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

FINANCES IN A MARKET ECONOMY

In the markets for goods, services, and labor, prices are expressed in terms of some currency, or money. But money itself is also traded in market economies, because some people want to save money to use in the future, while other people -- including many businesses -- want to borrow money to use today. The price for the use of that money -- known as an interest rate -- is determined in the markets where these funds are exchanged.

From a broader perspective, banks and other firms in a market economy's financial sector are most important in linking those who have resources to save and invest with those who have the most promising uses for those funds, and are therefore willing to pay for their use. Through these markets, decisions about how and where to invest funds are decentralized, just as production and consumption decisions are decentralized in the markets for goods and services.

To Buy a House

Let's look at our family of Robert and Maria several years after their talk about job changes and further education. Maria did, in fact, take an administrative job with the school system, and Robert pursued advanced training in computer programming and found employment in a new and growing field. As a result, Robert and Maria, having earned higher incomes than previously, have been able to save money toward what is normally the largest single purchase that most individuals ever make: a house.

Here, the role of financial institutions such as banks is critical. Banks serve two related functions. On one hand, they accept deposits from people like Maria and Robert -- savers who want to keep their money safe and to earn interest on it. On the other, they lend money to borrowers who can demonstrate that they have the financial ability to pay back such a loan over time. Borrowers and lenders are not only individuals, of course, but also private companies that wish to save their money or that wish to borrow money and invest in new or expanded businesses.

In a market economy, individuals like Maria and Robert can play the role of savers and borrowers at different times. To attract their money, banks offer savers like Maria and Robert a certain rate of interest in competition with other banks and savings institutions. Now, Robert and Maria have approached the bank as potential borrowers, seeking a loan that will enable them to buy a house. If the bank finds that they have the income to pay back the loan in monthly installments over a period of years, the bank may loan them the money. It will, however, charge them a higher rate of interest as borrowers than it paid them previously as savers: the difference is the bank's rate of return for the financial services it provides.

Borrowing and Investing

The same process takes place with businesses seeking investment funds for new factories, stores, and equipment. And as with other industries in a market economy, competition among banks helps ensure that interest rates will be as low as possible while still providing a satisfactory rate of return to banks that are run well and efficiently. Further, because the pool of money available for loans is limited, the borrowers -- individuals and companies -- will compete among themselves to win the bank's approval. This competition helps ensure that bank loans are allocated to investments with the highest potential return in a manner much more efficient than if the government made borrowing and loan decisions itself.

Businesses seek these investment loans for new facilities or machinery to increase their production and sales. These firms expect to earn profits on these new investments for many years, so they are willing to pay interest for funds they can use to purchase those assets and start their production now, not later.

Of course, if the interest they have to pay is higher than the rate of return they expect to earn, the businesses won't borrow the funds. And in fact, if a company doesn't have an investment in mind that pays more than the current interest rate on borrowed funds, it will save the money rather than trying to borrow more funds itself. Or, more likely, the company will try to shift its resources into a different line of business, where the expected rate of return is higher than the rate paid on borrowed funds. That is simply another way in which resources are directed to firms that have identified the most profitable uses of resources -- based, as we have seen earlier, on providing the things consumers want most, at prices that meet or beat the prices for similar products offered by competing firms.

Here, too, international trade can be important. Just as countries can exchange products, they can also exchange financial services and investment funds. Foreign investment can increase the amount of money, or capital, available for businesses seeking to borrow and invest. By competing with domestic banks and financial institutions, foreign investment can also help keep interest rates -- the cost of money -- down.

Foreign investment, if perceived to be too extensive, can trigger fears that parts of the economy are no longer under a nation's control. Such fears are almost always unwarranted, in large part because the dynamics of a market economy apply equally to international as well as national investments and business activity. Foreign direct investment, like any other kind of investment, is a vote of confidence in economic growth. By bringing in a new source of funds, foreign investment usually improves efficiency, adds management expertise, and helps keep interest rates down.

Stock Markets and Investments

As we have seen in the example of Robert and Maria, successful banks earn money by serving as an intermediary for savers and borrowers, and play an important role in the economic system by bringing them together so that funds that are saved can be reinvested.

There are other, even more specialized kinds of businesses in the financial sector of a large market economy. Suppose that, in a few years, Robert and Maria decide to start a small business that takes advantage of their combined skills and experience in education and computer programming. Together, they develop a line of educational computer software for schools, and they need money to start the new business, called R&M Educational Software. They could go back to the banks and try to secure a loan, as they did for their house. Or they could sell ownership shares, known as corporate stocks, in their fledgling business to hundreds, even thousands of people who believe that R&M Software has the potential to make a profit. Small entrepreneurs such as Maria and Robert, as well as the world's largest corporations, offer such stocks for sale through brokers who work on stock exchanges throughout the world.

The people who buy these stocks are willing to invest some of their own money in these businesses in return for a share of the businesses' future profits. These people become, legally, the real owners of the firms and receive voting rights for every share of stock they purchase. That gives them a voice in what the company does, and in deciding who the directors and executives of the company will be.

They also share in the risks of the company. If R&M Educational Software performs poorly, or fails altogether, the investors will lose some or all of their investment money. If the company succeeds, however, these same investors will have an opportunity to realize a profit on their investment, whether they choose to hold their shares for even longer-term gain or sell their shares for many times their initial value.

As long as stockholders expect a company to do well, they will hold that stock to claim a share of the firm's expected profits, and may even buy more shares. But stockholders who aren't happy with the company's future outlook for sales and profits will sell the stock they own on a stock market, through companies that specialize in finding both buyers and sellers of stocks of all of the major corporations in the economy. These companies are known as brokerage houses, and it is groups of these firms that have joined together to establish the major stock markets in locations around the world such as New York, Tokyo, and London.

Like the banking industry, these stock markets have come to play an important role in their national economies and in international trade. They help stockholders and other people make investment decisions, evaluate how efficiently corporations are being run, and assess the general business climate. This is done through the prices of the thousands of corporate stocks that are traded daily on these exchanges, rising and falling in response to changing business conditions for individual firms, their competitors, and the overall economy.

The investment process offers individual savers and investors a great deal of freedom and opportunity in deciding what risks and new ventures to undertake. They stand to gain substantially if they save and invest wisely; but they can also lose a great deal if their investments are not sound. That is why most investors choose not to put all of their investments in one project or company, but instead keep some of their assets in very safe, "tried and true" companies or accounts. Only those who choose to take a big gamble and put all of their assets in a small number of high-risk ventures are likely to lose a fortune in the financial markets or, on the other hand, to make one.

Over the past century, it is revealing to compare the record of private investments in the development of new products and technologies to the investment record of national governments, especially those with centrally planned economies. The record of the private-sector investments, despite periods of failure, is clearly superior. Why? The reasons again point to the very nature of market economies: a decentralized process in which large numbers of people are making investment and borrowing decisions in response to changing economic conditions, not a small group in a central government. Further, the decisions are made by those whose own money is at stake -- certainly a strong motivation for making careful, shrewd choices.