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

CONSUMERS IN A MARKET ECONOMY

Consumers in both market and command economies make many of the same kinds of decisions: they buy food, clothing, housing, transportation, and entertainment up to the limits of their budgets, and wish they could afford to buy more. But consumers play a much more important role in the overall working of a market economy than they do in a command economy. In fact, market economies are sometimes described as systems of consumer sovereignty, because the day-to-day spending decisions by consumers determine, to a very large extent, what goods and services are produced in the economy. How does that happen?

Buying Oranges and Computer Chips

Suppose a family -- Robert, Maria, and their two children -- go shopping to buy food for a family dinner. They may originally be planning to buy a chicken, tomatoes, and oranges; but their plans will be strongly influenced by the market prices of those goods.

They may discover, for example, that the price of oranges has increased. There are several things that might cause those higher prices, such as freezing weather in areas where oranges are grown, which destroys a large part of the crop. The effect of the freeze is to leave the same number of consumers trying to buy a smaller number of oranges. At the old -- lower -- price, therefore, sellers would soon run out of oranges until the next harvest. Instead, by raising the price, all consumers are encouraged to cut back on the number of oranges they buy, and producers are encouraged to grow more oranges as fast as they can.

There is another possibility: suppliers could choose to import a larger number of oranges from other countries. International trade, when it is permitted to operate with relatively few barriers or import taxes (called tariffs), can give consumers wider choice and allow producers to offer more competitive prices for a wide range of products, from oranges to automobiles.

On the other hand, the orange crop might be spared freezing weather, but instead consumers decide to start buying more oranges and fewer apples. In other words, instead of the orange supply shrinking, demand increases. This, too, will drive up the price of oranges for a time, at least until growers have time to bring more oranges to market.

Whatever the reason for the higher price, Robert and Maria will probably respond in a predictable way once they discover that the price is higher than they anticipated. They may well decide to buy fewer oranges than they had planned, or to buy apples or some other fruit instead. Because many other consumers make the same choices, oranges won't disappear from store shelves entirely. But they will be more expensive, so only the people who are willing and able to pay more for them will continue to buy them. Shortly, as more people start buying apples and other fruits as substitutes for oranges, the prices of those fruits will rise as well.

But the response of consumers is only one side, the demand side, of the equation that determines the price of oranges. What happens on the other side, the supply side? A price increase for oranges sends out a signal to all fruit growers -- people are paying more for fruit -- which tells the growers it will pay to use more resources to grow fruit now than they did in the past. It will also pay the fruit growers to look for new locations for orchards where fruit isn't as likely to be damaged by bad weather. They may also pay biologists to look for new varieties of fruit that are more resistant to cold weather, insects, and various plant diseases. Over time, all of these actions will increase the production of fruit and bring prices back down. But this whole process depends first and foremost on the basic decision by consumers to spend some part of their income on oranges and other fruits.

If consumers stop buying, or if they decide to spend less on a product -- for whatever reason -- prices will drop. If they buy more, increasing demand, the price will rise.

Keep in mind that this interaction of supply, demand, and price takes place at every level of the economy, not just with consumer goods sold to the public. Consumption refers to intermediate goods as well -- to the inputs that companies must purchase to provide their goods and services. The cost of these intermediate, or investment, goods will ripple throughout a market economy, changing the supply-and-demand equations at every level.

Let's take the example of the semiconductor chip that is at the heart of the modern computer revolution. As with the case of oranges, higher prices will tend to reduce demand for computer chips and, consequently, for computers themselves. Over time, however, the higher price will signal manufacturers of computer chips that it may be profitable to increase their production, or for new suppliers of chips to consider entering the market. As chip prices come down, so eventually will the cost of computers (assuming that the cost of other inputs remains unchanged), and demand for computers will grow.

That demand for computers will do more than simply spur suppliers to increase their output. It will also encourage innovation, which will result in computer chips and computers that are more powerful and efficient than earlier models -- a competition of progress and price that occurs in virtually all genuinely free markets.

Prices and Consumer Incomes

The other economic factor that consumers must consider carefully in making their purchases of goods and services is their own level of income. Most people earn their income from the work they perform, whether as physicians, carpenters, teachers, plumbers, assembly line workers, or clerks in retail stores. Some people also receive income by renting or selling land and other natural resources they own, as profit from a business or entrepreneurial venture, or from interest paid on their savings accounts or other investments.

We later describe how the prices for those kinds of payments are determined; but the important points here are that: 1) in a market economy the basic resources used to make the goods and services that satisfy consumer demands are owned by private consumers and households; and 2) the payments, or incomes, that households receive for these productive resources rise and fall -- and that fluctuation has a direct influence on the amount consumers are willing to spend for the goods and services they want and, in turn, on the output levels of the firms that sell those products.

Consider, for example, a worker who has just retired, and as a result earns only about 60 percent of what she did while she was working. She will cut back on her purchases of many goods and services, especially those that were related to her job, such as transportation to and from work, and work clothes -- but may increase spending on a few other kinds of products, such as books and recreational goods that require more leisure time to use, perhaps including travel to see new places and old friends.

If, as in many countries today, there are rapidly growing numbers of people reaching retirement age, those changing spending patterns will affect the overall market prices and output levels for these products and for many others that retirees tend to use more than most people, such as health care services. In response, some businesses will decide to make more products and services geared toward the particular interests and concerns of retirees -- as long as it is profitable for firms to produce them.

To summarize: whether consumers are young or old, male or female, rich, poor, or middle class, every dollar, peso, pound, franc, rupee, mark, or yen they spend is a signal -- a kind of economic vote telling producers what goods and services they want to see produced.

Consumer spending represents the basic source of demand for products sold in the marketplace, which is half of what determines the market prices for goods and services. The other half is based on decisions businesses make about what to produce and how to produce it.