What is a market economy? (Advantages and how it works)

By Indeed Editorial Team

Published 5 December 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

In the field of economics, there are three distinct types of economic structures which include market economies, command economies and mixed economies. The type of economy we're most familiar with is the market economy, which is also known as a free-market economy. If you're looking to understand how many businesses function, learning about this type is the most appropriate type to look into. In this article, we're going to find out what a market economy is, how it works, the advantages it provides and the disadvantages of this system.

What is a market economy?

A market economy is a specific type of economic structure that uses the laws of supply and demand to guide the production of goods and services. Supply and demand outline that there's a balance to strike between the supply of goods and services and the consumer demand for them. Demand helps to establish the pricing of company offerings, so when demand is greater the prices of goods and services rise. Similarly, when demand is low the price drops.

Businesses that exist in this economy strive to supply their offerings at the highest price while still ensuring customers buy their goods or services. In contrast, consumers actively seek the lowest prices for the goods or services they want. The framework for this method runs through many areas of society, including employment. Companies look to bring in staff for the lowest wages while employees look to secure work at the highest salary possible.

Related: Types of economic systems and what makes them different

How does it work?

Most modern market economies bring in aspects of mixed economies to effectively balance the free market with government intervention to ensure a safe and fair society. This includes government intervention for things like controlling the sale of dangerous or illegal goods and offering tax subsidies for public goods. There are a few unique identifiers for market economies, such as:

Freedom of choice

This method affords businesses the freedom to manufacture, produce and procure goods or services they want to sell in an open market. Companies have the ability to choose what products they offer consumers with the only real limitation stemming from how much capital the business has and the price the market is willing to pay for the offerings. This freedom of choice is a strong motivator for individuals to start their own businesses and grow competition across different markets.

Self-interest

Both companies and consumers can exhibit self-interest in this type of economy. Consumers look to purchase goods or services at the lowest possible price, while businesses seek to gain the most profits from sales by offering goods or services at the highest price. By focusing on self-interest on both sides, the market naturally strikes a balance between pricing offerings too low or too high.

Limited government intervention

Governments tend to play a smaller role than other market structures, as it relies on consumer demand to guide this type of economy. Governments only intervene or enact regulations to ensure fairness across the economy and to provide public goods or services across society. This helps to minimise the risk of monopolies controlling the market or individuals with lower incomes struggling to receive essential public services, like transportation or healthcare.

Related: What is an economic environment? Definition and examples

Competition

Market economies heavily encourage competition to effectively moderate the market. Competition helps push businesses towards offering more innovative and high-quality products or services as they want to draw in the largest portion of the market share. This high-level competition helps to encourage companies to provide the best possible offerings at the lowest possible prices.

Focus on privatisation

Market economies tend to place a strong emphasis on privatisation and private property. As property is in the hands of private ownership, they aren't constricted by much government regulation. This gives private property owners the ability to negotiate contracts that suit them better. The main driving force behind private property ownership is that individuals stand to earn profits from their privately owned assets. Assets in this case could mean any number of things, from housing to products sold by businesses.

An established system of markets and prices

Market economies require a thriving system of markets and prices to allow for the sale of various goods and services. Ideally, all buyers and sellers in this type of economy enjoy equal access to the same information and infrastructure to compete in a fair market. This allows all companies to find ways to draw in consumers and make profits. It also gives consumers the freedom to choose where they buy their goods or services.

Related: Emerging market: definition, types, risks and benefits

What are the advantages?

There are several advantages associated with adopting this type of economy. Some of the advantages include:

Consumers receive goods or services when required

It works on the principle of supply and demand, so businesses make profits when offering goods or services when the market requires them. The demand for these goods or services facilitates the supply of them, so society generally has access to what they need when they need it. This doesn't account for the quality of these goods or services and in some cases, pricing means certain socioeconomic groups don't have access to these goods or services.

It promotes entrepreneurship

Market economies thrive on innovation, so entrepreneurs are heavily emboldened under this type of economy. It's a system that encourages the discovery of new products or services while still giving companies the ability to decide on what they offer consumers. Businesses of any size have the ability to generate profits while fulfilling the needs of a specific market or customer base.

It drives competition

Market economies create a free market for businesses to exist in, but they're constantly under threat due to competition. This high level of competition encourages innovation and high-quality offerings to draw in customers and generate profits for the business. Any organisations that fall behind in terms of quality or innovation lose sales and run the risk of becoming unprofitable. This motivation to survive is pivotal to the success of both businesses and the market as a whole as it promotes improved products or services for consumers.

Lower need to stockpile or store goods

As this type of economy focuses on supply and demand, companies that produce goods are more agile in terms of items produced. These companies manufacture to meet demands, which lowers the need to stockpile surplus goods as these companies have a clear understanding of demand. Ideally, companies strike a balance between the demands of consumers and the supply of goods they create.

Related: Growth markets: key attributes, opportunities and risks

A healthier job market

Market economies encourage the growth of smaller businesses as a result of high entrepreneurship levels. As innovation is such a powerful tool in this type of economy, lots of small businesses appear to carve out a niche and draw in customers. In the process, this establishes a diverse market for job opportunities, giving jobseekers more variety in terms of where they work. Whereas larger organisations might opt for outsourcing abroad, smaller businesses hire locally, which helps the job market flourish.

Prices are organically lower

Due to the high levels of competition, product and service prices tend to stay low. Companies find the best price to offer goods and services to customers, which means they keep prices low to draw in as many potential customers as possible. If one company decides to increase pricing, a competitor might steal customers by undercutting them and offering goods or services at a lower price.

Related: What are economic factors? (Importance and examples)

Improved organisational efficiency

This type of economy encourages more efficient businesses due to the high levels of competition across different industries. As government intervention is quite limited in this type of economy, companies exist in a highly competitive, yet efficient, market to ensure profit levels stay optimal for the business. Businesses might look for as many ways as possible to bring down costs and drive up sales to yield even bigger profits.

The high level of competition found in this type of economy pushes companies to look for new ways to find a competitive advantage over rivals. This allows them to absorb a greater market share for their offerings, resulting in greater profit margins. To do this, companies look into innovative ways to cut costs, make their offerings better or appeal to wider audiences to draw in more customers.

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