We explain what a market economy is and how it works. In addition, we explore its main characteristics, advantages and disadvantages.
What is a market economy?
A market economy is a model of exchange of goods and services that is regulated by economic forces, i.e. buyers and sellers who set market prices. It requires free competition and the least possible state intervention.
Also known as a free-market economy, it is self-regulating, meaning that for every product that is demanded or required, there is a product offered on the market. These two basic economic laws establish the "law of supply and demand," additionally contributing to the diversity of competitors, which does not happen in economies strictly regulated by the State.
In contrast, a state-directed economy is regulated by state constraints, regardless of what sellers may offer for profit or what buyers may purchase.
In most of the world's markets, a social market economy prevails, where both economic systems coexist: a free market which is partly regulated by the State. This is the basis of the capitalist system that promotes capital accumulation and defends private ownership of the means of production.
- Se also: Free market
How does a market economy work?
A market economy or free market is a physical and virtual space in which buyers and sellers interact. The rules of this exchange are established by the law of supply and demand, as well as by various measures implemented by the State.
Supply is the availability of goods that are exchanged at a freely set price based on demand, which is the quantity of goods and services available on the market according to what consumers are willing or able to pay.
- Example of the law of supply. The relationship between price and quantity produced is directly proportional. That is, the more expensive a good is, the more the seller will produce.
- Example of the law of demand. The relationship between price and the quantity of products sold is inversely proportional. That is, the lower the price of a product, the more units will be sold; the higher the price of a product, the fewer units will be sold.
- Market equilibrium. The laws of supply and demand reach a price equilibrium in which the amount of goods demanded and offered are equal. In other words, market equilibrium allows the market to self-regulate and set a price that buyers are willing to pay and is favorable to the seller.
- See also: Demand
Characteristics of a market economy
The main characteristics of a market economy are:
- It allows freedom of choice among various goods and services.
- It allows free market participation to sell.
- It encourages the development of competitors who strive for comparative advantages in order to stay competitive on the market.
- It meets price equilibrium that is subject to the market’s purchasing possibilities and not to the centralized decisions of a monopoly.
- It reduces government intervention in decisions related to prices, production and marketing.
- It contributes to capital accumulation and investment as sources of wealth.
Advantages of a market economy
The main advantages of a market economy are:
- There is minimal or no taxation and state control.
- It allows for a variety and diversity of products (suppliers) on the market, resulting in greater price competitiveness.
- It promotes the quality of customer service, products and innovation so that buyers are able to choose a product among many others.
- It promotes capital accumulation, freedom to produce and freedom of contract between companies.
Disadvantages of a market economy
The main disadvantages of a market economy are:
- It does not consider the most vulnerable sectors, as people with no sufficient capital, resources or knowledge do not usually have access to the market.
- There may be cases of monopoly and unfair competition.
- It promotes an increase in consumption aimed at generating economic profit, which may result in irreversible damage to the environment, a variable not usually contemplated in liberal economic theories.
- It has difficulties achieving effectiveness between a free market and an optimal level of state regulation.
Marxism vs. liberalism
Marxism and liberalism are opposing political and economic theories which propose two types of development for a nation.
- Marxism holds that the means of production should be state-owned, so that the different social classes do not exist.
- Liberalism states that the means of production should be privately owned and that everyone should participate in market decisions.
In modern societies, both theories have failed to be applied integrally. They present market failures or situations in which market balance is not achieved and negative consequences are generated.
- For example: imperfect competition, unequal distribution of wealth, the existence of public goods and the instability of economic cycles.
Examples of market economy
Some examples of different situations in a market economy include:
- A strawberry production affected by extensive droughts. Due to the scarcity of supply, the few producers managing to harvest strawberries sell them at a high price in the market to offset losses during the planting process, but they will not be able to meet all the demand.
- The release of a new cell phone model generates high demand, making the previous model still available on the market more affordable to compete with the new product.
- Fast fashion promotes the consumption of new garments every year, which requires the sale of a whole production. Therefore, prices are reduced at the end of the season to entice consumers into buying them.