Meaning of Market Economy

The resources are limited in the society. Hence, throughout history, every society has faced the fundamental economic problem of deciding what to produce, and for whom. According to R.G. Lipsey and C. Harbury, "the term economic system refers to a distinctive set of social and institutional arrangements within which answers are provided by determining how resources are allocated."

In the 20th century two competing economic systems were used for the solution of these problems: command economies directed by a centralized government and market economies based on private enterprise. The market economies are prevalent in North America, Western Europe and Japan. The command economies were prevalent in the former Soviet Union, Eastern Europe and parts of Asia over the past half-century.

At present in the last decade of 20th century the command economy has been found to be a failure. It has "failed to sustain economic growth, to achieve a measure of prosperity, or even to provide economic security for its citizens."

The market economies are, by nature, decentralized, flexible, practical and changeable. The central fact about market economies is that there is no center. The 'invisible hand' works in the private market place. The market economies are based on the principle of individual freedom: freedom as a consumer to choose among competing products and services, freedom as a producer to start or expand business and share its risks and rewards, freedom to choose a job, join a labor union or change employers.

According to R.G. Lipsey and C. Harbury, "In a type of economic system all decisions about resource allocation are made without any central direction but, instead, as a result of innumerable independent decisions taken by individual producers and consumers: such a system is known as a market economy."

Functioning of Market Economy

The functioning of a market economy may be described as follows:


Decision In command economies the economic planners, production experts and political officials establish production levels of goods and designate which factories will produce them. The central planning committees establish the prices of the products and wages for the workers who produce them. It is the set of central decisions that determines the quantity, variety and prices of products. Due to this, there either shortages or surpluses of the products in the economy. The planning authorities are unable to make efficient decisions when number of people, products increase and the production technologies change rapidly.

The phenomenon of command economies does not happen in the market economy. In a market economy, government ministry, or planners do not decide the quantity, quality, and design of the products. Anyone individual or company, can decide and sell products. This leads to direct competition between different firms producing the products. Competition is the heart of market economies. Due to competition there are different products available to the consumers.

Pricing Decision

Another key point about market economies is that the planning committee does not fix the prices of products. The sellers are free to raise or lower prices according to changing market conditions. When products become scarce, the price usually rises. The price increase accomplishes two things at the same time. 

The price rise makes the product more expensive compared to other products. Hence, some consumers will choose fewer of them. 

The higher price goes directly to the producers and sellers. Hence the higher price increases the profits of the firms enabling them to produce and sell more goods. Attracted by high price, other firms will also begin to make the popular product. 


The higher prices give every consumer and producer incentive to respond. Because, they are allowed to reap the benefits of their own decisions while also bearing the associated risks and costs. For example, the consumers willing to pay the higher prices can get the popular product. But they have to give up more money and other goods and services to do so.

On the production side, the firms making popular products can sell them at competitive prices and earn profits. The producers who make unwanted products or produce inefficiently incur losses. Eventually, they must either learn to produce efficiently or will go out of business. In sum, the economic incentives work in a market economy.

Efficient Resource Allocation

The consumers, producers and workers all work in their own self-interest in open and competitive markets. They use their economic resources in ways that have the greatest value to the national economy. They are useful in satisfying more of people's wants. The first person to point out this fact in a systematic way was the great classical economist Adam Smith. He published his famous book 'An Enquiry Into The Nature and Causes of Wealth of Nations,’ in 1776. He was first to describe how an economy based on a system of market could promote economic efficiency and individual freedom.

Smith described the feature of market economics in these words, "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 willing to pay for, even though that may have been "no part of their original intentions". In market economies, with a decentralized system of private markets, resources are efficiently allocated to satisfy consumer demands.

Despite many benefits of market economy, it provides no magic solutions. "The market economies are by no means immune to issues such as inflation, unemployment, pollution, poverty and barriers to international trade". Hence, the government will have to play a critical role in helping correct problems that cannot be fully solved by a system of private markets.

Features of Market Economy

Two major types of economic system are command market economies. In command economies, resources are allocated by decisions taken by central planners. In market economies the allocation of resources is determined by decentralized decisions coordinated through the price mechanism.

The basic features of market economy are as follows:
  1. Decentralized decision-taking: In a market economy, decisions relating to basic economic issues are decentralized. But they are coordinated. The main coordinating device is the set of market-determined prices. 
  2. Freedom of enterprise: People are free to choose nay occupation or take up any business according to self-interest. 
  3. Profit motive: The economic activities are undertaken with the aim of earning profit. People themselves borne the risk and return of business. 
  4. Consumer's sovereignty: The consumer is the king in the sense that they have complete freedom in making choice of the products. 
  5. Price mechanism: The price mechanism guides producers and consumers in making production and consumption decisions. The price system is the coordinator of decisions. Every day millions of people independently make millions of decisions relating to consumption and production. Most of these decisions are not motivated by a desire to contribute to the social good, but by the consideration of self-interest. The price system coordinates these decentralized decisions. Due to this the whole system is sensitive to whishes of the individuals who compose it. Price is a signaling device, which give signals about scarcities and surpluses. 
  6. Perfect competition: There is perfect competition in the market between producers, consumers and consumers and producers. 
  7. Specialization in production: There is specialization in production. It is accompanied by freedom to exchange what is produced among individuals. 
  8. Market-determined prices: The most remarkable feature of the market economy is that it requires no planning authority to allocate resources. The key to the whole process is to be found in the role of prices. The prices perform the crucial function of providing signals that help to determine the allocation of resources. 
  9. Lack of conscious direction: The market economy fulfills its function of coordinating decisions without any one having to understand how it works. For example, a farmer need not know how many people eat rice and where they live. He needs to know only the cost of production and price of rice. By responding to such public signals as the costs and prices of what he buys and sells, the farmer helps the whole economy fit together, to produce what people want, and to provide it where and when they want it. 
  10. Laissez-faire: There is what is called laissez-faire in the market economy. This French expression describes the belief that the market economy would perform most efficiently if left free from government intervention. Adam Smith opined that the 'hidden hand' of market forces should be allowed to govern the economy.