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, 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.

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.

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 determine 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, and the decisions about how to allocate such resources are made by those individuals rather than governing bodies. This economic theory, known as laissez-faire, believes that governments should have no hand in business and if they do, it most often leads to market inefficiencies. Because governments always have some involvement, there are no recognized economies that are 100% free.

Advantages of a Market Economy

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 and most rules it enacts are to protect consumers, the environment, market participants, and national security. The limited role of governments 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.

Because businesses compete with one another, they must determine ways in which to have 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

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.

The United States is considered to have a market economy, whereas countries like China and Cuba are considered to have a socialist market economy.

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 because no matter how much harder you work, you will not see any additional monetary benefit.

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 from 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.

Competition usually leads to better quality products for consumers at lower prices because companies need to figure out how to attract customers. This allows them to innovate not only in the production of the good or service but also in its quality. Innovation leads to better technology that further improves society.

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 factors, primarily the law of supply and demand. Market economies have little government intervention, allowing private ownership to determine all business decisions based on market factors. This type of economy leads to greater efficiency, productivity, and innovation.