U.S. ECONOMY > An Overview of the U.S. Economy > What is a Market Economy?

What is a Market Economy?

By Michael Watts

Introduction
Command and Market Economies
Consumers in a Market Economy
Business in a Market Economy
Workers in a Market Economy
A System of Markets
Finances in a Market Economy
Government in a Market Economy

COMMAND AND MARKET ECONOMIES

Products such as bread, meat, clothing, refrigerators, and houses are produced and sold in virtually every country of the world today. The production methods and resources used to make these products are often very similar in different countries -- bread, for example, is made by bakers using flour and water, often with salt, sugar, and yeast added, then baked in ovens. Once the bread has been baked, the loaves are sold to consumers in stores that, at least superficially, can look very much alike, even in countries with very different kinds of economic systems.

Command Decisions About Clothing

Despite those apparent similarities, if we compare such market economies as those of North America, Western Europe, and Japan to the command economies found in the former Soviet Union, Eastern Europe, and parts of Asia over the past half century, the processes used to determine what products to make, how to make them, what prices to charge for them, and who will consume them are starkly different. To see those differences more clearly, consider how production and sales decisions are made in the two kinds of systems for a specific kind of product, say shirts and blouses.

In command economies, government committees of economic planners, production experts, and political officials establish production levels for these goods and designate which factories will produce them. The central planning committees also establish the prices for the shirts and blouses, as well as the wages for the workers who make them. It is this set of central decisions that determines the quantity, variety, and prices of clothing and other products.

Predictably, the products from this limited number of choices sell out quickly, disappearing from store shelves. Why? Because factories failed to meet their production quotas, perhaps, or because the central planning group underestimated how many shirts people want to buy at the prices they set. In either case, unless the planners take steps to increase production, raise prices, or both, the shortages will continue.

As the number of people living in the command economies increases, along with the number and sophistication of new products, it becomes harder and harder for central planners to avoid or eliminate shortages of the many things consumers want -- or surpluses of the products they don't. With more products, more people, and rapidly changing production technologies, the central planners face an explosion in the number of decisions they have to make, and in the number of places and ways where something could go wrong in their overall plan for the national economy.

This phenomenon doesn't happen in the market economies, because that kind of economic system works in a very different way. To begin with, no government ministry decides how many shirts or blouses to manufacture, or what styles and colors. Anyone -- individual or company -- can decide to produce and sell shirts and blouses in a market economy, and many will do just that if they believe they can sell these products at prices high enough to cover their production costs -- and earn more making such clothing than they can doing something else. This leads to direct competition between different firms making and selling these products, and that competition is one of the basic reasons why there are generally so many different styles, fabrics, and brands of clothing for consumers to choose from in market economies.

Of course, if consumers decide to buy just one kind of shirt and blouse month after month and year after year, producers would soon learn that there was no reason to produce any other kind. But that simply hasn't happened where people are allowed to choose from a wide selection of clothing products.

The Price of Shirts

Another key point about market economies is that the prices for shirts, blouses, and other products sold in stores aren't set by a government planning committee. Instead, every seller is free to raise or lower prices according to changing market conditions. For example, if one kind of shirt becomes very popular for a time, and stores are worried about running out until they can get more, the price of such shirts will usually rise, at least until new shipments arrive. This price increase accomplishes two things at the same time: first, by making this kind of shirt more expensive compared to other shirts and products, some consumers will choose to buy fewer of them and more of other items. Second, because the higher price goes directly to those who produce and sell the shirts -- not the government -- the higher price increases the profits of firms that make and sell this shirt, enabling them to produce and sell more units. Firms that make other products also see those higher profits going to the shirt producers, which leads some firms to stop making something else and start making those popular shirts.

For all of these reasons -- consumers buying fewer shirts, current shirtmakers producing more shirts, and other firms deciding to begin making shirts -- any shortage will soon be eliminated. Notice that it doesn't take a central planning committee to make any of these decisions. In fact, the process happens faster, and in some sense automatically, precisely because consumer and producer decisions are decentralized.

Markets

The higher prices for shirts give every consumer and producer incentives to respond this way, because they are allowed to reap the benefits of their own decisions, while also bearing the associated costs and risks. For example, consumers willing to pay the higher prices can still get the most popular shirts, but they have to give up more money (and therefore other goods and services) to do so. On the production side of the market, firms making shirts that are popular with consumers can sell them at competitive prices and earn profits. But producers who make unwanted products, or operate inefficiently and pay too much to make their products, will incur losses. Eventually, they must either learn to produce and compete efficiently -- making products consumers want at competitive prices -- or they will go out of business, and someone else will take over their factories, machines, and other resources. In a nutshell, that's how economic incentives work in a market economy.

The same basic process operates in many different kinds of markets -- literally wherever any kind of price is free to rise and fall, including prices for the work people do, for the food they eat, and for the money they save in or borrow from banks.

Market economies provide no magic solutions, however, and government plays a critical role in helping correct problems that can't be fully solved by a system of private markets. Moreover, market economies are by no means immune to pressing public policy issues in today's global economy -- issues such as inflation, unemployment, pollution, poverty, and barriers to international trade. Nevertheless, in comparison to the chronic shortages and inherent inefficiencies of command economies, a free-market economic system offers greater opportunities for economic growth, technological progress, and prosperity.