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
BUSINESS IN A MARKET ECONOMY
As we have seen, a firm's success in a market
economy depends on satisfying customers by
producing the products they want and selling
those goods and services at prices that meet
the competition they face from other businesses.
Doing that requires firms to develop careful
answers to one of the most important questions
every economic system faces: how can a society
produce goods and services most efficiently?
In a market economy, that means getting the
greatest value of output from the inputs producers
use.
To Build a Bicycle
Let's take the case of a firm that is considering
the manufacture and sale of bicycles. Before
launching such a venture, any entrepreneur
or company has to consider a host of factors.
First, what is the potential size and nature
of consumer demand for a new brand of bicycle?
Is there a single, large market for standard
model bicycles? Or is the bicycle market
divided into many smaller markets, or niches,
for specialized bicycles for children, customized
racing bikes, or bicycles built for two?
A new trend, such as the sudden popularity
of so-called mountain bikes that can handle
wilderness trails, might also attract new
manufacturers who see an opportunity to make
a profit. On the other hand, prospective
suppliers may simply feel that they have
developed innovative manufacturing techniques
for a standard bicycle, or possess significantly
lower labor costs, so that the company can
undersell their rivals in the marketplace
and still make a profit.
Not only are there many kinds of bikes to
make, but there are many ways to make these
bicycles -- from using a highly automated assembly
line to stamp out thousands of identical parts
and put the bikes together, to using more labor
and much less machinery to design and make
customized bikes. Once again, the firm making
these decisions in a market economy has to
consider several different prices that may
rise or fall in response to the behavior of
people who buy and sell those products.
For example, the prices the firm has to pay
for its inputs will obviously play a major
role in determining how much steel, aluminum,
labor, machinery, and other materials the firm
will use in making its bicycles. If the price
of steel rises and the price of aluminum falls,
many bicycle firms will look for ways to use
more aluminum and less steel. Similarly, if
wages for workers rise sharply, firms will
have a strong incentive to look for ways to
use more machinery, or capital, and less labor.
A firm might decide to buy more forklifts,
for example, using fewer workers to move its
inventory around the company's warehouses.
Or it might use more machines to make routine
and repetitive welds on its bikes, and thus
hire fewer workers to do welding jobs. (As
a consequence, the number of workers in factories
producing the welding machinery used by the
bicycle manufacturers would increase.)
Any such venture carries a large element of
risk: a new bicycle design may fail to attract
customers, or manufacturing costs may be unexpectedly
high, pricing the company's bikes out of the
market. Companies alone bear this risk of failure
-- and reap the economic rewards of success
if they have planned correctly and their bicycle
venture succeeds.
This balancing of risk and rewards by individuals
and private companies points to an essential
role of government in any market economy: protecting
private property rights and enforcing a law
of contracts. Property rights must be well-defined
legally, and business owners and investors
must be treated the same by the law and commercial
regulations whether they are citizens of the
country or foreign nationals.
Only if property rights are free from the
threat of expropriation by government, or exploitation
by political interests, will individuals and
companies be willing to risk their money by
investing in new or expanded businesses. Moreover,
they must be assured that the state's legal
system will settle disputes over contract terms
in a fair and consistent manner.
In short, entrepreneurs, whether domestic
or foreign, must be willing to face economic
uncertainty in their ventures -- but should
not have to face political or legal uncertainty
about the legitimacy of their enterprise.
Competition and Productivity
Making these adjustments as the prices for
a firm's inputs change is an important part
of what it means to produce efficiently and
to compete with other firms making similar
products. Companies that don't hold their
production costs down may try to charge a
higher price for their products; but that
just won't work if other firms can make the
same quality products at a lower cost and
sell them at a lower price.
Consumers benefit from this competition among
firms because they get better products at lower
prices. And if most goods and services they
buy are made in markets characterized by a
high degree of competition, their budgets will
go further and allow them to buy more products
with the income they receive.
