Advantages of a Market Economy

What Is a Market 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.

There are four types of economies: traditional, command, market, and mixed (a combination of a market economy and a planned economy).

Understanding Market Economies

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

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.

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

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, in their limited roles, work to promote this by creating and enforcing legislation that places limits on 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, and achieve 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 motivated to work increase productivity and output for the economy. 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.

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.