Market economy is an economy in which the questions of what to produce, how to produce and for who to produce are guided solely by the invisible hand of market forces of demand and supply without any external intervention.
Market economy is one of the three ways in which a society can organize its economic system, the other being a command economy and a mixed economy.
The most popular proponent of the market economy is Adam Smith, who famously coined the concept of ‘the invisible hard’ which refers to the force that automatically allocates resources to production based on the demand and supply. Under the market economy, the what, how and who are answered as follows:
- What to produce? Goods that generate the highest profit because they have the highest demand.
- How to produce? To maximize the profit by improving quality to be able to charge higher price, reducing costs by adopting more efficient means, etc.
- For whom to produce? For consumers who have liberty to consume whatever they consume.
However, for the market economy to work, there must be no barriers to entry for producers and consumers and there must be many producers and consumers of which no one is big enough to dictate the market price.
In a pure market economy, the extreme case called laissez faire (which literally means let go) economy, the role of government is only to enact and enforce laws and regulations to ensure property rights. In such an economic structure, there is no role whatsoever for government, i.e. there are no regulations, no taxes, no minimum wages, no tariffs, etc.
The major advantages of a market economy include:
- Resources are automatically allocated to their most efficient use because goods which the consumers want are produced.
- The consumers have a wide range of choices of products depending on their preferences and no one dictates them what to study, where to work, when to work, what to consume, etc.
- The profit motive and the self-interest of the market participants encourage innovation which fuels economic growth.
- Competition ensures better quality products (because producers fear loss of customers), hard-working labor (because they fear being laid off if not being productive enough) and hence high efficiency.
Market economy in its pure form hardly exists anywhere, because it is not without its weaknesses which include:
- Many economic activities result in negative externalities such as damage to the environment which is not priced in the market economy automatically and hence government regulation is needed to save environment.
- Breakthroughs in technology have the potential to results monopolies which are in many cases exploitative in absence of effective anti-trust legislation.
- Where the return on capital is higher than the economic growth, it results in increase in income and wealth disparity between different segments of the society which may destabilize the economy in the long-run. This is the point made by Thomas Piketty in his book ‘Capital in the Twenty-First Century’.
- The automatic allocation of resources is a double-edged sword, it may result in certain not-very-profitable yet vital sectors left-off without enough resources which might have serious consequences over the long-run, for example education, health care, etc.
- The system is prone to crises due to several factors, for example, the profit motive may result in adoption of automation and worker exploitation thereby dropping the disposable income and hence reducing consumption and plunging the economy to a recession.