A market that is totally controlled by invisible hand of market forces i.e. supply and demand, in order to answer basic questions like what to produce, how to produce, and for whom to produce, is called market economy. There are three types of economic systems namely market economy, command economy, and mixed economy. Adam Smith, the father of economics, was the biggest proponent of the market economy. He pioneered the concept of “the invisible hand” which refers to automatic forces of demand and supply which automatically allocate all resources to production.
- What to produce? Goods that generate the highest profit because they have the highest demand.
- How to produce? To maximize the profit by improving quality to be able to charge higher price, reducing costs by adopting more efficient means, etc.
- For whom to produce? For consumers who have liberty to consume whatever they consume.
There is only one assumption for the market economy i.e. free entry and exit of producers and consumers. There is no one who can affect the market price. Therefore, the market will automatically adjust and set the market price
In a pure market economy, the extreme case is called a laissez-faire economy, in which there are no government interventions. There are no taxes, no tariffs, etc.
Advantages of Market Economy
- Resources are automatically allocated to their most efficient use because goods which the consumers want are produced.
- The consumers have a wide range of choices of products depending on their preferences and no one dictates them what to study, where to work, when to work, what to consume, etc.
- The profit motive and the self-interest of the market participants encourage innovation which fuels economic growth.
- Competition ensures better quality products (because producers fear loss of customers), hard-working labour (because they fear being laid off if not being productive enough) and hence high efficiency.
Disadvantages of Market Economy
Market economy in its pure form hardly exists anywhere, because it is not without its weaknesses which include:
- Many economic activities result in negative externalities such as damage to the environment which is not priced in the market economy automatically and hence government regulation is needed to save environment.
- Breakthroughs in technology have the potential to results monopolies which are in many cases exploitative in absence of effective anti-trust legislation.
- Where the return on capital is higher than the economic growth, it results in increase in income and wealth disparity between different segments of the society which may destabilize the economy in the long-run. This is the point made by Thomas Piketty in his book ‘Capital in the Twenty-First Century’.
- The automatic allocation of resources is a double-edged sword, it may result in certain not-very-profitable yet vital sectors left-off without enough resources which might have serious consequences over the long-run, for example education, health care, etc.
- The system is prone to crises due to several factors, for example, the profit motive may result in adoption of automation and worker exploitation thereby dropping the disposable income and hence reducing consumption and plunging the economy to a recession.