What is a Market Economy?

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, is a system in which economic decisions, such as the prices of goods and services, are determined by supply and demand. 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, at what price the goods should be sold, Et al. The advantages of a market economy include increased efficiency, productivity, and innovation.

In a truly free market, all resources are owned by individuals, and the decisions about how to allocate such resources are made by those individuals rather than governing bodies. Because governments have some involvement, there are no recognized economies that are 100% free.

Key Takeaways

  • A market economy is an economy in which supply and demand drive economic decisions, such as the production of goods and services, investments, pricing, and distribution.
  • A market economy promotes free competition among market participants.
  • Notable benefits of a market economy are increased efficiency, production, and innovation.

Business Efficiency

Unlike other types of economies, a market economy increases the efficiency of businesses. The government is limited in how it regulates transactions within a market economy. Most rules are enacted to protect consumers, the environment, market participants, and national security. Their limited role promotes increased efficiency and free and increased competition. With the existence of competition, a business tends to do whatever is necessary to lower its costs and achieve a higher number of sales to increase profits.

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. When people are motivated to work, there is increased 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.

Innovation for a Competitive Edge

A country with a market economy also has increased innovation. With money as the main motivating factor for firms and individuals, they look to create new products and technologies to generate higher incomes. In a market economy, firms and individuals are encouraged to innovate to gain a competitive edge. This is different than a command economy, where the government controls production, including supply and demand, so there is no reason for companies to compete. Innovation also leads to a variety of goods and services, which provides a wider selection for consumers.