Market Economy

Updated on January 30, 2024
Article byKhalid Ahmed
Reviewed byDheeraj Vaidya, CFA, FRM

Market Economy Definition

A market economy (ME) refers to a form of economic system where businesses and consumers drive the economy with minimal government intervention. In other words, the laws of demand and supply determine the price and quantity of goods produced in an economy. It encourages entrepreneurship and results in greater production efficiency and consumer satisfaction.

Market Economy

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Market economies are free economies or free marketsFree MarketsA free market refers to an economic system free from government interventions and controlled by privately owned businesses.read more where the extent of state intervention varies from minimum to moderate. Capitalist economies like the US come close to it. It is based on the idea that the profit motiveProfit MotiveProfit motive refers to an entity’s intention that drives the entity to indulge in profit-making activities to achieve financial gain and profit.read more of private businesses in trading would promote competition and innovation among companies and offer greater freedom of choice to consumers. As a result, economic efficiencyEconomic EfficiencyEconomic efficiency in microeconomics refers to the state that manifests optimum resource allocation, the minimum cost for producing goods and services, and maximum outcome.read more improves, benefiting the entire economy.

Key Takeaways

  • A market economy is a system where private individuals and businesses operate the economy on the basis of demand and supply without much state intervention.
  • It increases economic efficiency and provides more independence to both businesses and customers, in turn promoting economic growth.
  • Though the market economy positively impacts a nation’s economy, the profit motive hampers social welfare.
  • There are six major types of markets—perfect competition, monopoly, monopolistic competition, oligopoly, oligopsony, and monopsony.

Market Economy Explained

The Market Economy is a market system where businesses independently produce goods and services based on their demand in the market. In this type of economy, all means of production are under the control and ownership of private entities or individuals. They are free to invest, produce, or trade as per their will without any government interference. Let’s see how it works.

When consumers purchase goods and services, it tells the economy their preferences. So, businesses try to produce more of such goods at the least possible cost to meet the demand. Since the profit motive primarily drives them, they try to charge the highest possible price. However, competition among sellers keeps the prices low.

As a result, the interaction of demand and supply establishes an equilibrium price for goods or services. As evident, consumers and businesses decide the price and the quantum of goods and services produced in such an economy.

Thus, the market forces of supply and demand, rather than the government, drive most of the activities in a Market Economy.  The range of government interference in a market economy differs. A 100% market economy will have no intervention from the government. However, that is possible only in theory. In real life, the government’s role in such an economy is limited to:

  • Providing equal opportunities for trading in the market to all
  • Ensuring applicability of market rules equally
  • Charging taxes on the market, businesses, and individuals for the welfare of people
  • Regulating the market as per government policies

Furthermore, the Market Economy is based on the premise that the more the trade is conducted freely and fairly by individuals and businesses with a profit motive, the more it is beneficial to the nation’s economy.

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Invisible Hand in a Market-Based Economy

As mentioned, the prices of goods or services directly depend on demand and supply. So, the scarcer a good or service is, the higher its demand and price. Therefore, demand and supply form the invisible hand responsible for the sustainability of the trade in the ME.

The concept of the invisible hand in economics was the brainchild of Adam Smith, which assumed that the selfish interest of businesses and individuals would lead to the betterment and sustainment of the economy. Also, without the invisible hand, the trade would collapse as:

  • If the demand for goods or services increases without the rise in supply, the price increases.
  • If an increase in demand does not follow the rise in supply, the price falls.

Hence, the invisible hand forms the backbone of the market-based economy.

Types of Market Economy

In market economies, there are six major types of markets. They are as follows:

#1 – Perfect Competition

Perfect CompetitionPerfect CompetitionPerfect competition is a market in which there are a large number of buyers and sellers, all of whom initiate the buying and selling mechanism. Furthermore, no restrictions apply in such markets, and there is no direct competition. It is assumed that all of the sellers sell identical or homogenous products.read more is an ideal where:

#2 – Monopoly

It is a market system where there is no competition between sellers, and only one seller sells the product to the public.

