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A market economy is an economic system that allocates scarce resources based on the interaction of market forces of supply and demand. It is an economy that operates by voluntary exchange and is not planned or controlled by a central authority. A market economy, also called a free economy or free enterprise economy, is the conceptual opposite of a command economy, also known as a planned or government-controlled economy, where all goods and services are produced, priced, and distributed under government control. In the twenty-first century a market economy is most often associated with a capitalistic economy.
The market is a process in which individuals interact with one another in pursuit of their separate economic objectives. The basic principle under which the market functions is: If an individual has undisputed ownership of something and wishes to exchange it for another thing that is owned by someone else and the exchange is executed without violence, theft, or deception, then the individual becomes entitled to what the other person was previously entitled and vice-versa. Both parties to an economic transaction in the market benefit from it, provided the transaction is bilaterally voluntary and informed. In this way, through the market process everyone is able to escape coercion at the hands of any one buyer or seller by turning to another. The market prevents one person from interfering with another, allowing a high degree of autonomy. In addition, the society is able to reap the benefits from the division of labor and specialization and function.
The prices that emerge from voluntary transactions, which are motivated by separately self-interested individual behavior, generate a spontaneous order. Many economic theorists argue that these prices coordinate the activity of people in such a way as to make everyone better off. An individual who intends only his or her own gain (profit) by producing goods and services at the same time is satisfying the needs of other people for these goods and services. According to the Scottish economist Adam Smith, individuals pursuing their own self-interest are led as if by an “invisible hand” to behave in a socially desirable way by satisfying people’s needs for goods and services (1976).
The result of the operation of a competitive market, efficient scarcity prices, in the absence of market failure is indispensable to the operation of the market system. Scarcity prices perform three functions in organizing economic activity: first, they transmit information about the divergent preferences of the economic actors; second, they provide an incentive to adopt least cost methods of production; finally, they determine who gets how much of the product. Prices can perform these functions only if the market is able to function freely; that is, able to function without any discretionary intervention, which results in distorting prices producing the undesirable results of shortages, queues, and low quality, as occurred in the Soviet Union. Before the collapse of the government-controlled economy of the Soviet Union, prices were set by the government, not by the market, below equilibrium. As a result, enterprises did not have an incentive to satisfy consumer demand.
Market-based economies require at least limited government intervention, because a market requires appropriate laws and institutions including defined property rights that are respected and enforced and procedures for guaranteeing the execution of contracts. Markets are also characterized by market failure; that is, an allocation of resources that is not efficient. The market is not able to produce public goods (defense, law and order), it is not able to include the social cost or benefits of externalities (environmental pollution, education), and it creates monopolies and oligopolies. The state takes on the responsibility of producing public goods and subsidizing positive externalities funded through taxation, while restricting negative externalities, monopolies, and oligopolies.
- Friedman, Milton, and Rose F 1980. Free to Choose: A Personal Statement. New York: Harcourt Brace Jovanovich.
- Smith, A 1976. An Inquiry into the Nature and Causes of the Wealth of Nations. Oxford: Oxford University Press.
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