There are four types of economies: traditional, command, market, and mixed (a combination of a market economy and a planned economy).
A market economy, also known as a free market or free enterprise economy, is a system in which economic decisions, relating to things such as the prices of goods and services, are determined by supply and demand.
Command economies, on the other hand, utilize central planning by a central authority to make all economic decisions.
- In a market economy, supply and demand drive economic decisions.
- The production of goods and services, investments, pricing, and distribution are in the hands of private enterprises.
- In a command economy, economic decisions concerning production and pricing rest with a central authority, such as a government.
- A market economy promotes free competition among market participants.
- Notable benefits of a market economy are increased efficiency, production, and innovation.
What Is a Market Economy?
The assumption behind a market economy is that supply and demand are the best determinants for an economy's growth and health. These market forces influence what goods should be produced, how many goods should be produced, and at what price the goods should be sold.
These factors also influence other economic decisions, such as how many individuals companies should employ. The advantages of a market economy include increased efficiency, productivity, and innovation.
In a truly free market, 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. If they do, their interventions often lead to market inefficiencies.
The fact is, governments always have some involvement so there are no recognized economies that are 100% free. However, government is 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.
Advantages of a Market Economy
Unlike other types of economies, a market economy increases the efficiency of businesses. Governments, in their limited roles, promote increased efficiency and free and increased competition.
In the face of competition, a business tends to do whatever is necessary to lower its costs and achieve a higher number of sales to increase profits.
Competition forces businesses to find ways to achieve a competitive advantage so that they can capture a larger market share for their product or service. This leads them to figure out how to reduce costs, improve their product, and so on in order to capture that extra market share.
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 motivated to work increase productivity and output for the economy. In a command economy, where wages, levels of production, prices, and investments are set by a central authority or government, there is less worker motivation because no matter how much harder they work, they will not see additional monetary benefit.
The United States is considered to have a market economy, whereas countries like China and Cuba are considered to have economic systems more like a command economy.
Innovation for a Competitive Edge
A country's market economy supports increased innovation. Firms and individuals are encouraged to innovate to gain a competitive edge. With money as a main motivating factor, companies look to create new products and technologies to generate more revenue and higher incomes. Innovation also leads to a greater variety of goods and services, which provides a wider selection for consumers.
In a command economy, the government controls production, including supply and demand, so there is no reason for companies to compete.
Competition usually leads to better quality products at lower prices for consumers. To stand out from the competition, companies innovate not only the ways of production but also to improve product quality. Innovation leads to better technology that can provide benefits to a society at large.
What's a Market Economy?
A market economy is one in which the forces of supply and demand determine the course of actions that companies take to provide products and services to customers and earn profits. Private ownership is in the forefront of such an economy while government plays a limited role. Companies and their employees are rewarded financially for their efforts.
This differs from a command economy where a central authority imposes its economic decisions on businesses.
Does a Market Economy Drive Innovation?
It can. Businesses and the people who work for them can be rewarded with additional income and other benefits for their work efforts in a market economy. Therefore, companies compete to create products and services that consumers will want to buy. In turn, this drives innovation in various forms.
Is Capitalism the Same as a Market Economy?
Yes. Capitalism is an economic system in which private companies make the decisions concerning the production and distribution of 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.