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

A SYSTEM OF MARKETS

By following their own self-interest in open and competitive markets, consumers, producers, and workers are led to use their economic resources in ways that have the greatest value to the national economy -- at least in terms of satisfying more of people's wants. The first person to point out this fact in a systematic way was the Scottish philosopher Adam Smith, who published his most famous book, An Inquiry Into the Nature and Causes of the Wealth of Nations, in 1776. Smith was the first great classical economist, and among the first to describe how an economy based on a system of markets could promote economic efficiency and individual freedom, regardless of whether people were particularly industrious or lazy.

The Invisible Hand

Smith argued that if people are naturally good and kind, a market economy offers them a great deal of economic freedom to carry out their good deeds, backed up by an efficient system of production, which generates more material goods and services for them to use in doing those good works. But what if people are selfish, greedy, or lazy?

Anyone who wants to enjoy more of the material goods and services produced in a market economy faces strong economic incentives to work hard, spend carefully, and save and invest. And most successful businesses have to produce good products, sell them at market prices, pay their employees market wages, and treat their customers courteously -- even if that isn't their natural way of doing things.

The basic reason for that kind of change in some people's behavior is competition. As Adam Smith pointed out, when there are several butcher shops in a community, any butcher who is rude or tries to sell inferior meat at unreasonable prices soon loses business and income to other butcher shops. If your neighborhood butcher is naturally friendly and benevolent, so much the better.

But even customers who do not know a butcher personally don't have to depend on such altruistic characteristics to get good service and products. The more a greedy, selfish, or lazy butcher wants to enjoy a higher standard of living, the more he or she will try to meet the competition and build up a large base of satisfied customers. Or as Smith described this feature of market economies, people are led "as if by an invisible hand" to work and behave in ways that use resources efficiently, in terms of producing things that other people want and are wllling to pay for, even though that may have been "no part of their original intentions."

One other factor must be at work for Smith's invisible hand to function properly: the butcher must own or rent the shop, so that he or she has the rights to its profits. Without this right to private property, and to the profits it brings, the invisible hand of competition will not motivate businesses to offer the best and most varied products at reasonable prices. Butchers who are employees of the state will view their jobs very differently than those who are in business for themselves. This fact holds true throughout the economy, whether one considers a butcher, a carpenter, a restaurant chain, or a multinational insurance company.

Of course, if there is no competition -- if there is only one place to buy meat in some market area -- things won't be as pleasant for consumers. And that will be true even if the butcher shop is owned and operated by the government. Inevitably, removing competition also removes many of the most powerful market incentives to provide good service, high-quality products, and low prices. That is why, except for a few special cases that are discussed later, most economists view competition between producers as the consumers' best friend.

In even broader terms, by decentralizing the control of economic resources -- letting individual producers decide what and how to produce to satisfy their customers -- competition and self interest ensure that most resources available in a market economy are used efficiently, which is to say in their most valuable uses as directed by what consumers demand and buy.

An Economic Chain

Such a system of economic individualism is also built on the idea that individual producers and consumers are in a better position to know what they want, and what is happening to market prices for the products they buy and sell, than is a centralized planning committee in the national capital.

For example, millions of people are fed in New York City and other metropolitan areas throughout the world every day without any planning agency to establish quotas for the amount of bread, meat, vegetables, and beverages that will be shipped into the city every day, month, and year. In fact, no one really knows the total amounts of these products that are used in this market, or even has to know. Instead, restaurants and sandwich shops are run by private owners who, as a group, offer a wide variety of meals at competitive prices. Consumers patronize the shops they like best and pay prices that are high enough for efficient owners to earn a profit and stay in business. Sellers who offer unpopular items, charge prices that are too high, or provide inferior service, will simply not survive as business owners and managers.

The same kind of process goes on with the bakeries competing to sell bread to these restaurants and shops, and with the companies that compete to sell ovens to the bakeries, and with the companies that compete to sell steel and other materials to the companies producing the ovens. At each step along the way there are buyers and sellers who know their own part in this overall production process very well, but who have little or no idea about the other links in this economic chain of events.

In this way, with a decentralized system of private markets, resources are efficiently allocated to satisfy consumer demands. Because the process is so decentralized, many producers and consumers may not understand how it works or even be aware that individual markets routinely interact in such an efficient and systematic way. But it is precisely this decentralization that is responsible for much of the efficiency in the first place.