Even in competitive markets, however, not
all firms will choose to use exactly the same
materials or production methods. In many cases,
that will reflect the different kinds of bicycles
or other products they choose to make. For
example, firms making a very basic bike for
young children to ride or for adults who use
the bikes as daily transportation to and from
work will very likely want to make a large
number of identical bicycles and put them together
using standardized materials and assembly line
methods that keep production costs and prices
very low. On the other hand, companies specializing
in customized racing bikes are likely to use
more labor, special design tools, and more
expensive metals, but use fewer stamping machines
and assembly lines making identical parts.
Not surprisingly, prices for the customized
bikes will usually be higher than prices for
the bikes that are mass produced in large factories.
Ideally, of course, everyone would like to
have all of the things they buy face sharp
competition -- thereby holding those prices
down -- but face little or no competition from
others in what they do to earn their own income
-- so that their wages will remain high. More
generally, everyone seems to favor the idea
of high wages and low production costs (including
labor costs, which are most firms' largest
expense), because that seems to imply that
everyone will be able to afford to buy more
goods and services. But no economic system
can provide high wages and low prices at the
same time, because workers' wages represent
a company's labor cost in making and selling
the goods and services it produces. In other
words, as long as other costs and demand remain
unchanged, raising everyone's wages simply
raises production costs and product prices.
Over time, however, there are ways for workers
and firms to resolve this dilemma -- that is,
to earn higher wages and profits without driving
up the prices consumers pay for products and
thereby risk losing their jobs or sales to
competitors. The answer is to increase productivity,
the level of output that an industry or company
achieves from each worker or each unit of input
into its products and services. To increase
productivity, workers and firms must develop
new products for the marketplace or produce
goods and services more efficiently than the
competition, at a lower cost, or with better
quality. In short, their products must be newer,
better, or cheaper.
Higher production levels justify higher wages
and living standards. Higher productivity means
higher output per worker, which translates
into greater prosperity that can be shared
through higher wages and a better standard
of living. Cutting costs and working more efficiently
are ways of increasing productivity, but in
modern technology-based economies, research
and innovation are critical to the sustained
productivity and growth of a nation's and the
world's economy. Advances in computers, telecommunications,
and biogenetics are the result of scientific
research, experimentation, and testing. These
advances occur continuously in market economies
as companies seek to develop new products and
services, or to produce existing ones more
efficiently. The result: new jobs, expanding
opportunity, and greater prosperity for all.
This, too, is the same way all workers and
businesses in a country can improve their competitive
position in the world economy, to raise the
material living standards in their nation over
time.
International trade can make an important
contribution to productivity and prosperity
as well. Think for a moment of Robert and Maria
shopping for oranges. Robert is a machinist,
skilled and experienced in what he does. Suppose
that instead of working fulltime as a machinist,
Robert had to devote some of his time to growing
oranges -- and the orchard owner, who has grown
oranges and other tree crops for years, had
to spend time making machine tools. Neither
would be as productive and efficient in his
secondary job as in his primary work. The result
would be predictable: fewer oranges and lower-quality
machine tools for everyone. Just as two people
are both made better off when they buy and
sell from each other and specialize in the
production of the things they do best and most
efficiently, so too are regions and nations
better off when they can specialize and trade
freely with each other. When nations trade
in the goods and services they make well and
at low cost, the benefits accrue to the people
in all the countries involved.
The most popular arguments calling for policies
that limit free trade -- usually taxes on imported
goods or limits on their amounts -- claim that
protecting jobs in some industries is good
for a country because the workers and owners
in those industries will earn higher wages
and profits and spend most of that money in
their own country. This claim has an element
of truth, but it is only part of the story.
Protecting some producers and workers also
means that prices for the goods and services
they make will be higher. This is bad news
for consumers, for other producers who use
those products as inputs, and for firms that
find their sales falling because some of their
customers paid more for the protected products.