#3 – Monopolistic Competition

In this case, numerous companies within a certain sector sell similar products that are not identical. As a result, these companies cannot control the prices of the products for their profits.

#4 – Oligopoly

OligopolyOligopolyAn oligopoly in economics refers to a market structure comprising multiple big companies that dominate a particular sector through restrictive trade practices, such as collusion and market sharing. Oligopolists seek to maximize market profits while minimizing market competition through non-price competition and product differentiation. read more market system has a few sellers of some unique products and cooperates with each other to control the market power in unison. As a result, the firms can collectively raise the price to profit.

#5 – Oligopsony

OligopsonyOligopsonyOligopoly is a market structure consisting of a large number of sellers but a few buyers.read more is a market system comprising a few powerful buyers and numerous sellers. It is usually seen in markets for inputs.

#6 – Monopsony

MonopsonyMonopsonyMonopsony is a market condition with a single buyer and multiple sellers. It is an imperfect market condition—the single buyer is the controlling entity. Similar to monopoly, where a single seller dominates and controls product price. In a monopsony, a single buyer determines the factor price. read more is a market with only one buyer and multiple sellers. The buyer controls the market and obtains products at low prices.

Examples

The following market economy examples clarify the concept and applicability of ME to a great extent.

Example #1

The best example of a global market economy is the US. The US has a free market where buyers and sellers fully control the production and pricing. As a result, the supply and demand of a product determine the companies’ investment and manufacturing decisions. Moreover, the government has minimal control over the market; thereby, the demand-supply mechanism promotes the exchange of products and services and protects consumers and sellers alike.

Example #2

Another best example is Great Britain. Great Britain was the front runner of the industrial revolution in the 19th century. Therefore, its economy is completely driven by market forces. It is independent, highly developed, and internationally recognized for pro-market initiatives. There are no government policies affecting or controlling the market in any way. Here the buyers and sellers can make their own business decisions. The market regulations and pricing are due to the demand and supply mechanism. However, of late, politicians are pushing to steer the economy away from the free market system.

Characteristics

The following are some of the unique market economy features:

  • Private ownership of property and business
  • Freedom to consumers and business
  • Selfish motive for profit
  • Rivalry among businesses
  • Miniscule government regulation

 Advantages & Disadvantages

The market economy has its advantages and disadvantages like every other system. Here are some of them.

ME advantages  ME disadvantages
Competition increases efficiency in manufacturing goods and delivering servicesUncertainty and risk for both businesses and individuals 
Innovation thrives  Private entities struggle to provide public services
Market grows to attract foreign businessesDisparity of income arises between rich and poor
Variety of choices available to the consumersEssential goods may become costly
Entrepreneurship increasesInflation may occur
Rate of employment increasesSocial welfare takes a back seat

Frequently Asked Questions (FAQs)

What’s a market economy?

A Market economy is a type of economy driven by the market forces of demand and supply and profit motives of individuals and businesses. The government plays very little role in it. Companies reduce their costs and innovate to increase their profit margin. At the same time, consumers get a lot of choices in product selection and benefit from low prices due to competition among companies.

How do market economies work?

Market economies work on the principle of demand and supply. As long as a product has demand, its supply continues. This interplay of demand and supply determines the price and production in the economy. The interdependence of individuals and businesses on each other for trade creates an ecosystem of the market, with the common denominator of product and goods exchange being money. The market forces invisibly control the market.

Is the US a market economy?

The free market system in the US is an appropriate example of ME. Here, businesses and individuals trade among themselves freely without any government interference. As a result, the demand and supply determine the price of every product here, and the public has a lot of choices in the product for their needs.

This article has been a guide to Market Economy & its Definition. Here we discuss market economy, its types, characteristics, advantages, disadvantages, and examples. You can learn more about accounting from the following articles –

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Comments

  1. John Ayodeji says

    A very good academic and insightful write up

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