productivity and economic output. In a command economy, where a central authority or government sets wages, levels of production, prices, and investments, there is less worker motivation because no matter how much harder they work, they will not see additional monetary benefit.
Innovation for a Competitive Edge
A country's market economy supports increased innovation. Firms and individuals are encouraged to innovate to gain a competitive advantage and increase their market share. With money as a primary motivating factor, companies look to create new products and technologies to generate more revenue, higher incomes, and more profit. Innovation also leads to a greater variety of goods and services, which provides a broader selection for consumers.
It also usually leads to better quality products at lower prices for consumers. Companies are forced to innovate in their processes and end products to stand out. In a highly competitive market such as the U.S., customer demand for quality and satisfaction also drives innovation.
Some of the main disadvantages of market economies include income and resource inequality, high costs, environmental damage (from production/output increases), and failures in the market.
Market Economies vs. Other Economic Systems
Market economies are just one type of economic system. But, there are others, including traditional, command, and mixed systems.
- Traditional Economies: This economic system is also referred to as an old economy. It is characterized by little to no innovation and specialization by laborers. A traditional economy relies on older ways of doing business rather than using modern theories or techniques. Traditional economies often don't rely on technology to produce goods and services. Traditional economies still exist in parts of the world—especially in developing nations, rural areas, and places where access to technology is limited and expensive.
- Command Economies: In this type of economic system, the central government (or other authority) is responsible for determining production levels. It also sets out prices for the goods and services produced. All economic decisions are, therefore, the product of central planning. Purely command economies have no private sector and no competition. Since the government controls production in a command economy, there is no reason for companies to compete. Many communist countries like Cuba and North Korea have command economies.
- Mixed Economies: Mixed economies allow both private enterprise and government influence in the production and prices of goods and services. Government control usually comes in the form of regulations. This allows producers to remain competitive and earn profits while ensuring that a country meets its social goals.
What's a Market Economy?
In a market economy, the forces of supply and demand determine how companies provide products and services to customers and what they provide. Private ownership is at the forefront of such an economy, while government plays a limited role. Companies and their employees are rewarded financially for their efforts.
Does a Market Economy Drive Innovation?
It can. Companies are forced to compete with each other for customers. This increases their need to create new products or services or find a competitive advantage.
Is Capitalism the Same As a Market Economy?
Yes. Capitalism is an economic system in which private companies make decisions concerning producing and distributing goods and services. A government or other central authority does not. Capitalism and a market economy are considered the same thing.
The Bottom Line
A market economy is one in which the allocation of resources and the prices of goods and services are determined by market forces, primarily supply and demand. Market economies have little government intervention, allowing private ownership to determine all business decisions concerning how a business is run. This type of economy leads to greater efficiency, productivity, and innovation.
